31 May 2015
Themes For May
In May we saw the RBA cut rates for the second time in three months, and the Aussie banks sold off as NAB and WBC announced capital raisings, and regulatory pressures increased. The Financials sector finished the month down 1.7%. Elsewhere the Greek psychodrama continued with a likely climax, at least to this round of negotiations, due next month. The U.K. also opened up a second fissure point for the EU with a surprise election win for the Conservatives putting an EU referendum on the table for 2017, or possibly earlier. Meanwhile Europe grew at a faster rate than the U.S. in the first quarter, though forward looking indicators seem to indicate a rebound for the latter. Despite concerns around Greece the S&P 500 finished the month up 1%, the FTSE closed flat, and the Nikkei 225 closed up 5.3%, with the local market gaining 0.4%.

Greece – Deadline Fast Approaching

Much to our surprise Greece managed to make a payment to the IMF of EUR 750m due on May 12th. However it was later revealed that Greece pulled off this feat by pulling EUR 650m from its own reserves with the IMF. This is a bit like writing a cheque to yourself to clear your bank overdraft, and the money needs to be replenished within a month. Meanwhile June is the end of the line for negotiations, with EUR 1.6bn of repayments to the IMF coming up, and the European support package coming to an end. Furthermore the deposit outflow continues apace, in the four months to March about 16% if the deposit base has been pulled out of Greek banks.

However progress in negotiations has been fraught. Greek Prime Minister Alexis Tsipras railed against demands being made by creditors, suggesting a referendum would be necessary if any agreement departed too far from election pledges. Though a new poll showed over three-quarters of Greeks feel Athens must strike a deal at any cost to stay in the euro. It is hard to see how this ends though we still believe some kind of muddle through as the most likely outcome. A plausible scenario might see some kind of compromise agreed at the eleventh hour, with the ECB stepping in to provide liquidity and facilitate repayments of the June debts, and a referendum on the package held shortly after. There are plenty of potential pitfalls between here and there.

U.K. Election Surprise
The pollsters were confounded by an unexpected majority for the Conservatives in the U.K. election, winning 331 seats out of 650. This saw the Labour opposition leader, the Lib-Dems leader, and the UKIP leader all resign. It means there will be a referendum on the United Kingdom’s membership of the EU in 2017, if not earlier, which would also likely trigger a second Scottish independence referendum. Does this, perhaps, make it more likely that the EU will fight harder to keep Greece in the club, so as not to have major fissures on two fronts? Up until this point European leaders had not taken the referendum too seriously given the likely messiness of governing the U.K. in coalition.  Merkel has since come out and signalled a readiness to work with the U.K. to prevent the latter from exiting the EU, though EU treaty revisions have a bumpy history so it is unlikely Europe will embrace too large a divergence from the status quo.

The RBA Fires Again
The RBA cut its benchmark rate by a quarter point, the second cut in three months. The 2% cash rate is at its lowest since the 1950s. Bank Governor Glenn Stevens cited significant weaknesses in the economy, despite recent evidence of somewhat improved domestic demand and employment. Peter Arnold, banking analyst at, said typical borrowers would save around $1200 this year on their home loan repayments compared with what they paid the previous year. For a lot of people in the capital cities it will be around double that. The market was disappointed by the dropping of the easing bias language from the statement, but the RBA subsequently made it quite clear that they still have room to act. No doubt they were annoyed by the AUD rally after the last rate cut.

Australia’s Fantasy Budget
Australia’s unemployment rate rose slightly in April to 6.2%, up from 6.1% in March, with jobless rates jumping in Western Australia, South Australia, and Tasmania. Meanwhile we saw the release of the May budget which relied upon some heroic assumptions to keep the deficit under control, with expected growth of 3.5% in fiscal 2018 and 2019, a level unseen in six of the past seven years. This seems like an unrealistic trajectory. The projected deficit through June 2016 of 2.1% of GDP was also less than expected. Even so total debt is projected to hit a 21-year high. Meanwhile the RBA rate cut seemed to inspire consumers, with confidence rising 1.7% in the week following, and 3.6% the week after that. On the other hand the ABS reported a 4.4% fall in dwellings approvals between March and April. And with unemployment likely to trend higher we are not likely to see a large bump in consumer spending, we remain cautious on Australia.

Australian Banks Wobble
Reporting season saw underwhelming results for the Aussie banks, though no large misses. However other factors may have been more important for what has been a decent sell off in the majors. First was the decision by NAB and WBC to raise capital, which is a logical outcome of an increasingly stringent capital regime and elevated share prices. Second was the increasing concern over regulatory pressures. Data showed that in the year ended March 31st the banks expanded lending by 10.4%, more than the 10% designated by APRA as a threshold for greater regulation. In response to this the banks have been pulling back from their more aggressive efforts to boost their loan books. This coupled with profits driven by historically low bad debts, and dividend yields driven by historically high payout ratios, meant the banks were primed for a pullback. Rising bond yields have not helped. We believe that this may be approaching top of the current cycle for the banks, though they are likely to be supported by relatively attractive yields in the short to medium term.

United States – a Mixed Bag
In the U.S. we saw mixed data, but overall an improvement from Q1. Consumers had a soft patch with flat spending in April after a revised 1.1% rise in March, and the consumer sentiment gauge fell from 90.7 in May from 95.9 in April. Industrial output also declined 0.3% in April, however the more forward-looking manufacturing survey picked up in May for the first time in seven months, with the ISM rising to 52.8 from 51.5 in April. Sale of new homes were up an annualised 6.8% in April and construction spending was at a 6 ½ year high. Employment markets remain very positive with jobless claims remaining at a 15 year low, and wage growth ticking up a bit. Average hourly earnings increased 3 cents to $24.87 an hour. Over the past year, pay is up 2.2%, and a 0.3% rise in core U.S. prices last month brought the annual inflation rate to 1.8%. The annual rate is approaching the Federal Reserve’s target of 2%.

All this seems to point to an economy exiting its Q1 funk, where we saw GDP revised down to -0.7% from +0.2%. The biggest driver was the increase in the trade deficit, which was the largest amount since 1999. Economists have revised growth expectations for the calendar year down from more than 4% to less than 3%. However we still remain positive on the U.S.

China Slows, the Government Responds
The overall value of China’s foreign trade fell 10.9% in April, compared with a year earlier, the General Administration of Customs said. Imports declined 16.1% and exports dropped 6.2%. Meanwhile China’s producer prices dropped 4.6% year-on-year in April while consumer prices rose 1.5%, falling short of expectations and the government’s 3% target. Banks made $114bn of new loans in April, much less than expected, and house prices maintained the yearly declining rate of 6.1%. All this speaks to a slowing economy, as we have seen in prior months. However the government is clearly responding. Fiscal spending was up over 33% in April, from a 4.4% increase in March. Meanwhile the Chinese central bank cut interest rates by a quarter point, the third cut in six months. The deposit-rate ceiling will also be expanded to 150% of the benchmark from 130%.

Europe Outperforms the U.S.

Europe Out performs US
European economies collectively grew faster than the U.S. in the first quarter with a 0.4% gain, following an increase of 0.3% in the fourth quarter of 2014. This was the fastest rate of growth in two years, and the first time since 2010 that all four of the Eurozone’s largest economies grew at the same time. France, Italy and Spain were surprise gainers, while austerity-saddled Greece fell back into contraction. Germany slowed to 0.3% growth, missing forecasts of a 0.5% rise, though unemployment is at its lowest level since reunification. Meanwhile the composite PMI fell to 53.4 from 53.9 in May, still a relatively healthy number. Of course the European market is being held back by the issue of Greece, which will likely take a least another month or so to play out.

Japan – Positive Data
We saw some positive data out of Japan. It had a positive trade balance of $23bn in March driven by lower energy bills, and an influx of tourists. Core machinery orders were up 2.9% in March, after contracting 1.4% in February. And Japan revised its first-quarter growth numbers to a 2.4% annualised rate on the strength of a 7.3% Q1 year-on-year rise in capital investment. However, much of the gain was attributed to businesses building back inventories after last year’s recession, and economists note that future growth depends on consumers’ willingness to spend.

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

In the international value portfolio we executed the following trades:

Based in Germany, GEA is a manufacturer of production equipment primarily for the food and beverage industry. GEA has strong positions in oligopolistic markets where barriers to entry are very high. GEA focuses on markets where the customers are willing to pay a premium for engineering quality and reliability. The average order size is €100k and no customer accounts for more than 1% of sales. Growth is supported by rising food safety regulation, innovation in food and beverages, and growth from emerging markets customers.

In 2014 GEA announced a three-year program to consolidate its four divisions into a single production business and a single sales organisation. The company expects to realise savings of at least €125m pa through headcount reductions equal to 5.5% of the current workforce. These savings are equal to 29% of 2014 pre-tax profit, all of which management expects to retain as earnings. We view a fair value for GEA to be €53, well above the current price of around €44. In our assessment we give no value to the substantial cost savings management are targeting over the next three years. Successful delivery on the restructuring program would represent material upside to our valuation.

In the international growth portfolio we executed the following trades:

Hella KGaA Hueck & Co (HLE) is a German-based automotive parts supplier that develops and manufactures lighting and electronic components and systems. We believe that the company offers a strong case for re-rating due to margin improvement and cash flow generation, as the cost base is restructured. This restructuring is largely playing catch up with peers, so there is a lot of low hanging fruit. Furthermore the capex cycle is likely to slow in coming years. All this should lead to meaningfully higher free cash flow generation. In addition to this there is potential for an increased free float (from 15% to 40%). All these factors should see the company close its valuation discount of around 20% versus global peers.

Greece is likely to provide further dramas for the month of June, though we still believe a resolution is more likely than not. This may provide a distraction from gradually improving macroeconomic data, though the future still looks bumpy for Australia. As ever we remain vigilant for 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.