28 February 2015
Themes For February
In February we have seen the continuation of recent themes. The Greeks and the Troika continue their wary dance, with a tragedy averted for the time being. This probably remains the main geopolitical flashpoint for global markets, though the market is increasingly pricing out the risk of a traumatic event. We hope this remains the case. In the meantime the overarching input in to asset valuations remain the actions of central banks. After much speculation the RBA finally joined in, and cut the benchmark rate by 0.25% to 2.25%. This was perhaps inevitable when just about every other major central bank is cutting rates, and when economic growth is slowing, unemployment increasing, and inflation remains benign. It seems the domestic cutting cycle is not over, and the Australian market will remain supported by monetary policy. This does, however, only increase the potential for a large market pullback at some point, but history has shown that in the short-term investors are best not to fight the central banks.

Greek Tragedy Averted?
Drama and machinations continue to swirl around Greece. Largely this has been a process of the new Greek government waking from the dream of economic liberation / revolution, and finding that without the co-operation of their creditors, the hated “troika”, a bank run and subsequent economic collapse was likely imminent. Details have yet to be confirmed but Syriza has backed away from its election pledges to write down much of its EUR315bn foreign debt, and initially suggested swapping outstanding debt for new growth-linked or perpetual bonds. This was unacceptable to the troika, who have instead arranged an extension of the original bailout terms, and are awaiting confirmation from the Greeks on exactly what economic reforms they will enact. Tsipras and his finance minister had conducted a European tour looking for allies, but didn’t have much luck, and I am sure his pledge to seek World War Two reparations from Germany didn’t help. The fear is that being too lenient would spur far-left and far-right parties to electoral success elsewhere. Tsipras must feel like he has to deliver on his election promises, his campaign was based on an end to austerity, so the drama is likely to partially move from Greece’s relations with its creditors to internal ructions. The markets seem to have discounted a Greek tragedy for now, but this is still very much on our radar.

Global Credit – Back to the Future?
0215_Global Credit
Seven years after the global credit bubble started unravelling, debt has continued to grow strongly. In fact, according to a Mckinsey report, rather than deleveraging, all major economies today have higher levels of borrowing relative to GDP than they did in 2007. Global debt in these years has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points. Household debt is reaching new peaks. Only in the core crisis countries—Ireland, Spain, the United Kingdom, and the United States—have households deleveraged. In many others, such as Australia, household debt-to-income ratios have continued to rise along with property prices. This should not necessarily be a surprise given the action of central banks, but haven’t we read this script already?

Fuelled by real estate and shadow banking China’s total debt has nearly quadrupled, rising to $28 trillion by mid-2014, from $7 trillion in 2007. At 282% of GDP, China’s debt as a share of GDP, while manageable, is larger than that of the United States or Germany. This debt burden is a concern for three reasons: half of all loans are linked, directly or indirectly, to China’s overheated real-estate market; unregulated shadow banking accounts for nearly half of new lending; and the debt of many local governments is probably unsustainable. China’s government should have the capacity to bail out the financial sector should a property-related debt crisis develop. However the process is bound to be messy.

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Government debt is unsustainably high in some countries. Since 2007, government debt has grown by $25 trillion. Some of this debt, incurred with the encouragement of world leaders to finance bailouts and stimulus programs, stems from the crisis. Debt also rose as a result of the recession and the weak recovery. For six of the most highly indebted countries, starting the process of deleveraging would require implausibly large increases in real-GDP growth or extremely deep fiscal adjustments. To reduce government debt, countries may need to consider new approaches, such as more extensive asset sales, one-time taxes on wealth, and more efficient debt-restructuring programs. The bills from the crisis still haven’t been paid.

Australian Crawl
In Australia most fundamentals are deteriorating, albeit at a slow pace. The unemployment rate jumped to 6.4% in January, with the number of people employed falling by 12,200. The data out of the ABS does seem to be quite volatile, the unemployment rate had previously dipped strongly, so a few more months’ data would give us more confidence to make any conclusions, however the trend is troubling. Consumer confidence is at its lowest level of the past five easing cycles, despite the drop in fuel prices, and business conditions have held at soft levels according to NAB’s January business survey.

0215_Aus Crawl

Meanwhile political instability in Australia is likely to delay the already-slow pace of reform here. It may be worth reminding ourselves why reform is so necessary. In short – we are an expensive place to do business. Our average wage and input costs are high, our minimum wage is the highest in the world, and the regulatory and labour market regime is generally inflexible. The circus in Canberra is not going to help with any of that, perhaps we will just need a good old-fashioned crisis at some point to sharpen minds.

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In terms of the market, however, clearly it is not fundamentals driving valuations right now. It is the RBA. We don’t see that changing in the short-term, some unforseen crisis aside, though we remain cautious.

United States – Still the Main Game in Town
As we have discussed in previous notes, the U.S. has slowed somewhat but most data points remain broadly positive. New home starts reached an annual rate of 728,000, the highest rate since March 2008. Jobs-creation continues apace, a total of 257,000 new jobs were created in January. There also was an encouraging increase in hourly earnings in January, the biggest since November 2008. On the negative side the decline in U.S. retail sales that took hold in December extended into January, with sales down 0.8% from a year before. Consumer confidence was also down with the Thomson Reuters/University of Michigan index falling to 93.6 this month from 98.1 in January. Meanwhile the rising U.S. dollar began to tell in December as the U.S. trade deficit surged 17.1% to $46.6 billion, the biggest gap in more than two years. We remain positive on the U.S. though are keeping an eye on the rising dollar and the potential for Fed rate rises. Keep in mind that exports constitute around 14% of GDP, so a rising dollar is meaningful, but not a reason to turn completely negative at this stage.

China – Bad News is Good News?
In China all eyes are on the central bank and government, with the expectations of added stimulus as the data remains broadly soft. Therefore the scenario that bad news is good news, which has been a recurrent theme in many economies since the financial crisis, though is possibly a short-sighted investment thematic.

The price of new homes in 100 Chinese cities edged up 0.21% in January, marking the first gain in nine months, according to a report by the China Index Academy. Prices were up in 44 of 100 cities. Structural issues remain, and it would be surprising to see a sustained bounce, however we have seen what an easing bias from central banks can do for property markets elsewhere. Meanwhile declining domestic investment options meant that in 2014 China became a net exporter of capital for the first time ever, according to the Ministry of Commerce. Direct outbound investment and investment through third parties totalled $140bn, while inbound investment was $119.6bn. When, and if, China properly liberalises its financial markets this trend may abate.


Chinese annualised inflation fell to a five year low of 0.8% in January, though The Economist argued that this was largely due to spending leading up to Chinese New Year, which varied in month from 2014 to 2015. However the economy is clearly continuing to slow down – steel prices have fallen 12% in the first five weeks of the year, almost as much as in all of 2014. The tonnage of iron ore imports is down 9.3% in January from a year ago, while the tonnage of imports of refined products like gasoline and diesel was down 37.6%. Meanwhile China is reportedly setting a “bottom line” for annual growth of 6.5% in its latest five-year plan. This year’s forecast is for 7% growth, but the 6.5% floor over the remaining years of the plan would mark the slowest annual growth since 1990.

We remain cautious on China, though believe further stimulus is likely. However it is worth noting that the market is partly pricing this stimulus in, so if it does not materialise there could be turbulence. In addition Australia’s terms of trade are likely to continue declining.

Europe – Continues to Bounce off Low Expectations
The upside of falling prices is it continues to spur retail spending in the Eurozone, with retail sales rising 2.8% year-on-year in January. In theory falling prices should delay consumer spending, as the goods and services you buy will be cheaper in the future. Presumably the rise is driven by the nature of the deflation, in that falling petrol prices are like a tax cut, however we are seeing consumers react differently in different regions. The fear is that falling energy prices will translate to even lower inflation expectations across the board, which can then impact core inflation. Consumer confidence also ticked up in January to a six-month high.

In Germany consumer spending picked up in the fourth quarter of 2014, spurring a 0.7% increase in GDP. And real wages rose 1.6% last year, the most since data collection started in 2008. Spanish GDP also expanded at 0.7%, its fastest rate in seven years. France and Italy meanwhile are still stuck in neutral, registering next-to-no growth, and France saw deflation of 0.4% in January. Overall the 0.3% gain in the fourth quarter meant a 0.9% rise in GDP for the Eurozone in 2014. The composite PMI also rose to 53.5 from 52.6 in January. Hardly setting the world on fire, but around the middle of the year it looked like it could be a lot worse. Is this the start of a turning point for Europe? I would argue that high unemployment is likely to make any recovery a long-simmering affair, but valuations look compelling enough on a relative basis that we are turning less negative on Europe.

Inflation – Still Looking for the Genie
Inflation across the 34 members of the OECD fell in December to its lowest point since 2009, averaging 1.1%, down from 1.5% in November. The OECD cited low energy prices, but also noted generally sluggish economic performance that could presage deeper cuts in benchmark interest rates. According to the OECD, 13 of its members experienced a decline in prices over the 12 months to December, only one of which wasn’t European: Belgium, Estonia, Greece, Hungary, Ireland, Israel, Luxembourg, Poland, Portugal, Slovakia, Spain, Sweden and Switzerland. Inflation remains an incredibly important thematic for global economies and markets. The lack of inflation, and the spectre of deflation, are a key factor driving central bank rate cuts at the moment. And it is the actions of central banks that remain one of the key drivers of asset valuations. When the inflation cycle starts turning, it will be a major event for all markets.

The RBA lowered the benchmark rate by 25 bps to a new record low of 2.25%, its first change since August 2013. This sent the AUD sharply lower, though it recovered quickly. AUD assets may still look attractive when central banks the world over are cutting, though we believe with further RBA cuts likely the AUD will remain under pressure.

In China the central bank is cut the reserve ratio by 50 basis points, and the bank noted that it injected 375 billion yuan worth of three-month loans into major banks in the final two months of 2014. There is definitely and easing bias.

Discretionary Portfolio Changes
In the Australian equities portfolio we made the following trades in February:

Code Change Rationale
QBE 1.1% Results show QBE is finally moving on from restructuring. Adding to Position.
REC (2.6%) Taking profits, some chance the takeover falls over. Sold all shares.
BXB (1.3%) Taking profits after strong performance. Partial sale.
CSL 2.1% Price dip post-results unwarranted. Adding to Position
AIO 2.0% See Note. New position.
SHL (1.1%) Taking profits after strong performance. Partial sale.
BHP (1.1%) Reducing exposure, the commodity complex likely to remain under pressure. Partial sale.
EGP 2.0% See Note. New position.
IPL (0.9%) Taking profits after strong performance. Partial sale.

AIO looks like it will deliver on its $300m cost-saving target by FY16. Recent results were in-line and the dividend was at the top end of consensus, we believe management will continue to raise dividends through stronger cash flow and higher payout ratios.

EGP has a smaller exposure than Crown to the VIP market, and no overseas exposure to Macau or other troubled regions. It is priced on a similar EV / EBITDA, but has more positive optionality for the short to medium term.

In the international value portfolio we made the following trades in February:

Code Change Rationale
GWW 1.25% Business performing in-line with view, valuation remains cheap. Adding to position.
ECL 1.25% Business performing in-line with view, valuation remains cheap. Adding to position.
PX (0.75%) Reducing Position after slightly disappointing result. Partial sale.
FISV (1.00%) Taking profits after strong performance. Partial sale.
AXP (2.50%) Loss of Costco contract is material at 10% of cards in force. Sold all shares.
OMC 0.50% Business performing in-line with view, valuation remains cheap. Adding to position.
REL 0.50% Business performing in-line with view, valuation remains cheap. Adding to position.

Our broad thesis remains that, excepting some exogenous shock, markets will continue to be broadly supported by central bank action. This narrative may start to shift, however, when the Fed starts having a discussion about raising rates. Whilst other central banks will likely remain in an easing cycle, this dichotomy itself will likely increase volatility. We remain sensitive to this risk and may look to portfolio protection if we see this risk increasing.

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