Quarterly investment report

September quarter 2008

The environment

The September quarter began relatively quietly, with global economic activity very subdued and the credit crisis well established but not deteriorating noticeably. While global economic activity continued to weaken as the quarter unfolded, the credit crisis reached new depths in the month of September. This was characterised by the global financial system struggling to remain viable in the face of financial institutions refusing to deal with each other due to heightened fears of corporate collapses. These events led to a dramatic shakeout of global financial firms, massive government intervention and extreme levels of financial market volatility.
                 
In September, the major global investment bank Lehman Brothers filed for bankruptcy and the huge insurance company AIG was saved from the same fate by a $US85 billion loan from the US Central Bank. Two US government sponsored mortgage enterprises, Freddie Mac and Fannie Mae were nationalised to prevent bankruptcy, as were the Benelux financial services company Fortis and the UK mortgage provider, Bradford and Bingley. Meanwhile, two other major global investment banks, Goldman Sachs and Morgan Stanley transformed themselves into banks to stave off future bankruptcy.
 
Amidst this backdrop, financial market volatility reached extreme levels. In the month of September, the Australian equity market saw only 4 trading days out of 22 in which its movement was less than 1%. In an attempt to limit market volatility, regulators in the US and UK placed a near-term ban on the short selling of financial stocks, while authorities in Australia placed a one month ban on the short selling of all stocks. Additional government intervention came in the form of a US bailout package of $US700 billion, which aims
to buy poor quality assets from banks, thus freeing up their balance sheets, a $US50 billion loan package
to US car makers and a number of measures by the major Central Banks to inject liquidity into global
money markets.  
 
During the September quarter, global economic activity weakened further and the earlier threat of higher inflation subsided in line with a dramatic decline in commodity prices, particularly oil. In the US, the housing sector remains weak, as evidenced by house prices being 16.4% below the levels of a year ago. This is occurring simultaneously with a rise in the unemployment rate. The latest data from Europe suggest that economic growth is declining, with manufacturing activity particularly weak. The UK economy has also stagnated, with consumer and business confidence declining sharply. In Australia, while employment
levels remain robust for the moment, more forward looking economic indicators suggest that a sharp slowdown in activity is likely in 2009. These include weakness in the housing sector, private consumption
and business confidence.

Financial market performance

Against this backdrop, equity markets fell sharply, with global equities hedged into Australian Dollars declining by 11%. However, an ever larger fall in the value of the Australian Dollar meant that global equities in unhedged terms actually rose by almost 4%. Amongst the important markets, the worst returns were recorded by Hong Kong (down 18%), Japan (down 16%), China (down 16%) and the UK (down 13%). Declines in other markets, while still significant were less severe, with the US, Germany and France all down 9% and India down 5%.

The Australian equity market fell by 11%, with various parts of the market experiencing wildly contrasting fortunes. Industrial shares as a group experienced flat returns, while resource shares as a group declined by just under 30%. The weak performance of resource stocks mainly reflected a large fall in commodity prices lead by oil, which fell by around 28%. Other commodity prices also suffered significant declines, with Nickel and Copper down by 27% and aluminum by 22%. Gold fared well in a relative sense, declining by 6%. Large capitalisation stocks again outperformed small capitalisation stocks, with the small ordinaries falling by over 18%. Sector performance dispersion was again very large in the September quarter. Material stocks fell by 31%, energy stocks by 19%, utility stocks by 10%, and information technology stocks by 9%. This contrasted with a 10% increase in health care stocks and flat to slightly positive returns from consumer staples, financials and telecom stocks. property trust stocks, whilst performing better then the previous quarter, declined by around 2%.

In the September quarter, government bond markets benefited from both a ‘flight to quality’ and future anticipated central bank short-term interest rate cuts. This resulted in global bonds rising by 3.9%. Australian bonds fared somewhat better, managing a rise of 5.3%, while cash returned 1.9%. Reflecting the rise in global bond markets, 10 year government bond yields fell by 0.2% in the US, 0.6% in Europe, 0.7% in the UK, 0.1% in Japan and just over 1.0% in Australia. Credit spreads (over government bond yields) rose markedly over the quarter to near historic highs in line with the deepening of the credit crisis.

The Australian Dollar experienced an extremely weak quarter, hurt by both the large decrease in commodity prices and the unwinding of the carry trade due to increased global risk aversion. This is shown in the 17.4% fall in the Australian Dollar against both the US Dollar and the Japanese Yen. Falls against other currencies, while more subdued, were still significant. This involved a decline of 9.5% against the Swiss Franc, 8.2% against the British Pound and 7.7% against the Euro.

CSS performance

Given the bleak economic and financial market backdrop, the majority of ARIA options recorded negative returns in the September quarter.

For the year to the end of September 2008, performance was dominated by the very large declines experienced in share markets. Single digit negative returns were recorded by the CSS default option.

CSS performance for both the September quarter of 2008 and one year to the end of September 2008 is provided in the following table.

CSS performance – periods ending September 2008 *

Option

3 Months

1 Year

 

%

%

CSS Default

-4.4

-8.8

CSS Cash

1.6

6.4

* these figures are after fees and tax

Alison Tarditi
Chief Investment Officer
22 October 2008