2007 - The year of living dangerously

2007 was not for the faint hearted, with turmoil on global financial markets creating far more volatility for investors than has been experienced in recent times.

On face value, the year doesn’t appear too bad. With the exception of listed property, all asset classes provided positive returns with Australian equities once again performing well above its longer-term average.

* van Eyk Research. Refer to page 1 for list of benchmarks these returns are based on.

However, ongoing fears of a recession in the United States (US) and the potential for further fall-out from the sub-prime loan crisis have created a more uncertain environment for investors than the one that of 12 months ago.

Asset class performance

Australian equities
Economic growth in Australia returned to levels above 4%, and Australian companies were generally able to maintain profit at high levels in 2007 supporting continued share price growth. Whilst there wasn’t the same spectacular escalation in commodity prices as in previous years, the prospects for mining companies remained bright and this sector was again the best performer.

In contrast, the banking sector under-performed as rising interest rates reduced prospects for loan growth. Bank shares also weakened in response to large profit write-downs by overseas banks, even though Australian banks were generally far removed from the rising loan defaults that triggered the sub-prime loan crisis in the US. Over 2007, Australian bank share prices rose by an average of 10%.

International equities
With the exception of Japan, major overseas markets edged higher over 2007, with the MSCI World Index rising by 4.4% (for Australian investors with hedged currency positions). Whilst overall international equity returns were quite modest, there was significant out performance from Emerging Markets, particularly Asia, as developing economies continue to contribute significantly to overall global economic growth. European markets also performed strongly, with the German DAX index 22% higher over the year.

For Australian investors with unhedged currency positions, the movement in the Australian dollar was once again a more significant determinant of investment returns than the international equity markets themselves. Against the US dollar, the $A finished the year 11% higher at US 88.2 cents. The higher currency reduced the $A value of international investments and as a result international equity returns for unhedged holdings averaged -2.6%.

Listed property
Australian listed property provided negative returns for most of 2007, as strong price increases over the previous 4 years reduced yields to levels that could not be sustained in a rising interest rate environment. The largest fall in listed property prices came in the final month of the year, when news of Centro’s difficulty in re-financing debt led to a general sell-off across the sector. For 2007 as a whole, Australian listed property fell by 8.4%.

Global listed property fared little better, as the US sub-prime loan crisis led to a sell-off in property related assets, particularly those with a gearing component. The 20.4% decline in global listed property prices has returned valuations on those markets to more attractive levels.

Fixed Interest & Cash
There was significant divergence in interest rate trends between Australian and major international economies last year. In Australia, both longer-term interest rates and overnight cash rates increased, as evidence mounted that inflation was rising. This prompted the Reserve Bank to tighten monetary policy twice, with the official overnight cash interest rate rising from 6.25% to 6.75%. Longer-term interest rates rose by a similar margin, with the Government 10 year bond yield increasing from 5.9% to 6.3% over the year.

In addition to rising longer-term interest rates (which led to falling bond prices), some fixed interest investors were also negatively impacted by widening credit margins. Concerns stemming from the rise in delinquencies on US sub-prime housing loans resulted in the price of securities with any form of credit exposure to corporate of household sectors being marked down. The combination of interest rate and credit market movements meant that cash investments significantly outperformed fixed interest investments in 2007.

Whilst the deterioration in the price of credit related investments was a global phenomenon, many overseas markets’ interest rates moved in the opposite direction to Australia’s. Attempts by the US central bank to cushion the impact of turmoil on financial markets via a loosening of monetary policy saw US cash interest rates fall. Longer-term Government bond yields were also lower, as investors bid up the price of investments providing a “safe haven”. Over 2007, overseas fixed interest investments generated a 6.5% return.