Funds Update

Markets on tenterhooks

So far, it hasn’t been a particularly happy new year for investors. Due largely to the drop in the Australian share market, which has fallen nearly 15 per cent (including dividends) in the first three months of 2008. On top of this, investors are also feeling the pinch of record petrol and food prices - and the recent round of interest rate rises have caused further pain for home owners.

Domestic factors return to focus

Domestic issues played a key role in the market’s jitters - especially concerns surrounding higher inflation and rising interest rates, with the prospect of more to come. The RBA increased interest rates by 0.25 per cent in February and again in March, taking the official rate to 7.25 per cent - the highest in nearly 12 years.

In turn, the tighter credit conditions triggered by rate rises and tighter borrowing conditions in offshore markets contributed to the performance of many financial stocks and companies with high debt levels, such as Allco and ABC Learning.

In times of uncertainty corporate earnings become increasingly important. The month of February represented the start of reporting season, with a number of Australian companies announcing their profit results and expectations for future earnings. Surprisingly, company profits were remarkably better than feared and this helped calm concerns to some extent.

Why is the RBA increasing interest rates?

Many central banks continue to cut their rates significantly to stimulate economic growth. So why is the RBA bucking the trend? Contrary to the US and Japan, the Australian economy continues to grow at a strong pace - unemployment is running at 33-year lows, domestic demand remains strong and underlying inflation is above the RBA’s targeted annual rate of 2-3 per cent.

The RBA’s prime mechanism to deliver sustainable economic growth is interest rates. While higher interest rates will cause further pain for those with mortgages, the RBA’s aim is to take some of the heat out of the Australian economy while still allowing it to grow at a steady pace. If the RBA doesn’t act now, it may have to raise rates by a lot more later on.

Surging A$ impacting international shares

International shares have largely followed the same path as Australian shares, falling 9.3 per cent so far this year, however after allowing for the strong Australian dollar, unhedged returns for Australian investors were much weaker at -13.9 per cent.

Higher interest rates, strong commodity prices (particularly oil, gold, iron ore and coal) plus a weak US dollar pushed the Australian dollar to a 24-year high above 94 US cents.

Putting short term falls into perspective

The market downturn has had a knock-on effect for balanced super funds which typically have a 50-60 per cent allocation to Australian and international shares. According to research house SuperRatings, the median balanced super fund fell 5 per cent during January.

Over the past 20 years the Australian share market has had many ups and downs, but it has always bounced back and climbed to new record highs. That’s why it’s important to put these short-term falls into perspective. Your superannuation is a long-term investment unable to be touched until retirement, which for many investors is still many years away. While it might be tempting to switch out of shares into a ‘safer’ asset class such as cash during these turbulent times, be warned it can be a disastrous strategy. Chopping and changing is usually a recipe for locking in losses.

When it comes to your investments, the best strategy is to be patient, and remain focused on your longer-term goals, ensuring you maintain the right mix of investments to assist you in achieving them. Most of the long-term gains on equity markets are actually made or lost in just a few trading months each year. Take away those ‘big’ months and returns are more like what you would expect from a defensive investment. Investors who lose patience and get out of the market run the risk of being absent when significant gains are made.

For example, as you can see in the below chart, if you had invested $10,000 in Australian shares in 1980, 28 years later it would have grown to $357,261 (making an annualised return of 13.58%). On the other hand, if you had invested the same amount over the same period except for the biggest month in the market, it would have grown to $304,233 (an annualised return of 12.93%), and if you missed the 10 biggest months you would have just $107,868 (an annualised return of 8.84%).

Markets are unpredictable, so picking those ‘big’ months is impossible. Staying invested means you capture the full benefits of the share market. Your returns might be down one month, but by withdrawing from the market you run the risk of missing out on the recovery.

Taking a long-term perspective

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