Investment winners and losers in 2014

20 December 2014

The Australian Financial Review, 20 December 2014

By Christopher Joye

What did we learn from this year’s polarities? Local equities were up more than 8 per cent in September, only to lose all those gains and some by early December. They are staging a comeback as I write.

The Australian bond market was expecting a 3 per cent cash rate (rate increases) in February, March and September, but by December its best guess was that the Reserve Bank of Australia’s 2.5 per cent cash rate would fall by 25 to 50 basis points.

In July, the Aussie dollar was trading around US95¢ – today it is 15 per cent lower at about US81¢. In August, RBA governor Glenn Stevens warned about financial markets’ “exceptionally low volatility”.

Normality rapidly reasserted: by the end of September, global sharemarkets had crashed 5.3 per cent. After bouncing 4 per cent in October, they dropped another 3.2 per cent in November. Investors again had brain damage from equities’ volatility.

In October, $3 billion of retail money thought that the Commonwealth Bank of Australia’s new “hybrid”, Perls VII, was worth $100 per share. In the last 30 days, Perls VII has been sold down as low as $95.20, imposing striking losses on investors who thought it was as good as cash. (We warned you!)

Last year, there seemed  to be no chance our troops would be back in Iraq. In November, that became a reality, with special forces operating out of Baghdad and the pseudo-state ISIS entering the popular vernacular.

This year has reminded us how interconnected our investment world has become – whether it’s a mercurial Russian president’s decision to invade Ukraine depressing European growth; the end of the US Federal Reserve’s unprecedented $4.5 trillion money-printing program jacking up credit spreads; dissipating Chinese demand crushing iron ore values; the willingness of the Japanese and European central banks to initiate their own multitrillion-dollar investment schemes, inflating asset prices; or war waged by a Middle Eastern oil cartel on the threat posed by the higher-cost US shale industry.

In 2014, when a nation state (North Korea) wants to express its displeasure about a Hollywood movie (The Interview), it launches savage cyber-attacks on parent company Sony. This shut down Sony’s computer network for a week and resulted in devastating leaks of four unreleased films and thousands of documents.

And it’s worked: after the hackers threatened to blow up cinemas showing The Interview, Sony announced it was scrapping the film.

Regular readers will be familiar with several related tenets that I have pushed here for years. These include:

• Beware geopolitical shocks wreaking havoc on your portfolio;

• Don’t mindlessly diversify into foreign jurisdictions with fat-tail catastrophe risks that could be crystallised by conflict;

• While the tyranny of distance shielded us from world wars I and II, we must now contend with the tyranny of proximity – our five biggest trading partners (China, Japan, India, South Korea and the US) are potential combatants in any future Asian war;

• “Diversification” is only helpful if it protects you when the faeces hits the fan. Yet we know the correlation between Australian and global shares converges to one in crises.

Given these crosscurrents, which investments won and lost in 2014?

There were certainly some surprises. As we anticipated, the best-performing asset class was housing. A portfolio of properties spread across Australian capital cities gave you gross capital gains of 8.5 per cent plus rental returns of about 3.5 per cent (or 12 per cent before costs).

While this columnist is better known as a housing “bear” these days, we did predict double-digit housing returns in 2013 and 2014. And I expect the housing market to continue to deliver annual capital gains of 6 per cent to 8 per cent (or more than double wages growth) until the RBA normalises the cost of borrowing.

This year’s surprise was Australian Commonwealth government bonds. In total return terms, they have delivered more than 10 per cent, or multiples of what you earned in Australian shares. Fixed-rate bond prices soared as interest rate expectations plummeted in the final quarter of the year.

While global and Australian shares suffered similar maximum losses in 2014 (the worst monthly drawdown was about 7 per cent), the return outcomes were very different. As at the close of business on Wednesday, Australian share prices were lower in 2014 and flat after including dividends.

In contrast, global shares hedged in Aussie dollars were up a healthy 9.6 per cent. Naturally, this is a moveable feast. Since Tuesday, Aussie equities have jumped over 2.7 per cent, so 2014 might not be a complete write-off.

On a “risk-adjusted” basis, the best investments have arguably been Australian floating-rate bonds, which pay an attractive margin above the RBA cash rate and returned 3.9 per cent (or 1.5 per cent above inflation), while never enduring a negative month. This makes them very different to fixed-rate bonds, which have much higher volatility and experienced monthly losses as large as 1.3 per cent in 2014.

Investing in long-term fixed-rate bonds with yields near 100-year lows is playing Russian roulette with your portfolio. A 1 percentage point increase in 10-year government bond yields would trigger capital losses over 10 per cent. That could be horrific for people who assume these are bullet-proof investments.

The one thing I know with certainty is that nobody can forecast interest rate changes accurately beyond 12 months. The RBA’s own research emphatically proves this point – economists and the futures market cannot get rate changes right beyond six months.

Making long-dated interest rate bets on fixed-rate bonds with yields at all-time lows is, therefore, just gambling. And while some think that fixed-rate bonds are a hedge against equities (yields can fall when equities crash), you would be better off stripping out equities risk explicitly by investing in a “market neutral” or “long-short” hedge fund.

Some of my best investments in 2014 have been in these products.

On the policy front, 2014 was more predictable. As expected, we got macro-prudential brakes on home loan growth as housing started to bubble. The RBA did not cut the cash rate. The Aussie dollar is heading towards US80¢. And David Murray recommended substantial increases in the major banks’ equity capital.

The author is a director of Smarter Money Investments.

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