30 April 2015
Themes For April
In April Greece looked to be entering the final act, for this chapter at least. It seems likely that Greece will default by mid-May if an agreement cannot be reached with its creditors. The desperation of the government is starting to show, which seems likely to lead to an agreement in the coming weeks, even if it is only another short-term solution. The market is pricing for this outcome to a large degree, so if an agreement is not reached we would expect some volatility. Meanwhile the economic data in Australia took a positive turn, giving the RBA some excuse to surprise markets by not cutting rates (again). The global backdrop would certainly warrant a cut, as growth has slowed in most regions, and certainly China has continued its soft run. Though we have seen some signs that the United States may be exiting a soft first quarter, and Europe continues to show signs of stabilisation. We will be watching for an improved global economy over the coming months, though note that the soft data lends itself to dovish monetary policy, which undoubtedly is underwriting the markets at present.

Greece – Time Running Out
Despite Finance Minister Yanis Varoufakis’s assertion that Greece “intends to meet all obligations to all its creditors, ad infinitum”, discussions over Greece’s putative bailout extension have failed to produce a meaningful breakthrough. Indeed Varoufakis’s propensity to lecture his counterparts and to block any avenues for compromise was seen as a major burden to the process, and his role was subsequently downgraded, with the deputy Foreign Minister taking more of a lead. Time is now running short – Greece owes the IMF EUR 750m due on May 12th, which it is unlikely to be able to pay. Meanwhile the government issued a decree instructing local and regional agencies to send cash reserves to the Bank of Greece for use by the central government, totalling EUR 2bn. The desperation of the government, and the muzzling of Varoufakis, leads us to believe that a compromise will be reached, though it could be a tense month ahead.

Iran Surprises
A preliminary nuclear deal was announced with Iran that was more comprehensive and specific than had been expected. Final details will be fleshed out in negotiations set to begin in June. President Barack Obama said the agreement “cuts off every pathway” that could lead to Iran building a nuclear weapon. Other parties were not so sure. If a deal is reached it is likely to send large geopolitical ripples through an already volatile region.

Australia Bounces
In Australia the economic data has taken a positive turn. Retail sales were up more than expected in February, rising 0.7% after several months of gradually increasing returns. This was against expectations of a 0.4% rise, and came despite consumer pessimism over the economy and political climate. The strength in retail sales continues to surprise, and I can only assume it remains driven by the wealth effect of rising property prices. Meanwhile employment rose by 37,700 in March compared to an expected 15,000 increase, with the bulk of the rise coming from full-time employment. In addition the participation rate rose to 64.8% from 64.7%, so a good quality result. The unemployment rate declined to 6.1%, the lowest level since December. In addition to this there was a pickup in the NAB business confidence survey, which presumably was in response to the RBA rate cut. On the downside the slowing economy has sparked the first monthly drop in job advertisements in nine months, with ads declining 1.4% in March. All in all some encouraging data, though given the macroeconomic backdrop and political impasse we remain cautious.

China Slows, China Reforms
China confirmed GDP growth of 7% in the first quarter, in line with forecasts, and down from 7.3% in Q4 2014. The number seemed surprisingly strong, however, given that monthly retail sales, industrial output, and fixed asset investment data all missed expectations. Growth in fixed-asset investment, a key economic driver, was the slowest since 2000, while industrial output grew at its weakest since the global financial crisis in 2008. In addition power output, which some economists use as a proxy for economic activity, fell an annualised 3.7% in March, the biggest fall since the 2008 crisis. All this makes the headline figure look a bit curious, and it would not be surprising if it had been massaged. In addition the trade data for March was alarming – exports plunged 14.6% from a year before, and imports were down 12.3%. Shipments to the U.S. dropped 8%, to the European Union fell 19%, and to Japan tumbled 25%. Such figures are not only concerning for China, but speak of a broader global slowdown.

As China slows down reform becomes both more pressing, and more perilous. China is undertaking traditional stimulus measures to blunt the impact of slowing growth, such as a full percentage point cut in the amount that lenders must set aside as reserves. It is the second such reduction this year, and the largest since 2008, this speaks to the scale of the slowdown. In addition China is taking meaningful steps towards financial liberalisation by preparing to launch bank deposit insurance. Deposits and interest up to 500,000 yuan ($81,000) will be fully covered. Whilst the move was widely anticipated it is a meaningful step, as it makes it more likely that banks will be allowed to fail.

One reason we may not see larger stimulus measures from the government is a healthy employment market. Urban unemployment, a key consideration for government action, held steady at the end of the first quarter at 4%. 3.24m million new jobs were created in the first quarter. If this number were to deteriorate you would expect much more strident action from the government, as finding jobs for an expanding workforce, and rising wages, is very much an existential issue for the unelected communist party.

United States – End of the Soft Patch?
In the U.S. the market took fright at the weak March employment number of 126,000 jobs added. This ended a yearlong stretch in which more than 200,000 jobs were gained each month. This number can be volatile, and it is perhaps not surprising to see a soft patch after such a strong run, but the figure for April will be watched very closely. Meanwhile U.S. manufacturing activity in March was at its lowest level since mid-2013 with the ISM factory activity index falling to 51.5 from 52.9 in February. Core durable goods orders also fell 0.5% in March after a revised 2.2% drop in February, marking the seventh straight month of decline. The revised February decline was the biggest since July 2013. On the positive side jobless claims came in lower than expected at 281,000 initial claims in March, and retail sales rose 0.9% in March. That is the first rise in retail sales since November, consumers may finally be starting to spend their petrol savings. We continue to believe that first quarter weakness will be transitory, and expect a pick-up in coming months.

Europe – a Mixed Bag
In Europe we were happy to see the Eurozone CPI almost back to positive levels with a -0.1% reading for March. Also encouraging was to see unemployment ease to 11.3% in February, the best level since May 2012. This does, however, disguise the fact that unemployment varies widely across member states. In Germany the unemployment rate is 6.4%, compared to Spain at 23.2%. In addition industrial output rose 1.6% in February from a year earlier, and 1.1% from January, the best result since April last year. Meanwhile the Eurozone composite PMI declined from 54 in March to 53.5. Forecasts were for a rise to 54.4 so the number is a disappointment. However the March reading had been the best since 2011. Bit of a mixed bag, but we think Europe will continue to show mild improvement.

With 201 companies in the S&P 500 having reported earnings, first-quarter profits are on track to post a 2.8% decline from a year ago, according to FactSet. Analysts had predicted a 4.6% decline in profits ahead of earnings season, owing largely to the negative impact of a stronger dollar and lower oil prices. As we have mentioned previously the equity market was primed for a small bounce given such low expectations.

The RBA Holds Fire Again
After the 25-basis-point rate cut in February, the RBA has now left rates steady for two months in a row. The markets had priced in a 75% chance of rates being cut in March. Meanwhile inflation data come in moderately stronger than expected. Though the headline number was in line at 1.3%, core inflation came in at 2.35% versus expectations of 2.25%. This kicked off a rally in the dollar with a further boost from the bounce in commodity prices. Glenn Stevens did, however, sound decidedly dovish at a conference convened by Goldman Sachs where he stated that “inflation risks in Australia are low, so interest rates should be low, and falling.”

U.S. Inflation Expectations
Inflation expectations are on the move in the U.S. Trading in the TIPS, which are inflation-indexed treasury bonds, as a percentage of total Treasuries volume reached an all-time high of about 2.75% this month, Fed data tracked by Barclays Plc shows. The implicit inflation rate has move up half a percentage point from the end of 2014 to 1.71% for the next five years. That is the biggest jump over a comparable period in four years, and is interesting given the soft economic data. The Fed will be watching closely.

Chinese Defaults
In China the market barely noticed a couple of defaults on dollar debt. On the day that Kaisa Group, a major property developer, defaulted on a $52m interest payment the Shanghai Composite index was up 1.8% and sovereign CDS declined. On the same day Baoding Tinawei became China’s first state-owned company to default on a local bond. Both defaults were not unexpected. The market reacted positively given there were some nerves over how increasing defaults might impact an untested credit market, in the end there was no panic at all. Expect more defaults to come.

Enter the Behemoth
Royal Dutch Shell announced it had reached an agreement to acquire U.K. oil and gas producer BG Group, valuing BG at £47bn, a 50% premium to BG’s share price prior to the deal. This could produce a company with a value of more than £200bn, and will add 25% to Shell’s proven and oil and gas reserves. This was one factor in the rebounding oil market, as industry consolidation should be positive for the oil price.

Markets wobbled with renewed concern over Greece, as the country informally requested a postponement of repayments to the IMF. The IMF refused. Yields on Greek bonds soared following the news, with yields on three-year paper rising 134 basis points to 25.10%, the highest since the country’s restructuring. Its 10-year yields climbed 45 basis points to 12.18%. The government, which must repay more than €9bn to the IMF this year relating to its first bailout in 2010, is locked in a two-month-long stand-off with its bailout creditors to release some of the remaining €7.2bn in its current €172bn bailout in order to make those payments. The risks are rising, and the time to make reach an agreement with the Eurozone creditors is running out.

greece concerns

Discretionary Portfolio Changes

In the Australian portfolio we executed the following trades:

Stock Stock Trade Remarks
21-Apr-15 OSH -1.0% Reducing position, after strong rebound from lows.

In the international growth portfolio we executed the following trades:

Date Stock Trade Remarks
15-Apr-15 Fosun International -2.0% Reducing position, taking profits after a very strong performance
15-Apr-15 ASML 4.0% New Position. See Note.

ASML is a Dutch company that is the largest supplier in the world of photolithography systems for the semiconductor industry. The company manufactures machines for the production of integrated circuits (ICs), such as CPUs, DRAM memory, flash memory. The addition of the company fits in with the thesis of the burgeoning “internet of things”. It also has a next-generation printing technology, extreme ultraviolet or EUV, that will allow ASML to print ever smaller circuits. Given the potential growth options the company is attractively priced.

Global growth has clearly hit a slow patch at the start of the year, though Europe continues to show positive signs of stabilisation, and the U.S. seems likely to exit its weak first quarter as it did last year. As always this soft economic backdrop lends itself to the central bank doves, and we continue to look to them to support the market.

Please be in contact if you wish to discuss any of these themes further, or wish to make any changes to your portfolios.