Life is never linear
Whilst life is never linear and tipping points are hard to foresee, the past month or so has reminded us that seemingly stable, but unsustainable, economic systems can easily become unstable. Three market belief sets were all challenged, and found wanting, through the month - Chinese growth, sovereign debt levels, and expectations for Australian corporate earnings. Unfortunately, the former two of these issues may take years to revert to stable levels, and we see ongoing volatility in markets until we reach that point.
China and Resources
What is happening in China and how did this influence the performance of resource stocks through May? We have in recent months highlighted signs of instability in the Chinese economic system, through musings on unsustainable capacity additions in steel and cement through the past decade. More importantly though, this year we are seeing evidence that the Chinese themselves see their economic system as unstable, and wisely are looking to address the imbalances, as evidenced by an increasing focus by Chinese policymakers upon social equity and not just growth and inflation. Over the past thirty years or so, China has changed from a country with one of the most evenly distributed income levels (as measured by the Gini co-efficient, which measures income dispersion ) to a country with one of the worst, being even more extreme now than the self anointed poster child of global capitalism, the USA. Private wealth in China is even more concentrated than incomes, with two basis points of the population owning 20% of private assets. Put together, it is perhaps not surprising that President Wen has recently promised to address “deeper” issues behind social instability, which have manifested themselves in guards being placed at pre schools in China. Also, in April the Chinese State Council announced the strongest tightening measures relating to property ever seen in China, including raising the minimum down payment ratio of first and second home purchases, restoring the mortgage interest rate to 1.1x benchmark rate for the second or more purchases, rejecting third purchase mortgage applications and suspending residential sales to non-locals. Globally, the knock on effect of Chinese tightening saw resource stocks suffer, and whilst the Australian resources sector actually outperformed the market through May, one would never have known this, however, as the proposed introduction of the Resource Super Profit Tax gained headlines and became the subject of intense political debate, with Accounting Professors, Barnaby Joyce and Grant Denyer all debating the true rate of tax paid by major miners in Australia on breakfast television in front of an enthralled nation.
Apart from resources, the other sector impacted by global rather than local factors in May was banks, with the Financials sector representing almost half of the points loss in the market in the month. Each major bank dropped more than 10%, despite reporting results largely in line with expectations. Of course, as was the case with the GFC, banks have become the levered option on the direction for the Australian equity market. This is probably fair for businesses geared close to 20 times, and which have a business model aggressively tied to long term financing for Australian residential property, funded through short term offshore borrowings. When the availability and cost of foreign borrowings hiccups, as occurred with the GFC and again with the emergence of European sovereign issues in May, it is natural that the market focus turns not just to the sector’s vulnerability to these interruptions but also hones in on those stocks most leveraged to this domestic housing dependency. The relationship between loan growth and property prices is an interesting dynamic, and an argument best sung to the tune of “Which came first, the chicken or the egg?”. Japan gives us a stark example; loan growth tripled to 500 trillion yen in the eight years to 1990, and yet twenty years later it sits at 10% below that 1990 level, having peaked in 1997. Loan growth in Australia has been mostly double digit, or multiples of GDP growth, for the past 30 years, and has no doubt fuelled liquidity and prices for domestic property. Given these systemic dependencies, we certainly feel it’s responsible for RBA Governor Stevens becoming the first Central Bank Governor in the world to appear on breakfast television in order to cool consumer ardour for housing. The kitbag of tricks for managing a major Australian bank have been relatively stable since 1992, but now may change dramatically through the next decade. Especially until the Basel III reforms are finalised, we will continue to favour those domestic banks with a lower price to NTA ratio, or put another way those with a lower dependency upon an assumption of ongoing strong loan growth and high returns, especially in the housing sector.
Finally, May saw the emergence of downgrades, with stocks in disparate industries – such as IAG, Sonic Healthcare, Virgin Blue, and several retailers – all cooling expectations, and Downer freezing them. Whilst New Zealand is the only country with a worse earnings revisions ratio than Greece currently, Australia is next in the world, faring worse than the other “PIGS”, with each of Portugal, Spain and Ireland enjoying relatively more robust corporate earnings stability than Australia. Given Australia is currently enjoying a strong economic environment, with virtually no unemployment, this confirms our concern for corporate earnings in Australia once the terms of trade revert to more sustainable levels.
As usual, we become more excited about the potential returns available in the market when our entry prices are reduced, and notwithstanding the sovereign risk issues that dictated global and local market performance last month that is again the case. Whilst not seeing outstanding value in the market yet at an overall level, the level of fear that has fuelled emotional reactions to downgrades at a stock specific level has seen us aggressively initiate positions as much as at any time since the GFC passed. Volatility is yet again proving our friend, not our foe as the statisticians in charge of risk models would attest.
Challenges remain, and our caution towards each of commodity prices, capitalisation rates for the REIT sector and the secular headwinds facing bank earnings in the Australian market remains. Nonetheless, May gave us a glimpse of what we believe the next few years may look like, and our portfolio and the market behaved largely in line with what we had anticipated. That is, offshore earning industrial stocks, especially those with an appropriate capital structure, are relatively best placed to prosper during these times. Whilst we will continue to take advantage of tactical moves in markets as they occur, our focus on long run sustainable earnings means that significantly greater changes in market prices would need to occur before our major sectoral settings are no longer appropriate on a risk return basis.
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