2007 The year ahead

If predictions prove correct, 2007 could well be the year of the financial underdog.

As 2006 drew to a close, local economists donned their gypsy garb, gazed into their financial crystal balls and made their predictions for the year ahead. But unlike last year’s predictions of little change, the outlook for the coming year suggests a number of sectors will trip on a slight hurdle at the beginning of 2007, muddying the waters in terms of pinpointing definite performance patterns.

Even the experts were not able to distinguish a ‘golden child’ sector that immediately stood out, nor were their predictions able to point to any above average growth across the board.

In fact, for a number of sectors — including Australian equities, global equities, Australian bonds and emerging markets — the outlook for 2007 offered a less-than-inspiring start to the year.

Global equities

Though, while such predictions do not sound very encouraging from an investor standpoint, the experts’ claimed no specific financial sector should be discounted entirely, particularly when it comes to global equities.

According to data from Vanguard Investments Australia, the global equities sector looks set to continue its good run of the past 12 months.

In 2006, the sector was marked by significant initial public offer (IPO) activity, with four of the 10 largest global IPOs on record occurring in 2006 (ICBC, US$22 billion, Bank of China, US$11billion, Telstra, US$11 billion, and Rosneft, US$10 billion).

And while continued strength of the Australian dollar relative to the American dollar has dampened returns for unhedged investors, local currency has risen from a low of just under 71 cents in March to over 78 cents by the end of November 2006.

ING Investment Management economist Eric Siegloff predicts a positive outlook for the global equities sector for 2007.

He believes as a result of world economic growth in the coming year, global equities are likely to prove resilient.

“Corporate earnings and corporate profitability are both likely to ease in 2007, but the overall picture is expected to remain relatively robust, enough to generate a 9 to 10 per cent average total return (including dividend yield) for the global share market,” he said.

Siegloff believes the sector’s boost stems from a varying number of factors. He said the demand in oil and commodities as well as price dynamics had been a major boost in the sector’s performance. Other factors include the central bank’s monetary policy setting.

Siegloff also believes geopolitical events and merger and acquisition activity have also helped with the positive outlook, claiming it is “the risk appetite underpinning of global share market behaviour over the past year. [With] resilience in corporate earnings and balance sheet health also a feature”.

Weighing into the global shares debate, Vanguard Investments Australia head of global equities Roger McIntosh said: “The returns for any geographic or industry sector are driven primarily by economic activity. The benefit of global investing is that different countries will be at different points in their economic cycle.”

Australian equities

However, despite the positive news for global equities, when the looking glass is turned towards the local equity and bond sectors, the view isn’t as clear — or rosy.

BT Financial chief economist Chris Caton believes the Australian equity market is unlikely to be as strong in the next 12 months. Caton said the reason for this was a result of the sector’s current state of being slightly overvalued.

“The market is probably slightly overvalued at the moment, and profit growth is unlikely to be as strong in 2007 as it has been in recent years,” he said.

“Accordingly, there is likely to be a better entry point for investors than the current level, and gains over the course of the year are likely to be only moderate, say of the order of 6 to 10 per cent,” Caton added.

Macquarie Bank economist Daniel McCormack remained neutral. He predicted the Australian bond markets would have a steady, but unspectacular year.

“With the economy growing below trend, but the Reserve Bank of Australia unlikely to cut rates, we expect bond prices to remain largely unchanged for most of the year,” he said.

In the case of emerging markets, Siegloff said the outlook was quite positive. He believes strength in emerging economies and emerging share markets will continue through 2007.

“Emerging markets are expected to outperform, potentially rising 15 to 20 per cent in 2007, underpinning our expectation for double-digit returns in that year,” he said.

Caton believes the lacklustre prediction for Australian equities stems from the influence of increased volume of merger and acquisition activity in recent years.

Growth in private equity

He believes another reason behind the lack of enthusiasm surrounding the sector is the phenomenon of private equity. Though, on the whole, Caton is taking a ‘steady as you go’ view on global equities.

“Steady as you go may be a good description, but there are risks. In particular, if the US economy weakens substantially further, then equity markets around the world will experience difficulties,” he said.

Echoing Caton’s comments regarding private equity, McCormack said the increased popularity of private equity deals was also a concern in regards to the bond market, particularly when it came to corporate bonds.

“The current wave of private equity deals represents a risk for investors in corporate bonds. Potential holders of debt in companies targeted by private equity will need to consider the impact that a company being taken private has on gearing levels,” McCormack said.

“Increased gearing levels are more often than not a feature of deals involving private equity. If this does occur, traded debt of the target public company tends to lose value as credit spreads move higher — to compensate for the increased risk of default.”

McCormack said, because of the somewhat random nature of private equity deals, corporate debt was an asset class that needed to be handled with some care.

“In private equity deals, debt from target companies, which may have been lowly geared with highly rated debt, can turn into higher geared, less rated debt as the company is taken private. Ironically, debt investors that have set up their portfolios conservatively (with highly rated debt) may be at most risk to this.”

However, on the flipside, Siegloff continues to deliver good news for global shares.

In his view, the reason for the positives is down to increased asset allocation towards international shares.

He said this was evidenced by the higher strategic benchmarks given to this asset class in diversified portfolios.

“The evidence is that investors are willing to include international shares in their portfolios. Investor attention to specialist strategies, such as global emerging markets, global property and global high dividend, has been observed. Broadly, investor willingness is likely to accelerate as the global opportunity set widens.”

So, while the news is good for well-placed global equities, are there any reasons why investors should stay loyal to the remaining sectors, Australian equities and bonds?

Caton puts it simply: “From the point of view of overseas investors, Australia continues to be a market worth looking at. In particular, the resource sector is a good way to play the China story.”

The bond market

McCormack staked his claim of the benefits of this sector on its attraction of lesser volatility, as well as the simple fact that “the humble bond” should never be ignored.

“Bonds, particularly Government sector bonds, are low risk due to the taxing powers of the Government, and the income (yield, interest) derived from them is predictable. Equity dividends are less predictable.”

According to McCormack, Government bonds are in vogue as they are not an asset class that needs to be monitored particularly carefully.

He said in the current macroeconomic environment — which he believes is a relatively stable one by historical standards — bond prices do not move around a great deal.

McCormack said while investors should always keep up to date on the value of their portfolio and the evolving risks to it, investors should devote more of their time to monitoring more risky — and therefore more volatile — asset classes, such as equities or corporate debt.

“The most important reason why investors should include bonds in their portfolio is the diversification benefits. That said, there is probably a case for giving bonds a slightly greater weight in their portfolio than 12 months ago. In our view, the outlook for the Australian economy is a little more subdued now than it was 12 months ago.

“As such, we believe there is currently less risk of a small fall in bond prices (and greater chance of a rise in prices) than there was this time last year.

“With equity markets performing so strongly in recent times, it is this asset class that has dominated investors’ focus. However, the diversification benefits mean the humble bond should never be ignored,” McCormack added.

Siegloff believes the range of investment strategy choices stemming from global shares is the reason why investors should jump on board.

“The global shares asset class offers investors a wider range of investment strategy choices, opportunities and diversification benefits compared with, for example, Australian shares as a stand-alone asset class. As an example, our investments in global property securities have produced a 41 per cent return so far this year. The global development of this asset class is expected to continue, underpinning healthy returns in 2007.”

However, while Siegloff painted a seemingly flawless picture of the global shares sector, McIntosh offered a dose of reality. He said the way investors are currently viewing global equities is a topic of interest and while he believes the sector is strong in terms of investing, investors are still hesitant.

“Any reluctance could stem from a lack of understanding about what the outcome is after making an investment into international markets. Returns are generated from both asset markets and (in the case of funds with no currency hedging) movements in currencies,” he said.

Though, McIntosh said, a steady head in terms of investing is the key.

He said, like all asset classes, it was important for investors to take a long-term view on any investment and asset allocation decision.

This, he believes, will leave the way clear for investors to avoid falling into the trap of thinking international shares carry too much risk.

“Upward movements in the Australian dollar over the last 12 months have contributed to lower unhedged returns compared to hedged returns. Importantly, the decision to hedge or not hedge would need to be made in a long-term portfolio context and with the assistance of an adviser,” he said.

“Some investors tend to be return-driven in their assessment of different sectors by historical performance. Astute investors understand the benefits of broad diversification at low cost,” McIntosh added.

Regardless of how the experts’ predictions pan out, 2007 looks set to be a very interesting year for the Australian financial services sector.