From pillar to post – investors feeling the pain
Weak commodity and oil prices are putting pressure on mining and energy company profits. This, in turn, raises questions about their ability to repay creditors; hence the spike in high-yield credit spreads and the concern around banks – particularly European banks. On its own, this issue would concern investors. However in this instance it has been tossed into a market already skittish over the potential for policy mis-step, on two fronts: will there be a hard landing in China (worsened by capital outflows), and can the Fed embark on a tightening cycle without tipping the economy into recession?
We don’t think this is the new GFC. The GFC occurred because banks were unable to accurately assess their true exposure to the deflating sub-prime mortgage bubble – let alone anyone else’s. The pressure on energy and resource companies presents a risk for banks earnings. There is also a risk that concerns become self-fulfilling and that funding costs increase to the point where they start to significantly impact lending. Yet, fundamentally, bank commodity exposure is far better understood and far less opaque than was the case with property-backed securities in the GFC.
Australian banks, for example, have very little exposure to the high yield corporate bond market. There is a real risk that higher funding costs constrain the banking sector’s ability to grow earnings. However there is a low probability that weakness in the commodity sector leads to banking insolvencies, or to a freezing of credit markets as was the case in the GFC.
The international situation
We are by no means bulls on China – however we believe that recent bouts of paranoia related to currency devaluation and domestic equity market volatility are overdone. There is no doubt that Chinese economic growth is slowing and it retains significant overcapacity in heavy industry. But this is already well known. Scenes of Chinese officials scrambling to avert A-share market volatility are hardly edifying, but the equity market bears a tenuous relationship to the economy at best.
Uncertainty over the pace and direction of US monetary policy is likely to persist. A combination of higher US rates and competitive depreciation from other countries – such as renminbi devaluation and the Bank of Japan moving to negative rates – is driving the dollar higher, effectively tightening economic conditions in the US. This is showing up in corporate profits rolling over, although not at this stage in unemployment or wage inflation.
There is a risk that further rate hikes could tip the US into recession. However, at this point the US economy remains reasonably healthy and the Fed are cognisant of the risks. The Fed’s recent comments leave the door open for rates to remain unchanged in March which is consistent with our view that the US will not raise rates in the first half of 2016.
Where does this leave the Australian market?
This is a challenging environment, yet one that presents significant opportunity for the long-term investor who is able to judiciously select stocks.
The S&P/ASX 300 is down over -9% for the year to date, with global concerns reflected in the performance of various sectors. The miners have been volatile, with BHP Billiton down over -15% given its exposure to both iron ore and oil. The major banks are down between -13% and -18%, while Macquarie Group is off -27%.
Macquarie: rolled over?
Macquarie’s experience is telling, having been driven down by the confluence of fears over commodities, investment banking and a re-run of the GFC. Yet Macquarie Group is a good example of how the experiences of the GFC have changed the nature of some companies. It has changed its business model from a traditional investment bank relying on M&A, trading and capital markets activity, to a diversified asset manager where 70% of its revenue stream is generated from annuity-like fees from its asset management and leasing businesses.
This reduced revenue variability also reduces the valuation and price risk, in our view. The current sell off in the stock represents a pre-GFC valuation of Macquarie and does not represent the stability and outlook for its cashflows. It is a good example of what we believe is an overreaction to the, admittedly daunting, combination of fears facing the market.
The Australian corporate environment
We believe we remain in a low-return environment. Economic growth is sluggish and constraining revenue growth. Australian companies have generally proven adept at cutting costs to drive profits, but there is a natural limit to how far this can go. A subdued outlook for banks – constrained by higher capital requirements and potentially higher funding costs – and for miners provides a drag on a large portion of the Australian index.
The banks are looking interesting from a valuation standpoint, however persistent concerns over credit and funding costs caution against a simple mean-reversion trade. That said, the divergence within the sector is wider than that justified by fundamental earning profiles and capital positions and does offer an opportunity.
Resources remain challenged by declining demand and oversupply and any further Chinese currency devaluation will only exacerbate this. The fundamental drivers of oil remains negative, however this could swing quickly, given the multitude of influential geo-political factors. We therefore remain broadly neutral on the sector, while looking to add alpha through stock selection within it.
Market valuations are reasonable, especially given historically low interest rates, and should provide some support to the market. The historically high premium of dividend yield to bond yield is also helpful, as we still see “bond refugees” flocking to defensive yield stocks such as Transurban and Sydney Airport.
However it is difficult to see the index making significant gains over the year, given the dual headwinds of the macro concerns detailed above and subdued earnings growth are likely to persist.
Glass half-full or half-empty?
Yet opportunities exist. This is a good environment for stock picking. There are pockets of growth in the Australian economy; in tourism, agriculture, outdoor advertising, aged health care and anything related to Chinese consumption. Often the opportunities in these sectors lie outside the large-cap names which outperformed the market for several years up until Q1 2015.
It is in these challenging markets that our ability to identify opportunities comes into its own. In this vein, we retain conviction in several of the positions which drove our strong return in 2015 – including Qantas, Macquarie and Caltex Australia. We also remain underweight in Woolworths and in BHP Billiton.
This is not our team’s first bout with market volatility – nor is it likely to be our last. These times demand a disciplined adherence to a proven strategy. In our case, that is using our team’s long experience and knowledge of companies to identify stocks where a likely change earnings or valuation rating is not yet reflected in the price. These opportunities exist now, as they do in almost all market conditions. We continue to concentrate on picking stocks and combining them in sensible portfolios, confident that we will continue to deliver on our long-term record of outperformance.