December 2015 Review & Comments
Written by Tony Gray   
Tuesday, 19 January 2016 09:26

Welcome to 2016 – a year of (continued) uncertainty we suspect.

The Macro View

Investment markets are jittery for a variety of reasons; set out below are several of the key points as we see them:

China Slowing

Economic growth in China is slowing, but so far is not markedly different from the estimates set out in the most recent Chinese 5 year plan (which showed a steady decline in the percentage rate of economic growth). There are several issues of relevance to global investors and especially Australian portfolios:

Capital investment in China has slowed dramatically – overcapacity exists in many industries and lower or negative demand growth for inputs (most especially metals from Australia) is clearly showing through in terms of low prices – with direct impact on the profitability of Australian mining and energy stocks.

The surprise for us was not a slowdown in China’s demand, but just how low commodity prices then fell once the ‘price tension’ in the market between supply and demand eased. Once increasing supply caught up with moderating demand (whether it be oil, iron ore or coal) prices collapsed. Iron ore is a case in point – when the price was circa $120 per tonne the estimates were for falls to circa $80 per tonne by 2015/16 – as new lower cost supply was offset by the closure of higher cost production (especially within China). So far production has remained stubbornly high and producers have been able to cut production costs to a greater than expected degree – with consequently an iron ore price below $40 per tonne!

Within Australian, further reductions in capital expenditure in the mining and energy sectors will occur as existing projects complete and some existing operations fail – with flow-through impacts for all suppliers and impacts through falling/lost wages. This has a direct impact on the Australian economy.

Debts within China are concentrated in the corporate sector and in particular State Owned Enterprises – and to a much greater extent than other parts of the world. By comparison consumers are running low debt levels and there is a high savings rate. The Central Government level of debt is also on the lower side, although there is a structural budget deficit of 4% to 5% of GDP and China is already a high taxing economy.

The consequence is that some debt laden enterprises in China will most likely fail and this could have consequences in the banking sector. By comparison, rising consumer spending and high wage inflation present opportunities.

Given the index weighting to industrials and banking in China, an index related exposure is not recommended – although exposure via active managers who are correctly positioned is worthwhile.

Very significant capital outflows are running down foreign reserves from high levels. There is a significant risk in our opinion that the Chinese government crackdown on the amount of money leaving the country.This could be very important for the Australian economy and especially the housing market – where something in the order of 30% of new homes in Melbourne and Sydney are purchased by overseas investors. We note a few early instances of investors walking away from their property deposits. Pulling back this demand could see rapid and sizeable price falls – especially in the apartment market.

There is a lesson from commodity markets – when rising supply meets moderating demand, the released ‘price tension’ could see much more rapid and sizeable falls than anyone presently forecasts. This is especially the case as in Australia we have very high property values relative to income and also have very high levels of personal debt as a proportion of the economy.

The residential construction market does appear to be slowing – so suppliers to the sector and those directly involved with construction and development (including some property trusts) could continue to fall.

United States – the market

If the lead global sharemarket is falling that will weigh on other markets.

1.Buy, buy, buy… sell, sell, sell.

There’s a cycle and as outlined part way through 2015 it appeared to us that the 7 year US sharemarket bull market was at risk of reversing. Behaviour in late 2015 and so far in January 2016 seems to be confirming this view. Further, except for the strong performance of high index weighted stocks such as Alphabet (Google) and Amazon, the index would appear weaker. A narrow group of large stocks leading the index is classic end of cycle behaviour.

We note that respected international fund manager Platinum has just over 20% exposure to the US market in their lead fund – about 1/3 of the global index weight – but after short positions their net exposure is just 10% - to the largest sharemarket in the world! As an aside, that fund has an 18% weight to India.

2.Corporate earnings – slow global growth and a strong $US is making it tough for US corporates to maintain or grow earnings. With unemployment in the US having halved since the GFC, with the economy growing at a slow rate and with interest rates finally on the move higher, it is difficult to envisage the strong earnings growth necessary to justify current valuations.

Credit Risks

1.Global debt levels have increased dramatically since the GFC – although the extent varies from economy to economy. In the US government debt levels (including US Federal Reserve) are dramatically higher, but the corporate sector has not gone on a debt binge (generally) despite low interest rates. Consumer debt relative to income has declined materially.

By comparison, in Australia government debt has expanded dramatically, as has the budget deficit. Company debt overall is not an issue – many Chief Financial Officers learnt the lesson from the GFC and are better positioned in terms of gearing levels and also longer rolling refinance positions.

Australian consumers have lifted personal debt (relative to income and relative to the size of the economy) to record levels – taking full advantage of lower interest rates. Similarly, banks now lend far more for each dollar of actual capital (as opposed to risk adjusted measures) than in 2007 (immediately before the GFC). Even with APRA’s increased capital requirements by July 2016, the major banks will still be lending 50% more for housing per dollar of capital!

2.Debt provisions are at or close to all-time lows in the Australian banking sector. To provide a point of comparison, provisions during the last recession in Australia were 18 times larger (as a proportion of each dollar lent). This is despite much higher gearing in the Australian economy today compared to 1991. Falling provisions were one of the major drivers of bank profitability over the last couple of decades and even a modest reversal would lower profits and potentially dividend payments.

3.Higher levels of debt restrain the rate of economic growth. This is especially true when the debt is not being applied to lifting productivity but merely to sustaining deficits. There will be a tipping point where credit risk (risk that money is not paid back) becomes the focus – the world can handle this with a small economy such as Greece, but inevitably the current trends will see a major economy stumble.

4.Failures in some sectors (e.g. corporate loans to some mining and energy stocks) and loss making Chinese corporates could well see (further) rises in credit spreads – putting up the cost of money and resulting in losses for bond holders. This is important for an open economy such as Australia, where we borrow money offshore. A weakening economy and rising interest costs would be a seriously negative position for Australia.

Demographics & Welfare

There are some studies/theories that investment market returns are correlated to certain demographics – such as proportion of workers in the population.

1.The world population is ageing and in some parts of the world (e.g. Japan and Italy) this is reflected in low rates of economic growth and high government debt levels. It’s normal for reduced spending to occur as people age and that in preparation they also increase saving rates and cut spending. This in conjunction with an indebted and slow growing global economy is a really poor combination.

2.Almost all developed economies are finding it nigh on impossible to restrain spending on welfare, with a consequently rising share of national income being taxed and redistributed by government. This cuts money in the private sector and the bureaucracy eat up a sizeable portion of funds to be redistributed.

Australia and the US have a much slower rate of ageing in the population (due to immigration and also modestly higher fertility rates than in some other ‘developed’ economies) – whereas Russian and Japanese populations are ageing and declining. China’s population is ageing rapidly due to the one child policy (in place since 1979 but in 2015 became a 2 child policy) and the working age population peaked in 2014. India by comparison has a younger, growing population and rising proportion in the 15-64 ‘working age’ bracket.

CONCLUSION

Too much debt, lower global economic growth and China related economic impacts or regulatory decisions could have seriously negative outcomes for the Australian economy. The sharemarket can be a leading indicator of recession and this risk should not be ignored. Separately, a negative lead from US (and Chinese) shares and sentiment (fear) could result in continued local market falls.

Economists have a poor track record of forecasting recessions and fund management groups tend to work on probabilities. In real life at some point the less likely but severe outcome does come to pass. At that time how you are positioned with your personal finances and investment portfolio will be far more important than which individual asset is held over another (e.g. if the sharemarket ‘tide’ is going out, then holding a lower allocation to shares will be the main determinant of returns).

We caution that the above discussion is merely our own opinion and we are not (1) outlining the above to send you screaming into your cave with survival gear (you do have a cave ready, don’t you…), or (2) even suggesting that the above concerns are a likely outcome that lead to big property falls, recession and sharemarket losses. The purpose is (1) to highlight that there are risks and that the wrong chain of events could have serious outcomes – which would be reflected in investment portfolio values, and (2) for you to consider your broader financial position and your plans – especially in relation to debt.

We are taking the above concerns into account when we consider our advice as to overall asset allocations and also the nature of individual holdings recommended. The risk is that we are too conservative or risk averse too early and that markets in fact advance through 2016. We will continue to re-assess our views and if the facts change, so will we.

Beyond the macro view, we will be very much focused on individual assets – for example, deposits over bonds and active management over passive index exposures.

We will be making asset specific recommendations on a regular basis – there are a number of holdings we believe it is now safer to exit in the short-term.

As always, if you have questions or concerns about your portfolio or your broader position (if that forms part of our mandate) then please make contact (phone, email or in person).

Best wishes,


A.W. (Tony) Gray BCom, LLB, Dip FP, GDipAppFin, CFP, FFin

Principal, TG Financial


Please treat the above comments as General Advice or general information, with no action to occur until we have considered with reference to your financial position, needs and goals.

Last Updated on Tuesday, 19 January 2016 11:01
 

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