The view from the bridge – May 2011
Posted on 01 June 2011
As we cross May off the calendar, time to reflect on the shape of the portfolio and consider any adjustments.
From where we sit (that’s next to the captain – holding her campari and soda), the outlook for the Australian economy continues to deteriorate. While China’s demand for coal and iron ore remains strong, the high value of the Australian dollar is undermining our non-mining related economy. We see this in surveys such as the CBA Aussie dollar barometer (here) that place fair value of the currency closer to 0.91 – at least from an exporters point of view. And in our PMI data that has the Australian economy on the same side of the ledger as Greece and Ireland:
Add to this the raft of indicators (building approvals, retail sales, new motor vehicle sales and new lending) that are heading south and the weight of evidence suggests that things are getting tougher at the core of the economy – remembering that domestic consumption contributes around 65% of GDP.
Globally, leading indicators are suggesting that a slowdown in growth is imminent (here) and that inflation in the developed economies is peaking with it. Our read of consensus expectations is that the another round of QE is inevitable, an opinion we agree with, the question is what is required to trigger its launch. In Europe, the ultimate default by the periphery has also gained general acceptance – though once again timing remains subject to debate. While the question as to whether China will suffer a hard landing as it seeks to reign in rampant credit growth remains unresolved.
Valuations on Australian equities are mixed – with some sectors already priced for a domestic contraction while others are yet to make their run. Looked at in aggregate, the market is beyond what we’d argue is fair value given the local and global outlook.
We believe stock prices are vulnerable to the downside as earnings are likely towards cyclical peaks and in some cases already contracting. In summary, we are underweight equities and overweight cash.
Running through the sectors – with an eye to the weightings of our longer term investment portfolio:
Resources – Notwithstanding the softening economic outlook, expectations for another round of QE by the Federal Reserve cloud the prospects for commodities. At the very least, we expect that precious metals and energy will be well bid on any dips – their resilience was notable during May. We remain committed owners of our favoured stocks in this space – though note that we have an AUDUSD short as a hedge against a deeper correction in risk markets. We think that the probability of a correction increases as we move into the second half of the year.
The tangible risks around a shorter term decline in China’s import demand for industrial commodities means that we are avoiding this sub-sector for the moment. This assessment is made easier by the fact that inventories are at historically high levels for most metals and given the unwinding of some mischievous financing arrangements in China that will reduce near term demand. Additionally, we remain very concerned by the large investor presence in the sector that we believe has distorted prices – and which could cause a deep and rapid correction should a mass liquidation ensue.
Discretionary – The Australian consumer has pushed their credit card to its limit. The time has come to deleverage. Equities that rely on the discretionary dollar have been sold down in anticipation of the contraction. But given we have not crossed the recessionary rubicon as yet, there is plenty of time left before we look seriously at this sector. No exposure.
Financials – Given they surrendered their leadership with the onset of the GFC, the prices of financials have proved remarkably resilient. Of course, government sponsored credit binges have helped to swell near term earnings for our banking majors. But reported earnings reflect the past, balance sheets swollen with over-leveraged borrowers funded by offshore investors speak to the future. Sentiment has begun to turn on the Australian banks, but again there is no need to rush to buy in the sector as valuations are likely to become materially better before this cycle is through. Our exposure to the financials sector is limited to wealth management – and even then, it is under where we would like to be.
Property – As a general comment we are wary of the property sector – most particularly those equities with residential exposure. But there are some pockets that are starting to show value – particularly stocks with international exposure, those with large long dated lease books and those that can tap into the more commercial end of the construction game. Still, we expect better opportunities and are under our target exposure in the sector.
Defensives – Healthcare, Telecoms, Gaming and Utilities – Predictably perhaps, we are overweight large cap defensive stocks with a weighting towards telecoms in particular.
Cash/Fixed Interest – Reflecting our expectations of a selloff in risk, we remain overweight cash and fixed interest (comprised of a term deposit and a portfolio of hybrids). The currency exposure is split 50/50 AUD and USD.
Conclusion – The current portfolio is reasonably well set in anticipation of continued market weakness. In the unlikely event that circumstances warrant a shift towards a more bullish stance, for example some government with deep pockets decides to throw more money into the boiler, then we may add to existing holdings. Otherwise we’ll be sitting tight until we see further market weakness.
3 responses to The view from the bridge – May 2011
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G’day Rohan
I agree with your thoughts that we’re heading into some quite strong headwinds. As you say, healthcare, utilities, cash and hybrids are the place to be for the next few months (I’m not overly keen on gaming – while I admire their resilience, the regulatory risk always beats me off).
What do you think about agriculture? I know we’ve had some short chats before regarding a couple of ag stocks.
Agriculture remains the investor’s nightmare – at least in the listed markets. SHV got the better of me – I’d imagined (hoped?) they were through the worst – recapitalised and simple business with a reasonably straight shooting CEO (I’ve even met the blighter – but based on the recent shambles, I’ll have to review my opinion). It might be worth another look when the smoke clears on the Olam contract termination, but it could just as easily push down to $1.75 from here. Elders are still in recovery mode (and I’m long the hybrid but not confident of resolution on that until 2013 given their auto exposure). The list is a relatively short one – and no stock really jumps out but plenty have poor management. Perhaps the only way to get decent exposure is to go offshore (ironically) – maybe agrium. What are your thoughts?
On gaming, I’m a fan of Dick McIlwain. TTS aren’t cheap at $2.30, but on a dip they’re interesting given their 50 year licenses in the lotteries. They have the regulatory certainty that the others lack, and technology less likely to chip away at the franchise. That’s the logic anyway.
Any thoughts on any hybrids offering relative value?
I’d probably agree with you on TTS – I view the lotteries business as not as ‘evil’, in the sense that gambling on lotteries is largely invisible to the public and to pollies who want to make a name for themselves. Online gambling, pokies and possible punting on the races are more problematic – too easy a target for a do-gooder with access to the levers of power (having said that, pokies bore me to tears and I love to see them kicked out of pubs and clubs but that’s a different story).
I still like a few hybrids, but there’s slim pickings out there at the moment.
ELDPA as we have discussed, will be worth something one day, but every bad profit result from ELD pushes that day further away. AAZPB and MXUPA out of the non-bank sector are still (relatively) good value. A couple of the Bendigo Bank ones are also worth a look I reckon.
Most of the others are simply too expensive (SBKPB, IANG, ANZPB were a couple that were great value 12 months or so ago). BZAHA and BZBHA were also worth a look on issue but not anymore.
That said, you could probably construct a fairly well diversified hybrid portfolio offering a return somewhere around 8% or so, which looks pretty good in the current climate.