December 2011

The strange thing about the stock market is that when prices are low nobody wants to buy, and when prices are high people rush to buy. This is the exact opposite to what happens with "specials" at the supermarket. Fear about the Euro and the US economy is causing many investors to miss the real game. Stocks are cheap and dividend yields are high. For the true investor that's what counts. Europe and the US will sort themselves out over time. When this happens investors will be buying the same stocks, but at (much) higher prices and lower dividend yields.

The Euro countries have taken a major step forward with their latest agreement for tighter integration and fiscal controls. What is coming across loud and clear is that all of the 17 Euro members want to save the single currency.

Importantly the European Central Bank (ECB) is supporting Eurozone banks with what appears to be unlimited credit and liquidity. This helps remove doubt and fear about the solvency of Euro banks.

Markets are hoping that the ECB will also become an unlimited buyer of last resort for member country sovereign bonds. The ECB has not yet made this commitment, and without this assurance sovereign bond interest rates for countries such as Italy and Spain may stay high. However, the ECB is reportedly buying $20 billion of these bonds weekly, which is massive support over time.

How did it come to this? Because of debt. If European countries had not over borrowed there would not be a Euro crisis. There is nothing inherently wrong with having a single currency, provided you are fiscally responsible.

The problem for the 17 countries that have adopted the Euro is that they can no longer print their own currencies. There is therefore a risk that some of these countries may default on their sovereign debt. Because of this risk, investors are demanding higher interest rates from these countries. This makes their budget deficits that much more difficult to manage. Countries that have their own currency and central bank (e.g. US, UK, Australia) don't have sovereign debt risk, because they can always print money. This is what the US and UK are currently doing. Greece, Italy, Spain, etc, don't have this option.

The European Central Bank (ECB) can print Euros to bail out member countries. Germany is against this because it would potentially be inflationary. However, if the Euro is to stay together this seems part of the longer term solution.

The US economy has been recovering since 2009. The latest retail sales and employment numbers show this trend is getting stronger. Virtually every sector of the economy is improving, with the exception of home construction. During the pre 2008 property boom too many homes were built, and there is still an excess inventory of unsold properties. However, this inventory is being worked off and the upturn in home building when it comes, will have a powerful impact on US employment and growth.

Just about every country in the world is running deficits. These debts have been built up over decades as a result of voter demands, politicians and the political process. Many countries have now reached the limit to what they can borrow. One way to handle this debt is to inflate it away. People with interest only investments, such as bank deposits and bonds, pay the price of inflation. Stocks and property are protected as their value rises in inflationary times. Inflation in Europe in the last year was 3.0%, the UK 5%, the US & Australia 3.5%. Politics being what it is, greater inflation can be expected in the years ahead.

The companies in which we invest are making sound business progress. For example, the four major banks as a group increased their dividends by 11% over the past year. Market fluctuations don’t affect you unless you have to sell. However, a growing dividend income is important and what matters for an investor.

It's been a good year capped by the takeover of Cellestis at a generous price and the reinvestment of tens of millions of dollars, in a very depressed stock market because of fears about the Euro crisis and US recovery. The future is always uncertain, however assuming the Euro holds together and the US recovery continues, the outlook for the forthcoming year is promising.

Wishing you the very best for the Christmas and New Year festivities.

Kind regards,

Gavin Ross