Shifting back towards equilibrium
Optimism on renewed global growth and the diminutive returns available on most other forms of investment, saw improving enthusiasm for equities in the latter half of 2010. The recipe for improving risk appetite is one baked by policymakers, rather than fundamentals. Whether the soufflé can keep rising will depend very significantly on investor perceptions as to whether policy manipulation will result in desirable outcomes, or better yet, whether fundamentals can improve and policymakers can step back from the current excessive levels of intervention. Although global growth is very strong (4%+ growth is solid by any measure), the dispersion is incredibly high. As such, the challenges for policymakers vary hugely across the world, with developing economies beginning to suffer from excessive inflation stimulated by too much growth, and developed economies struggling to stimulate growth and avoid deflation. Harking back to the ‘Goldilocks’ economy analogies of days gone by, the porridge is scalding in countries such as China, stone cold in countries such as the US and UK and in countries such as Spain, Ireland and Greece there are just a few crusty bits stuck to the bottom of the bowl.
Intervention from policy-makers
The record of policymakers manipulating a smooth and desirable outcome is less than encouraging. The reasons for this lack of success are debatable, but the exercise of maintaining any economy on a smooth uninterrupted growth path is an almost impossible one to start with, and when the task is then left to a randomly selected collection of largely unqualified participants arranged into a committee large enough to render effective decision making virtually impossible, the chances of success begin to evaporate altogether. This goes some way to explaining why investors tend to be wary of government intervention. The US record over the past decade is disastrous, with Congress arguably less guilty than the supposedly qualified participants at the Fed in exacerbating the amplitude of the cycle. A housing boom and subsequent bust has left the US picking up the pieces and struggling to renew confidence. Europe makes the US look good, with the formation of the Euro and the coincident boom and bust which has been inflicted on the peripheral nations, making a single currency and interest rate policy look like a brain fade of the highest order. In light of this litany of disasters, it is surprising that policymakers in China are accorded such a great degree of reverence. Although there is a high likelihood that they are acquitting themselves better than their western peers and may be highly capable, there remains a zero likelihood that they can obviate the occurrence of economic cycles. In assessing the risks to prevailing sentiment in investment markets at present, this remains one of our greatest concerns. Whilst European and US policymakers would be prime candidates to star in the investor version of ‘Dumb and Dumber’, Wen Jiabao would be odds on to star as Ferris Bueller.
The track record of policymaking in both the short and longer term holds important lessons for investors. Cycles are a matter of certainty. The difficulties arise in working out which of the numerous cycles matter and whereabouts a business or a country is within them. There are a number of cycles that we could point to in Australia which will be crucial to the performance of both the Australian market overall and sectors within it. Obvious ones include interest rates, unemployment, house prices, commodity prices and the $A, but others, such as the balance between consumption and investment within the economy are becoming increasingly important. The extreme levels at which Australia is currently positioned in many of these cycles suggest investors should be particularly attentive, as the odds of an uneventful 2011 are low. This is particularly so given the propensity of different cycles to correlate at inopportune times.
At the risk of sounding like a broken record, the risk inherent in the commodity sector remains one of those we believe to be vastly underappreciated. Despite the divergent stages of growth referred to above, policies have aligned to create a perfect storm in commodities. On the fundamental side, booming emerging markets and resource intensive fixed investment, particularly in China, have created a massive supply demand squeeze, as production has failed to keep pace with demand. In concert, fears of $US debasement as a result of US policies to address collapsing growth have created mountains of non-fundamental demand. Malthusians are coming out of the woodwork, predicting that the world is about to run out of everything from oil and copper to food. Despite having not run out of anything to date, the day is nigh when all commodities become simultaneously scarce. Increasing scarcity is an obvious issue in some (not all) commodities, however, it does not detract from the need for caution when almost every factor points towards commodity prices being nowhere near average levels across a cycle.
One of the major reasons that we believe markets would benefit significantly from less aggressive intervention from policymakers lies in our belief in free markets and the importance of capital allocation in generating long term value. Manipulation which induces artificially high or low exchange rates and interest rates is a bad idea. The result of this manipulation will always be sub optimal capital allocation, and the result of sub optimal capital allocation will always be that capital is destroyed. Manipulation will often be viewed very differently by investors depending on whether short term outcomes are beneficial, but that doesn’t make them good. The aim of policy should be to minimise distortion. Mercantilist policies in Asia have been built on artificially low exchange rates and are currently viewed favourably due to the beneficial impact on growth, whilst artificially low interest rates in the US are viewed far less favourably. The former is creating imbalances, as economies become overly dependent on exports while the latter is attempting to combat the decimation inflicted by imbalances created by a lengthy period of artificially low interest rates. Once the process of manipulation starts (usually with the aim of stimulating growth or employment) it is difficult to stop.
From an investment perspective, manipulation increases the complexity of determining the amplitude of cycles. Having believed that commodity prices and the $A were already at extreme levels, these have moved further. The materials sector gained a further 13.3% in the December quarter and energy 7.5%. The $A gained a further 5.8%. The key question from our perspective, is how best to optimise the trade-off between risk and return in this environment. Nearly all the current returns in the equity market are being driven in the sector which we believe has the greatest risk, and investment in much of this universe seems like picking up pennies in front of steamrollers (although with companies yet to produce capitalised in the billions, perhaps pennies are a bad analogy). Opportunities are becoming increasingly sparse, with few undervalued opportunities remaining without suspending a belief in the existence of cycles. We will not suspend this belief.
Having just begun a new year, the timing would suit a traditionally unctuous statement reassuring investors on market valuation and encouraging them to expect returns of around 10% for the coming year. Such statements would further highlight the importance of ongoing global growth and recovery despite its lack of correlation with investment returns. Without intending to be iconoclastic, we suspect this will remain a low probability outcome. With so many economic and policy variables so far from equilibrium, expecting their interaction to produce an average outcome is ambitious. The actual outcome will depend significantly on confidence and trust, attributes that are currently in short supply, as politicians have earned little. In Australia, we continue to believe that the Reserve Bank deserves much praise, however, exogenous forces and a less flattering political report card offer less cause for optimism. Despite full employment, and being in the midst of a massive commodities boom, the country has saved nothing and reinvested nothing in replenishing infrastructure. Instead, we continue to worship rising house prices, exactly the reason that massively higher levels of debt in the US failed to generate any sustainable growth. Much debate continues to fly around the economics of the national broadband network. While it may be a sub-optimal and badly administered strategy, there is no doubt that it will contribute more to future growth than spending the same amount in increasing the value of the existing housing stock. Some return on capital is better than none.
Our optimism would increase markedly if both governments and companies could renew focus on profitably deploying capital and provide comfort to voters and shareholders alike that they were more concerned about how the country/company will look in five years rather than five minutes. As it stands, we can only observe that the current extremes in some of the aforementioned cycles are not likely to be sustained. We remain positioned for a world which will hopefully shift back towards equilibrium, as current global efforts at manipulation will only become more difficult as the scale increases. More speculative elements of the market will not fare well in this adjustment, however, we believe the broader and longer term impact will be very positive.
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