Archived Monthly Report

Little did we know how difficult the seemingly modest objective of capital preservation would be but, as the table above shows, it would have been very easy to lose a lot more than our 3.97%. In our working lives we have never seen so many different markets and asset classes exhibit such sustained volatility. Obviously, that external environment meant that there were innumerable opportunities for making and losing money in currencies, commodities, equities and bonds.

Although equity markets were down sharply during the month most of our negative performance can be attributed to the weakness of the Australian dollar which fell 3.4% against the New Zealand dollar. By month end 70% of our cash and 55% of our equities were invested in Australia so the translation loss on this currency movement was the single biggest negative influence on the Fund’s October performance.

We continue to view the New Zealand dollar as expensive relative to the Aussie, and also expect any increase in the Fund’s equity weighting in the foreseeable future is likely to be biased towards Australian equities. Therefore investors should be aware that the Fund’s performance will continue to be influenced by this cross rate in the short run.

We were disappointed with our performance in September relative to our cash holdings and in some ways October saw a reasonable amount of mean reversion.  Methven, which reported a meritorious interim profit in difficult circumstances, rose 10% during the month following a 19% fall the previous month.  Michael Hill and The Warehouse also posted positive returns for the month after collapsing in September.

We increased our weighting in shares during the panic of October, with our cash holding falling from just under 60% to just over 40% by month end.  At the time of writing, this looks to have been reasonably good timing, but, given the state of the world, it is too early to be crowing too loudly or to be becoming much more adventurous.

Ostensibly, the strong rally in many equity markets in the last week of the month was completely inconsistent with the tidal wave of negative economic news, particularly globally. However, the fact that we increased our own equity weightings during the carnage was a direct result of our belief that prices were discounting for all the foreseeable bad news and then some. At the time of writing we are open minded about the efficiency with which the market is doing its job of discounting future earnings. The panic which was so evident mid-month  has given way to an uneasy calm. With credit markets also responding favourably to the massive Govt and central bank interventions it is not surprising that equity prices have rallied.

However, other asset classes, in particular corporate debt, securitized loans and commercial and residential real estate are still at very distressed levels with appallingly low liquidity. There is also a price to be paid for the Government bailouts of banks and central bank purchases of various forms of toxic waste. Given the coincidence of a global recession and its implications for fiscal policy we expect an avalanche of issuance of Government bonds with the world’s most profligate country, the United States, leading the charge. We have seen credible estimates of the US Government’s gross borrowing requirement for fiscal 2010 as $2trillion which will approximate 12% of GDP.  It is difficult to imagine this funding requirement being met internally and we expect the US$ will have to depreciate materially over time to encourage buying from international investors.

Both New Zealand and Australia will be caught up in this global competition for capital as a result of our continuing current account deficits but we start with some very significant advantages such as;

• Long traditions of respect for lenders’ and private property rights which compares very favourably with most emerging markets like Argentina, Eastern Europe and Asia.
• Very healthy Government accounts and fiscal positions.
• Well managed, regulated and capitalized banks.

Our conclusion from all of this is that we are in for years, not months, of deleveraging and global recession is inevitable but that Australasia is a pretty good place to ride it out from- particularly as the currencies have already been discounted heavily to reflect our status as commodity exporters with high current account deficits. 

The challenge is in judging how much of this gloom is already in prices. By the end of October global sharemarkets were down about 40% on average for this year. Extremely lucid, long term bears like Jeremy Grantham, John Hussman and Gerard Minack all concluded that equities offered fair long term value. So did Warren Buffett. It would be presumptuous to join our names to this list but our move from 40 to 60% weighting in equities is a reasonable indication that we agree with them.

Our asset allocation at the end of the month was approximately:

Despite the earlier contention that equity markets were a sideshow to the main event they managed to provide their followers with a seriously white knuckle ride.

The following is a very incomplete list of some of the financial milestones which occurred during  the month:

• October was the worst month for the US equity market for 21 years (the 1987 crash). The broad-based measures of US performance, the S&P 500 and the NASDAQ were both down 17%  but this was only after one of the best one week rallies in history as US markets recovered 11% in the last week.
• The S&P 500 index was the most volatile in its 80 year history.  There were nine days with at least 4% rises or falls, including two days when the market was up more than 9%.
• Japan’s Nikkei index hit a 26 year low (i.e. it was below levels of 1982) and had its worst ever month, falling 24% in part due to a dramatic rise in the yen.
• The MSCI index for emerging markets was down nearly 30%, with Argentina, Brazil and Iceland being notable decliners.
• Commodities had their biggest monthly fall in over 50 years.  Oil was down 33%, gold 18%, and copper 36%.
• In currency markets investors seemed to swarm towards the US dollar and the yen.  The US dollar rose 14% against the euro, 28% against the New Zealand dollar, and 31% against the Australian dollar.  The yen was up approximately 7% against the US dollar.

The New Zealand sharemarket was, relatively speaking, a tranquil backwater in the turmoil of October capital markets.

October was simply a month when worry and panic took over.  It is thought that record amounts (over $US70B) were withdrawn from US-based mutual funds during the month, and the market was continually awash with rumours of hedge funds selling or going bankrupt etc.

Problems in some minor countries such as Iceland, Argentina and Hungary added to the nervousness, but in reality were noise when measured against the real issues within the global economy.

As investors attempted to rationally factor in the now common view of a prolonged recession the uncertainty of future profitability was heightened.

Undoubtedly, the panic within financial markets over the past two months has now started to influence individual and corporate behaviour, leading consumers to spend less and companies to react by freezing hiring and dropping capital expenditure.

Whether these behaviours will quickly reverse if markets settle down is a moot point – and probably an important determinant of the depth of the recession.  We would regard access to reasonably priced credit for corporates as an essential pre-requisite to this. At this stage that is not in immediate prospect.

Markets have rallied back strongly in the last week or so but we would be surprised if everything was a box of roses from now on.

Many companies in the US, Australia and, more recently, New Zealand, have stopped giving guidance for their full-year results, which gives some indication of the uncertainty which remains regarding the depth and length of the recession.

In New Zealand the major news was the 1% cut in the official cash rate by the Reserve Bank.  Also of note, the recent positive business indicator surveys were shown to be somewhat premature by the latest National Bank quarterly survey which exhibited a very sharp drop in business confidence and was the worst result in the survey’s 20 year history.  Such a result probably suggests a further contraction of economic activity over the next two quarters, although it is possible that businesses have been influenced by the panic within global financial markets.

New Zealand is currently experiencing an enormous stimulus "package" in the form of lower interest rates, a lower currency, the sharp drop in oil prices and the tax relief now coming through.  It would be unusual if such a combination did not pick the New Zealand economy off the floor, although we are living in unusual times given the global backdrop. We expect households to provide some of this stimulus through increased consumption but the forces for deleveraging are very strong and balance sheet rebuilding will be their main priority.

The Australian economy is also contracting currently with job ads down 5% in October, house prices under pressure and retail spending insipid. The resource boom is coming to a shuddering halt but the consequences will be felt very unevenly with many junior miners now uneconomic and/or starved of capital creating opportunities for the well-capitalised majors.

Of note in the Australian sharemarket during October was the large recapitalisation of two significant property funds via share issues. GPT and Goodman Group between them are in the process of raising $2.5B. This follows a $300m raising by Stockland Group earlier in the month. In the first week of November we have also seen significant new equity raisings by AMP and Mirvac.

These equity issues/placements have taken place at substantial discounts to the prior sharemarket prices and to us signal that some of these companies are not confident of rolling over existing debt lines.  Welcome to the reality of global credit shrinkage.

Companies which are not well capitalised with strong banking relationships will increasingly need to look to the equity market, opening up potential value adding opportunities to investors with cash.

Whilst we have committed some of our cash in the latter half of October, we continue to believe there is significant option value in cash currently. We have already seen examples of this in the first few days of November such as the AMP capital raising and a block trade in Ryman where we were able to buy stock at a 10% discount to the previous close.

Unit holders will note a significant change to our top 10 holdings this month. There is ample evidence that, over the long term, mid and small cap stocks will outperform large caps and this has influenced our portfolio composition. The last few months have caused us to re-assess this in light of the declining liquidity in small caps and the sharp fall in price/ improvement in value among many large caps. In the current environment, we attach a high value to being able to take profits or minimize losses, neither of which is easy in illiquid positions.