History tells us that financial recessions take a lot longer to work through than normal recessions as the deleveraging occurring in both the private and public sectors reduces the effectiveness of traditional government stimulatory measures. Furthermore, governments need to re-establish confidence in the financial sector as risk aversion causes the velocity of money (lending) to reduce significantly.

Thus governments will turn to unconventional tools (e.g. quantitative easing) to reposition their economies for growth. The outcomes from using these unconventional tools is far from certain which is creating the extreme volatility we are witnessing in today’s financial markets.  Private Portfolio Managers states that this volatility throws up many opportunities as investors mistake market risk (share price fluctuations) for company risk (insolvency). 

Currently in Australia, we have a downward sloping yield curve where the forward looking bond market sees weak growth ahead. This seems at odds with recent economic data (strong GDP growth and low unemployment) but it takes into account the reversal in our terms of trade (due to falling commodity prices) and a slow credit growth environment (both personal and business).

Domestically, defensive stocks (e.g. healthcare, consumer staples, utilities) are well sought after while cyclical stocks (e.g. miners, steel, contractors, building materials) are friendless.  Banks and Telstra are somewhere in between offering modest growth but attractive dividend yields which help generate overall portfolio returns.

Relative to bonds, equities present significant value trading on earnings yields of 8% compared to the 10-year government bond yield that is less than 3%. This is a rewarding environment to invest in stocks where fear is prevalent and no differentiation is being made between a company’s cyclical or structural earnings drivers.

However, caution needs to be exercised in determining a company’s sustainable earnings.  Moving from an environment of easy credit to one of deleveraging requires careful consideration of earnings in a more normalised environment. This is also at a time of significant structural change in some industries such as retail and media.

SOURCE: - Andrew Beirne, Portfolio Manager, Private Portfolio Managers (PPM)