In Australia corporate earnings have been reasonably good although some sectors such as discretionary retail have struggled. Australian shares are offering historically high dividend yields with an earnings outlook to support them. In a falling interest rate environment they are an attractive alternative to large holdings of cash.

A useful strategy to use in a volatile market is dollar cost averaging where rather than investing a large lump sum, smaller regular investment amounts are contrbuted. I’ll explore this more fully in a future post.

For a more detailed analysis of the state of play see this report from Shane Oliver at AMP Capital Investors.

It’s an exciting time for them as a family and I’m excited about working with them. Our first priority will be to make sure that the husband’s income is protected in case he gets sick or injured and is unable to work. The thought of what they would do without his income caused great concern for them both. This led to a discussion on other types of insurance.

The other concern they expressed was the feeling that they wouldn’t be getting ahead financially while they were on a single income. To address this concern we spent some time looking at their income and expenses to determine whether they have a surplus or deficit. By working through their financial position not just this year but in detail over the next ten years we could get a clearer picture of where they are headed. By developing a plan and committing to it they are now comfortable they are on the right track.

Of course there was plenty more to work on – debt repayment strategy, saving for children’s education, putting wills in place…

Let’s look at some of the economic forecasters and where they think the ASX200 index will be by the end of 2012:

Chris Caton                       BT                     5,000

Shane Oliver                    AMP                    4,700

Savanth Sebastian        Commsec         4,600

How good are these as a guide for what will happen? Well if we look back 12 months ago the views were very optimistic! The predictions included:

Citi                         5,500

UBS                      5,450

JP Morgan           5,000

I’m not just singling these three out (they were the first I found in a google search), most economists predicted the market would be well above the year end close.

In 2011 the index finished the year at 4,056. What does this tell us? Certainly trying to forecast the ASX a year ahead is near enough to impossible. At best it gives some indication of sentiment at the time the prediction is made.

Focus on what you have more control over – what dividend will you receive? How much can you regularly save to invest?

With the benefit of hindsight it is easy to say we should have been in cash for the last 5 years. But one year or even 5 years is not enough to rely on when making a decision.

Robin Bowerman, Principal at Vanguard Investments Australia examines this question in more detail below:

The idea of shifting from growth assets into an all-cash portfolio at this time may seem tempting to some investors.
Understandably, many investors are troubled by the deep European sovereign debt crisis, the lingering aftermath of the GFC and high sharemarket volatility.

The reality is that the annual returns from cash have been markedly higher than for Australian shares over the past 12-month and five-year periods.

Morningstar’s latest table of long-term asset class returns records that the total return from Australian shares (based on the S&P/ASX 200) was a negative 3.7 per cent for the 12 months to the end of October. And more significantly, local shares returned a negative 0.2 per cent a year over the five years.

These negative returns for shares compare with positive returns from cash for the same periods of 4.9 per cent and 5.4 per cent, respectively.

Yet looking more closely at the Morningstar statistics reveals a different angle to the cash-versus-shares issue. Over longer periods, local shares produced annual returns that were markedly superior to cash:

• Over the 10 years to October, Australian shares returned 7.3 per cent a year against a 5.3 per cent cash return.
• Over 15 years, shares returned 8.4 per cent a year against a 5.3 per cent cash return.
• Over 20 years, shares returned 9.1 per cent a year against a 5.6 per cent cash return.

It should be emphasised that past returns are, of course, no guarantee for future returns. However, gaining an understanding of past long-term returns is particularly valuable when planning investment strategies and the asset allocation of investment portfolios.

The bottom-line from studying past long-term returns over different asset sectors is that having an appropriately diversified portfolio – giving close attention to an investor’s personal tolerance to risk – is  a crucial part of sound investment practice.

No asset class will outperform other asset classes every year. And sometimes the highest performer in any one year is the worst performer in the following year.

An investor who moves from shares to an all-cash portfolio during following a sharp sharemarket downturn often crystallises losses and could miss out on a possible rebound in share prices. And such investors lose the benefit of shares as a potential buffer against inflation.

This is a cause close to his heart after his wife Kerri suffered an acquired brain injury in May 2010 in a mountain bike accident. This has forced Andy and their two sons to face an adversity they never expected. Kerri has been Andy’s support crew for the ride which is on track to be completed inside 3 months.

I’ll be joining Andy for the last 3 days as part of a ‘Ride with Andy’ sponsorship that will include about 70km-80-km per day of riding. The ride is due to finish at Parliament House at 1pm on Saturday 3rd December.

To find out more information about this fantastic cause or to donate, click on the link below:

If you’ve taken out a mortgage of $300,000 over 30 years and are making only the minimum repayments then it’s going to take 30 years to pay it off. And your bank will love you! So if you reduce your repayments in line with the 0.25% cut you’ll be paying $46 less per month.

However if you maintain the same repayments on a $300,000 mortgage you can cut 2 years and 3 months off your loan and reduce your total interest bill over 30 years by $37,300.

That’s a great reason to ignore the rate cut and pay the same off as last month.   

Note: Based on an interest rate of 7.25% dropped to 7.0%.

But What is an ETF?

ETF’s (or Exchange Traded Funds) are managed funds quoted for trading on a securities exchange. Generally ETFs are constructed as indexed portfolios of shares, bonds or real estate securities. This is done through purchasing all, or a representative sample of the individual shares in the index. While the majority of ETFs track market indices, other ETFs may track a narrow sector of a market or even be based on stocks with particular characteristics, such as their dividend yield. ETFs which track securities with particular characteristics such as dividends can be thought of as listed quantitative managed funds.

ETFs can be bought and sold through share trading accounts and investment platforms in the same way as shares at any time during exchange hours at intraday prices, rather than end of day prices as with unlisted managed funds.

Advantages of ETFs

Low costs

The management fees for index-based ETFs are usually significantly less than investing in the same exposure of individually purchased securities. ETFs are also more cost efficient than actively managed funds and are often priced lower than comparable unlisted indexed managed funds.

Diversification

Index funds invest in all or a representative sample of securities in an index and provide a highly diversified investment.

Potential for tax efficiency

The low turnover of an indexing approach minimises the capital gains distribution impact. This improves after-tax performance and tax efficiency over the longer term. ETFs also offer other potential tax benefits in comparison to managed funds as a result of the different process for redemptions.

Liquidity

Unlike unlisted managed funds, investors are able to trade ETFs during ASX trading hours and at a price quoted on the ASX. The authorised participant’s ability to create and redeem ETF securities on a regular basis ensures an underlying depth of liquidity.

Transparency

The issuer of the ETF provides daily information to the market including the ETF basket and the Net Asset Value (NAV) of the ETF, making ETFs a highly transparent investment option.

Disadvantages of ETFs

Below Market Returns

ETFs, like indexed unlisted managed funds, don’t offer the potential for above-market returns, in contrast to actively managed funds. Even the most efficient ETF will only ever be able to provide investors with the return of the relevant ETF less its management fees and transactional costs.

Tracking a market index also means that ETFs don’t have the potential to minimise the effects of market downturns. Most active managers have an allowance under their mandates to allocated funds to cash in periods of heightened risk and volatility.

Liquidity

While liquidity in terms of the ability easily transact and settle ETFs via an exchange is one of the purported benefits of ETFs, the structure of the ETF market creates potential disadvantages in terms of liquidity. Here the ability to execute a transaction at an appropriate price is the important issue. ETF liquidity is largely determined by the liquidity and volatility of the underlying market being tracked but market supply and demand and sentiment conditions also play a part. If an ETF or underlying market is not widely traded then the buy/sell spreads can move wider, however the activity of the Authorised Participants is designed to mitigate this and liquidity has not been seen to be a real problem for ETFs traded to date.

The update below is reproduced with thanks to Ausbil Dexia Australia:

Over the past couple of months, the risks surrounding the global economy have increased significantly, manifest through significant moves in bond markets (yield falling aggressively), a spike in the gold price and global equity markets being aggressively sold off. Presently both bond and gold markets are overbought and equities oversold. However, whilst this may be the case, markets can stay at extreme levels for extended periods of time.

Another feature over recent months has been the extreme volatility in financial markets, the impact of which is however felt in the real economy, through:

• Undermining business and consumer confidence, and generating a delay in investment and and/or consumption.

• Risk aversion which can increase global funding costs for banks and/or economies that carry external funding requirements

• Rapid falls in global sharemarkets create negative wealth effects which can further erode consumer and business behaviour.

It takes quite a savage spike in volatility, and quite a large fall in global sharemarkets, to result in a significant shaving of global growth. The recent downward revisions to the last three years of US GDP growth estimates have certainly not helped matters. Despite the foregoing, the global economy is still likely to grow by around 3.8% this calendar year, albeit down from the IMF 2011 June forecast of 4.3%. It is worth noting, as seen in the following table, that the majority of global growth through the last decade was actually derived from Asia.

As a consequence of a strong Asia, global commodity prices and the AUD are likely to remain relatively elevated, as Asia remains the largest regional global consumer of commodities. Asia also remains Australia’s largest regional trading partner, with 75% of exports going directly to the region.

The risks to the global outlook remain tilted towards slower growth, with the largest being the prospect of the US economy reentering a recession. If it eventuates, it is highly likely Europe will follow and global growth will fall well below trend. In such an environment, commodity prices will move lower and the AUD will decline. Despite the growing risk of a US recession, this is not our central view.

We believe that, despite the weak August employment report, the US will grow moderately this year and pick up in 2012. We continue to believe the US Fed will take some decisive action (such as “Operation Twist” – buying long dated paper and funding it from short dated treasuries), in an attempt to revive the housing market and the US consumer, as consumers will be able to reset their borrowing costs at significantly lower rates. Furthermore, the Fed has committed to keeping rates between zero and 0.25% “at least until mid-2013”.

It should also be noted that it is not just the Fed making adjustments. The European Central Bank has entered the secondary market to buy Eurozone member government bonds as part of the Securities Market Programme, while at the same time re-commencing long-term refinancing operations as part of their euro-liquidity-providing operations. The Bank of Japan has further increased its Asset Purchase Programme by ¥15 trillion (US$195 billion) to ¥55 trillion (US$707 billion) and intervened in the foreign exchange market in an attempt to weaken the Yen. The Bank of England’s Monetary Policy Committee has tilted, by way of a vote, towards an easier policy bias. Finally, the Swiss National Bank has flooded the market with liquidity, helping to push two-year government bonds into negative rates of interest.

So whilst risks remain in financial markets, we believe that the negativity is more than priced in. Australian equities have been sold down – we believe excessively – and in many cases offer excellent value. Whilst the global macroeconomic picture remains troublesome, Australia is better positioned due to its leverage to ongoing strength in Asia. Moreover, in a wider sense, policy responses from major central banks are helping to stabilise and will eventually strengthen a weak global growth environment. As such, we believe it is wise to be cautious, but dangerous to be too pessimistic.

The reason the take up of trauma insurance is so low has to be awareness. Years ago I worked in a funds management business. I was amazed by how few of the staff actually invested in the funds our business managed. I wonder if it is the same with trauma insurance for those working in financial services? If those who understand how it works don’t take it out, it’s no wonder only 3% of Australians have it!

I know from talking to clients that many have never heard of it. It used to be that life insurance was the most important cover to have. If you had a major illness you were far more likely to die from it. With medical advancements over the past 20 or 30 years, you are now more likely to survive cancer or a heart condition. And while there are many events that trauma insurance covers, the majority of claims are in relation to cancer, heart attack, stroke and heart bypass surgery.

A few years ago I switched the premium on my trauma insurance from stepped to level. Over the next 28 years I will pay about $2,000 pa (or $56,000 in total) for my $500,000 of lump sum cover. By putting my cover on level premium, I pay more now but the cost doesn’t increase as I get older. In doing so the cover will still be affordable as I get older and am at a higher risk of trauma claim. Many people either reduce or cancel their cover when they need it the most simply because they can’t afford it.

How do you see the situation playing out in the US and Europe?

US 

• The weight of evidence is line-ball as to whether the US is going back into recession.  If you look at the bond markets, it is definitely going into recession and there is no doubt and the recent surveys also would back this up – for example, our Fixed interest team’s  observation that when the Philly Fed Business Outlook surveys get reading to these levels, the US always goes into recession.   While, some of the underlying data actually seems to be holding up (e.g. retail sales), expectations are extremely weak.
• So what can change to the positive in the US?  They do have some weapons in their armoury.  It has been suggested that they could step into the equities market or initiate another round of QE.  The latter would come under a lot of scrutiny as the last bout proved to have only a short term effect.
•  The risk is that the Fed looks desperate.  As one Fed member pointed out, their job is not to bail out equity markets and the situation is not comparable of 2008 as the financial system remains intact and corporates have strong balance sheets – US banks will not fail and this looks more like a conventional ‘demand-driven’ slow-down.
•  The quick reversal in equity markets has been driven by the sharp realisation that growth forecasts are way too high, as well as worsening sentiment exacerbated by the political impasse over the US debt ceiling

EUROPE

• In Europe, the situation still looks more worrying as there are issues with the banking system, which looks like it is going to need recapitalising at some point.  Where they get that source capital from remains to be seen but partial nationalisation would seem on the cards at this point.  Furthermore confidence in policy makers remains very low on both sides of the Atlantic – which has done serious damage to investor sentiment. 
• France is now the issue….growing at 0% and banks will need recapitalising. The recent ECB buying has been supporting Italian yields (22bn) worth moved yields down to c.5% where they’ve stayed but the question is how long they can sustain this buying for.  And will the French be able to keep stumping up the cash for the EFSF?  Ultimately Germanywill have to fund the Eurozone bail-out and at this point there is not the political will to do so. 

 What is the likely impact of these events in Australia?

•  The Australian share market is likely to be influenced by these macro issues for the short term so you can expect returns to mirror US and European markets rather than stock specific issues – despite the fact that it has been a positive reporting season. The Australian market however is arguably more defensively positioned.
•  Market valuations are not stretched either on an absolute basis, relative to other countries or relative to its own history.  In the domestic economy related stocks in particular, there is already a lot of bad news priced in.  While these stocks are likely to trade in line with macro themes too, the downside is ultimately more limited.  For context, the average Australian industrial stock is now trading on a yield of over 5% (ex franking), which is a large discount to the bond yield.
•  The Australian market has already underperformed other markets this year  so it has arguably less downside.

 China is continuing to grow strongly and as we know Australia is very dependant on this. What are you thoughts on their growth in coming years?

•  Chinese growth remains robust and in our view is likely to remain so, particularly as the Chinese can quickly move from a tightening monetary stance to a neutral stance if required.
•  The large amount of investment in the resource sector is likely to continue, providing a solid base for earnings for next year for companies across a lot of different industries.  The RIO buyback and announcement bid for Coal & Allied a couple of weeks ago demonstrated that those with cash are prepared to spend and we don’t see this changing.  (Very different from 2008).  However, the ‘wall of work’ building up in resource infrastructure’ projects is bound to come off if softer global conditions persist.  Activity is likely to remain strong but importantly expectations will come off.
• The two most significant commodities that Australia produces, iron ore and coal, are not subject to the same levels of speculation and volatility as other commodities as they are contract rather than exchange traded.  This means they will reflect the underlying supply/demand fundamentals rather than market sentiment.  Nonetheless, the overall level of commodity prices remains high and is a clear risk if global conditions soften materially.

Are corporate earnings and current dividend yields in Australia sustainable?

•  Market consensus earrnings forecasts have been too high in our opinion but even if they are cut to more realistic levels, there is still, on aggregate, high single digit earnings growth for next year, which will also be reflected in dividends.