This month we discuss the poor start to the year. While sentiment remains weak, the reasons for the market fall are not particularly obvious from our perspective. The Chinese economy remains soft (but this is largely known to the market). The US economy has slowed a little but remains reasonably robust. The market has been reacting to the fall in the oil price but this should be positive for global growth. Nonetheless the weakness has remained persistent and in some pockets, such as tech stocks, it has accelerated. While individually the reasons for the correction do not seem particularly convincing, a range of factors are contributing to the weakness including the following:
- US Federal Reserve tightening. We asked ourselves last year whether the beginning of US Federal Reserve tightening would add to volatility or whether it was already reflected in markets. The price action this year suggests the removal of this support has left the market more vulnerable to volatility (the market no longer has the confidence that the US Federal Reserve will step in with quantitative easing to support markets).
- US market strength last year. The US market had held up well into the end of last year despite some evidence that the economy was softening. Further we had seen excessive valuations in tech stocks which left them vulnerable to a pull-back were sentiment to turn (which we have seen).
- Chinese policy mistakes. The Chinese authorities have been undertaking the delicate task of rebalancing their economy away from investment and doing a reasonable job. We are seeing service sectors grow and heavy industry investment decline. However their handling of the market has been ham-fisted over the past year which has undermined confidence and encouraged outflows from the Asian region. We see two major mistakes—limiting the ability of investors to sell stocks that were up 80% and the signal that they were to devalue the currency only encouraged capital outflow. Our major stocks have been caught up in this selling.
- Lower oil price driving credit concerns. While the lower oil price is yet to have a positive impact on global growth, the correlation of lower oil price with the stock market is more to do with deterioration in high yield credit markets given there is a significant amount of debt exposed to oil companies. We note from an Australian bank perspective exposures to resources as a whole remain around 1.7% of book (this compares to 12% for Singapore banks and 17% for Indonesian banks).
The key questions we are asking from here include:
- How does the pull-back compare to other corrections?
The market is off nearly 20% from its high. Of the previous 12 episodes when Aussie equities crossed the 20% peak-to-trough threshold, index levels were higher in a year's time in eight cases and they were lower in four. The determining factor is whether the decline in equities preceded a recession and the level of valuation support post the fall.
We tend to think this pull-back will prove to be one of the better times to buy the market. Certainly sentiment is negative as noted below and in the Asian region we have seen significant outflows (which is a contrary indicator).
- What is the risk of recession and where are the growth areas of the economy?
Globally we have seen a slowdown in growth rates but nothing to suggest a recession. The outlook for growth remains around 3%. It may surprise many that the G7 has experienced the fastest drop in unemployment on record. The US economy has experienced a slowdown in the oil states as well as a seasonal slowdown in activity levels. Yet consumer confidence is strong, home sales are robust as is unemployment.
China clearly has its challenges (unwinding excess construction investment) and leading indicators remain soft. We would not rule out a further slowdown in the Chinese economy, but note they have been stimulating the economy for some time and there has been some improvement in service sectors, car sales and house sales. The Chinese economy remains one in transition where incomes are growing at 7% pa, household debt is low and savings are high which provides a good base for further growth. However excess capacity remains in industries tied to construction. Within China we are seeing strong growth across a range of consumer service sectors and this represents opportunities for Australian businesses.
- Ecommerce/internet—growing ~30–40% yoy
- Healthcare—growing ~15–20% yoy
- Travel services—growing ~15–20% yoy
- Entertainment/Movies—growing ~40% yoy
- Environmental services—growing ~20% yoy * Sportswear—growing ~15% yoy
Even allowing for a further 2% slowdown in Chinese growth rates, the impact on Europe and the US is only around 0.2% of GDP (given modest export levels to China). The most negative scenario would be a messy devaluation of the currency which could have a spill over into Australia but even in this scenario global growth should be positive.
The Eurozone continues to recover with business confidence solid and leading indicators supportive of further growth
Recent economic data from Australia has been encouraging. Job ads were up 1% in January and 11% on the previous year. Unemployment has held up well and while we are cautious on the outlook for housing we see opportunities in areas such as tourism, agriculture, and education. Once we move beyond 2016 then a number of non-residential construction projects should begin to offer support to the economy. So while the global economy continues to have some growth challenges and sentiment remains soft, we continue to expect the economy to grow. As we cycle through the decline in energy capital expenditure then the benefit of a lower oil price should begin to become apparent.
- Are valuations compelling yet?
Valuations remain attractive relative to interest rates with a grossed up yield of 6.7% and are beginning to trade below long term average PE’s at 14.5x. We see this as attractive but not especially cheap. However if we peel back the onion on valuations we see more compelling opportunities. There has been a divergence between companies with earnings certainty (which the market has chased) and those without. We are seeing some stock specific opportunities emerge in the current environment. Key areas where valuations look attractive include:
- Financials. Financials have been sold down with global markets yet capital levels are strong, asset quality appears sound (albeit some potential pockets of resources stress). They are trading on a long term average PE (11x) and an attractive dividend yield. We see Macquarie Bank as offering significant value with the market selling it off in line with global investment banks when its earnings have a greater proportion exposed to annuity like earnings streams (such as funds management).
- Anything resource related is being heavily discounted although some caution is warranted especially for companies with stressed balance sheets.
- Domestic exposed companies taking costs out can enjoy positive leverage as the domestic economy improves.
When considering the earnings of the market we note that earnings growth has been flat for the past few years as the market cycles the deterioration in resource earnings. The outlook should begin to improve (5-7% growth) from here given:
1. Resource earnings have already fallen (law of small numbers applies).
2. Currency will continue to provide a tailwind for exporters.
3. A small improvement in domestic demand will have outsized impact on profits given the level of cost cutting that has been occurring.
4. Offset by a slowdown in housing related activity.
Further a trend analysis suggests the market is trading significantly below trend.
- What are the major risk areas for portfolios?
The major risks we identify include the following.
- Credit spreads. Clearly the main concern of the market is the lift in high yield credit spreads. The credit market seems to be following equities rather than the other way round however there are pockets of issues within the oil debt markets.
- Geopolitical concerns. A further possible cause of weakness might be associated with geopolitical instability. A low oil price is causing a substantial deterioration in the strength of budgets in the middle east and adding to an already volatile political climate. Furthermore extremist politics is on the rise in Europe and elsewhere (Trump, Sanders) as the global political structure deals with the aftermath of the GFC. The central bank response to the GFC (quantitative easing) has boosted asset prices (which has a positive impact on the wealthy) but has not resulted (or not yet) in an increase in investment (which would provide a greater impact on jobs).
- Australian housing. From a top down perspective the Australian housing market contains risk. High levels of consumer debt, high house prices and a deteriorating terms of trade is not an attractive mix. It is difficult to see consumer confidence bouncing strongly in an environment of deteriorating house prices so creates some risks for the domestic economy. We note only 6.5% of the ASX 200 has exposure to this issue (if there is no credit event as we expect).
- Inflation. Given valuations have been supported by low interest rates, any sign of capacity tightening driving up inflation would be a negative for the markets. There are some pockets of capacity tightening in the US but the world continues to be awash with excess capacity (so it would seem to be too early to be overly concerned with this risk).
We have seen an opportunity to start building some contrarian positions as the market polarises between some heavily in favour sectors and out of favour sectors.
- De-rated quality stocks which have de-rated in recent years (Woolworths).
- Improving quality. We see opportunities in those companies turning around their businesses—Clydesdale, NAB
- Sustainable earnings growth has been identified in a range of areas including:
- Stocks benefiting from a low A$— Macquarie Bank, Brambles.
- Domestic exposures benefiting from cost out and improving demand—Healthscope, Tatts.
- Business models with strong structural growth—IRESS, Dulux, SEEK.