The end of the ‘30 year miracle’
Confidence is the lifeblood of free markets, albeit, it takes many forms. Following the liquidity fuelled rush of 2010 which saw rapid gains in the prices of most assets, 2011 has been marked by confusion and unsettling events, masked by stable index prices on the surface. Whilst the ASX200 fall in April was the first monthly fall this year, every month this year has seen the index move less than 2% either way. Even the golden run of commodity stocks paused during April, however modestly.
We attribute the lack of confidence in the Australian market to a grappling with “what is sustainable?”. We have lived through a thirty year “economic miracle”, which in the West has ended not so miraculously, and are now eyeing with equal parts envy and suspicion the rise of China to its current position as the second largest economy in the world, unleashing a refreshed five year plan promising 8% growth amidst low inflation and “social harmony”. Macro factors are hence having more of an impact upon an assessment of “what’s sustainable?” and security valuations now more than at any point we can remember through the past twenty years. We discuss five of these factors below, touching on how they affect the Australian equity market.
At a recent presentation by a senior Reserve Bank official, it was intimated that, on balance, bonds may be expensive elsewhere in the globe, reflecting undue complacency on the part of investors as to the ability of western world governments to deliver fiscal reform. Reinforcing this concern, and in the spirit of financial prescience characterising their work through the past cycle, Standard & Poor’s downgraded the US sovereign outlook during April. Treasuries proceeded to rally every day through the ensuing week. Credibility is hard to win, and easily lost.
It is hard to mount a credible case against US bonds continuing as the world benchmark for risk free returns through the foreseeable future, however, if for no other reason than through an absence of alternatives. As the US teeters with its global benchmark status, China continues its economic ascension, with April seeing it raising rates for the fourth time since last November, by another 25bps to 6.3% and the banks’ reserve requirement ratio for the fourth time this year, by another 50 bps to 20.5%. In turn, within China, private lending rates have escalated, with monthly rates now equal to or more than the 6.3% benchmark rate. China has come a long way in a short time, but together with a tied currency, this highlights why we remain confident US Treasuries remain a global risk free benchmark, and the $US will not be secularly debased. There clearly are risks and US fiscal and monetary policy is addressing neither core problem of too much debt growth nor too little productivity growth. Hence S&P’s warning to address both factors, repeating their 1996 negative watch call, in our view may be ultimately helpful, a view it appears was shared by the bond market. We have a significant skew towards $US earnings in our portfolios, due to the valuation impact arising from our long run currency assumption of 75 cents. Hence this outcome matters to our performance, not just in the month past but in the years to come.
As an aside, S&P are also taking this new pro-active stance to bank ratings globally. In January, they released a preliminary banking industry country risk assessment in 23 countries, including Australia. Australia was downgraded from BICRA (Banking Industry Country Risk Assessment) group 1 (lowest risk) to BICRA group 2, due to economic imbalances and system-wide funding concerns. S&P want to introduce this new methodology by the end of this year. If introduced in its current form it appears certain the banking industry will be globally downgraded, a conclusion difficult to argue with given the experience of the last cycle. Should Australian banks be downgraded within that context, it could materially affect their funding costs. Much of the political risk attaching to the banks through the past year has now passed, remarkably benignly. However a material risk, as yet not remarked upon in the market, is starting to emerge.
Whilst commodity prices continued to strengthen, equity prices for resource stocks underperformed, albeit just, in April. We continue to see the outsized excess returns currently being earned by virtually any producer of commodities as an aberration and not a baseline. Our views are shared by RBA Governor Glenn Stevens, who commented “We have to turn confidence into lasting prosperity … When the terms of trade are high, the international purchasing power of our exports is high. To put it in very (over-) simplified terms, five years ago, a ship load of iron ore was worth about the same as about 2,200 flatscreen television sets. Today it is worth about 22,000 flat-screen television sets. On all the indications available, we are living through an event that occurs maybe once or twice in a century …. “. With all of the net earnings growth in the market this year forecast to come from resource stocks, as high currency, interest rates and wages growth, along with a subdued consumer, ameliorate the operating leverage industrial stocks might otherwise expect from a full employment scenario, a productivity focus by management becomes critical.
Where companies do start to apply some ‘self-help’ with respect to productivity, the market is swift to reward them. Westpac is an example. In March, their management told us how a material productivity initiative had already commenced within the retail bank, which whilst nascent amounted to double the impact of programs of this type we had heard outlined by a major bank previously. After being a serial underperformer since buying St George, Westpac has started to outperform its peers through the past two months. We do not think these two events are unrelated and it serves as a clarion call to other management teams as to how thirsty the market is for productivity focus by management in a world otherwise beset by slowing revenues, cost pressures and more conservative gearing structures than we have witnessed recently.
The developing world continues to drive world growth. However, it would be churlish to ignore their intent and action in slowing their own rates of growth, which leads to its own risks as per the shadow Chinese financial system. Equally, some parts of the developed world see strong signs of growth, with inventory rebuilding lifting the US ISM Index to levels now rarely seen in the past 30 years. 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 Portfolio is 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. Signs of fatigue are emerging from the liquidity injections of the past several years and rate increases in Europe and China saw the market moderate here in April. Whilst financial demand for commodities may continue to see hard assets being bid well above fair value, it would be imprudent for us to ignore what we see as the ongoing risks detailed above, which only become amplified the longer they remain unaddressed. This balancing act has dominated the past four years and will continue to dictate our assessment of not just future likely returns, but also risks, in our portfolio.
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