If I were you I wouldn’t be starting from here
“Well, if I were you I wouldn’t be starting from here” is the joking response of the Irishman when asked for instructions. Financial markets have been more sanguine than the Irishman with September continuing the strong run of equity market performance. Fundamentals haven’t changed much; bonds look expensive, on any traditional measure equities look cheap, the Australian dollar is weakening but still defying not just weakness in commodity prices but more importantly logic, and major economies are weakening.
Distortions abound. Like the hall of mirrors – sequentially lined up to make you look smaller, wider, wavy, or my personal favourite, taller and thinner – they are taking many forms. We profile six below, each of which is presenting different risks and opportunities to us in determining what the sustainable level of earnings is for companies across sectors in the Australian market.
Global monetary policy
Monetary policy globally has seen an unprecedented, extended period of low interest rates, led by the US but more latterly joined by the EC, which has not provided the hoped for boost to activity. In turn, quantitative easing – again, across geographies – has been parlayed on top of low interest rates; an increased dose of monetary stimulus, as it were, to generate underlying growth. For the very reason that we watch anxiously as a 12 year old dons a lab coat and uses a bunsen burner to initiate yet another new experiment, gently (sometimes loudly) encouraging him to try this in the backyard rather than the kitchen, we also squeeze our hands in anxiety as the US Fed announced through the month that “exceptionally low” interest rates will stay in place for three more years, having been close to zero since 2008, and that purchases of US$40bn a month in mortgage debt would augment monetary policy. With US unemployment still above 8%, and housing starts still at 50 year lows it’s hard to accept that more of the same is the right approach, even as equity markets and housing prices rally through recent months. The opportunity arising from this policy for investors does not rest with buying bonds – equity risk premiums continue to be outsized.
A second distortion is in fiscal policy. Apart from growth in government spending, Bank of America Merrill Lynch recently highlighted that all of the major EC economies and the US, have seen a contraction in underlying GDP through most years leading up to the GFC. In itself, as equity investors, we do not find this troublesome but for one behavioural side effect. The importance of GDP growth is so ingrained as an economic right and social principle that most forecasts are predicated upon growth, albeit seemingly modest, even when austerity programs are introduced. The budgeted GDP growth in the face of these synchronised austerity programs is, hence, highly unlikely to be achieved. Again, opportunity arises as can be seen in northern hemisphere (including Chinese) equity markets through the past year, which continue to be uncorrelated with GDP growth, as has been the case consistently across time and geographies. Worse than expected GDP growth need not translate to poor equity market returns. We are, however, cautious on companies heavily reliant on government spend, especially if those companies make excess returns, as they are vulnerable to reclamation by the state in years to come (as has happened with pathology providers and miners in Australia through the past year).
The third distortion in economies and financial systems is the amount of debt being carried, especially by governments and households (thanks to various forms of transfers from the financial sector through the past five years). After unprecedented levels of household deleveraging in the US, debt to income is still at the levels it was just a decade ago and almost double the levels of just 20 years ago. At the same time, government debt to GDP has almost doubled through the past decade and is still meaningfully increasing. The fiscal cliff awaits later this year. Only the appetiser in global deleveraging has been tasted. The other three courses in the degustation menu are still to come. Inappropriate debt structures are also at play in stock performance; for example, Bluescope Steel was the best performing stock in the index through the month, reflecting operating and financial leverage generally being rewarded during the month, whereas the other major domestic steel producer, Arrium, was among the very worst performers reflecting poor cashflows and an unsustainably high debt burden. Of course, a new owner need not worry about refinancing risk!
The Australian dollar
A “stronger for longer” Australian dollar continues to distort industry structures, company profitability and, in some cases, company survival. Manufacturing has halved as a proportion of GDP through the past decade in Australia. Refining oil for vehicle consumption is not an industrial activity any longer undertaken in NSW. Steel making is unprofitable, although the steel makers are not at the low end of the global cost curve. Gunns was, however, and yet a confluence of factors, with the currency being a major one, meant that the stock was placed in administration during the month and the administrator has announced equity holders will not receive a return. Our equity investment in Gunns has been a poor one and augments the view that applying leverage to long dated cashflows is ill advised. Our mid cycle currency assumption remains US$0.75 but the standard deviation around this point estimate increases in synch with other market distortions. As the debasement of currencies continues, the case for gold as a risk mitigant improves, albeit deriving the fundamental value of a non-income producing instrument remains as problematic as ever.
The fifth distortion affecting us as investors in the Australian equity market is commodity prices. Fortescue Metals Group began the month trading at $3.55 per share and ended at $3.49. On the surface, this is benign. Through the month, however, it traded as low as $2.81 and spent two days in suspense – when the grey market price, if it existed, would have been well south of this low - as it sought to refinance. Given its high operating and financial leverage means that Fortescue receives about US$4/tonne in pre-tax cashflow at a US$100/tonne China spot price, or about 10% of what RIO and BHP receive, it is easy to see why Fortescue equity experienced turbulence mid month as iron ore prices fell materially and lenders panicked. We still see iron ore prices as well above mid cycle levels and hence expect leveraged plays to continue to experience large volatility.
A final distortion is in bank equity prices. Being leveraged 15 to 1 means that banks are hyper sensitive to economic cycles, as most recent loss experiences tend to be extrapolated into perpetuity by regulators, boards and management and investors. Given relative unemployment levels, unsurprisingly Australia looks terrific on that basis relative to most other advanced economies, although we can’t help but wonder why cashflow is so weak (DRP’s are needed to fund dividends) when earnings are so strong for the domestic banks. The accounting may not be as conservative as many would like to believe. Nor are the multiples. Whilst Australian GDP/capita is less than or the same as the US, Canada, the Nordic states, Germany, Switzerland, Singapore and Hong Kong, our banking sector market capitalisation per capita is usually much more, up to eight times more, than those peers, with Singapore the only exception. Maybe Australian consumers are fond of paying more for mortgages than their peers around the world throughout their lifetimes? We’ll know more when unemployment increases.
Our longer term observation that making sense of the current global picture is, to say the least, challenging, remains. The major themes affecting the Australian markets, relating to the six distortions detailed above, all remain afoot. Equally, markets are thirsty for what they perceive to be good news, and high equity risk premiums mean allow them to rally when it is received. That will continue to be the case, and we need to continue to be prepared for that likelihood with our portfolios. Equally, 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. It is this balancing act that will continue to dictate our assessment of not just future likely returns, but also risks, in the portfolio.
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