Themes for December

1 December 2014

In December we saw a continuation of recent volatility in the markets. The commodity complex remained under pressure, with the savage correction in energy prices continuing apace. A declining oil price should be a net positive for the global economy, if you assume that it is mostly to do with oversupply, rather than global demand being weaker than expected. The truth will emerge over time, though whatever the reason we are beginning to see the geopolitical fallout. The biggest and most obvious example is Russia, which is heavily reliant on energy exports to finance itself. This, coupled with Western sanctions over Ukraine, has seen the rouble dive and the economy on the brink of a jarring recession. Add in Greece’s return to international headlines due to renewed fears over its exit from the euro, as well as concerns over growth in most major economies outside the U.S., and the perennial central bank guessing game, and you have the ingredients for volatility to continue in to 2015. We will be watching closely.

Geopolitics
Greece’s ASE Index slid 13% in one day as the government announced that voting for a new president would commence. The post is largely ceremonial but if an agreement cannot be made after three attempts this triggers a general election. In the event this is what has transpired, with an election called for January 25th, and currently far-left Syriza leads the polls. Syriza have previously campaigned to rip up the terms of Greece’s bailout, and potentially leave the euro, though they have moved to the centre somewhat since 2012. Current polling shows that Syriza does not have the numbers to form a majority government, indeed the majority of the population do not wish to leave the euro. In addition the improved state of the Eurozone periphery, and pledges from the ECB, mean that the potential fallout from a Greek exit is not as extreme as it would have been in 2012. However the danger of an exit should not be taken lightly. The 1992 Maastricht Treaty, the forebear of the euro, does not allow for a nation to leave the currency bloc. If this were to occur it is undoubtable that we will see extreme volatility as the Eurozone enters uncharted legal waters, and the potential for contagion cannot be ignored.

Japan’s Abenomics and Prime Minister Shinzo Abe’s coalition government easily secured a new mandate in December’s snap election, but a record-low turnout suggested voters may be growing more sceptical that either Abe or the opposition can reflate the economy.

Nearly 200 nations agreed to back a deal that effectively commits the entire world to reducing fossil-fuel emissions, depending solely on peer pressure to ensure compliance. The Lima Accord doesn’t include a binding requirement that any participant reduce emissions by a specific amount, though it is the first agreement that includes commitments from both rich and poor nations.

Ukrainian President Petro Poroshenko said his country is working toward becoming a part of the EU and expects to submit an application for full membership by 2020. In addition most of the Ukrainian parliament voted to join NATO. The parliament officially abandoned its position of neutrality between Russia and the West.

Macroeconomic news

Inflation slowed in Australia as the impact of the lower currency began to dissipate, and was more than offset by a slowing economy. The TD-Melbourne Institute gauge registered an increase of only 0.1% in November, for an annualised gain of 2.2%. However retail sales data was once again a strong number – rising 0.4% in October from September. This followed the 1.3% rise in September. With unemployment rising to 6.3% in November, and our terms of trade declining, it still surprises me that households aren’t looking to increase their saving, even if rising property prices makes households feel richer.

The U.S. remains the one bright spot amongst major economies. Payrolls continue to post big numbers – the acceleration in hiring puts 2014 on track to be the strongest year for job creation since 1999. The services survey from the ISM came in at 59.3 in November, a post-recession high, and up from 57.1 a month prior. The University of Michigan index of sentiment jumped to an eight-year high of 93.8 from November’s 88.8. And finally the U.S. economy grew at a 5% annual rate in the third quarter, the strongest pace in 11 years and much better than expected. As we have discussed previously the missing piece of the U.S. growth story remains wage growth. Compensation per hour increased 1.3% in the third quarter, and growth in the second quarter was downgraded from 2.3% to minus 0.9%. However these numbers are improving, slowly, and we continue to believe that the employment boom will eventually feed in to wage rises as the remaining slack is absorbed in the employment market.

In China the slowdown continues. Research-company Gavekal Dragonomics forecast home completions to fall by 1 to 3% annually from next year to 2025, after almost tripling in 13 years. Meanwhile prices of newly built houses in China fell for the third month in a row in November. Industrial production rose 7.2% in November on an annualised basis, down from 7.7% in October. The Purchasing Managers’ Index from HSBC Holdings Plc and Markit Economics fell to 49.6, indicating contraction for the first time in 7 months. On the positive side (for China at least, not so much for Australia) China’s trade surplus hit a record $54.47 billion in November as falling energy and commodity prices slashed the cost of imports, which fell 6.7%. Overall the data points to a continued slowdown, which is a major contributor to declining commodity prices on the demand-side of the ledger.

The Eurozone continues to struggle. Markit said its composite PMI, which was downgraded to a 16-month low of 51.1 for November, suggested the Eurozone will grow by only 0.1% in the final quarter of 2014. The lack of demand in the region is evidenced by disappointing lending data for November, where loans to the private sector contracted 0.9% year on year, following a contraction of 1.1% in October. This comes despite the ECB offer of ultra-cheap four-year loans to the banking sector. Lending was especially weak in the periphery, Ireland -11.4%, Spain -8.5%, Portugal -6.5%. Meanwhile Russian GDP registered its first contraction in five years, shrinking 0.5% in November from October. More pain is expected ahead as sanctions and low oil prices continue to bite. The Russian government forecast a contraction of as much as 4% in the new-year.

In Japan markets continue to wait for meaningful structural reform, which may arrive after Abe re-established his mandate. Meanwhile the reported data remains soft. Real wages slid for a 16th straight month in October, with paycheques down 2.8% from a year earlier. Retail sales slid 0.3%, while consumer prices excluding fresh food rose 2.7% from a year earlier. Fresh from a new electoral mandate the government did announce a $29bn stimulus package aimed mainly at accelerating consumer spending, however analysts doubted the scale is enough to yield much effect.

Australian Equities
Australia’s Financial System Inquiry recommended much higher capital holdings for the nation’s banks. It estimated that Australia’s big banks have a common equity tier one capital ratio of between 10-11.6%, which is below the 12.2% level held by the top quartile of international banks. The review did not set a specific figure for the level of capital banks should hold, but recommended that they maintain adequacy ratios within the top 25% of global banks. This would mean somewhere between $20bn and $45bn of extra capital required depending on what assumptions you use. This was towards the low end of what had been suggested by analysts.

NAB sold a further $2.3bn of loans in its British real estate portfolio, taking another step towards exiting the U.K. market.

Qantas came in from the cold with an upgraded full-year profit forecast that could easily exceed $600m based on pre-tax profit guidance for the second half of up to $350m. The last time Joyce stood in front of investors he was announcing a $2.8 billion loss for the 2014 financial year. He is now looking at paying down $900 million of debt in 2015, potentially taking on a new unspecified number of 787 Dreamliner aircraft and even reintroducing dividends. The improved picture was driven by the cost-cutting program and the decline in the oil price.

Recall finally received a $2.2bn bid from Iron Mountain. It was pitched at $7 a share, and is about 80% scrip. UBS reckons Iron Mountain could pay $8 a share for REC and still generate about 15% accretion to cash flow per share. This assumes $130m in cost synergies (5% of the combined cost base).

Santos was forced to delay its putative debt raising until market conditions improve. This puts its progressive dividend policy under threat.

Telstra negotiated a four year NBN deal worth $390m to assist NBN Co with their modified rollout plans.

Rates / FX / Commodities
The commodity complex posted further losses in December. Overall in 2014 commodities posted their biggest annual loss since 2008, and have retreated for four years running now. The Bloomberg Commodity Index, which tracks 22 products from crude to copper, dropped 16%. Energy prices retreated in 2014 as a jump in U.S. drilling sparked a surge in output and a price war with OPEC, which chose to maintain supplies to try to retain market share. A slowdown in China also hurt demand for raw materials as policy makers grappled with a property slowdown. Commodities have tended to do poorly in years of dollar strength, which looks set to continue. The Bloomberg Dollar Spot Index, which tracks the U.S. currency against major peers, advanced 11% in 2014.

Although the U.S. and U.K. central banks will be scaling back stimulus in 2015, Credit Suisse reckons that the ECB and Bank of Japan will more than compensate with total balance sheet growth of $1.3trn. That would mean a monetary expansion of 13% in 2015, versus 5% in 2014. Meanwhile markets were initially disappointed by the lack of action from the ECB at December’s meeting. However two bank officials suggested the bank will consider putting in place a bond-buying program next month that may include a broad range of assets (but no equities or gold). Draghi also indicated strongly that he would not allow any blockage of necessary action, clearly aimed at Germany.

Russia’s central bank raised its benchmark interest rate to 17.5% from 10.5% in one move, the largest increase since the nation’s 1998 default, hoping to stem the decline in the rouble. The rouble still fell 11% the next day, and finished the year down nearly 50%.

For the Fed watchers out there – the December announcement shifted from keeping interest rates low for a “considerable time” to being “patient” on when to raise rates. This was broadly interpreted as wanting to give themselves more flexibility on when to raise rates.

Portfolios
In the Australian equities portfolio we trimmed our Amcor and Transurban positions after a strong rally in both names, and are looking to increase our Telstra long should we get a pullback in the share price.

In the international value portfolio we sold down Schlumberger to zero in light of the OPEC decision, and the rapidly changing fundamentals for oil. In addition we increased our holding in W.W. Grainger and Legrand as the investment case remains strong for these names, though their performance does not reflect this.

In the international growth portfolio we reduced exposure to Sumitomo Mitsui Financial Group and added Mitsubishi UFJ Financial to diversify our Japanese bank exposure. We sold LyondellBasell Industries as it is sensitive to the oil price vis-à-vis its ethylene business. We bought Wells Fargo as its focus on retail business continued to prove successful. We reduced our exposure to Google as increasing development and acquisition costs caused concern. We also reduced exposure to Skyworks to take profits after a strong run.

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