Payments through smartphones

Recently there was an article in the Australian Financial Review about the demise of credit cards. We have been reading and hearing from different sources over the past few months about new technology being implemented in certain stores and locations in the United States. It is now coming to our shores.

While credit cards may be utilised less and less over time, it will not spell the end of the big three card companies – Visa, MasterCard and American Express. In fact, quite the opposite. The big three card providers (along with PayPal) have all been involved in the evolution of the payment system. This will be the future of shopping.

In the future, we will all be using our mobile phones to pay just by swiping the cash register. Of course, security will be at the top of the critical list of things to get right with this system. Some smartphones have already started to install this technology with Google’s Android operating system.

While consumers have a more efficient way to pay in the future, we would also like to see this as a long-term investment opportunity in the companies involved in the payment evolution. Companies such as Google, Apple, credit card providers and eBay are at the forefront of this change and we follow them constantly as leaders in this charge to make our lives more efficient.

This blog is brought to you by Financial Decisions, a leading financial planning firm offering a diverse range of services that include investments and superannuation, personal insurance, estate planning, mortgages, tax planning and family office.  Please call us today and take control of your financial future.

Will we have a Santa Claus rally?

With the recent pullback in the stock market over the past couple of weeks, there are questions hanging over the market as to whether the seasonally strong period in the stock market will be broken this year. In previous years, the market has been inclined to trend upwards during the November and December period. There are several psychological as well as mathematical reasons for this seasonal factor.

Investors begin to focus on the upcoming holiday and shopping season. As often is the case leading into Christmas, consumers shop more for friends, families and themselves. There is a natural uplift in sentiment as well as spending due to the closing of the year. This psychological effect generally feeds into the stock market.

The early numbers appear to demonstrate that consumers both locally and abroad are still spending for the Christmas and holiday season. While it is a good start that may lift sentiment in the short-term, investors remain cautious with the ongoing problems in Europe. Money is still staying on the sidelines afraid to be invested into the market, even when valuations are reasonable and company fundamentals have improved.

While we can be hopeful for a few good weeks in the stock market leading up to Christmas, could the European sovereign debt crisis make this year one of the very few years where Santa Claus decides to stay home? Only time will tell.

This blog is brought to you by Financial Decisions, a leading financial planning firm offering a diverse range of services that include investments and superannuation, personal insurance, estate planning, mortgages, tax planning and family office.  Please call us today and take control of your financial future.

Australia – The wealthy country

Australia is well-known as the “lucky country.” Now we can also add the title – the “wealthy country.”

With the resource boom of the last decade, a strong currency and not having experienced the economic and housing turbulence that has rocked countries like the United States of America and many parts of Europe, Australia has been catapulted to the top ranks in terms of median wealth, at around US$222,000 according to a recent Credit Suisse research report.

Our love for real estate was a noticeable but somewhat expected large composition of this wealth. Having a dominant middle class, we were also not surprised to read that very few Australians had net worth less than US$1,000, compared to the rest of the world.

Despite having only 0.4% of the world’s adult population, we believe what really sets us apart is that with 1,861,000 people in the global top 1%, Australia accounts for 4.1% of the members of this wealthy group.

After a difficult financial market over the past few months, it is great to read some good news. While maintaining this top spot will need continuous hard work, we can at least give each other a pat on the back at our next BBQ.

Can the Eurozone learn from the Latin American crisis 10 years ago?

Most of the comparisons in the media about the current European debt crisis have been based on the memories of the 2008 crisis following the collapse of Lehman Brothers. Perhaps the better parallel is that of the Latin American crisis more than 10 years ago.

So what were those lessons?

Before Eurozone members can think about returning to growth, they almost certainly require a huge involvement from the private sector and finance.

Firstly, the governments of the affected Eurozone members need to commit to primary surpluses (having a budget surplus before interest payments) and stop the drain on private sector resources. This position was determined by the International Monetary Fund around 15 years ago to stabilise debt in Latin America. Now, it is not surprising that these same countries are calling for the equivalent position for the Eurozone.

Secondly, the European Central Bank should stop buying sovereign bonds as that simply prolongs the primary cause of the crisis. Instead, it can provide “incentives” for the banking sector to renew lines of credit to the Eurozone while lowering the overall debt burden. This plan was a US-sponsored strategy that did emphasise some debt forgiveness through a debt-swap plan.

Finally, banks will require more capital to absorb the potential losses from this debt-swap, while accounting standards may need to be relaxed in the short-term to facilitate this. The fresh capital will need to be swift so as to not affect equity markets for too long. Banks will then need to sell-off non-banking assets and non-core assets to help with the recapitalisation.

While it will take some time to end this crisis (Latin America took five years to stabilise its economy), it can be achieved if policies encourage private sector to become involved. At present, markets are not seeing this and consequently economic growth in the region could continue to disappoint.

What is the Australian yield curve indicating?

Recent market events have changed the direction of the Reserve Bank of Australia’s (RBA) opinion on the direction of interest rates. Many analysts and economists look at the yield curve to provide guidance when forecasting the future direction of the economy.

Where are we in the cycle and what is the warning in the Australian yield curve?

While most investors take their cue from Wall Street on the direction of the market, there is a growing belief that the yield curves of countries and continents such as the United States, United Kingdom and Europe, are no longer “honest” due to the enormous intervention by central banks into the bond markets. The change in yield on the bond market creates the so-called “yield curve”. When the curve moves down, it means an expectation of an interest rate cut as a result of the weakening economic outlook or recession.

Why does an expected change in interest rates predict a recession?

This is the case as interest rates tend to move the economy and central banks utilise interest rates to slow down or reinvigorate economic activity.

The Australian yield curve is one of the few remaining “un-manipulated” curves. We believe it may be more reliable in forecasting the economic outlook. Currently, the yield curve is pointing downwards for the next two years before rising again. This indicates that investors are expecting a recession sometime over the next two years.  Further, we feel that if other nations had not manipulated their yield curve, they would also point downwards. Consequently, could the warning in the yield curve be right?

How will investors regain confidence?

We all know the world economy is in the midst of a slowdown since the recovery from the 2008/09 Global Financial Crisis. Up to now, all eyes have been on the economic and financial capacity to strengthen growth, but we wonder whether the real question is whether the world has the political ability to do the right thing.

With interest rates so low in most major economies, enormous budget deficits and extensive financial imbalance, there is only so much that policies can do to help these deficiencies.

We believe the missing piece is not the economic realities that we have all adapted to, but more the political paralysis that we have experienced over the past few months.

While the actions to regain momentum on world economic growth will be no easy feat, we feel that the three primary events that need to happen for this occur include:

1.	The US needs to pass the substantial fiscal package announced by President Obama in order to boost growth and lower unemployment. The package targets public investments, tax incentives and jobs together with careful reforms to restore fiscal sustainability.
2.	European governments need to take more forceful action by working together and alongside the European Central Bank in supporting Europe’s financial system and ensure governments can borrow at sustainable interest rates as they reform.
3.	Growth economies, such as China, will need to keep pushing for greater domestic demand and allow their exchange rates to adjust to market forces, although the latter may take time to evolve.

What else can the Fed do?

We certainly don’t envy Federal Reserve (Fed) Chairman, Ben Bernanke’s position. A student of the Great Depression and the Keynesian theory of growing out of trouble through loose monetary and fiscal policy, the Fed Chairman is now in a major dilemma. With Quantitative Easing Rounds 1 and 2 (QE1 and QE2) having not worked, Bernanke seems to be running out of options and time.

Recently, Bernanke announced that the Fed still had plenty of tools remaining if and when required. However, some economists are wondering whether it is nothing but a big bluff. Let's look at the facts. Since the recovery from the March 2009 lows, the Fed has implemented QE1 and QE2 by buying bonds and depositing much of the funds into banks to enable them to lend to corporations and boost confidence and lower unemployment. The results have been far from ideal.

Since QE2, unemployment has stayed stubbornly high, barely declining by less than half a percentage point. Meanwhile, the stock market took off after the announcement, but by the end of the easing timeline, stocks had again fallen to similar levels prior to the announcement. The only item that appears to have gained is asset prices such as commodities, bringing nothing more than asset price inflation as a consequence.

So why would investors believe a third round of quantitative easing will help? Unless the Fed changes its strategy from QE1 and QE2 and the stimulus is intended for more productive activities such as directly lending to industries in need of a confidence boost, the effects of more bond buying will do nothing more than push up precious metals to even higher levels.

The risk factors

Great investing requires both generating returns and controlling risks. And recognising risks is an absolute prerequisite for controlling risk.

Investment risk is largely invisible before the event – unless you have some unusual insight – and often still murky after the event. Most financial disasters have therefore occurred due to the failure to foresee and manage risk. This occurs because, risk only exists in the future and we all know it is impossible to know what the future holds. There does not seem to be any ambiguity when we view the past as only the things that happened, happened.

Understanding, identifying and controlling risks are extremely important components of strong portfolio management.

Investors tend to overestimate their ability to gauge risk and understand the mechanism of events they have never seen before. In general, humans do not have to experience something to know if it is dangerous or not, but for some reason, during bullish market periods, investors do not perform this function of identifying risk prudently. Instead, they tend to overestimate their ability to understand and foresee the complex financial market’s web, especially with new information coming in each day.

So the question remains, how do you measure risk? To put it simply, it is nothing but a matter of opinion. You can have an educated and hopefully skilful opinion or estimate of the future we see, but it is still an estimate.

Source: Howard Marks – The Most Important Thing

Implications of the US AAA rating downgrade by S&P

Last week, our view was that the AAA rating for the United States will hold for the time being if the debate over the debt ceiling is resolved. However, this week’s downgrade by ratings agency Standard & Poor’s from the AAA to AA+ rating was unexpected.

So what does this mean for markets over the short to medium term?

The short term impact is being felt around the world now with markets falling heavily. The downgrade was unexpected and the repercussions on investor’s psychology have been enormous. The main difference between 2008 and the current turmoil is that the credit market is still functioning. It appears that the current fear has been predominantly caused by two factors including:

1.    fear of another recession in some developed economies; and

2.     a crisis of competency as markets question the ability for policymakers in Europe and the

       US to effectively deal with their respective fiscal challenges.

In the medium to long term, the likely impact to the borrowing costs of the US may be fairly minimal unless more downgrades are made. The greater concern is the impact of weaker economic activities and for consumer confidence. The full implication is still hard to determine at the moment. As such, we believe many investors will take selective opportunities and the rest will likely remain on the sideline.

Will the US lose its AAA rating?

With significant media focus on the recent debate about the United States debt ceiling, there are many reasons for investors to feel nervous. However, we believe this is a short-term problem.

What is more concerning is what happens if the US, the “risk-free” benchmark from which all other assets in the financial market are priced, loses its coveted AAA rating? The heated debate about the US debt ceiling has sparked some of the rating agencies like Moody’s and Standard & Poor’s to issue a warning to the US that it may downgrade its AAA rating to AA if a decision on lifting the debt ceiling is not finalised in the near future.

If the unthinkable happens and the US loses its AAA rating, the psychological repercussions could be serious. This could set the stage for further deterioration in the markets, which may have a longer lasting effect.

One example of a severe repercussion is in US treasuries. With some countries, including China, having their currencies pegged to the US dollar, a certain amount of US treasuries need to be purchased in order to enable the currency to be pegged and maintain stability. This “safe haven” mentality will vanish and there will be major instability in global trade and currencies around the world.

Our view is that this will not occur in the foreseeable future, particularly as there is currently no reliable alternative. However, to even contemplate the downgrade, means that while the probability is low, it is not impossible.

Upcoming profit season

Investors know that the long-term driver for growth in sharemarkets is profit growth. Therefore with markets fluctuating over the past 18 months, we look to the upcoming reporting season in both the United States from mid July and Australia from mid August, to provide us with a better understanding of what is transpiring in the corporate world.

As financial markets are forward-looking mechanisms and prices discount the expectations of investors in the future, we can examine the outlook of a particular company, sector or overall economy based on the statements by corporate executives.

With recent macro-economic fears and natural disasters disrupting supply chains, some analysts are now questioning whether this reporting season will contain a more subdued outlook, given the already weak consumer spending and sentiment.

There are several important factors that investors will be anticipating, which may affect the general mood of sharemarket participants, including:

• profit margins and whether labour and rising commodity/input costs have had a detrimental
  impact on their net profit;
• how the banking sector is dealing with low credit growth;
• trends in consumer sentiment in light of the headline troubles in Europe; and
• the clarity and confidence in which corporate executives describe their company’s outlook.

If we receive positive news regarding these points, markets will more than likely increase. However, if not, brace yourselves for continued choppiness.

Quantitative easing

Wall Street is aware that the second round of Quantitative easing (QE2) is ending in June. This is despite the fact that both quantitative easing programmes have had little effect on unemployment in the United States. The real outcome was the effect on lowering bond yields (to the extent that we worry about another crash), driving down the US dollar and fuelling the rise in equity and commodity prices. As soon as it concludes, we will start to see sloppy data in manufacturing, unemployment and home prices. It is almost like a drug, where they continue to require an injection of “financial morphine” to the financial system. Once people are accustomed to it, they don’t know what to do without it.

At present, the markets may be holding the Federal Reserve to ransom. If there are continuing signs that the US economy remains sluggish and asset values continue to decline, could this be a trigger for the Federal Reserve to consider and implement a third round of quantitative easing?

Our view is that the Federal Reserve is just delaying the inevitable. It seems to continue to believe it can smooth out large falls and rises in markets only to see that what it has created will eventually lead to much larger swings. Did the Federal Reserve not learn from the Global Financial Crisis? Perhaps those currently in office do not want to look like the bad guys, however, if they take the pain now, they may become heroes in the future.

Inflation data

Most central banks closely monitor the core inflation as one of the key figures in determining monetary policy. However, with large increases in base and agricultural commodities over the past decade, we think stripping out food and energy prices from the inflationary figures makes “core” inflation no longer useful.

It's not difficult to figure out that our daily cost of living has risen sharply over the past few years. While larger items such as cars, TV and some luxury imported goods have stayed flat due to our strong currency, the typical family does not often get the benefits of these luxuries. Instead, they are slapped with almost a daily “tax” every time they go out to buy groceries, fill up their car and take public transport. It is these issues that make us brush past some inflationary data as being unrealistic.

Further, governments are able to manipulate the goods and services making up these inflation figures by replacing goods that have increased more in price compared to those that have had a more neutral price effect. This enables them to somewhat control the inflation numbers so that it appears lower than the actutal figure.

Sector bias and asset allocation

If you follow share markets on a regular basis, you might have noticed that the Australian share market has outperformed international markets over the past decade. With large developed markets providing low returns over this period, our mantle of being called the “lucky country” certainly seems justified.

The natural question investors would ask is "why should we invest anywhere else?" There’s certainly some validity in this, but if we go further into the asset allocation, we are able to better determine the risks and reasoning for this outperformance.

Asset managers and financial advisers preach that good asset allocation is the biggest key to long-term investment success. However, looking at the ASX200, we realise immediately that our banking and mining and resources sector account for 70% of our index. In comparison, the widely followed S&P500 only has 30% in these two sectors, while globally it only makes up 40%.

This large bias is the key reason for the outperformance over the past decade as both of these sectors had strong returns. This bias also provides greater risks and when the commodities boom ends and/or our housing sector slows down, investors will truly need to think twice about having their money so heavily invested in these two sectors.

This is one of the big reasons why it is still important to allocate a certain percentage to international markets. No one knows when our “lucky” run will end, but to be certain, by the time you find out, you will have missed the boat.