Why is it so?
We can go through the “what” readily enough – what moved through the past month and year to see us outperform, or through the prior two months to see us underperform. It’s in the “why”, though, that we can provide insight into how we are positioning the Portfolio and how that’s changing, in order to convey the “why” of relative performance. Why do we think we are in a low growth and investment return world? Why have Australian equities rallied 24% through the past year, and global equities a similar amount, given this? Why do we see commodity prices as elevated but many resource stocks as under-valued and can they outperform in a low growth, and declining commodity price environment? Why do we see Australian banks as overvalued and why do we think a residential property price correction, if it ever happens, won’t hurt them? Why is the influence of government policy on returns only likely to continue to increase?
Excessive levels of indebtedness and demographics are the twin reasons we expect lower investment returns prospectively than have been experienced through recent decades. For all of the talk of global deleveraging in the five years since the GFC, in reality little has changed, other than the socialisation of debt previously held by banks. McKinsey have highlighted that deleveraging periods often see debt to GDP ratios drop by 25%; and yet among major economies, debt to GDP ratios today are higher than in 2008. This has implications for confidence, as terms like “Austerity”, “Tapering” and “Fiscal Cliff” will keep recurring until the deleveraging process matures, creating both the likelihood of policymakers extending unconventional monetary policy, and ongoing volatility in markets. These global factors have local market implications; indeed, both impacted returns in bond and equity markets through September. The second consequence of elevated debt levels for equity markets is that sales growth will remain low. Sales growth in Australia for F13 for the entire market was 1.5%, with banks and industrials marginally higher, and resources lower (negative). The US has experienced only marginally higher sales growth. From sales growth of low single digit numbers, the only way profit can grow at a meaningfully faster rate, in the absence of pricing power, is through cost reductions; this is now an enduring core competency for Australian corporate management. There has been significant turnover at CEO level through the past year, and in no case was that despite proficiency in productivity. The second pillar behind our low growth assumption is demographics. A major retailer shared with us the spend by age decile of their store card holders – those retired spend approximately ½ of what they did 20 years earlier in their life. As unfavourable demographics increasingly emerge, levels of investment and consumption growth are dropping, crimping growth in corporate cashflows. These same factors also crimp government fiscal balances; which is why, as we detailed in the August commentary, we expect attempts by the Government to tax pockets of excess return (especially in regulated markets) will only continue, meaning that the relative appeal of stocks earning profits in unregulated markets – such as Woolworths, Brambles and James Hardie – are of increasing relative appeal.
Given this expectation of a low return world, how do we reconcile the returns of 24% in the Australian equity market, and 20%+ returns in most developed equity markets, through the past year? In brief, a policy maker’s picnic - interest rates pushed to such low levels that money flows have been squeezed into equities, has prompted a market rise through rerating, not earnings growth. As with sales growth, earnings growth has been anaemic in Australia. A year ago we highlighted the high equity risk premium being paid to equity market investors, which meant equities looked attractive relative to other asset classes. This appeal has obviously dropped in simpatico with the market rise, especially as this has been fuelled by rerating rather than earnings growth, to the point where we see equity markets now as broadly fairly valued.
Within this broad market level, however, some variables remain materially away from sustainable levels. We use a long run AUD/USD assumption of 0.75, and hence still see the Australian dollar as prone to a material fall. Commodity prices are another area we still see as being materially above sustainable levels, most notably iron ore. Having said that, an even more dire outlook than we forecast is currently priced into many resource stocks, especially the majors, and hence we continue to see relative appeal in them, especially in the new environment of reduced opex and capex. This pattern – reduced levels of demand, leading to reduced costs and a focus on improving cashflow – is the same rhythm that Telstra has followed in recent years, and many mining service related companies (including larger ones such as Orica and ALS Limited) are now confronted with. As has unfolded with Telstra, good investment opportunities often emerge when angst as to the demand environment is most acute.
If great value does not lie indiscriminately across the market, where lurks the pending stellar outperformers in the ASX200 right now? History suggests there to be some – on a rolling 12 month basis there are invariably stocks that outperform by 100% or more. The rise in the equity market has seen fund managers do relatively best through the past year. Prospectively, our favour is, as always, more driven by relative valuation than thematics, and to that end low cost resource and energy stocks, and their suppliers, currently dominate our portfolio purchases.
The Australian banks are the most expensive in the world relative to their asset base, and relative to the GDP of their host country. However, that has been the case for a while now, and yet they continue to outperform. Neither revenues nor operating costs have positively surprised through recent years; it is only through the credit loss line that the banks have seen earnings grow at a greater rate than the market. This is obviously a function of the low unemployment rate seen in
Australia through recent years. In turn, to the extent that unemployment rises, credit losses will increase. Having said that, we doubt that housing will ever be the source of outsized losses. This view of ours has changed through recent years as the experience in the UK market – where losses on the mortgage books did not go above 15bps, even when unemployment and house price declines both breached 10% - became clearer. Both markets enjoy the systemic support of their respective central banks, and similar market structures, and hence we would expect the UK experience to be a very good template as to the Australian banking sector loss experience. It has been characteristically savvy of Macquarie Bank to aggressively grow its business in the mortgage market in Australia in the past two years.
Outlook & strategy
The five “why’s” detailed above reinforce why we continue to believe the levels of western world monetary policy distortions, and Chinese industrial production over capacity, will continue to influence Australian equity market returns, and why the domestic economy is facing a period of tumult, with unemployment as likely to surprise to the upside as growth is to the downside, for years to come. Sales growth will remain hard fought, and taxes are likely to increase as the Federal
Government seeks to curtail the current fiscal deficit. In this environment, a focus on productivity (more commonly associated with foreign earners), and an ability to make the price for the goods and/or services the investee company sells will remain critical valuation drivers. Gearing, especially for stocks exposed to a slowing domestic demand environment in a deleveraging world, may ultimately hurt equity holders disproportionately.
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