31 January 2015
Themes for January
2015 began with a continuation of the volatility we saw at the end of last year. The dynamic of over-supply and slowing global growth continues to rattle commodity markets, whilst central bank moves have driven bond markets higher. For equity market volatility both these factors have been important. Commodity moves have triggered greater equity volatility, whilst central bank actions have served to reduce volatility, except perhaps around announcement dates, by offering “free downside insurance”. However perhaps the biggest factor in equity volatility of late has been concerns around Greece, again, which we discuss below.

It is perhaps worth asking how volatile equity markets are currently compared to history. The chart below shows the 90 day realised volatility in the S&P ASX200 since the start of 2002. You can see that since the back half of last year equity volatility has increased markedly, rising well above the one year moving average (the blue line). However on a longer timescale current volatility is not abnormally high and, as mentioned above, central banks are effectively supressing it. This will not continue indefinitely, indeed the Fed is likely to start raising rates this year, so current market moves are likely to be a taste of what is to come. Having said that with most central banks outside the U.S. on an easing bias, those days of reckoning may be some time away yet.

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Developments in Greece
In Greece the anti-austerity party Syriza won a larger-than-expected victory in the snap poll, and successfully formed a coalition government. Whilst this was expected, and had already been a key driver of volatility coming in to the election, it is unclear what will happen from here. What we have seen so far is a lot of stacking of pieces on the board, and practitioners of game theory have a juicy problem to sink their teeth in to. Syriza’s leader Alexis Tsipras began with emollient words, stating that the “new Greek government is ready to cooperate and negotiate with Greece’s partners a just and viable solution…. there will be no catastrophic clash”. However immediately after this the government halted the privatisation of several government-owned transportation and energy companies, promised to rehire thousands of sacked pubic workers, and the finance minister said the new government will turn its back on the rescue program that allowed Greece to pay pensions and public wages for the past five years. This latter action caused Greek bonds to tumble. The Euro-area finance chiefs have signalled a willingness to negotiate, but not to write down the value of the debt. I think a deal could have been struck to relax the fiscal constraints on Greece, and to enact some form of debt restructuring, but with so many of the hard-fought structural reforms being wound back by Syriza at a rapid clip these negotiations will be fraught.

In Australia political ructions have provided much distraction, and is unfortunate at a time when we need the government to be able to present and enact a message of structural reform. Meanwhile the data remains mixed. On the positive side the $925m trade deficit in November turned out to be considerably better than the AU$1.6bn originally predicted. Employment figures for December were also a positive surprise with the unemployment rate unexpectedly easing to 6.1%. The quality of jobs added also looked good, with 41,600 full time jobs added, and 4,100 part-time jobs lost. Though perhaps we should take any employment data from the ABS with a grain of salt whilst they work through their sampling issues. On the negative side business sentiment continues to decline according to NAB, and our terms of trade also continue to decline.

Our outlook remains cautious on Australia. The political distractions only delay the conversation that needs to be had with the electorate, to convince them of the need for restructuring. The decline in the currency will help with this, but there are still too many hindrances to our global competitiveness.

United States


In the United States the employment numbers continue to impress. Job growth in 2014 ended up at 2.95m new jobs, the best showing since 1999. These are fantastic numbers, though for December’s release the market honed in on the 0.2% decline in average hourly earnings, which nearly erased November’s gains. This is one of the great macroeconomic conundrums in the U.S. at the moment. How do you reconcile galloping employment with negligible wage growth? One possible factor is the population outside the workforce, who have given up looking for a job and may be re-entering the workforce. Though the declining participation rate seems to discount this. Some economists believe that the “natural rate” of employment, the rate at which the employment market is in equilibrium, might be lower than it has been historically. This means that there may be more slack present than would appear in the headline numbers. We continue to believe that wage growth should be forthcoming. Indeed a National Association for Business Economics survey revealed plans for more hiring as well as bigger pay envelopes among 51% of businesses this quarter, up sharply from 34% in the previous survey. This will be positive for the U.S. consumer and therefore the U.S. economy (don’t forget the consumer is just under 70% of the economy). Though it is somewhat ambiguous for U.S. stocks, as the consumer effect would be partially offset by reduced profit margins, and is potentially negative for markets in general if it spurs the Fed to raise rates.

Meanwhile U.S. growth for the third quarter was revised up to a blistering 5%, the fastest pace since 2003, following 4.6% growth in the second quarter. Data in the fourth quarter, though, has been a bit more variable. In December producer prices dropped 0.3%, the biggest drop in three years. Non-defence capital goods orders excluding aircraft, a closely watched proxy for business spending plans, dropped 0.6% in December after a similar decline in November. Orders for these so-called core capital goods started falling in September, producing the longest downward stretch since 2012. This likely reflects weak overseas demand for capital goods, and weak domestic demand for energy-related equipment. All this contributed to U.S. economic growth easing to 2.6% in the fourth quarter. Given the slow start to the year overall growth for 2014 clocked in at a respectable 2.7%. On the brighter side U.S. consumer confidence strengthened to 102.9 from 93.1 in January, its highest level in more than seven years.

We continue to have a positive outlook on the U.S. given the strength in the employment market, deleveraged households and cashed-up corporates.

We saw mixed news out of China. On the positive side the trade data for December was surprisingly strong, with a 9.9% year-on-year jump in exports, and a contraction in imports of 2.3%, producing a record trade surplus. On the negative China’s industrial profits fell 8% year-on-year in December, marking an acceleration in the sector’s sliding profitability since November, when profits fell 4.2%. In addition the price of houses slid 0.3% month-on-month in December, and the official PMI slipped in to contraction, to the lowest level since September 2012. Despite all this China managed GDP growth of 7.4% for 2014 due to better than expected numbers for the December quarter of 7.3% growth. It was still the weakest annual growth since 1990.


Meanwhile the spectre of a Chinese credit bust was reinforced by new data. China’s shadow-banking sector saw record lending activity in December, even as lending by banks came in around 20% less than expected, despite reduced interest rates. Total social financing, which includes shadow lending, rose to $270bn from $186bn in November according to Standard Chartered. Their analysis found China’s debt-to-gross domestic product ratio jumped from 147% to 251% over just six years, placing it just behind the U.S.

Our outlook for China remains mixed. On the one hand no country has historically experienced such rapid credit growth without a subsequent bust. And sliding inflation, house prices, and imports, speak of weak domestic demand. On the other hand the government has ample firepower to support the system should a crisis emerge, indeed its very existence relies on economic and employment growth. We believe they will act accordingly.

Europe – Deflation


We have spoken about it for some time, but the deflation story in Europe is now coming to a head. Wholesale prices fell for the fourth month running in December, and consumer prices finally tipped in to deflation with a -0.2% reading. This is the weakest reading since September 2009, and is down from +0.3% in November. Meanwhile the unemployment rate in November was unchanged at 11.5%. The backdrop was undoubtedly there for the ECB to take action (discussed below).

Meanwhile for the first time in a while, some data points have turned positive in Europe. The German economy bounced back somewhat from zero growth at midyear to finish 2014 with 1.5% growth. The government budget surplus was 0.4% of GDP for the final quarter, the second-highest since reunification, and in stark contrast to most other European countries. This gives you a sense of the friction in the Eurozone, where exchange rates obviously can’t adjust, and trade imbalances can persist. Elsewhere U.K. inflation collapsed to a 0.5% annual rate in December with the declining oil price. GDP also matched this figure, growing 0.5% quarter-on-quarter in Dec, with the struggling Eurozone taking a toll on growth.

Our outlook on the Eurozone remains cautious. We believe it is likely the Greek issue will be resolved without a Eurozone break up, but don’t see any imminent exit from the zone’s structural issues. On the other hand European equities trade at a steep discount to their U.S. counterparts, so even limited growth could spark a rally, and some data points are ticking up.

Australian Company News
– Orica has indicated it may return capital to shareholders following the $750m sale of its chemicals business, which is expected to be concluded before the end of March.

– Santos has indicated it may look at asset sales to shore up its balance sheet. Woodside warned of spending cuts and $400m of write-downs. Oil Search warned of a 200m write-down. In other commodities news, according to Bernstein, Vale is now the lowest cost producer of iron ore, over BHP and RIO. This is due to the oil price slump cutting shipping costs.

– Figures from Veda showed that demand for business credit in Australia slowed in December, the banks had been expecting business lending to accelerate.

– Transurban’s Queensland Motorways acquisition, as well as healthy traffic growth, boosted revenues by almost 37% in the Dec quarter to $761m.

International Company News
– U.S CEOs are the most bearish since the financial crisis according to research from Bespoke Investment Group. The percentage of companies cutting profit forecasts during this earnings season was greater than those raising by 8.6%, the widest margin in six years.

– Google Inc.’s dominance of the U.S. internet search market slipped last month in the biggest drop since 2009 while Yahoo! Inc. posted its largest share gain, as the companies grappled with the fallout of a search deal on Firefox browsers. Despite this Google’s revenue grew 15% in the fourth quarter but fell short of Wall Street’s target as foreign exchange and falling ad prices weighed on the company. While the number of consumer clicks on its ads increased 14% year-on-year, “cost per click” decreased 3%, as more consumers accessed its online services on mobile devices, where ad rates are typically lower.

– Visa announced an 11.5% increase in profit during the quarter, as a strengthening U.S. job market and cheaper gasoline prices encouraged people to spend. Beating both top and bottom line estimates, net income rose to $1.57bn from $1.41bn, a year earlier. Visa also announced a four-for-one stock split, cutting its weight in the Dow from 9% to 2.5%. This demonstrates why price-weighted indices such as the Dow and the Nikkei are nonsensical as a benchmark!

– Yahoo announced a tax-free $40bn spinoff of its entire stake in Alibaba Group Holding Ltd., seeking to maximize its return of cash to shareholders and minimize taxes on the sale.

Interest Rates
For the first time ever, the average 10-year bond yield of the U.S., Japan and Germany has fallen to less than 1%, which is even lower than during the Great Depression. This is a strong signal that bond markets don’t expect the global economy to generate much growth for a long time. Though to be fair the structure of financial markets has changed somewhat since the 1930s, so the “natural” interest rate is lower than it used to be.

Central Bank News
It has been a very busy period for central banks! The undoubted trend has been for further easing:

– Not long after a top legal adviser to the European Union indicated that a QE program would fall within the boundaries of the law, the ECB announced a program that was larger than expected. The program exceeded expectations by agreeing to buy €60 billion in government bonds per month, in addition to purchases of asset-backed securities and covered bonds, for a total balance sheet expansion of more than €1 trillion. This sent the EUR to its lowest value versus the dollar in more than a decade.

– Financial markets around the world were rocked as the 3-year-old cap on the Swiss franc against the euro, at CHF1.20, was suddenly removed. The move caught markets by surprise as the Swiss central bank had recently described the measure as a cornerstone of its policy. The bank also lowered its deposit rate to -0.75%. The exchange rate moved nearly 20% in one day. This is a very apposite example of how central bank actions can suppress volatility only for it to pop up again somewhere, or sometime, else.

– India’s central bank cut interest rates by 25 basis points to 7.75% in an announcement outside its normal schedule. This was in reaction to signs that inflation is easing.

– The Canadian central bank surprised economists and traders with an interest-rate cut that brings the overnight rate among commercial banks to 0.75%. The Bank of Canada said it acted to protect the economy from risk brought on by plunging oil prices.

– Edging away from the doves the Federal Reserve has indicated that it won’t increase interest rates before June but remains silent about what happens after that. Although the central bank’s policy committee is upbeat about the economy, it says it expects a deepening of inflation slowdown.

A number of other central banks also cut rates. This is in response to slowing growth, and slowing inflation (disinflation). This speaks of slow growth, but for bond and equity markets the bullish message is clear.

Discretionary Portfolio Changes
In the international growth portfolio we sold Mitsubishi UFJ Financial Group and bought Iron Mountain. We have reduced our weighting to Japanese financials given uncertainty over the government’s reform program, though still maintain a position in Sumitomo Mitsui Financial Group. We have added Iron Mountain due to its dominance of the document storage business and compelling valuation.

It is interesting times for the markets. On the one hand global growth outside the United States is slowing, and geopolitical issues remain at the fore in Greece, and to some degree Ukraine. However we have seen central banks taking action to combat the spectre of deflation, and we know from history that it does not pay to fight the central banks. How it ends up in the medium term is hard to say, but it does seem clear that the environment for higher volatility remains intact.

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