• US market negative 4%;
• UK market negative 2%;
• German market positive 0.4%;
• Hong Kong market negative 11%;
• Japanese market negative 8% and
• Australia negative 9%.

The above are price indices, and therefore do not take account of dividend flows which would improve the returns by about 2% to 3%. But, overall the returns have been negative and Australia’s recent returns have been very poor when the recent fall in the $A is considered.

So, after a surge in equity prices from March 2009 to about August 2009, the Australian market has retreated somewhat. Eleven months into the financial year 2009/10 the Australian market has returned to investors about 14% including dividends.

The above review gives us an insight into the workings of markets as well as some hints as to what may lay ahead.

Firstly, the volatility in currencies, based on debt concerns, is usually positive for US dollars and US assets. Volatility is the result of uncertainty caused by poor valuation methodologies and results in capital flowing to the perceived safe haven of US dollars. It is a safe haven only because it represents a highly liquid market and not because it offers better long term returns.

Secondly, there is a slower adjustment to equity valuations from currency moves. Indeed, the adjustment takes place once the market gains confidence that currency moves are relatively permanent. For instance, the weak outlook for the euro is now more certain. The result is a natural rally in stock prices in Germany which will benefit from euro devaluation. However, the continued strength in the US dollar will begin to negatively affect the value of major US corporations who rely on exports. The outlook for US stock prices is not good if the $US remains strong.

Thirdly, whilst the low interest rate settings adopted by US, European and Japanese central banks support short term financial stability, they also actually stoke volatility. The low interest rate settings are not supporting credit growth but rather are supporting speculative flows between markets. For as long as interest rates stay low then volatility will remain. Ultimately, interest rates will rise. We note that last night Canada lifted its rates by 0.25% to 0.5%.

Fourthly, the volatility in currency markets does affect commodity prices, which are actively traded on metals exchanges. However, bulk commodity contracts are affected less as these are determined by long term negotiation. There is too much emphasis placed on the direction of spot markets which are the domain of traders and hedge funds. Prices paid in these markets have in recent years been consistently higher than term contract prices. Gold is probably the best indicator – the more uncertain the outlook for currencies and economies, the higher it will trade. However, it is the ultimate fear proxy and the risk at some point is that confidence rebuilds and gold retraces.

Finally, the critical issues for the World remain sovereign debt, climate change and an aging western world population. The focus of world economic policy has switched between these issues as priorities change. None of them has been adequately addressed, but this has got to happen in the next few years. All the above issues have one consistent solution and that is higher taxes.

So where does that leave us and what should our investment strategy be?

Our view is that, at this point, an investment strategy must adapt to the volatility in markets. Based on the above analysis, volatility will remain for the foreseeable future and taxes across a whole range of enterprises are going to increase. Indeed, taxes we have not thought about or that now exist are likely to be introduced.

Whilst we do not actively promote short term trading (and in particular day trading) we do see increasing opportunities to utilise market gyrations to our advantage.

MyClime is a powerful investment tool. The valuations it formulates are not based on market or analyst sentiment. By ignoring price earnings ratios, which are merely a sentiment index, MyClime derives real valuations based on a company’s historical and potential profitability.

When markets fall due to a rush of short term traders to the exits, MyClime identifies quality companies that are unfairly discounted. Alternatively, when traders re-enter markets and indiscriminately purchase companies, then companies of either good or questionable quality can be exposed as overvalued and thus identified as appropriate for sale.

It is our view that it is folly to be unconscious to the observable developments in world markets. It is even more dangerous to ignore the likely rapid changes in fiscal policies around the world. These policies will increase taxes across a whole range of sectors as a means of repaying debt, balancing budgets and providing for an aging population.

Our aim should always be to acquire good quality companies, at deep discounts to value, for a long term hold. However, it is imperative that gains that occur through irrational market behaviour are banked. These gains are identifiable when prices clearly exceed the real value of a company’s shares.

There are two other rules to adhere to. Firstly, we must maintain liquidity at all times so as to avail ourselves of mispricing. Gearing of portfolios is to be avoided. Secondly, yield is vitally important and we believe there continues to be value in the market for listed corporate paper which yields around 8% (rated bank and corporate paper) and 12% for unrated corporate debt. Whilst these securities are volatile, they do offer investors opportunity to generate consistent income. Ultimately, the compounding of income is a key feature of all strong performing portfolios over time.

The US – The G20 finance ministers meeting next week should be watched with interest, as it could give us insight into major policy changes in US and Europe later this year.

The mixed news continues from the US but it is generally mildly positive. The manufacturing sector is showing signs of a mild recovery and employment is slowly recovering.

The housing market continues to improve. Existing home sales in April rose 7.6% to an annualized rate of 5.77 million units. April marked the final month that existing home buyers could take advantage of the government’s tax break. New home sales spiked an annualized rate of 504,000 from 411,000.

Consumer delinquency rates are dropping at U.S. retailers and banks such as American Express Co. and Bank of America Corp. Past-due loans at Bank of America, the second-largest card lender, fell for a fifth month in April and by the most in four years, while American Express’s delinquencies were down 34% from a year earlier. Target Corp., the second-largest U.S. discount retailer, last week reported its lowest delinquency rate in the latest quarter since the second quarter of 2008.

US bond interest rates perversely rallied hard on the back of European sovereign debt concerns and the US Government used this flight of capital to achieve bond raisings at particularly low settings. Last week seven-year notes auctioned drew a yield of 2.815%. It was the lowest since the security yielded 2.63% at a $26 billion sale in April 2009. The Treasury also sold $42 billion of two-year securities and $40 billion of five-year debt. The ten year bond yield is currently about 3.3% and this has rallied strongly from 3.7% in early April. We maintain our view that this bond yield is symptomatic of very low projected growth for the US.

The March quarter annualised GDP was revaluated down to 3% p.a. This rate of growth will hold unemployment rates at about 9.5% and is insufficient to lower it.

Energy companies suffered losses after the US Attorney General declared the U.S. Justice Department is investigating whether any criminal or civil laws were violated in the BP oil spill in the Gulf of Mexico.

Finally, Apple announced that iPad sales have reached two million in less than 60 days since its launch on April 3. Apple began shipping iPad in Australia, Canada, France, Germany, Italy, Japan, Spain, Switzerland and the UK this past weekend.

Europe – Euro zone manufacturing activity continues to be mildly weak with the benefits of a weaker Euro not yet reflected. By contrast, the UK manufacturing sector has benefitted from a weaker pound.

The European Central Bank has warned that euro zone banks face up to 195 billion euros in a “second wave” of potential loan losses over the next 18 months due to the financial crisis, and disclosed it had increased purchases of euro zone government bonds. The ECB said euro zone banks would need to make provisions for further losses this year of 90 billion euros, and 105 billion in 2011, on top of some 238 billion euros in bad debts written off by the end of 2009. The jobless rate in the 16-nation euro area increased to 10.1% in April, the highest rate since June 1998.

Denmark’s central bank may be forced to cut its main interest rate to match the euro area’s benchmark for the first time since 1999, as demand for kroner assets threatens to strengthen the currency beyond its peg. Denmark, like most Scandinavian countries, has stable fiscal policies and trade surpluses. We now see capital being diverted to these stable economies.Fitch’s lowered its Spain rating to “AA+” even though it said the outlook for the nation was stable.

Spain’s parliament approved by a single vote the government’s request for €15 billion ($18.29 billion) in additional budget cuts this year and next. Spain has the third largest budget deficit in the euro region.

The European Central Bank disclosed increased purchases of euro zone government bonds. The ECB began buying up mostly Greek, Portuguese and Spanish bonds on May 3 in a disputed action to help stabilise the euro zone and support an emergency $1 trillion package agreed by the European Union and the International Monetary Fund.

Australia – Australian retail sales rose 0.6% in April, with March revised up to +0.8%. Building approvals fell a large 14.8% in April, reversing the strong 16.8% gain in March. Private houses fell 13.5%, while private apartments fell 5.4%.

The Reserve Bank of Australia kept the cash rate at 4.5%, and suggested, “the Board views this setting of monetary policy as appropriate for the near term.” The rate had been lifted six times in the previous seven meetings to prevent consumer-price gains from breaching the top of the 2% to 3% inflation target range. Inflation did accelerate to 2.9% in the March quarter which is the fastest pace in more than a year.

JFE Holdings, Japan’s second- largest steelmaker, and two other steel producers agreed to a 12.5% quarterly price increase for coking coal contracts starting July 1 with BHP Billiton Limited (ASX:BHP).

Asia – China’s Purchasing Managers’ Index slid to 53.9 from 55.7 in April suggesting a slowing in the growth of manufacturing activity. This is further evidence that the policies by the Chinese Administration to slow growth are beginning to work. However, it did result in the Shanghai index slumping by 9.7% in the last month. It has dropped 22% this year as the central bank raised bank reserve requirements three times to avert asset bubbles.

Deflation is still a feature of the Japanese economy with the CPI falling by 1.4% over the last year.

India’s economy grew strongly in the March quarter with GDP recorded at an annualised 8.6%. It is interesting to note that India’s GDP is approximately the same size as Australia.

Should you have any questions about The View, please email members@myclime.com.au