Same issues, same result
Same issues, same result. Northern hemisphere developed market sovereign debt, an EC banking system where asset values are as unstable as minority governments are prevalent, mean spirited debate about the introduction of new taxes in Australia, without any emergence of a cogent plan for how to address the productivity of the nation, and emerging markets bidding up stores of wealth other than the US dollar, all lead to a declining equity market in Australia through July, albeit one where resource stocks outperformed following the lead of commodity prices. The introduction of the carbon tax pricing regime early in the month, and Rupert Murdoch’s travails of mid month already seem so long, long ago.
Amidst the gloom, one public official continues to provide a genuine public service, in our eyes. Reserve Bank Governor Glenn Stevens is coming up to five years in the job. In a speech on “The Cautious Consumer” made during July, Stevens’ spoke to six themes;
- A number of major economies are addressing long-term structural issues in their fiscal accounts, stemming from the inevitable collision of long-run trends in demographics and entitlements.
- Australia is in the midst of a once-in-a-century event in our terms of trade, the biggest gift the global economy has handed Australia since the 1850s.
- Real income growth in Australia grew at 2% per annum since 1995 and has accelerated since, as the terms of trade have also accelerated, whilst consumption growth was 2.8% per annum until the past three years, when it has been flat.
- Real household assets grew at almost 7% per annum in the same period, led by non-financial assets (housing) and the household debt to asset ratio almost doubling to 20%. That is, the great moderation prompted a lengthy period of rising household leverage, rising house prices, high levels of confidence, a strong sense of generally rising prosperity, declining saving from current income and strong growth in consumption. The role of the household sector in driving demand now will not be the same as in the past, as it is unlikely that spending growth will now outpace growth in income or increasing leverage. The rate of household savings now looks more normal than it has in the past.
- The rise in the terms of trade has now probably come to an end.
- There is only one source of ongoing higher rates of growth in per capita income, and that is higher rates of growth in productivity, which has been poor since at least the mid 2000s.
We agree with all six themes, as regular readers of these commentaries will be aware. Each will have a material impact upon equity market performance, as they have recently. To wit:
Demographics and unfunded pension liabilities will see upward pressure on taxes and interest rates, and a resulting downwards pressure on house prices, demand for credit and consumption. A major department store shared with us last year the spend by age cohort of their cardholder base. As could be expected, those in their forties spend materially more than those in their thirties, who in turn spend the same as those in their sixties. Our population has migrated through their demographic peak in terms of spending. As an industry, sales per square metre will continue to fall, internet or not, as the population continues to age. Landlords (and their finance providers) need to assume this base case as well. Banks also need to manage for margin and not volume – winning market share by discounting in the mortgage market is not a sustainable strategy, even if you convince yourself it’s a high return on equity product. It’s amazing how good returns look even when making a market at record high prices, when the asset is geared fifty to one and no losses are assumed forever more. What we saw through July – consumer discretionary, REIT’s and Financials being the worst performing sectors – reflects this thematic.
The term of trade (commodity price) boom is problematic, prompting the term “two speed economy” to enter the common vernacular. In the short run it is a powerful fillip to revenues, with strong prices and volumes, but increasingly cost growth is neutering the translation of revenues to profit. As one senior mining company executive admitted to us six months ago, they too cannot make sense of the copper price (ex financial buyer impact), but, equally, so long as high prices prevail the rational response is to produce as much as they can, as soon as they can, even if this means short term productivity is sacrificed. Putting this genie back in the bottle once the terms of trade and commodity prices revert to fundamentals will be an interesting trick to watch. Of course, the single biggest driver for our currency is also the terms of trade – the short term appeal of all foreign earnings will be significantly boosted at this time as well. If the Governor’s view prevails, in other words, that the rise in the terms of trade has now come to an end, then lower quality resource stocks – often now trading at multiples of fresh book value – will underperform. In the interim, materials continue to perform well, with the sector being one of the best performers in July, along with the classic defensive sectors (Utilities and Telcos).
Finally, productivity growth is an issue across the economy, here and globally. We rationalised why resource companies are rationally ignoring it, at the present, above. The challenge lies ahead for Banks, which are starting to move, and host enormous productivity scope, and other industrial stocks. Interestingly, the Chair of a major retailer remarked to us during the month he saw all costs for that business as variable. This may come as a surprise to their landlords, but rent does appear an obvious source of productivity for retailers to us. Equally, in the public sector this issue will need to be addressed: globally, as debt ceilings and sovereign bailout’s force the issue; and locally, where this year’s Commonwealth payments of $350bn are $100bn higher than just four years ago.
Governor Stevens ended his recent speech with “… So everything comes back to productivity. It always does…”. We agree and this will be the key this reporting season. Look behind the current sales number, given that for almost every company it is distorted by extreme cycles, whether in commodity prices, offshore activity levels, or currency. Focus on what the company is doing to improve productivity. Good management will differentiate on this front in the next several years. The best teams are already aggressively attacking the issue. Management that hopes things will revert to “normal” better watch out for that light at the end of the tunnel!
Portfolio outlook & strategy
Growth in the developed world is anaemic and slowing, with demand weakening and the financial system clearly needing further recapitalisation. The major themes affecting the Australian markets of too much debt, albeit concentrated in the financial and household sectors, aging demographics, and commodity prices continuing to trade at levels well above what we consider long term sustainable prices, all remain on foot. Our portfolios are positioned accordingly, with a bias to industrials with earnings exposure to economies where we believe upside to mid cycle exists more than can be said to be the case in Australia, or with exposure to domestic industries where cyclical debasing has already occurred, such as Pathology. It remains imprudent for us to ignore what we see as these ongoing risks, which only become amplified the longer they remain unaddressed. This balancing act has dominated the past three years and will continue to dictate our assessment of not just future likely returns, but also risks, in the portfolios.
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