As seems to have been the theme this year, there is both bad and good news from global economies, which continues to create uncertainty for Australian investors.
First, the good news. China is still performing strongly, and there is no reason to believe this will change. China’s dependency on demand from the US and Europe is perhaps overstated, with net exports accounting for approximately six percent of China’s economy (which includes intra-Asia trade).
Policymaking decisions in China have been encouraging. The Chinese economy has experienced an engineered slow-down to levels that Beijing policymakers consider robust enough to absorb the new labour force, but at more sustainable levels. China is also attempting to reduce its reliance on fixed asset investment, which was boosted to stimulate economic activity during the crisis, and to balance its economy towards increased consumption.
Geographically, the emphasis in China is shifting inland as the improved living standards of the coastal provinces have opened a gap in the per capita incomes of the two populations, which the government is seeking to bridge. For instance, land reform granting farmers more certainty of tenure is an area of focus.
Anecdotal evidence suggests that these initiatives are working. Migrant workers laid off in industrial centres during the crisis have obtained employment closer to home and have not returned to the cities. As a result, labour shortages and wage cost pressures are being reported in places like Guangzhou (China’s third biggest city).
Increasing the supply of affordable housing is another area that Beijing appears to be targeting. Such initiatives will prolong China’s immensely positive impact on Australia’s economic growth.
There is also good news from Europe, where the rescue package has contained the resurgence of systemic risk. Credit market spreads such as LIBOR-OIS and TED have retreated from the elevated levels of April and May. Credit default swaps on peripheral European economies are still elevated, but they reflect the fundamentals of those countries rather than contagion risk that has now been mitigated due to the coordinated effort of European governments and the European Central Bank (ECB).
The fact that ECB will remain as active in the sovereign bond market as necessary will maintain liquidity and keep spreads under control.
Europe is also likely to see a positive impact on its economy from Chinese demand. Already German car-makers are experiencing exponential growth in sales in China. High-end consumer goods manufacturers in Europe will be the main beneficiaries of an emerging Chinese consumer, just as China’s urbanisation and resulting fixed asset investment have boosted Australia’s resources sector in the last ten years.
However, news from the US is less positive. Recovery is stalling as consumers, who represent over two-thirds of the economy, remain hunkered down due to: high unemployment levels; a housing market back in the doldrums; and historically high household debt.
The US Federal Reserve has signalled its willingness to undertake further quantitative easing, and it is likely that intervention may be required to squeeze long yields down now that the cash rate is close to zero.
In Australia, the relatively hawkish stance of the Reserve Bank of Australia (RBA) has been driven by terms of trade (net exports) and investment components of the economy (mainly in resources) which are both strong because of the China (and to a lesser extend India) theme.
Domestic consumption demand in Australia is relatively contained. However, the RBA remains concerned that the spare capacity in the economy is low and, should domestic consumption pick up when exports and investments are strong, inflation could easily become an issue - the two-speed dilemma that has been referred to by economists and politicians. While the most recent decision by the RBA was to keep interest rates on hold - and the timing of the next rate rise can be debated - there is little doubt that the tightening bias remains.
Based on economic fundamentals, the equity market appears to be range-bound in the near term despite attractive valuation metrics. The subdued growth outlook for the US is probably the biggest macro factor weighing on markets. A year-end rally cannot be ruled out, as sentiment among investors remains bearish and fear elevated.
Strong monthly performance in September, despite expectations, was a classic example of how markets can catch investors out when sentiment swings substantially in one particular direction. Also, renewed quantitative easing is likely to be supportive for risky assets including higher beta equities and commodities. Australia is a likely beneficiary.
Some of the uncertainty has now been taken out of the equation, specifically with a decision on who will form the new government. However, this has also raised new questions and uncertainties. A new cabinet means delayed decision-making, which is not a Labor-specific issue but one that affects business in every election cycle. The likelihood that we will return to polls sooner than the full three year term is also something for investors to keep in mind.
Looking at some specific opportunities for investors, retailers with strong business models such as JB Hifi, Super Cheap Auto and David Jones continue to appeal. The RBA has muddied the water somewhat for retailers in the lead-up to Christmas but those with a unique offering, low-cost or low-risk model, and an expanding footprint, will deliver on earnings expectations even in a tough operating environment.
Smaller miners with low costs and expanding production are always of interest. Copper and nickel are our two preferred base metals and we remain bullish on coking coal and iron ore over the medium term. OZ Minerals, Western Areas and Gloucester Coal are currently in the portfolio.
Gold is likely to remain well-bid as global asset allocators look for an alternative to the US dollar, Euro, and Japanese yen. Emerging gold producers with strong exploration prospects and a growing production profile such as Regis Resources are interesting.
A strong Australian dollar is a headwind for healthcare companies, but the underlying franchise quality of stocks like Cochlear and Resmed is second to none and earnings will grow strongly for these names for some years.
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* Prasad Patkar is portfolio manager at Platypus Asset Management, an Australian equities joint venture partner of Australian Unity Investments
