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Forward Thinking Magazine : December 2010
By Richard Gibbs, Global Head of Economics, Macquarie Research economic commentary The return of shorter, sharper investment cycles has certainly been in evidence during the past six months as investors, traders and speculators alike have struggled to establish a clear framework for assessing the prospects for key assets. Rapid changes in perceptions of risk have also added to the uncertainty confronting value- driven investors. Significant divergence in the outlook for global economic conditions and in particular the fortunes of the US, UK, Euro area and Japan have prompted global investors to seek out assets that are perceived as less risky. As a result, the past six months has witnessed a surge in buying support for sovereign and corporate debt. The frenetic activity in debt markets has resulted in a significant narrowing in credit spreads and of course has dramatically lowered the cost of raising debt capital. In late September 2010, Microsoft Corporation set a new record low for a US$4.75 billion debt offering. According to the International Financing Review (IFR), Microsoft’s three-year bond sold at a quarter of one percent above comparable US Treasury Bonds. This implies a coupon of just 1 per cent, making it the lowest on records that date back to 1970. Like many corporate borrowers in the US and elsewhere, Microsoft has a strong balance sheet with almost US$37 billion in cash holdings. Needless to say, many analysts and investors are now focussed on the risks associated with the seemingly insatiable demand for debt securities, particularly the emergence of asset bubbles in specific segments of global debt capital markets. Looking forward, there are several forces now at work in the global economy and financial markets that are likely to provoke a reappraisal by investors and traders of the relative merits of equity capital markets. This reappraisal is expected to steadily gain momentum in the early months of 2011. First, the recent announcement by the US Federal Reserve of a further round of quantitative easing will substantially boost global liquidity, acting as a stimulus for global economy. In particular, the emerging economies and their commodity-based trading partners, such as Australia, Brazil and Canada are likely to experience further strong growth in income and domestic demand. Second, the effective global stimulus is expected to propel cost and price pressures in the higher growth economies. This prospect of higher inflation will support stronger revenue and earnings growth, particularly for those firms that have little debt on their balance sheets and a capacity to raise selling prices. Third, the opportunity cost of concentrating investments in debt capital markets has widened considerably as the cost of debt issuance has fallen along with effective yields. Increasingly, investors must choose between running yields of 1 to 2 per cent in prime-rated corporate debt, compared to a dividend yield of 3 to 4 per cent in major listed companies. Fourth, the prospect of capital management initiatives and an upsurge in merger and acquisition activity can be expected to boost earnings per share assessments, reinforcing the need to return the investment focus to growth assets. For Australian investors, there is a need to focus attention on the risk of higher inflation, rather than the contrasting risk of deflation. It is true that many of the major economies are continuing in their attempts to reflate economic activity, but this is not the case in Australia, where the economy is struggling with supply and capacity constraints, against a background of still robust income and demand growth. Moreover, there are increasing signs that the ongoing robust demand for bulk commodities is about to be bolstered by surging demand for agricultural commodities with markets facing supply squeezes in the grains and soft commodities segments. This suggests that Australia’s terms-of-trade, which is the most appropriate measure of the rate of growth in external income, is set to again accelerate in 2011. Not surprisingly, investors should refocus on the tried and tested axiom that argues that to share in the benefits of economic growth you must be invested in growth assets. Australia is and will remain a relatively high growth economy for the foreseeable future and it follows that the next chapter in the short sharp investment cycle will feature equity capital markets. 27