April Market Update

2 April 2014

Is the Australian Fiscal Position Really as Bad as the Government Suggests?

The S&P/ASX300 accumulation index added 1.7% for April, building on the gains of the first quarter. Global equity markets were typically positive, although the Japanese Nikkei was the clear exception, losing 3.5%.

Equity market sentiment was once more hampered by geopolitical tensions in Russia and Ukraine. The region is important in terms of both energy supply and crop production and hence both the oil and wheat price continue to remain supported. In the US, the end of a severe winter has seen a pleasing improvement in recent economic data.

The best performing sector in April was Utilities, followed closely by Energy. The worst performing sectors were Healthcare and Information Technology.

This month we take a look at the economic backdrop to the new Federal Government’s first budget, highlighting the revenue pressure the country faces as the terms of trade decline.

Market Update
The S&P/ASX300 accumulation index (+1.7%) outperformed the US S&P500 (+0.6%) for the month in local currency terms. Profit taking and de-rating of the high profile technology and biotechnology sectors weighed on both the NASDAQ index and the broader US market. Economic data in the US however recovered from a winter pause, with retail sales, employment data, and industrial production all improving.

Geopolitical concerns focused on the territorial dispute between Russia and Ukraine. Russia supplies considerable amounts of gas to Europe, with key pipelines traversing Ukraine. Also, Ukraine is one of the world’s largest crop producing nations. The territorial dispute is therefore placing upward pressure on prices for both oil and wheat.

Closer to home the Chinese economy continues to slow with first quarter GDP slowing to 7.4%, inflation controlled at 2.4% and HSBC manufacturing index again coming in below 50 (at 48.3), the first rise in 5 months. In Australia, business and consumer confidence appears to have taken a pause as the new government has flagged an end to the ‘Age of Entitlement’ ahead of their first budget in May.

Corporate News
In the Australian market, $5bn worth of takeovers were announced with David Jones (DJS) and Australand Property Group (ALZ) amongst the targets. Transurban Group (TCL), together with their financial partners paid $7.01bn to acquire Queensland Motorways. TCL raised both debt and equity to fund nearly two thirds of the transaction. Days later, TCL then announced an $850m proposal to expand and upgrade their CitiLink asset in Melbourne. At the smaller market cap end, several new stocks completed their initial public offering (IPO), including Burson Group Limited (BAP), Beacon Lighting (BLX) and Japara Healthcare (JHC). In the Energy sector, mid cap stocks Roc Oil (ROC) and Horizon Oil (HZN) agreed to a proposed stock based merger. Finally, Melbourne based Equity Trustees (EQT) raised $150m from new and existing shareholders to fund the acquisition of ANZ Trustees from the ANZ Banking Group (ANZ).

The Best of the Month
The best performing sector for the month was Utilities which rose by 3.4%. Amongst the larger Utility stocks, SP AusNet (SPN, +3.9%) and DUET Group (DUE, +4.3%) were the top performers.

The Energy sector also performed well delivering a gain for the month of 3.4%. A rising oil price, together with progress on key projects for the majors, saw Oil Search (OSH, +5.1%), Woodside Petroleum (WPL, +4.6%) and Origin Energy (ORG, +4.3%) move higher.

The Worst of the Month
Healthcare (-1.4%) was the worst performing sector, with both Ramsay Healthcare (RHC, -6.9%) and CSL Ltd (-1.6%) weighing on sector returns. A positive third quarter profit result from ResMed Inc. (RMD, +14.1%), offset some of the sector weakness.

The Information Technology sector also underperformed the market for April, although finished largely flat, declining a mere 0.2%. Computershare (CPU, +2.1%) went against the negative sector trend.

Economic Outlook
As the Federal budget approaches there has been plenty of commentary about the sustainability of the current levels of projected government expenditure. Much of the growth in revenue since 2003 can be linked to the economic effects of the China driven commodities boom. Over the past decade both sides of politics have fed substantial tax cuts, new rebates and other welfare-like payments into the system. This has been a key driver of the growth in household disposable income growth over this period.

One of the keys to understanding where this revenue comes from is to appreciate how the growth in nominal income for the economy has been impacted by the rise and now fall in commodity prices over this period. We last highlighted the importance of nominal income growth on corporate profitability and government revenue in April 2013. It continues to be important to have an appreciation of this economic driver on the share market.

The following analysis may seem academic. However, it is critical if you want to get an understanding of one of the key drivers of the economy and its likely future impact on government revenue, household income and equity market returns. Nominal Income = GDP growth + Inflation (CPI) +/- Terms of Trade.

Let’s assume for these purposes GDP growth (measure of the change in volume of goods and services produced) and inflation are fixed at say 2.75% and 2.25%. Before the terms of trade impact this gives a nominal income of 5%. For most countries this is where the story ends.

As a commodity exporter, Australia is periodically impacted by a temporary change in the terms of trade. The best way to think about the terms of trade is to use the experience of the last decade as an example: the price of our coal and iron ore exports went up and the price of plasma TVs went down.

Let’s assume the terms of trade has had a 2%pa impact on nominal income during the commodity boom – this would mean for an extended period nominal income rose at 7% (i.e. 5% +2%). Now the terms of trade has turned down, let us assume the impact on nominal income is 2%pa for the next few years (it could be more aggressive given the sharp rise it has had). This means nominal income growth grows at 3% pa – on an economy of roughly $1.6trn base this is a big shift in national income (i.e. approximately $64bn without other offsets).

There can be offsets such as declines in the Australian dollar or improved productivity growth which can also grow nominal income ahead of where it would otherwise be. As the benefits of the commodities boom begin to wane, it becomes apparent not enough has been done to ensure there are adequate replacement income drivers (specifically around productivity improvement). However, these measures require pain for a segment of the community and this is often a tough sell when times are good.

So this shift in nominal income will affect:

Corporate Profits: mining companies see reduced profits and cash flow. As a result, they cut back on mining expansion which impacts a string of service companies. And on it goes.
Government Revenue: the Federal and State governments see a decline in the rate of revenue growth as corporate profitability and employment growth declines.
Households: the rate of household income growth will also be lower as the government has to change what it delivers in the form of tax cuts, rebates, welfare payments and employment opportunities.

Market Implications
From an investor’s perspective, this means it will be tougher for domestically focused corporates to generate the same level of revenue growth they achieved whilst the commodities boom was fully underway. Instead, you need to look for management which can find other sources of earnings growth, such as offshore earnings, new product segments or productivity improvements (i.e. either cutting costs or generating more product out of an existing asset base). This requires a different set of management skills to those required to manage through the strong income growth phase in the economy (i.e. attracting and retaining the right staff was tougher).