Themes for October

6 October 2014

October saw the return of volatility to financial markets after a long hiatus. The VIX, the index that measures the pricing of risk vis-a-vis S&P 500 options, nearly tripled from its levels a month earlier. The US treasury markets saw unprecedented intraday moves as liquidity was found to be absent, possibly as a result of the increasingly stringent regulatory regime for banks. However as quickly as the panic arrived, it was gone, with markets rebounding strongly to top new highs in some regions.

The triggers for the sell-off were ostensibly related to concerns over a slowdown in global growth. I believe that the current environment, where risk is being priced cheaply primarily due to the financial oppression enacted to central banks, will lend itself to these bouts of volatility. In this case the fundamental macroeconomic situation had not shifted significantly, earnings (in the U.S. at least) remain healthy, and it felt like a shake-out of nerves. I do believe, however, that it was an appetiser for what is to come when global central banks start undertaking opposing policies (the Fed and BOE tightening whilst the ECB and BOJ loosen), which will cause large capital flows between countries and asset classes. This could be a story for next year.

Geopolitics
In Europe Germany continues to state the case for fiscal rectitude, with an aim to balance the books in 2015. This is despite calls for stimulus, given the deteriorating economy in the Eurozone. Germany clearly can afford the stimulus, domestic consumption and infrastructure investment is relatively low. The issue is that Germany does not want to open its cheque book whilst France and Italy fail to make the deep structural reforms required to improve their competitiveness. Meanwhile France and Italy backed away from a confrontation with the European Commission over their proposed budgets. Both countries said they will make further spending cuts to narrow their deficits.

In Brazil president Dilma Rousseff was narrowly re-elected. Most of her support in the runoff election came from low-income voters. Markets in Brazil, and the real, dropped heavily on the outcome. Rousseff has not been seen as an effective manager of the economy.

Nuclear talks with Iran continue as the deadline approaches towards the end of this month. Iran says it is willing to ship much of its uranium stockpile to Russia if it reaches a broader agreement with the West on its nuclear program. Some officials see the tentative agreement on the uranium as a possible breakthrough that could end trade sanctions on Iran.

Macroeconomic news
In Australia we saw mixed data released in October. Retail sales for September were up 1.2%, the fastest pace in 19 months and well ahead of the forecasts of a 0.4% rise. The new Apple models were cited as a factor in this rise. Meanwhile the trade deficit widened to $A2.26bn as commodity prices continued to fall, even as volumes improved. This compared to the forecast of $1.8bn. In employment news the ABS continued to confuse markets by restating August and September figures, resulting in a net loss of jobs and a rise in the unemployment rate to 6.2%. It does seem hard to reconcile the rise in retail sales with the worsening trade and employment data, but I believe that low rates and rising property prices continue to make households feel enriched. This dynamic is unlikely to last in the long-term.

U.S. GDP grew at an annual pace of 3.5% in the third quarter despite some drag from business investment, consumer spending and the housing market. The rate was down from 4.6% in the preceding period. Growth was driven by a smaller trade deficit and a surge in defence spending, which points to slower growth in the final quarter of the year. Meanwhile the U.S. has narrowed its budget deficit dramatically over the past few years amid spending austerity and a slowly improving economy. The gap as of Sept. 30 was 2.8% of GDP. Most data points outside the employment market point to a minor slowdown, the preliminary services PMI slipped to 57.3 last month, the lowest reading since April, whilst orders for nondefense capital fell 1.7%. On the other hand consumer confidence climbed to 94.5, the best reading in seven years, no doubt tied to a very strong labour market. We continue to remain bullish on the U.S. economy, though are we waiting for a pick-up in real wage growth to arrive.

In China a 15.3% gain in China’s exports for September topped even analysts’ optimistic expectations, and imports were up strongly as well. However the export sector was credited for most of the lift to imports, indicating that domestic demand remains weak. Property prices fell in all but one of 70 major Chinese cities reporting in September, extending the decline in the market to five straight months. This comes despite the People’s Bank of China and the China Banking Regulatory Commission cutting the required down payment for a second-home mortgage from 60% to 30% to stimulate the property sector. Given the low household leverage, and centrally-commanded structure of Chinese financial markets, the government has some ability to manage any turmoil should the property market really tip over. However this would likely be a period of extreme volatility, so we continue to monitor the situation.

European data points remain at concerning levels, though there was a slight bounce in October. Germany downgraded its GDP expectations for this year to 1.2% growth, from 1.8%. However for the region as a whole we saw slight positive surprises, with manufacturing activity unexpectedly climbing and economic confidence moving from pessimism to optimism (albeit at very low levels). All business sectors became more confident, especially retail, services, and the construction sectors. Inflation remains at a low level – prices are falling in eight European countries (though this is not an issued confined to Europe – as per the chart). Many commentators have made parallels with Japan’s previous long affair with deflation and low growth. Though at least Japan has a homogenous, stoic society, unlike the Eurozone. We remain on watch for populist political parties that may threaten the structure of the region, and remain cautious on the region overall.

Australian Equities
Two thirds of the 5% rise in the big four banks’ $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.

Coca Cola Amatil rose strongly after sacrificing economic control of its Indonesian bottling venture in return for a $570m cash injection from The Coca Cola co. It also forecast a return to profit growth next year, and will use the sale of the 29.4% stake in the Indonesian business to fund accelerated capital expenditure and market development.

CSL announced it would be buy back $950m in shares through an on-market buyback, or around 3% of issued capital. This had been mooted by the company earlier in the year.

News Corp 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.

Recall (REC) rose nearly 12% when it was reported on Bloomberg that Iron Mountain approached it for a takeover deal. However REC denied it is in discussions. Prior to the jump REC was trading at 9X 2015 EBITDA, compared to 11.2X EBITDA for Iron Mountain. This would make the deal accretive in the $2bn – $2.5bn range. Iron Mountain has a market cap of around $6.5bn, and REC is its only listed peer.

RIO is going to push ahead with a new mine expansion to increase ore exports by 70m tonnes pa. This is on top of the 270m tonnes pa it already mines. Meanwhile BHP plans to raise its iron-ore capacity by nearly 30% and is targeting production costs at less than $20 a ton (more than 25% lower than its average in the year through June 2014). The inexorable trend to lower production costs by increasing production continues.

Telstra’s David Thodey has indicated that the $11.2bn NBN renegotiations may stretch in to next year, despite the government’s assertion that a deal would be struck by the middle of this year.

International Equities
Markets were volatile in October. Europe’s benchmark index saw the most consecutive days of falls in 11 years. Meanwhile 25 European lenders failed a stress test led by the ECB, which found the biggest capital hole in the region’s banking system in Italy. The ECB identified a total capital shortfall of 25bn euros as of the end of 2013, though as many banks have raised capital already the current shortfall is only 9.5bn euros across 13 banks. The capital shortfall was at the low end of market expectations. European bank stocks fell as possibly a harsher outcome would have been well received as a moment of catharsis.

Foreign sales last year accounted for 46.3% of revenues for companies in the Standard & Poor’s 500 Index in 2013, leaving them prone to a rising greenback and the recent slowdowns in Europe and Asia. By contrast, U.S. exports compose just 13.5% of the economy. This dichotomy is an interesting dynamic should the rising greenback lead to political debate over monetary policy.

Time Warner Inc. (TWX)’s HBO said it will offer a streaming video service independent of pay-TV subscriptions next year. Others, including CBS Corp.’s Showtime, said they may also do so, creating more competition for Netflix.

Wall Street analysts projected that Google would produce a $6.53-a-share profit for the third quarter, but the Internet search giant reported $6.35 a share. The company boosted spending on research and development and hiring by almost 50%.

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 characterization of U.S. labour market slack as “significant”. I would expect the Fed language to continue to slowly change over the coming months.

Driven by a flood of supplies and declining demand, oil prices have fallen to their lowest level since 2012. The question is what is the main driver of falling prices? Weak demand or increased supply, or both? If the primary reason is weak demand this is a concern as it would signal dramatically declining global growth. If it is a supply issue the declining price is likely to be positive, energy-importing countries tend to spend the savings more quickly than energy-exporting countries will spend any gains. It seems likely that a mixture of both is responsible. There has certainly been a supply shock. Thanks partly to increases in shale-oil output, the U.S. pumped 8.8m b/d in September—13% more than the year before, 56% above the level of 2011 and not far short of Saudi Arabia. And Saudi Arabia itself continues to increase supplies (in perhaps an echo of BHP and RIO’s tactics in iron ore). Though there are also clear signs of slowing growth just about everywhere except in the U.S. Without a turnaround it seems unlikely the oil price will rebound rapidly in the short-term without some major disruption. (Source: The Economist).

Portfolios
In the Australian equities portfolio we increased our holdings of NAB and Incitec Pivot by 1% each in October. This investment came out of our cash holding, and was to take advantage of the market pullback.

In the international portfolio we sold 1% of Nestle to buy 1% of Praxair. This was to take advantage of the relative price performance of the two names where Nestle is left closer to our fair value, and Praxair some way below.

In the multi-asset portfolios we took advantage of the pullback to allocate some of the cash (3%-4%) from the sale of SLF to an increased international equities allocation, either by investing in the international portfolio or through purchasing VTS. We continue to favour the US over the rest of the world. Our purchases were well-timed during the market dip.

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