The rebalancing path
While Europe continues to struggle in the mire of excessive government debt and high unemployment, Australia has opted for more inventive ways of making global headlines, with the RSPT (resource super profits tax) and the overthrowing of Kevin Rudd as prime minister making European dramas look positively mundane. Investors continue to struggle to make sense of an environment that does not bear an obvious resemblance to conditions prevailing over recent decades.
The downfall of Kevin Rudd has probably not come as a tremendous surprise to most, although the rapidity and method did surprise. As with most matters, Mark Twain probably brings it down to earth best: “Politicians are like diapers; they need to be changed often and for the same reason”. The criticism is harsh, but reflects an environment in which unpopular decisions will become increasingly necessary, and selling unpopular decisions more important. The RSPT is a case in point. One would think the electorate would embrace the idea of corporations (not insignificantly owned by foreigners) whose profits are derived from exploiting the country’s natural resources contributing a greater share of profits in preference to higher levels of tax elsewhere. Not so. The well executed opposition to the tax by the mining industry and the significant structural flaws in the government’s proposal swayed opinion. In contrast, the incoming UK Prime Minister, David Cameron, has delivered a budget involving far more pain for UK citizens which has met with far less opposition. The same cannot be said for Greece, whose citizens are greeting austerity measures with firebombs rather than stoicism. This will not change the necessity for reform.
From our perspective, this disparity in reaction highlights the chasm between domestic economic performance and the rest of the Western world. Whether your choice of indicator is unemployment, interest rates, house prices, government debt, GDP growth or sentiment, Australia looks like an attractive home for capital to foreigners and a good place to be a citizen. Conversely, most offshore markets are providing investors with ample incentive to press the panic button. How investors react to this disparity in conditions provides significant insight into how they perceive and deal with risk. Our assessment is that forward looking risks in a domestic economic sense are elevating sharply. The abovementioned conditions, together with the commodity boom have seen a massive influx of foreign capital. Whilst some capital has been gainfully employed in worthwhile projects, most has been deployed into housing. The productivity of lending is therefore deteriorating sharply. We now have an extensive offshore funding exercise each year (via the major banks), to maintain the status quo, and an increasingly large one if we hope to continue expanding credit. As complacency rises and extrapolation takes hold, risks in our view, almost invariably increase. Sentiment almost always moves at a faster pace and to a greater extent than fundamental value, and journalists, stockbrokers and most other commentators are incentivised to fuel overreaction. Good investment returns are nearly always borne of panic rather than complacency and rarely involve following the crowd. Confidence should be derived from cashflows, returns and the price you have to pay for them, rather than share price direction.
The reaction of investors to the events of recent months has left us a little befuddled. Despite the introduction of the Minerals Resource Rent Tax (the renamed RSPT), continued abysmal economic news from Europe, deteriorating economic news from the US and accelerating efforts to cool Chinese property markets, resource stocks have not fared poorly. While the religious belief in the strength of the commodity cycle has been evident for some time, the fortitude of the disciples has wavered little in the face of news which would seemingly create significant concerns over commodity demand. Ongoing wild enthusiasm for gold is perhaps a little less surprising, although from our perspective, similarly concerning. In a world which desperately requires the restoration of confidence in lenders to pass money to borrowers (thus increasing the velocity of money), the more popular wisdom at present is to hoard it in useless yellow metal. The belief that central banks, in trying to stimulate activity, are engaging in a covert Robin Hood scheme to ‘rob from the rich’, is probably a little far-fetched; but let’s accept it for a minute. If this ‘perversion of justice’ is occurring, it has been forced upon them by increasing income and wealth inequality, and low interest rates/money printing are merely a method to redress this balance. Assuming that those with the wealth can hold back the tide by hiding their money in gold is ludicrous. This will only serve to further stifle economic activity and induce collapse, although simultaneously promoting costly earthmoving and carbon emission to dig up the useless metal to then store in a vault. Humans are strange creatures. At least tulip bulbs were carbon positive!
The strength in commodities and gold would indicate that many still believe that the liquidity injected by central banks will eventually give rise to inflation as growth recovers. In the case of gold, it may also just be winning the “ugly contest” amongst desperate investors believing it will do well no matter what. Alongside this, bonds have rallied and property stocks have performed strongly as investors seek solace in more stable cashflows. We can’t see a peaceful co-existence in these investment themes prevailing for long. What this situation does reflect, however, is the uncomfortably significant impact which macroeconomic factors are having on stock selection at the present time. No matter how “bottom up” an investment process purports to be, the success which policymakers have in stimulating renewed economic growth and the path of rebalancing will have a meaningful impact on the revenue and margin outlook for companies.
We remain hopeful that rebalancing can occur in the world in an orderly manner. The austerity packages evident in Europe will be necessary elsewhere, and will include Australia at some stage. Kicking the can down the road in the hope that an absence of genuine productivity gain, growing bureaucracy, asset sales disguised as income and future liabilities not brought to account will miraculously disappear, or that the country can “grow” out of these problems, will not work. Whether it’s the RSPT, income tax, bank taxes or some other method, rebalancing will involve some pain for the citizens of countries used to spending the money of others. To borrow from Mark Twain again, “The only difference between a tax man and a taxidermist is that the taxidermist leaves the skin”. Successful rebalancing will depend on business investment and productivity gain, as big government and bureaucracy are almost always a disaster.
The oscillations between sadness and euphoria are likely to be a part of the landscape for some time to come, and we will continue to try and respond to these in a rational manner. Recent moves, driven in part by the widespread concerns touched on earlier, have already begun to offer stock opportunities which we believe will deliver exceptionally attractive forward looking returns. In other areas, where some believe there is safety, we see extremely high risk. As yields and returns on defensive assets fall and those on equities rise, it makes no sense to become increasingly concerned.
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