PERFORMANCE

Equity markets continued to beat up the bears in September, with strong performances globally in all but the Japanese market. That's six months in a row of positive returns at a time when economic news, while stabilising, is still erratic and long-term global problems remain.

Our performance in the month was moderate. Our cautious equity weighting, a static performance from our residual hybrid/corporate debt portfolio and the fact that the Kiwi dollar’s strength against the US$ negated the positive performance of our US$ exposures resulted in us underperforming both the New Zealand and Australian sharemarkets. The continued strength of the New Zealand dollar is also obviously a continuing headwind to our Australian returns currently.

We have been early with our caution, which has cost us relative performance but this will quickly be recouped if the markets correct from their current euphoric state.

None of our portfolio did particularly well or badly, we just did not have enough of the leaders (such as Fletcher Building in New Zealand and the banks in Australia) which performed well in September.

We have expressed an increasing level of caution about markets over the past two months and with prices continuing to rise at the same time as the US consumer and the New Zealand exporter gets weaker our outlook is shifting back to a relatively bearish stance on a short term view.

With the benefit of hindsight the bear market of 2008 and early 2009 left investors so fearful that the psychological preconditions for a rally were entrenched but the ensuing rally- the best in 70 years- has made investors greedy and confident- necessary, if not sufficient, psychological conditions for a correction.

Over the past six months markets have gone from pricing in Armageddon to now assuming the Goldilocks solution. As we have noted before Armageddon may have been averted, but the effects of the “ elixir ” in terms of huge government deficits and anti-capitalism/trade sentiments may in the long run prove as unpalatable as the original problem.

That private equity-owned companies such as Myers and Kathmandu are looking to float is a relatively good sign that investment ratios are nearing the top end of what is sensible. We are also aware that work is well advanced on a number of other possible IPO’s which will probably come to market while the current appetite for risk persists.

Such floats and the claims on liquidity from the prospective recapitalisation of companies such as PGC and PGW seem likely to limit the market’s upside absent unexpectedly good news on the earnings front.

History has shown that, in the majority of cases, such forward indicators are good predictors of sharemarket performance (although such forward indicators have often given false leads -- if one wanted to put an adjective in front of majority it would be more likely slim than vast). We have long held the view that, in the current environment, forward indicators such as consumer and business confidence surveys may be somewhat unreliable as there is a huge "phew" factor in terms of the belief that global economic catastrophe has been averted. Thus, respondents are perhaps more hopeful about the future than their current situation and the situations of others, particularly those joining the dole queue, would warrant.

A recent publication by the BNZ economics team headed "far out recovery" caught our eye:

The BNZ, in another portion of their report, commented on the statistical assembly of confidence surveys:

This ties in well with our own view that economic recovery will be insipid in the US which has historically been the global engine for consumer-driven expansion. Although there is a rising middle-class in much of Asia we do not think that this group will be able to replace the demand destruction out of the US caused by their large rise in unemployment and huge structural shift towards savings to repair balance sheets.

New Zealand may have officially come out of recession with 0.1% growth in the June quarter, but we believe that with rising unemployment and especially the strong currency, growth will be meek for some time. There are some areas of strength such as the housing/building market, but it is not racing away and hopefully will not do so. The weak retail sales of July (down 0.5% on the previous month seasonally adjusted) remind us that conditions are still tough.

We also noted the comments of labour hire leaders Allied Work Force (probably the only profitable operator in the sector) that its first half results will be down significantly on last year as it has witnessed no recovery.

The projected increase in Fonterra's payout for the 2010 year from $4.55 to $5.10 following a general increase in prices and some very successful auctions was the biggest economic news of the month. However, the continued strength of the New Zealand dollar (probably caused in part by this announcement) will mean that the traditional sheep and beef farmer will not be faring quite so well. Early indications are that lamb prices will be down at least $10 a head at the start of the season and the currency is going to take a toll on beef as well.

Apart from insipid growth our main concern globally is the rise in government debt as a result of all the stimulus packages. We believe the stimulus measures will need to be withdrawn and possibly even reversed via tax increases. If not, debt will spiral out of control and financial markets will force solutions upon governments with unknown consequences.

Fortunately, the New Zealand government to date has taken a very responsible attitude and avoided wasteful stimulus packages. The Australian government has resorted to stimulus packages but from a position of previous fiscal strength.

We have previously listed some of our favourite commentators and their website. This month we would recommend readers look at the latest musings of John Mauldin (http://www.frontlinethoughts.com ) who comments on amongst other things the US and Japanese debt problems.

Our writings might portray us as mega bears, this is probably an overstatement, we simply think that markets have become slowly over optimistic given the likely insipid recovery and the long-term risks that remain. The world has stabilised and there are money making opportunities, but there is still good reason to be relatively cautious with our and your money.