Returns for the month of August:
Global Growth Concerns and Volatility
Why have markets been so volatile of late? The first thing to note is that volatility and the market pricing of risk has been low in recent years, largely due to the actions of central banks flooding the global economy with cheap credit in the form of expanded balance sheets and low interest rates. Whilst the VIX index spiked dramatically last month, for much of the prior three years the index mostly remained unusually low as investors have accepted a lower risk premium to gain a return above a cash rate of zero in much of the Developed world.
This financial repression lends itself to sharp, sudden bursts of volatility as pent-up risk aversion is rapidly unleashed. A clear example of this was when the Swiss central bank ended the Swiss Franc peg to the Euro. The currency subsequently appreciated up to 30% in a single day, having had very low volatility up until that point. So part of recent market moves was simply the return of risk aversion to the market after a long period of relative calm.
The other element that has contributed to recent volatility has been increased concern over the global economy. The locus of much of this concern has been China, responsible for one third of global growth since 2008-09, where various factors have compounded to raise fears. We saw the Markit / Caixin PMI reading, which measures business activity, at the lowest point since March 2009. The preliminary reading for August came in at 47.1 versus expectations of 47.7 and July’s final reading of 47.8, where anything below 50 signals a contraction. Exports were also down 8.3% in July, the biggest drop in four months. Producer prices dropped at an increasing pace, 5.4% year-on-year, and consumer inflation remained below 2%. All this continues to speak of overcapacity. Perhaps even more concerning for the Chinese leadership, Chinese firms have laid off workers for 21 consecutive months, though the slack has been partly offset by the public sector. It would become an existential issue for the government if employment growth were to cease altogether.
All these data points were undoubtedly soft, but are undeniably a continuation of recent trends. What really shocked the market was the devaluation of the yuan, which lost 3.5% against the USD over the two days. There has been differing analysis of why China has done this, but the first thing to keep in mind is that until the devaluation China had actively been supporting the currency. It had been supporting the currency for a number of reasons: to encourage the transition from investments and exports to consumption and services, to prevent capital flight, and to encourage adoption of the yuan as an SDR currency by the IMF. The SDR is a global reserve asset administered by the IMF, and is currently made up of a basket of US dollars, euros, British pounds, and yen.
To put the move in the yuan in perspective it is worth looking at the performance of the currency on a trade-weighted basis:
Whilst this graph doesn’t tell us anything about whether the currency is fairly valued or not, it does tell us that the currency has had a strong run since the financial crisis, and it has risen strongly with the USD recently by virtue of its informal peg. In this context a 3.5% pullback doesn’t look particularly extreme. Indeed the government has been making the case that rather than interfering with the currency it is trying to make it a more market-based rate. Currently China manages the exchange rate through an official midpoint, from which it can vary 2% each day. The new mechanism supposedly will incorporate more market pricing to determine the official midpoint, though the whole process remains obscure.
Despite the official line, which admittedly should be taken with a grain of salt, the market inevitably took fright. Analysts interpreted the move as an admission by the government that growth and trade were much worse than reported, and that this would inevitably presage a new and destabilising currency war. Market forecasts were for an eventual decline of 10%-20% for the yuan, and the spectre of the late 90s was invoked in the media. Such a currency war would undoubtedly be destructive, but we do not necessarily think we are at that point as yet. There are many considerations for the Chinese government beyond cold, hard economics. A rapidly devalued currency does not fit in with its national narrative of rebuilding China’s standing as a major player in global affairs. In addition the government still has many levers to pull before it might resort to an outright trade and currency war.
The country’s $3.69 trillion of foreign-exchange reserves and relatively low national government debt levels mean it has the ammunition for fiscal stimulus. Indeed one idea is that the government has determined it needs to bring back some of these reserves to support increased fiscal spending, so why not devalue the currency? Beyond this, after recent cuts The PBOC’s one-year lending rate is 4.6%, compared with near-zero benchmark rates in the U.S. and Europe. And with producer prices declining around 5% pa, a near 5% lending rate looks quite hawkish. The PBOC also has significant room to lower required reserve ratios (RRRs) on banks to encourage lending. Even after a series of cuts, the RRR remains at 18% for major banks, among the worlds’ highest. Of course the government may be wary of pushing credit expansion too hard given the size of the credit bubble. Most likely it will be a combination of levers, a modest devaluation being part of that. Meanwhile the already easier credit conditions continue to support the property market, where prices have been rising for three months now though still remain 3.7% lower than a year before.
At Boag Financial we certainly share market concerns over China and global growth, a topic we discuss continually. However we believe that the real question is whether China is at risk of a hard-landing rather than an orderly slowdown. For it is the former scenario that would lead to further market dislocation. Whilst we do not completely discount the possibility of a hard landing, we do not believe that the data points to that outcome at this point in time, albeit we are concerned by the size of the credit bubble. We are certainly not saying that the market cannot fall further from here. Such risk aversion events can feed upon themselves to produce ever larger pullbacks. But we believe that at this point in time the fundamentals do not point towards taking drastic action, and that equity valuations are starting to look attractive where moves to date are discounting a very large drop in business activity (see chart below). We are therefore looking for opportunities to add to positions selectively, but remain vigilant to rising risks.
Oil – Searching for Equilibrium
Commodity-watchers will no doubt note that recent equity market volatility is entirely in keeping with events over recent months and years. Brent crude has dropped from $115 in June last year to a low of $42 in August, its lowest point since 2009, before rebounding to $54 at the end of the month. Quite a ride.
The geopolitical fallout from this plunge is still playing out and may continue to be felt for years to come. Spare a thought for the numerous petro-states globally that require a much higher oil price to balance their budgets, which can be seen in the chart to the left. And of course many of your portfolios will have been impacted by the move. Why is it happening?
Put simply – there are two broad potential explanations as to why the price drop has occurred. It could be to do with declining demand and global growth that is much slower than expected, which would be bad news for all asset classes. We examined this in the last section and whilst it is no doubt a factor, we do not believe it is the major cause of recent moves. The other side of the ledger is the supply picture.
OPEC estimates that in the second quarter of this year global oil output exceeded demand by 2.87 million barrels a day, in a market of approximately 90 million barrels. Much of the initial increase in supply was driven by a technological revolution in America allowing the extraction of oil from previously uneconomic shale reserves. Between 2008 and 2015, American oil production rose by 75%, topping nine million barrels a day late last year. OPEC estimate U.S. output to rise almost 1 million barrels a day this year and another 320,000 barrels a day in 2016.
OPEC faced a choice as to whether to cut production to support the oil price, or to try and run the new producers in to the ground. Indeed whilst many members of the block were agitating for the former approach, given their desire to protect their budgets, the Saudis chose the latter. In reflections of what is happening in the iron ore market it took a rational decision to protect its market share, attempt to drive new competitors out of business, and then hopefully be in a strong position to profit from the subsequent rebound.
In the event not only did the Saudis decline to decrease production, they actually boosted their own output from 9.6 million barrels to 10.6 million barrels a day. Iraq also boosted production as the activities of ISIS failed to impact oil production in the south, and Iran may add a further 1 million barrels of production over time if the nuclear agreement is concluded. Bank of America opined that OPEC was “effectively dissolved”. Low oil price have succeeded in killing off high-cost ventures in the Russian Arctic, the Gulf of Mexico, the deep waters of the mid-Atlantic, and the Canadian tar sands. Wood Mackenzie found that 46 large projects with a total value of US$200bn have been deferred. However perhaps the ultimate target of Saudi actions have so far remained relatively unscathed.
The shale oil industry in America has proved remarkably adept at bringing down production costs. OPEC believes that many projects in North Dakota are profitable at $24 to $41 a barrel, and for the short-term at least many producers had hedging programs in place which have protected profits. Meanwhile many forecasters had assumed that with the rapid decline in oil rig deployment that U.S. production would follow suit. However whilst the rig count has dropped from 1608 in October to 664 in August, oil production has not declined until recently. Old vertical drilling rigs were taken out of service while the remaining horizontal drillers produced more wells per rig. The ability to rapidly evolve was evident in the related shale gas business. With gas prices dropping from US$8 to US$2.78 since 2009, the rig count has fallen from 1200 to 209, yet output has risen by 30% over that period.
IEA forecasts global oil demand to rise 1.6 million barrels a day this year and 1.4 million in 2016, the strongest demand numbers in five years. However the supply glut may last in to next year, and given the overhang of excess supply it may take until the back end of next year to clear this inventory. In addition due to the speed with which shale wells can be stopped and started America has become the worlds’ de facto swing producer, and the oil price will likely face headwinds on any bounce. We do believe that, absent a demand shock, overall production costs for global oil producers do point to a higher oil price in the medium term. However for the short term the price will likely remain volatile, and could re-test recent lows.
United States – On the Way to a Rate Rise?
In the United States initial figures for Q2 GDP came in at 2.3%, but this was revised sharply upwards to 3.7%. That was up from a 0.6% rate in the first quarter. Consumer spending, which accounts for more than two-thirds of U.S. economic activity, grew at a 3.1% rate despite consumer confidence which has recently retreated from elevated levels. The US Commerce Department’s measure of non-defence capital goods orders excluding aircraft rose 2.2% in July for the strongest showing in just over a year. Unemployment also declined to 5.1% in August, a level the Federal Reserve has previously stated points to full employment. Though it should be noted that August figures can be quite volatile. On the other hand wage growth and overall inflation remains low, and some commentators have suggested recent market volatility will give the Fed pause.
It is true that the Reserve members have a difficult decision to make. We believe that whilst inflation remains subdued the Fed will want to be in front of any future shift, given the ever-tightening U.S. labour market. The distortions that central bank action has caused to risk markets will also not be lost on them. For these reasons, and for the fact they have basically spelt out that they will, we still believe in a rate hike this year. Though we also believe that the pace of tightening will be slower than in regular cycles. The market may still react to the initial rise, a whole generation of bond traders have never seen one, but we find it hard to predict exactly what markets will do. It is entirely possible that markets rally out of relief, assuming the Fed guides to a gentle approach. In any case the upcoming meetings are likely to lend themselves to further volatility.
Greece, Back to the Polls
The IMF indicated it would not take part in the current bailout program, at least not in the immediate future. It cited Greece’s high debt levels and poor record of implementing reforms. The IMF are able to grant bailouts of a larger-than-normal size only when a bailout recipient is able to prove it has the “institutional and political capacity” to implement economic reforms, and that “there is a high probability that the member’s public debt is sustainable in the medium term”. This, admittedly, does not sound like Greece. In earlier iterations of the crisis the IMF was able to waive these requirements as there was “a high risk of international systemic spillover”, which is no longer present. In the end this did not impact approval of the package in the Bundestag, which had previously indicated it would not approve the bailout without IMF involvement.
Meanwhile the Greek government called for snap elections on September 20th in a bid to give the ruling Syriza party the mandate to follow through on the harsh austerity it negotiated in the latest bailout deal. Presumably Tsipras wants to re-establish his mandate whilst he remains popular, and before the electorate has to swallow the bitter medicine of further austerity. He is expected to return to power, though Greek elections have been nothing but volatile. It does, however, seem unlikely that the hard-left that has broken from Syriza, or any other fringe parties, are likely to seize power and unwind the austerity package. On the other side of the fence Merkel has announced she will run for a fourth term in 2017, despite indicating earlier that she would not. She would have been pressured by her party to do so as she remains extremely popular, and a recent poll showed that the CDU may actually win an election outright. There has not been an absolute majority in the German parliament since 1961.
Discretionary Portfolio Changes
In the Australian portfolio we executed the following trades:
In the International Value portfolio we executed the following trades:
Experian is the world’s leading credit bureau, holding data on over 890 million individuals and 103 million businesses. This data and the software and analytics that accompany it are essential and embedded elements to the credit decision process for banks and other providers of credit.
Barriers to entry in this business are extremely high and this is reflected in an EBIT margin of 27% for the group. Experian is number one in its three main geographic markets, and benefits from technology platforms and services that are scalable and portable. There are an increasing number of avenues through which Experian can commercialise its data assets and analytic platforms. These include fraud prevention, healthcare payments and targeted consumer marketing.
Experian current trades on a multiple of about 18x March 2015 cash earnings. We believe the business warrants a multiple of 23.3x. The company has stated it will place a much greater emphasis on return on invested capital in its internal investment decisions and acquisitions, and look for returns well above its cost of capital. Acquisitions will be benchmarked against the return available from repurchasing Experian’s own shares.
Please be in contact if you wish to discuss any of these themes further, or wish to make any changes to your portfolios.