Q2 2015 Investment outlook – Atlas shrugged, as the resource tide goes out
The ASX 200 has had a great start to the year and now is flirting with the 6000 level, which we haven’t been north of since 2007. In fact, it has been the strongest market start to a year in 24 years, despite the arrival of the shutdown phase of the mining cycle. While including dividends, we have already well passed our pre-GFC market peak. These price levels have a large, perhaps disproportionate, psychological impact on markets and their participants. We have however entered the shutdown phase of our mining cycle. Atlas Iron was the latest victim of the dramatic slide in commodity prices and the highest profile casualty to date. This problem is not unique to iron ore either; it is becoming prevalent across the resource spectrum. Our government is now facing a shrinking tax base and rising deficits. Market sentiment is running very strong in light of this deterioration of our economic fundamentals. This is characteristic of the beginning of late cycle behaviour, as sentiment drives momentum, despite cracks appearing in the profitability of stocks and key parts of the broader economy. It is time for a more cautionary portfolio stance. On the stock selection side this means stepping up focus on balance sheet strength, earnings sustainability and reliance of business models.
Global backdrop: US in the driving seat, monetary policy boosts Europe but China weaker
World GDP growth forecasts in 2015 remained broadly stable at around 3%. One of the major developments at a global level this year is the large fall in oil prices. We have seen significant drops in fuel costs since the tail end of 2014, which has actually been a big boost to developed world consumers. The IMF estimates this will result in an increase for World GDP of between 0.3-0.7% in 2015. The US economy continues to grind out gains and there are some positive signs emerging for Europe, as a falling Euro boosts their exports. Asia, while still growing relatively strong, has a problematic outlook. With questions over demand in the region, and a rising US$ pulling many Asian currencies higher despite the weakening outlook for their regional powerhouse China. China’s data has been softening for some time now. However, the recent stimulus move should help to arrest the downtrend, it still needs to be watched closely. China has undoubtedly got a strong medium term outlook, nevertheless there is a growing risk of a near-term falter as their economy slows could cause waves in a world which has grown dependant on their high growth.
Australian Fundamentals: Job creation stays strong, but budget comes under pressure
Quite a lot has changed in the past few months: prices for our key commodity exports have all fallen towards their 2009 lows, the A$ has eased, growth is softening, but we are still generating good momentum, even if the fabled non-mining rebalance is resembling just that. Job creation has held up very strongly, with job adverts, hiring intension surveys and employment levels all improving. Recent drops in borrowing and fuel costs from the fall in oil prices have seen another pick up in disposable income, despite low wage growth. We see some of this windfall being spent in discretionary sectors such as leisure, travel and gaming. Conversely, the consumer staples sector seems to be getting more value focused. This is evident by the increased pressure on supermarket margins, and renewed breakouts of price wars designed to combat the growing market share of cut-priced competitors. We continue to have a strong preference for Wesfarmers in this space, due to their public perception of lower price points and their market leading housing exposure in Bunnings. Locally a leverage and construction trend has sprung up around the housing market, which has seen building approvals and apartment construction reach records. As a result, this has boosted the construction sector and benefited residential REITs and building materials companies, and will continue to do so for some time to come. Confidence is a key ingredient for domestic demand and it is picking up, this can be seen in improving business confidence and conditions.
Alongside this, the shutdown phase has arrived in mining and we are facing further falls in our terms of trade. There are mounting problems for iron ore, base metals and energy plays. The impact of the fall in exports profits to our federal and state budgets will be swift and thus making an expanding budget deficit inevitable. A softer and more considered approach is now needed for federal budget matters. Interest rates will also need to fall further in order to prevent a slowdown to the rest of the economy. Last year, the incoming coalition government raised a political maelstrom after attempting to bring in what was in many ways considered a fiscally responsible budget. It was met with outrage and public outcry despite the economy being in stronger state then. Much of the changes got held up in the senate which caused considerable political tension given most parties in society were detrimentally impacted to some degree. In the subsequent month the budgetary position has deteriorated materially. The chart on the left below shows how quickly the treasury have been revising down estimates for the budget. The chart on the right shows the real problem, which is that for all the extra revenue the government generated in tax receipts from mining and strong economic growth is now being matched by offsetting government spending. The trick from here is going to be how to tighten up areas of wasteful government spending whilst finding new avenues for revenue.
Source: Australian Financial Review and Australian Treasury
Valuation: purists start to wince, but this phase is more to do with liquidity and momentum
Since the Euro-crisis, our market has had sustained multiple expansion over the past three years without much in the while Australian equities are trading on historically elevated P/E multiples, it is a different story when we look at dividend yields. The current 12-month trailing dividend yield for the ASX 200 is 4.3% (and add another 1% for franking) and is in line with the long-term average. The current dividend yield in Australia is clearly attractive to income seeking investors around the world. As long as global bond yields remain low, and investors are still conducting their global-search-for-yield, we believe the dividends provided by Aussie companies will remain alluring. As such, the marginal buyer of Australian equities now are multi-asset investors, particularly from offshore as the A$ falls, and savers who are disillusioned with small and diminishing returns. We can see the relative yield advantage gross yields of Australian Equites have on the chart below and this will encourage flows. With the provision of global liquidity at historic highs at the same time as global rates cluster around zero, it’s clear that this wall of money coming from relatively high yielding assets can chase valuations further. However, this may cause problems in the future should this environment change, as market valuations may be more prone to gapping down if fundamentals do not support these new higher valuations. The key to this situation is not to fight the momentum, but to know that it is in the ascendancy despite pressured valuations and softening fundamentals. More risk adverse clients may want to take some profits at this point, but if dividends hold up and we get further spread, compression in equities markets will be pushed higher.
Rate cuts to come can boost banks, but increased focus needed on asset quality
The RBA has prudently more than halved rates since 2012 (from 4.75% to 2.25%) which has helped to bolster the economy. We expect further rate cuts this year, but each incremental cut become less effective as stimulus. They will not push valuations up as much as last time. Banks will also not be as defensive as they have been for the past three years, if rates are cut amidst a growth shock. Up until now, the environment could not have been more benign for the banking sector, with the mix of rates at all-time lows and growth around trend. They were able to grow their mortgage books at the same time as problem loans dissipated. The next cuts will be into a somewhat weaker economy, where problems loans might move up from all-time low proportions. For now, the banks provide strong dividends, but we will be watching asset quality from here to ensure they don’t move lower (dividends paid are a simple function of about 80% of bank profits).
Sector and stock focus: Rocks slide, means you need to question mining dividends
Since the last Investment Outlook we published in January, the iron ore price has fallen a further ~30% to about $50/t. The pace and severity of the mining sector slowdown is important as to how we transition into our next economic phase. While it was clear the peak of the mining boom is behind us, the common view was that commodity prices would hold up and volume increases would offset the profit impact of lower prices. However, this has not been the case. We are continuing to stick to our position that the unwind will be more pronounced. Increased supply has met weakening demand, and is starting to cause fallout across the mining and energy space as well as the industries that support them. In today’s market, the large diversified majors have the ultimate advantage as they own the expandable, low cost assets that continue to make profits (albeit with lower margins) while their rivals languish. The lower profits will make promised capital returns almost impossible. From here even dividends are looking vulnerable, even for the likes of BHP and RIO. That means that mining companies will have to make tough decisions about their dividends at a time when they’re cost structures need to be cut further. In the short term many will chose to pay their current dividends by adding debt to their balance sheet, but if major borrowing needs to be done to fund a dividend, then both the company and its investors will be better off with a lower dividend.
The domestic equities market still has strong momentum. This should be sustained for longer as interest rates and our currency fall. However, fundamentals are weakening and starting valuations are now at the highs of the last cycle. Investors need to focus more on capital preservation, earnings delivery and adding diversification.
> Persistent commodity price pressures mean rapid federal budget deterioration and a contractionary budget ahead.
> China is beginning to shift to a different growth model and there is some transition risk.
> Delays in the ability to put up Atlantic rates suggest ongoing economic stagnation.
> The Australian public is somewhat complacent about the post mining boom re-adjustment.
> The US is finally showing consistent signs of strength.
> The A$ is already moving lower and our interest rates should go lower in 2015. > Government stimulus programs are in the wings and can be quickly deployed. > Corporate balance sheets are in good shape.
Implementation guidance for the current market
> Let winners run in late cycle momentum – Stocks that can deliver on their earnings guidance
> Move up the quality curve – Clearly reducing exposure to lower quality commodity exposures is important now as prices retreat.
> Think more about capital preservation– Be patient and measured with your investments in this bullish market.
Quality won't perform as well in this climate, however will be better for you over the cycle. Pay particular attention to balance sheet quality, as prudent balance sheets are needed to run smoothly through a cycle.
> Look at dividend sustainability – After six years of ultra-low rates many of the assets traditionally used to obtain yield have been bid up. Don't target high yields at this stage of the cycle as you may well find yourself risking capital to get that higher yield. Don’t just look at headline yields; think about how sustainable that yield is and the earnings of that business is over time.
So, the cautionary stance on resources which we had beginning the year is playing out. The market reaction to this has been pleasantly surprising with an exceptionally strong first quarter. Investors are focussing on the positives of lower interest rates and currency, albeit make no mistake our fundamentals are waning. Therefore, don’t be surprised if this sentiment proves fragile. In recent portfolio changes we are moving up the quality curve and into stocks with stronger balance sheets. For now, be safe, patient and defensive. But be ready to rotate the portfolio as opportunities are thrown up.
Portfolio Manager – Direct Equities AMP Capital
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