Themes for November

3 November 2014

November started well will the market bounce from October’s pullback continuing. However commodity prices continued falling apace, with focus shifting from bulk commodities to oil as OPEC convened and opted not to decrease production. The fall in commodity prices will likely be an overall benefit for the global economy, as consumer countries tend to spend savings faster than producer countries invest profit. But the pace of the price moves triggered volatility in non-commodity markets. Meanwhile the U.S closed out the month at close to record highs, but the Australian equity market suffered from the drop in commodity prices, and concern over the upcoming Murray review of Australian banks. Our terms of trade are declining rapidly. This is impacting on our living standards, and is highlighting how uncompetitive we are. It may require many years of no real wage growth, and an AUD some way below current levels to restore our competitiveness.

Geopolitics
Republicans scored major gains across the board in the U.S. midterm elections, capturing control of the Senate and expanding their majority in the House of Representatives. Exit polls revealed a public concerned about the overall direction of the country, with a majority blaming the government for doing too much.

President Obama and Chinese President Xi Jinping announced that they have agreed to limits on greenhouse-gas emissions. Under the deal, the U.S. would cut emissions 26% by 2025 and China would accelerate its reduction of carbon emissions and conversion to nuclear, solar and wind power. Some Republican leaders in Congress said they will block the agreement when they take control of Capitol Hill next year.

China and Australia reached a free-trade agreement which has taken the better part of a decade to complete. The agreement opens up the service industries in China to Australian businesses, and will reduce tariffs of 12%-30% on agricultural products such as dairy, beef, wine, and horticulture, over four years. In addition Chinese private companies will not need FIRB approval for investments under $1bn, though the rules for state owned enterprises remain unchanged with a $250m hurdle rate. Sugar, rice and cotton producers will have to wait another three years until the deal is revisited. Meanwhile in other trade news India won its argument with the U.S. over maintaining its food subsidy program for the time being in an agreement that clears a snag holding up a comprehensive World Trade Organization accord.

In Japan a terrible Q3 GDP result set the stage for Prime Minister Shinzo Abe to delay an unpopular sales tax hike and call a snap election in order to re-establish a mandate for economic reform. No elections were otherwise due until the end of 2016, and some have questioned whether Abe needed to go back to the polls when he won the last election on a similar platform. No doubt he is trying to consolidate power within the party.

Macroeconomic news
Broadly speaking the macroeconomic themes we have been highlighting the last few months continued in November.

In Australia the outlook remains sobering. Pessimists have outnumbered optimists in the Westpac/Melbourne Institute consumer sentiment survey for nine straight months. The last time a run of such pessimism occurred was during the GFC, and before that the 1990s. Despite this retail sales were up 1.2% in September, the fastest pace in 19 months. Presumably this is still being driven by the “wealth effect” of rising property prices, and is unlikely to last. The trade deficit widened to $2.26bn in September, as commodity prices continued to fall. This dynamic is likely to continue – the RBA’s commodity price index was down 1.8% in November, the eleventh monthly fall in a row. The index is down 19% from a year earlier, and down 40% from the peak in 2011. Our terms of trade are rapidly declining, and whilst the declining AUD will help we have yet to seriously begin the necessary restructuring. Our political leaders do not seem to be able, or willing, to bring this message to the public.

The slowdown in China continues apace. Data-points released for October showed factory production rose 7.7% year on year (YoY), the second weakest pace since 2009. Factory gate prices fell an annualised 2.2%, a record 32nd straight decline. Electricity output grew 1.9% YoY, compared with September’s 4.1% increase. The HSBC flash manufacturing Purchasing Managers Index (PMI) for November dropped to 50.0 from the October final reading of 50.4. Meanwhile a private measure of consumer confidence in China revealed an accelerating decline, likely driven by the declining property market. Prices for new homes in 69 of 70 cities monitored by the National Bureau of Statistics fell in October. This weakening has prompted many pundits to predict large stimulus measures. I do not believe this is forthcoming, at least not a fiscal stimulus, and that the government will downgrade growth expectations and promote reform whilst taking piecemeal action to soften the blow.

The one bright spot amongst major economies remains the United States. U.S. GDP grew at an annual pace of 3.9% in the third quarter, following 4.6% in the second, for the best two quarters of growth in more than a decade. The job market continues to look very positive, the unemployment rate dropped to a six-year low of 5.8% in October. About two jobless workers were pursuing each opening in September, the fewest since early 2008 and down from almost seven in July 2009. The 2-to-1 ratio is the threshold that typically leads to larger pay increases in about six months as employers compete for a dwindling talent pool, according to research by economists at UBS. Wage growth will be the last piece of the growth puzzle to fall in to place for the U.S. Though perhaps semi-retired babyboomers, and technological displacement, means there will be a pool of “long-term unemployed” workers not registering in the unemployment rate that are ready to step in and keep a lid on wages for a while yet.
Eurozone industrial output bounced back, but only slightly, in September. Production was up 0.6% after a 1.4% decline in August, falling short of expectations. Production of durable consumer goods, including televisions and fridges, fell by 2.6%, the biggest monthly fall since August 2011. The Eurozone composite PMI fell from 52.1 in October to 51.4, just above the crucial 50 level that marks an expansion and the lowest reading in 16 months. Separate indices for France and Germany, which together make up more than half of all economic output, signalled the region’s problems now stemmed from its core rather than from its periphery, which had suffered the most during the sovereign debt crisis. The fear for Europe remains that the ECB can only do so much with stimulatory monetary policy, and that the political will is either mired in dogma or dulled by the supposed passing of the Eurozone crisis.

In Japan GDP fell at an annualised 1.6% pace in the July-September quarter, after a revised slump of 7.3% in the previous three months. Economists had forecast a 2.2% gain in the third quarter. However forward looking data does look somewhat better. A 2.9% jump in Japan’s core machinery orders in September easily topped forecasts, and pointed to robust capital spending. Growing demand from foreign buyers for autos, ships and electronic products also triggered a 9.6% jump in Japan’s exports in October. The growth, twice the 4.5% expansion anticipated by economists, marked the sharpest acceleration in eight months. If Abe wins the snap election with a workable majority, as is expected, we hope to see more real reform delivered. This might include taking on the agricultural lobby in order to agree a trade pact with Pacific countries, corporate governance reform, and energy reform. If these can be delivered Japan looks very promising.

Australian Equities
After reporting season wrapped up for Australian banks it is worth noting that two thirds of the 5% rise in the big four’s $45bn pre-tax profit in 2014 was due to reduction in provisions for bad and doubtful debts. These are now at a 20 year low. With the macroeconomic picture deteriorating for Australia it seems likely that the growth in the property market, and in mortgages, should slow going forward. We take a cautious view on Australian banks given this, and the increasingly stringent regulatory and capital environment.

Wesfarmers provided a trading update in which Coles had the strongest sales growth in 18 months, with same-store sales up 4.3% in three months. It has now had 26 consecutive quarters of same-store growth. Bunnings and Officeworks saw sales rise around 8%, with Target and Kmart the weak-spots. Wesfarmers is cashed-up after the sale of its insurance business and the market awaits how it will deploy capital.

Incitec Pivot reported an underlying FY net profit of $355m, up 21%, and ahead of market expectations. This was driven by upside in the US ammonia business, currency moves, and the deleveraging of the balance sheet. Overall fertiliser was stronger, and explosives weaker than expected.

Medibank Private was sold to institutions at $2.15 a share, whilst the retail component was capped at $2.0, netting the government $5.7bn. This puts it at 23X forecast earnings, a 15% premium to NIB, and definitely priced for delivery of its putative cost-saving measures. The multiple put it on a similar pricing to Japara, but behind stocks like Ramsay and Healthscope.

News Limited reported underlying profit of US$170m in its first quarter, up from $141m the prior year. It noted “tangible improvement” in the Australian business. It beat consensus revenues of $2.07bn with a $2.15bn headline.

Resmed announced tie-ups with Apple and Nintendo as it tries to broaden its sales base in to consumer health products outside their natural clinical market. Beyond the revenues directly generated by such licensing, presumably the hope is that this will lead to greater diagnosis of sleep apnoea and encourage take-up of its high margin product.

International Equities
With growth topping that of other developed nations, and a firm dollar, the U.S. marked a record $164.3bn inflow of foreign portfolio investments in September. The previous record was an inflow of $139.7bn in March 2010. Whilst we will keep an eye on such numbers we continue to believe that the U.S. remains the most compelling investment case in international markets at present.

Another metric we are keeping an eye on is the boom in global mergers and acquisitions. These have burst through the $US3 trillion threshold for the first time since before the financial crisis, fuelled by ultra-low borrowing costs and high stock prices. The high stock prices have encouraged acquirers to make scrip bids for targets. Cash-only deals represent 55% of announced transactions this year, the lowest proportion since 2003. Booms in M&A may portend a subsequent pullback as insiders view their stock as overvalued, and executives aggressively pursue growth. A bust has followed many of the previous M&A booms, though of course the timing is impossible to call. We will continue to watch this closely.

One of the recent major deals announced was an agreed $35bn takeover of Baker Hughes by Halliburton. The bid was a cash and stock purchase, and was the biggest oil-services deal on record. The combined company would still be smaller than Schlumberger, the leader in the field. If the oil price remains low further consolidation in the energy sector can be expected.

Rates / FX / Commodities
As expected the U.S. Federal Reserve formally ended its bond-buying program in October and signalled no change in its low-interest-rate policy. Though for the Fed-watchers out there it did drop characterisation of U.S. labour market slack as “significant”. I would expect the Fed language to continue to slowly change over the coming months.

In an unexpected move the Chinese central bank took 0.4% off the one-year loan rate to 5.6%, while knocking just a quarter of a percentage point off the one-year saving rate to 2.75%. It is unclear how effective the rate cut will be as private businesses, which are the true force behind Chinese growth, cannot access these rates.

Japan’s lapse into recession has brought a tide of investment to Australia, with Japanese investors buying $21.7bn in Australian assets over the 12 months ended in September. That’s the fastest rate of buying in nearly four years and is one factor that had been sustaining the Australian dollar’s value. By contrast, a year earlier in the 12 months to September 30, 2013, Japanese investors were net sellers of Australian assets, offloading $33bn. Japanese buying of Australian bonds represents about 6% of international flows, whereas Australia represents 1%-2% of the global bond market.

Oil prices dropped dramatically after OPEC announced it would not cut production, and would not meet again until the middle of 2015. Saudi Arabia resisted calls to cut from members such as Iran and Venezuela that need prices above $100 a barrell to balance their budgets. As we have witnessed in iron ore, what is rational for the market may not be rational for individual actors. In the case of Saudi Arabia, who are the only swing producer of consequence in OPEC, it has previously cut production only to lose market share and provide profits to other states. It seems likely that Saudi Arabia wishes to keep the oil prices low for a period to flush out high-cost producers, including some shale producers in the U.S., and consolidate its market share. This is not likely to be a short-term dip.

BHP CEO Andrew Mackenzie said the time for massive expansions in iron-ore production has ended. Which perhaps is an obvious statement.

Portfolios
In the Australian portfolio we sold Fletcher Building (FBU) as the NZ building cycle looks to be tipping over, and the uptick in Australian activity impacts too small a portion of FBU’s EBIT to justify holding the position. We also topped up Sonic Healthcare (SHL) to take advantage of recent weakness. This came after the company lowered guidance to 2%-4% growth, from 5%, with the street expecting somewhere around 7%. SHL is still well placed to benefit from AUD weakness, and potentially the post-budget pullback in health spending has played out already. We sold down half our Origin position after the OPEC announcement. We added a position in Pact Group as a good quality defensive. It trades at an approximately 20% FY15 discount to Orora and Amcor, and North American comparables, and provides a div yield of nearly 5%.

In the international value portfolio we reduced American Express (AXP) with the proceeds to cash. Electronic transactions are still a growth area but AXP is coming under pressure from new entrants to the field. For example Costco U.S., with $30bn of in-store spending, is said to be exploring a new partnership for its U.S. cards. Costco spending represents around 4% of AXP’s domestic spending. We are taking a slightly more cautious approach by reducing our holding.

In the International growth portfolio we sold United Rentals and bought Fedex. United Rentals has performed well this year though with U.S. construction slowing down, and with falling fuel prices providing a significant tailwind for Fedex, we saw the greater opportunity for returns with Fedex. We also increased our position is Sumitomo Mitsui Financial Group as we see the potential for Japan to outperform. We sold ITV as guidance failed to meet market expectations. We sold Bank of America after a solid rally since the middle of the year. We bought Intel as their technology lead is finally delivering returns, and dominance in the growing server / cloud market and increasing in-roads in mobile provide a positive backdrop. We bought Las Vegas Sands on the view that Macau weakness is more than priced in and Japan could be a big boost if gaming is opened up there.

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