All eyes on Greece – but are we missing the bigger picture?

By John Hewison  CEO

Over the past year world economic news and global financial markets have been dominated and concerned with the instability of the Greek debt crisis. The European Economic Union (EEU), the Central Bank, the International Monetary Fund (IMF) and the major banks in Europe have all pledged their support to help Greece achieve an orderly financial outcome. Yet despite this, there is little sign of resolution with Greece unable to effectively comply with the financial measures it must take to satisfy demands for economic responsibility.

With the world now intently watching every bit of economic news coming out of Greece, it’s time we regain perspective on its true global impact.

Based on 2010 GDP figures, Greece is ranked 32^nd in the world with a GDP of US$305 billion. For comparison purposes, Australia is ranked 13^th with a GDP of US$1.23 trillion, or around four times that of Greece. The EEU has a GDP of US$16.28 trillion with Greece contributing just 1.8%, while the US has a GDP of US$14.66 trillion.

Contrary to what we read in the press, it seems in quantum terms Greece is economically ‘irrelevant’ and a debt default, as unpleasant as that may be, would be unlikely to cause a major global disaster. Although, we can’t dismiss the fact that it is a member of the EEU which does give it a little more weight.

But this debt crisis is certainly not new. Greece has run economic deficits for the past ten years and when it entered the EEU in 2001 it already had a debt in excess of 100% of GDP. The situation has been gradually worsening over time, so why has there been so much fuss over the latest figures?

In the wake of the GFC, and the pressure placed upon the world economy to avoid such events happening again, debt has become an evil word, and rightly so. As a result of this pressure, the chickens have come home to roost for Greece and they are being forced to introduce fiscal policies that deal with their problems, despite being politically unpopular.

We are all responsible for our excesses whether an individual, business or country and hard decisions often need to be made. Affirmative action by the Greek government will no doubt dissipate the short term influence on the rest of the world.

Nonetheless, I find it astounding that such a small player on the world economic scale can cause so much disruption. Although it may take decades to resolve, Greece needs to instigate the hard, unpopular, but necessary, reforms that will enable them to pay their way and reach economic stability.

‘Renovating’ the borrowing in super laws…

By Andrew Hewison   Director/Private Client Adviser

I applaud the ATO’s most recent draft ruling regarding the rules that govern borrowing in super.

The rules, which allow for members to borrow funds within their self managed superannuation fund to purchase a single asset, typically a property, will now allow members to ‘value add’ and increase its worth. This is a landmark change which will have significant positive implications for investors keen to maximise their super.

The benefit of borrowing within super is twofold –

1. It allows younger people to access their superannuation balance to gain property exposure from a younger age. But beware – the property must be purchased at arm’s length. This means the property cannot be purchased from a related party, such as a family member, or yourself personally. Furthermore, the individual cannot live in the property at any stage!

2. It allows people approaching retirement age to potentially quarantine any future capital gains tax (CGT) obligations in the tax free environment of superannuation.

As the rules currently stand, once the property is purchased within the fund, improvements, such as renovating the bathroom, cannot be made to the property.

The ATO’s draft ruling is set to change this.

The draft ruling states that improvements can now be made to properties within superannuation, so long as the funds used to improve the property come from within the fund itself and are not borrowed.

This essentially means that SMSFs can use borrowed funds to purchase a property, however they must use cash flow from within the fund to carry out improvements. It means investors can purchase a property and improve its rental capability by renovating the kitchen, or adding an additional bedroom.

In instances where repairs are needed, borrowings can be used to fund the work. This would include such things as fire damage or replacement of gutters.

However, before the developers out there get carried away, the draft ruling does not allow for the development of a piece of land, for instance, knocking down an old house and building a block of flats. It states that the improvements must not fundamentally change the nature of the investment’.

Thus far, the current rules have made it more difficult to source appropriate properties for investors looking to borrow in super. However, the ability to add value to a property via capital improvements is a key attribute to a property purchase in my view.

Assuming the draft ruling becomes law, it’s a step in the right direction for SMSFs and borrowing.

Property – Where to from here?

By Glenn Fairbairn   Director/Private Client Adviser

In the June 2011 edition of Hewison Quarterly, I wrote an article titled “Are the good times over for property?”I declared that the property boom had come to an end and that I expected a short term reduction of around 15 per cent in median house prices.

 Without wanting to blow my trumpet too loudly, it seems this prediction may be coming to fruition. Recent statistics released by RP Data highlighted that the median house price across Melbourne is now $501,500, down 6.2 per cent in the six months to July. Apartments fared slightly better, down 4.3 per cent to $425,000. Across Australia, capital city house prices fell for the seventh month in a row, down 3.4 per cent.

 It was the top end of the market that suffered the greatest losses over this period. The first seven months of the year saw dwelling values in the most expensive capital city suburbs, drop 6.2 per cent. This compares with a much smaller 2.3 per cent fall across ‘middle priced suburbs’ and a 2.1 per cent decline in the cheapest suburbs. These statistics however, are not surprising considering that for the year ending June 2010, values in the top end housing market were up 12.2 per cent, compared with a rise of 7.8 per cent at the most affordable end.

 As the most interest rate-sensitive sector of the economy,  the housing market will be the chief beneficiary of any decision made by the RBA to reduce interest rates. However with interest rates likely to remain on hold until at least mid 2012, there is unlikely to be any immediate impact on the property market.

 So what does all this mean for property investment? Well first of all, these statistics do not mean that certain pockets of the property market cannot provide positive returns for investors. It would be naive to suggest that just because the median property value has dropped, every single property in Melbourne has reduced in value as this is not the case.

 A quality asset is a quality asset, regardless of short term price fluctuations.

 Too often we get caught up with the short term value of an investment without taking a step back and taking a longer term view. Overall, a blue chip property in a prime location is still likely to generate excellent returns for investors over the long term.

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Dividends – what lies beneath?

By Nathan Lear  Private Client Adviser

When making investment decisions, income yield is undoubtedly an extremely important consideration for most investors, but it’s also one of the biggest investment traps. Here’s why:

 Telstra and BHP Billiton are two well-known Australian stocks. Telco giant, Telstra, is known for providing investors with a high, fully-franked dividend yield, currently around 13% fully-franked. While diversified miner, BHP pays a much lower dividend of 3% fully-franked and has more of a growth focus.

 If you had invested a sum of money into both BHP and Telstra 10 years ago, you would have expected Telstra to have provided you with a greater level of income, right?  We all know that BHP has experienced phenomenal growth over the past 10 years – but surely Telstra would have given you more income?

 Well in fact the answer is no!

 Let’s assume that you invested $10,000 into both BHP and Telstra around 10 years ago (January 2002). Over this period, Telstra would have provided the investor with a total income return of around $6,400 including franking credits. However, if at the same time you have invested $10,000 into BHP, it would have yielded a total income return of around $8,700.

 The following table illustrates the last 10 years of dividend returns for both BHP and Telstra assuming a $10,000 investment:

As you can see above, while Telstra would have initially generated a higher income return in the first few years, the strong earnings and share price appreciation of BHP over time results in a higher total dollar return over the last 10 year period.

 This example shows that a higher dividend yield is not always a true indication of higher profits. BHP is a more growth-orientated company and retains profits to grow earnings, whereas Telstra pays out the majority of its earnings as dividends.

 The above case study demonstrates a classic investment trap – that is, not to make an investment decision based solely on income return. While yield is extremely important for investors, a balanced portfolio should consider a blend of both income and growth stocks. 

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Interest Rates – no easy decision?

By Simon Curtain   Private Client Adviser

The cash rate, set by the Reserve Bank of Australia (RBA) each month, is currently at 4.75 per cent. Over the past 30 years the cash rate has fluctuated between 3 and 14 per cent per annum.

 As most would know, the cash rate is set to keep the economy, or more specifically, inflation in check. The RBA aims to keep inflation between two and three per cent per annum. If the economy is performing strongly and inflation looks to be heading above this target band then the RBA will increase rates. Conversely the RBA will reduce rates if the economy is lagging and inflation is tracking below the band.

 Inflation is currently tracking at around 3.6 per cent annum, therefore, based on this figure one would expect the RBA to increase rates in the near future -slowing the economy and bringing inflation back within the target band.

 However when we dig a little deeper, we find a key problem presenting itself to the RBA – the two speed economy.

 While the mining industry is experiencing a ‘mega-boom’, other sectors of the economy, such as manufacturing and retail are struggling to perform in the current climate.

 This presents the RBA with a unique problem. They can’t simply raise interest rates to keep the mining boom in check, as this will significantly affect struggling industries. However, they can’t slash rates either as while this would certainly help some sectors of the economy it would also speed up the mining boom.

 While I certainly don’t envy the RBA in making their decision, I personally think that they should give consideration to the once in a generation mining boom we are experiencing by letting it continue to run and let inflation drift to above  three per cent band over the medium term.

 In doing so, the RBA will be able to reduce interest rates, stimulate the rest of the economy and assist those struggling industries through these difficult times.

 Unfortunately it is not this simple as there are a myriad of factors that come into play in determining the appropriate cash rate for our economy. Only time will tell if the decision to let the mining boom run, or stimulate the lagging sectors will be the right one!

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Funding retirement with a growing income stream

By Chris Morcom   Director/Private Client Adviser

Recently ASFA released their updated Retirement Standard, which benchmarks the annual budget needed by Australians to fund either a comfortable or modest standard of living in their post-work years.  The standard has been revamped to reflect changes in living standards, new expectations of retirees, and their evolving spending patterns.

The benchmarks are updated each quarter to reflect the impact of inflation,  and the most recent national figures (for the March quarter 2011) show a couple desiring a comfortable retirement would need to spend $54,562 a year while those seeking a modest retirement lifestyle need to spend $31,623 a year.  Details on the difference between the lifestyles and further information on the expenditure items in the benchmarks can be found on the ASFA website:  http://www.superannuation.asn.au/RS/default.aspx

The updated benchmarks show an increase of 1.3% from the December quarter – annualised this is an increase in the cost of living for retirees of some 5.2% per annum.  Retirees looking to fund their income needs personally should consider the rising cost of living when constructing their investment portfolios.  Placing your money in bank term deposits may seem safe, but the income generating capacity of your money does not rise.  This can result in a loss of purchasing power over time, and the need to draw on capital to fund your needs.

An alternative is to invest some of your retirement nest egg in assets that grow their income over time.  Consider the table below – it shows four quality Australian companies and the growth in their dividends over the past 10 years. 

Evidently, while share prices can move about in the shorter term, if money is invested in quality companies that are well run and have a track record of paying growing dividends, then retirees can to some extent protect themselves from the long term rising cost of living.

For advice on “inflation-proofing” your investment portfolio, speak to your Hewison Private Wealth adviser today.

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Are we witnessing the change of world order in terms of global economics?

By John Hewison  CEO

The wild reaction by world share markets to the European debt dilemma and the US political “game-playing” has resulted in the downgrade of their credit rating from AAA to AA+ by Standard & Poor’s. Surely this was a graphic market statement to the politicians that their performance was unacceptable and it’s time to lift their game in terms of making suitably strong policy to seriously deal with their respective debt issues.

It is certainly an intriguing era full of contradictions with respect to world economic and market performance – we have some countries struggling to achieve positive growth and deal with debt, whilst others flourish. Even within some regions there are stark contrasts in terms of economic performance and prosperity, particularly in Europe.

With the growth economies of Asia (led by China), the Pacific region in general, and other emerging growth economies throughout the world, could this be a change in the world order of economic power? We saw Japan rise to almost eclipse the USA economy in the 1980s, but the growth of China appears to be unstoppable, with 200 million people expected to graduate from the rural sector to the affluent urban sector over the next 10 years.  It is inevitable that China will become the world economic leader in the foreseeable future.

It used to be said that Australia “rode on the sheep’s back” when we mostly relied on wool and primary production for economic output. In the past we struggled to maintain a balance of trade when our major trading partners were the UK and the US. Now times have changed and the export of resources plays such a major part in our economy, with our major trading partners now our Asian neighbours. Certainly Australia’s economic profile has changed dramatically over the past few decades and our economy is now seen to be well-regulated, robust, and sustainable in the overall global scheme of things. Hence, the strength of the Australian dollar is likely to continue for some considerable length of time.
Economically speaking, where else in the world would you rather be than right here in Australia?

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Investing in Shares – is now a good time?

By Chris Morcom  Director/Private Client Adviser

When share markets are as volatile as they are now, one question we are often asked is, when is a good time to invest in shares? 

The answer to that question will depend on your circumstances.

If you are investing for the longer term (seven to ten years at a minimum), shares are attractive;  dividends that increase over time and long term growth in share prices make them  a great long term investment.

But share investors need to be able to cope with the short term volatility in their capital.  Shares are priced almost every second of the day.  Traders buy and sell their shares at what they consider to be an appropriate price and the share market is not an efficient market.  Emotion and sentiment play a big part in the actions of market participants, and this inefficiency offers longer term investors the opportunity to build wealth.

Consider the major Australian banks’ share prices.  The table below compares current five year term deposit rates to the expected dividends to be paid by the four major banks over the current financial year.

The table demonstrates that if dividends remain stable for the next five years, then investors are much better off to invest in shares rather than term deposits when considering income in isolation.

Traditionally, Australian banks have traded on a Price to Earnings ratio of around 13 times.  The current Price to Earnings (PE) ratio is much lower. This suggests that either the share prices of the banks need to rise around 40%, or bank earnings are going to fall by around 40%.

If you are thinking about investing in term deposits to keep your money safe, consider this: while your capital remains static, its purchasing power reduces over time due to the impact of inflation.  Even if share prices remain static, the higher income received would offset the impact of inflation on your invested capital.

With dividends remaining stable, an investor in bank shares could sustain a 20% fall in share price, and still be on an even par with the investor in the term deposit.

So is now a good time to invest in shares? 

The fundamentals for share market investment do look compelling, and while we expect the share market to remain volatile – for the long term investor, there is certainly value in investing in quality Australian company shares at the moment.

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US Default Unlikely

By Glenn Fairbairn   Director/Private Client Adviser

In recent weeks financial markets have been in a spin, with speculation of a possible US default sending shockwaves across the globe.

 The US currently has a debt ceiling of US$14.3 trillion and Treasury forecasts estimate that if Congress does not raise the debt ceiling by 2nd August then the US may default on some of its financial obligations.

 This predicament has sent Congress into frenzy – and whilst the solution seems pretty simple (i.e. raise the debt ceiling as has been done previously), it has unfortunately resulted in a political tug of war between the Republicans and Democrats.

 Many Republicans, especially those under the influence of the ‘Tea Party’ group, want the government to achieve budget balance by slashing spending without increasing taxes. On the other hand, President Obama and his Democrat colleagues are willing to cut spending – but want to raise taxes on the rich, so both can contribute to the deficit reduction.

 It seems that both sides of government have become so obsessed with gaining the upper hand leading up to an election in 2012, that they have lost sight of more pressing economic issues.

 In spite of the above, every political party agrees that a US default is unthinkable and neither wants to take the blame for the financial chaos that would ensue from a default. As a result the most likely outcome is at least a short term extension to the debt-ceiling.

 The likelihood of US default was downplayed by the head of ratings agency Standard & Poor’s on Wednesday 27 July when he said that the credit rating company’s analysts don’t believe the U.S. will default. However they are awaiting agreement on a “credible” plan – to increase the debt ceiling and also reduce the long-term budget deficit. S&P President Deven Sharma also said that the biggest risk is a downgrade in the nation’s AAA credit rating because Congress cannot agree on a package of spending cuts and possible revenue increases.

 Some of the proposed cost-cutting plans proposed by the Democrats and Republicans could result in the U.S. keeping its AAA rating, but S&P is awaiting news on the outcomes agreed to by the White House and Congress before making that judgment.

With all of this playing out like a Hollywood movie I cannot help but agree with Clifford Bennett, writer of the White Crane Report, who has long argued that the closer to the deadline that an agreement is reached, the more political upside spin can be created i.e. “Never fear, we have saved the nation from economic Armageddon”.

In the meantime markets are likely to remain volatile, as investors – fearing the worst – head for the safe haven of cash. Best not to follow the herd.

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Another round of European debt issues

By Nathan Lear   Private Client Adviser

Just when we thought we had heard enough about European debt issues and the PIGS (Portugal, Ireland, Greece and Spain) – a new country, and a new set of debt issues popped up last week. This time it is Italy.

We have previously known that Italy has a mountain of debt, with a debt-to-GDP ratio of 120%. To put this figure in perspective, Australia’s debt-to-GDP ratio sits at around 22%. However, what has set Italy apart from the PIGS is the fact that Italy has not experienced a housing bubble and does not have high household debt. Italy’s banking system has not needed to be rescued either.

Italy has been sitting quietly on the financial sideline, under the radar, hoping that no one would notice its outstanding bonds of US$2.2 trillion – which is the third largest in the world after the US and Japan.

The triggers for the recent concern in Italy were puzzling. It began with the downgrading of several Italian banks based on their exposure to struggling euro zone economies. In the blink of an eye, financial markets had panicked and pushed up the cost of borrowing (Italian bond yields) sharply, by around 1% up to around the 6% mark. While this rise in Italian bonds yields was sharp, it is small in comparison to Greece’s bond yields, currently sitting in the high-teens.

So what do the debt issues in Italy mean for Australia and the rest of the world? Apart from making good headlines and causing fear to enter into the market – the European debt issues have little impact on the vibrant and emerging markets of Asia and Latin America that are driving global growth. If a European country were to default, there is no doubt we would see ripples throughout the globe – in particular if the bigger economies of Spain or Italy were to fail. However the more immediate problem still lies with Greece at the moment.

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