31 March 2015
Themes For March
In March the RBA held fire, though market expectations are in favour of another rate cut if not now, then soon. This comes against a backdrop of gradually deteriorating data for the Australian economy. Meanwhile the Fed removed the word “patient” from its monetary statement, and remains the only major bank that is pondering when to raise rates in the short-term (with the Bank of England looking like it may take a bit longer). Though soft data out of the United States makes us think the Fed will take further pause. We continue to believe that when we finally see central banks acting in a divergent manner this will generate market volatility. Oil also continued its stomach-lurching movies with WTI dropping below $44 at one point. A dramatic fall in rig count has not, as yet, had a dampening effect on inventories. However we believe this dynamic may soon start to play out, so are turning cautiously more positive on oil. Meanwhile equity markets were mixed with the S&P 500 down 1.5%, MSCI Europe up 1.7%, and the Australian market largely flat, all on a total return basis. European stocks have been closing the valuation gap with the United States this year.

Greece – a Progress of Sorts
A broad economic reform plan for Greece won the approval of Eurozone finance ministers and governments. It seems likely, however, that the friction will continue as the details are debated over the course of the year, and as the Syriza leadership butt up against the hard-left of their party. Meanwhile Greece’s finance minister raised the possibility of a referendum or elections to approve the outcome of negotiations. The last time Greece said it would seek a referendum on bailout terms, in 2011, the prime minister was ousted and global markets panicked.

Advance Australia?
Australian Quarterly Wage Growth / Reuters
1503Advance Australia

In Australia the economic data remains unconvincing. GDP data was released for the final quarter of 2014, the 0.5% quarter-on-quarter pace was the slowest since the middle of 2013. Household spending picked up strongly, growing by 0.9%, but non-dwelling construction fell, bringing the total annual decline to 9.1%. The wealth effect apparently continues to support consumer spending, despite constrained wage growth. Wages rose 2.5% last year, which is the lowest growth for 17 years. On the one hand this is a negative, as it constrains consumer spending, on the other hand it is an essential element to Australia’s bid to regain competitiveness. Meanwhile, the terms of trade for the year fell nearly 11%, bringing the total decline since the export price peak in 2011 to more than 25%.

Furthermore an Australian capital investment survey found mining companies will cut investment next financial year by 20%, manufacturers by 20%, and the rest of business by 7%. That would be the worst investment results in 5 years. Capex was also revealed to have fallen 2.2% in the Dec quarter. One thing is clear – if these trends continues there is only more support for the RBA to cut rates further. Though low interest rates have not yet produced any pickup in business confidence, the NAB survey dropped 3 points to zero in February. This is well below the long-run average, and is at its lowest point since the 2013 federal election. We continue to remain cautious on the Australian economy, though believe further rate cuts from the RBA will support the market in the short-term.

China Slows
Chinese Premier Li Keqiang said his government has scaled back the growth target for 2015 to around 7%, which would be the slowest rate of expansion in 24 years. This was in line, or at the top end, of market forecasts. This year China will focus on liberalizing banking and the financial markets, reforming state-owned businesses and fighting corruption, he said. It is always a question of how much of a slowdown in growth the government is willing to stomach in order to enact necessary reform. The slowdown certainly continue apace. Industrial production grew at a 6.8% annual pace over the first two months of the year, well below estimates, and industrial profits were down 4.2%. The value of property sales also fell 15.8% in the first two months from a year earlier. House prices were down 5.7% year-on-year according to Reuters, accelerating from January’s 5.1% decline. In February export orders shrank at their fastest rate in 20 months. The list goes on. All this comes despite figures for lending coming in above expectations. Loan growth actually slowed to $163bn in February, down from $235bn in January, though the $235bn pace set in January was the strongest since mid-2009.

We continue to believe that the slowdown is beyond the government’s comfort zone, and that further stimulus will be carried out. This will buoy markets in the short to medium-term, but in the longer term the combination of exploding debt and slowing growth makes us nervous.

The Curious Case of the United States Consumer
The run of soft data, outside the labour market, continues in the U.S. factory production slipped 0.2% last month after declining 0.3% in January. The market was hit hard off the back of durable goods falling 1.4% in February from a month earlier, versus expectations of a 0.2% rise. January’s orders were also downgraded to a 0.1% contraction, from the previously reported 0.5% rise. The last time durable goods rose was in August, this all points to soft business spending plans. No doubt orders have been impacted by the rising dollar, the West Coast ports strike, and possibly the classic bogeyman of the weather.

U.S. Monthly Home Sales / Reuters
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Meanwhile retail sales fell 0.6% in February, marking the third month in a row of declining sales, expectations were for a 0.3% rise. This comes despite a buoyant jobs market, with jobless claims dropping to 282,000 and unemployment at 5.5%. In addition the housing market remains reasonably solid with prices up 4.5% year-on-year, and new-home sales rising to the highest level in seven years in February to an annualised rate of 539,000 homes. However we believe that in a true bull market for construction this number would be closer to 1m houses built a year. In addition lower petrol prices have delivered a substantial effective tax cut. U.S. consumers are saving the windfall, the savings rate has increased to 5.5%, the highest in two years. This presents a bit of a conundrum, though perhaps missing wage growth which is still the key element.

All these data points have prompted economists to drop their estimates of first quarter GDP by as much as 0.6%, to as low as a 1.2% annual rate. And the case is building for the Federal Reserve to delay a planned boost in interest rates. We believe that whilst this is the case that support for the U.S. market will remain.

Europe – Green Shoots Continue


Data out of Europe continues to improve, albeit from a very low base. It appears that unlike the United States, where consumers have been saving more, European consumers remain happy to increase spending in light of declining petrol prices. This, and the fastest real wage growth since data collection started in 2008, has prompted German business confidence to rise to a seven year high of 106.8 in February. The Eurozone’s combined PMI climbed to 53.7 in February for one of the best readings in years. Germany powered much of the growth, but France also registered its best performance since 2011. GDP growth in the Eurozone was also up 0.3% in Q4 versus 0.2% in Q3. We remain encouraged by European data though are watching closely as European valuations continue to close the gap on U.S. shares.

In Australia the major theme in the market remains the RBA’s easing bias and the hunt for yield. A major beneficiary of this dynamic has been the banking sector. UBS notes that it now makes up 32% of the ASX 300, the largest exposure of any banking sector of any developed market exchange in modern history. UBS also notes that the sector’s forward PE multiple of 15.6X is unprecedented. Though that probably won’t stop bank stocks rising further if the RBA continues cutting, relative to bonds the div yield still looks compelling. This of course means that valuations are likely to correct when rates start rising, though we don’t foresee that in Australia for some time, however a Fed tightening cycle would have some impact also.

Meanwhile dividend growth in Australia was more than double that of earnings in the February reporting season. The payout ratio rose by around 5% to 65%. Dividends grew by 5% for the six months to December, whilst earnings were up only 2%. This may be pleasing for the yield trade in the short-term, but increases the chances of dividend cuts, and a correction, when the cycle turns. The percentage of companies upgrading their profit forecasts was low by historical standards, at 42%. We continue to remain cautious on valuations in Australia, though in the short-term the market is likely to be supported by the RBA.

In the U.S. analysts have been downgrading their estimates for corporate earnings in the quarters ahead, due in large part to the strong dollar. Profits are now expected to grow only 1.9% this year, down from an expected growth rate of 8% in December, and 11.6% in September. First-quarter profits are expected to fall by 4.9% from a year earlier. The last time analysts cut their outlook on annual profit growth by that much was in the six months leading to March 2009, according to FactSet, as stocks were tumbling to their crisis-era lows. And should profit growth come in at the 2.1% rate for all of this year, it would be slowest pace of earnings growth since profits shrank 7.9% in 2009. We believe that with underlying fundamentals for the U.S. economy remaining broadly positive that low expectations represent an opportunity.

Oil – a Slippery Slope?
Oil prices have continued their slide, with front month WTI futures trading below $44 at one point before rebounding at the end of the month. The market took fright that inventories are still building. The amount of oil stored at Cushing has almost tripled since October, to more than 51 million barrels, that is the fastest increase on record. In mid-March nationwide stocks were at 449 million barrels, by far the most ever. However according to the EIA the U.S. is using a somewhat moderate 63% of its storage capacity, up from 48% a year ago. Though elsewhere I have read that storage facilities in the Midwest are about 70% full, while the East Coast is at 85% capacity. In any case the trend appears alarming for the oil price, but how much inventory build is already priced in?



WTI Spot Price / Reuters

1503_The FED

The Fed also released some data on the issue. Its oil extraction index clocked in at 179.8 in February, up 0.4% from January, and up 14.4% from a year ago.


This is striking given that oil and gas drilling has plunged, as can be seen in the chart below. The Fed index for that activity fell 17.4% in February from January, and is down 21.4% from a year ago.  Presumably this should start to feed through to lower production numbers, and higher oil prices. The question is how long will the market take to strike a balance? We are turning more positive on oil, and are watching the space closely.

1503_The RBA

The RBA Holds Fire
Australia’s central bank held its cash rate at the record low of 2.25%. However, the bank said “further easing of policy may be appropriate over the period ahead.” The AUD and stock market reacted strongly (up and down respectively), though this seems like a short-term response given the door is wide open for further increases.

The Fed Loses Patience
As expected the word “patient” was dropped from the Fed’s statement. The Fed continues to soften its language, so as to leave the door open for rate rises. However Yellen remains extremely sensitive to market overreaction, and was at pains to stress that dropping the word “patient” did not mean “we are going to be impatient.” Perhaps more tellingly the Fed downgraded both its forecast of economic growth, and of interest rate hikes. In 2015, for example, they said they expected economic output to expand by between 2.3% and 2.7%, a downgrade from their December estimate of 2.6% to 3.0%. Inflation is now expected to expand between 0.6% and 0.8% in 2015, rising to between 1.7% and 1.9% in 2016 and finally to near 2% in 2017. Importantly the Fed has also revised down its estimate of how low the jobless rate can fall before it starts creating inflationary pressure. In December officials estimated this long-run rate was between 5.2% and 5.5%. Now they say it is 5% to 5.2%. All this points to a potentially later start to raising rates, and a slower pace. This is bullish for the markets.

China Cuts
The People’s Bank of China announced a benchmark lending and deposit rate cut of a quarter percentage point last Saturday. The PBOC lowered the one-year deposit rate to 2.5% and the one-year lending rate to 5.35%. The market reaction was muted, however, as the cut was largely priced in.

Don’t be so Negative
Negative bond yields are popping up all over Europe. Yields on bonds with maturities as long as five years sold by Finland, France and Germany have dropped below zero. In fact more than one-quarter of the entire market of European government bonds now have yields below zero — a total of $2tn, according to JPMorgan. Negative yields may look attractive compared to even more negative cash rates, however perhaps the reason has more to do with QE – investors believe that there will be a willing buyer no matter what. That play could, of course, end very badly.

1503_Dont Be So Negative 1

1503_Dont Be So Negative 2

Discretionary Portfolio Changes
In the Australian portfolio we executed the following trades:

1503_Aus Portfolio

In the international value portfolio we executed the following trades:

1503_International Postfolio

Swatch is positioned in the brackets outside the super-luxury brands, so has weathered the slowdown in Chinese luxury spending well. It has maintained price discipline so is in a position to potentially raise prices, and is also looking to withdraw from supplying parts to the broader market, so may be able to pressure smaller Swiss rivals. Finally it has been hit by the rise in the Swiss Franc, though the greater part of its sales are in USD, which is also appreciating, and therefore looks attractive.

Nordson manufactures products used to dispense, apply and control adhesives, coatings, polymers, sealants and other fluids. Nordson serves many diverse markets, and 70% of sales are from outside the United States. It has a dominant position in very concentrated markets with high barriers to entry. In its best business it has a market share of 60%, and earns an EBIT margin above 30%. We believe Nordson can continue to grow EPS at a rate above 10% pa, so its current trailing PE ratio of around 19X does not look overly commanding.

We continue to believe that central banks will support the market. This increasingly looks to be the case with data in the U.S. softening, and the Fed downgrading their economic forecasts. Of course the longer the stimulus is applied the more potential for unravelling is built up for the future, we remain vigilant of emerging risks.

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