Welcome to a new financial year

09/07/2008 - 22:00

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Briefcase would like to take this opportunity to set the scene for the 2009 financial year.

Welcome to a new financial year

Briefcase would like to take this opportunity to set the scene for the 2009 financial year.

Last financial year was the worst on financial markets for 25 years, so if your finances are feeling a bit battered and worn, you are not alone.

During the coming financial year, global financial markets will begin to adjust to the reality of peaking oil production. The implications of much higher energy costs will be wide-ranging and largely unpredictable. Many major and painful adjustments to our economy and our way of life will begin to be instigated. China will continue to loom large as a major force on the global scene, as its economy continues to demand 20-40 per cent of the global supply of just about every commodity that you can think of.

The big risk for Australia remains a stumble along the road to economic growth in China, as our economy has become inextricably linked to the economic fortunes of China and the broader Asian region.

It is interesting to compare the situation of China today with that of the US during the 1920s. In that decade, the US economy was booming. America sustained very high economic growth as it transformed into the industrial giant it still remains today, backed by cheap domestic oil and the lack of damage that was inflicted on its economy by World War I.

At the turn of the 20th century, the US economy was largely based on agriculture, with a significant rural population bias. Urbanisation during the first 30 years of last century had an analogous effect on the US as China's urbanisation is having today. This period of exuberance ended with the Wall Street Crash of 1929, which reverberated around the world, followed by a decade of recovery leading to World War II.

Today, we face a similar transition. No doubt China will continue its spectacular growth into the coming decade, but major setbacks can be expected along the way, as social and political changes filter through in that country. Tensions over access to basic raw materials, such as water and clean air, will rise and ongoing conflict over access to oil and gas will form a backdrop to politics in our age.

Under such a scenario, investment in Australia's domestic energy companies looks to be a sound position, while oil producers operating in jurisdictions that do not have such strong financial markets or democratic and social backdrops may falter under local pressures to abandon free-market enterprise, so as to shore up domestic supply. Thus, companies operating in West Africa, China, and South America could find their upside limited.

Investment in any commodity that's needed by China also looks to be a relatively safe bet, as does investment in sound gold producers, since global production of gold peaked in 2001 and gold may well become more valuable as a store of wealth in troubled times.

The Australian government would do well to focus more on self sufficiency in energy, looking towards matching local refining capacity to hydrocarbon liquids production, multiple infrastructure capacity redundancy, use of natural gas as a transport fuel, population control and reduction, introduction of a domestic nuclear fuel cycle to support stationary power supply and provide a valuable export industry, along with the establishment of sound building codes for low impact, environmentally friendly houses and offices, along with an expansion of public transport to cope with a major swing away from private vehicle use.

It seems as though WA premier, Alan Carpenter, has been reading Briefcase, and has got the message, since he has just announced a major upgrade to Perth's public transport system. The only negative Briefcase can see to this initiative is that it will need to be instigated much more rapidly than planned.

Perth is going to need a major upgrade to existing capacity within five years, as well as major expansions to the network foreshadowed. Briefcase acknowledges that the initiative makes a start and will aid a system which, compared with others around the world, is already a lot better.

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Last April when Briefcase was in New York, traders were very buoyant and the world looked good. The Federal Reserve Bank and the US government had just engineered a rescue of major financial institution Bear Stearns, demonstrating once again its commitment to act as a lender of last resort.

However, I was not so sure that the bottom had been reached. Traders, who are notoriously fickle, have now become less ebullient as rising business costs, resulting from an ever higher price of oil, plus the continuing impact of the US sub-prime lending fiasco, drags down consumer sentiment and affects the bottom line.

Recent news out of the US auto industry, showing falling sales, heightens concerns about the sustainability of the vehicle-leasing model. Briefcase suspects that the US auto industry will be the big news story for the remainder of 2008. Rising fuel costs, higher interest charges and rising unemployment will result in lower auto sales and in fact negative 'sales', as more leased vehicles are driven back to the yard and simply deposited.

The whole leasing business is a pack of cards, with automakers and their in-house finance and insurance companies playing pass the parcel with lease finance.

Those holding this junk paper are due to receive a nasty shock as the industry crumbles with a similar impact to investor confidence as the ongoing sub-prime debt fiasco, which by the way will not begin to stabilise until early 2009, when the number of low front-end interest loan holders begins to subside, leading to a plateau of defaulter numbers.

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In Australia, tax loss selling has taken some blue-chip stocks back to levels last seen five years ago. This is indeed a major bear market, whose ultimate resolution is far from clear.

Interestingly, the overall market fall has been buffered by a stronger performance from resource stocks, as measured by the performance of Materials Index (see table above).

While the All Ords Index has fallen 25 per cent from its October 2007 high, the Materials Index has only fallen 11.5 per cent from that period and in fact it peaked very recently in May, from when it has now fallen about 18 per cent. Both the Industrial and Financial indices have fallen more than 41 per cent since their November 2007 highs, taking them back to levels last seen in late 2004.

This has been a very significant bear market move by industrial and financial stocks. Further weakness in resources stocks could take the whole market lower to a charting support level at 4,700 points, even though the industrial stocks may show little further weakness in this cycle.

Briefcase continues to recommend soundly based businesses which have a comfortable level of debt and strong cash flow to cover interest expenses along with energy stocks, since the price of oil and other forms of energy will continue to rise in the long term.

In the short term, the US Dow Jones Index appears to have recorded a significant intra-day reversal ahead of its July 4 holiday, which could foretell short-term strength while at home, an end to tax loss selling could remove some selling pressure, allowing All Ords Index to regain some composure around 5,100 to 5,600 points.

Bear markets tend to last for between six and 18 months, so by December 2008 the bear may have been satiated. Ultimately, a target of 4,700 points for the All Ord Index now looks likely over the coming two to four months, before a likely recovery during the first half of 2009.

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- Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au

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