Quarterly investment report

March quarter 2009

The economic environment

The March quarter further witnessed the extraordinary decline in economic activity that started globally in September 2008. At that time, confidence in the US banking sector was severely damaged by the bankruptcy of Lehman Brothers and the subsequent near-failure of policymakers to act to stabilise the system. As a result, banks immediately reduced their willingness to trade with, and lend to their counterparts, households and business. Many financial markets became illiquid, and the prices of exotic securities plummeted. Banking sectors in Europe, and particularly the UK were damaged by a combination of their exposure to these exotic securities, their reliance on cross-border funding, and their dependence on heavily indebted household sectors.

Household spending in the US declined at an exceptional rate through the last four months of 2008, but held steady through the March quarter. With banks aggressively tightening lending standards and consumer confidence at post-War lows, sales of automobiles almost halved. House prices have continued to fall as foreclosed properties flooded the market.

Business confidence fell even sharper than households’ in the wake of the events of September 2008. And while non-financial corporate leverage was not exceptionally high coming into the crisis, many business models rely on credit in the form of working capital to finance inventory, payroll and floor plans. As such, new upstream orders were slashed as wholesalers and retailers sought to avoid being caught with excess stock. This collapse in orders helps explain the fact that export-oriented economies, such as Germany, Japan, Korea and Taiwan, experienced the most rapid falls in GDP, despite being fundamentally healthier.

As the global supply chain adjusts to the lower level of demand, Australia’s export volumes are likely to continue to fall. Contract prices for the key commodities of iron ore and coal are widely expected to drop significantly, but to remain above average levels. In aggregate, Australia’s economy has been relatively sheltered from the global downturn by five main factors:

• The high levels of commodity prices through to September 2008 have provided a tailwind, resulting in strong employment conditions and an enviable fiscal position.
• The depreciation of the exchange rate absorbed much of the fall in commodity prices that occurred in late 2008.
• The Australian housing sector does not appear to have the same supply overhang, and lending standards did not deteriorate anywhere near the extent witnessed overseas.
• This has contributed to the strength of the domestic banking sector, which has been in a position to pass through most of the RBA rate cuts.
• Aggressive policy action by both the RBA and the government has significantly boosted household incomes after tax and interest.

Financial market performance

Equity markets began the year with a positive tone, but sentiment became grim as the extent of losses in the banking sector mounted. The Dow Jones Industrial Average pulled back on market concerns about the solvency of its largest financial institutions, until the US Treasury moved to convert its stake in Citigroup into common equity and absorb further losses at Bank of America. Early-March marked the lowest point to date for equity markets. A subsequent rally back from oversold levels reflects the equity markets conviction that policy has underwritten the banking system of the developed world. In this way, the financial crisis appears to have evolved from a system threat to a slow workout. The global inventory cycle that began in September 2009 is also showing signs of being completed by the June quarter of 2009. This should contribute to some stabilisation in the macroeconomic data.  

Over the March quarter, there was some distinction between the behaviour of equity markets in the developed countries labouring under impaired banking sectors (equity markets in the US, Europe and UK declined by between 11 and 15%) and the emerging equity markets and Australia, where the impact from the crisis has largely been indirect, through trade linkages (Australian equities fell just 4% while the MSCI Emerging Market Index rose 0.5%, led by gains in Taiwan, Brazil, Korea and China).

Nominal government bonds produced a flat return over the quarter, while inflation-linked bonds outperformed as extensive policy intervention triggered a lift in inflation expectations. Credit markets remain distressed, but investment-grade bonds posted a small positive return as conditions stabilised.

Cash returns have slowed, reflecting the RBA’s moves to cut the overnight cash rate from 7.25% in August 2008 to just 3.0% currently.

The US dollar strengthened by 10% against the Japanese yen, 9% against the Swiss franc and 7% against the European euro over the quarter, as crisis-induced demand for the reserve currency re-emerged. The Australian dollar lifted in line with the recent rally in equity markets and the better-than-expected outcomes across commodity markets, to be unchanged versus the US dollar, and 3% stronger on a trade-weighted basis.

CSS performance

The following table shows ARIA’s option performance for both the March quarter of 2009 and one year to the end of March 2009.

CSS option performance – periods ending March 2009 *

* these figures are after fees and tax

Alison Tarditi
Chief Investment Officer
27 April 2009