Over the last month or so, there have been a few wobbles in the sharemarket that may have caught some retail investors by surprise.
However, the fall-back in the Index should not be a major cause for concern on its own. At Platypus, we have held a view for a while that the market would not see significant increases for some time, but instead remain relatively range-bound, and that clarity on the shape of the recovery in the underlying economies of the OECD countries – and in particular the USA – would determine if the market broke out of that range.
We had identified the range to be between 4400 and 5000 on the S&P/ASX 300. However, the current correction has clearly broken this range on the downside from a rising risk aversion to the trembles in the European sovereign debt market and concerns around China’s policy tightening.
Investors are understandably worried that these macro risks and the European issue in particular could cause dislocations in the debt markets which would derail the economic recovery currently underway. The irony is that the macro data and corporate news flow from around the world and especially the USA has been strong, which tells us that investors are happy to lock in the gains made off the March 2009 lows and take risk off the table, irrespective of the improving outlook for the economy and corporate profitability.
This process is to be expected – we have had one of the most savage bear markets on record, followed by a spectacular recovery. Markets are now in a consolidation phase which will have several “risk on / risk off” periods and, as long as there is no left field event that causes another seizure in the debt markets, the recovery in the global economy should remain on course which in turn should bring back stability in global capital markets.
Potential threats
Could Europe or China cause the recovery to come off the rails? A policy mistake in China that results in choking of growth is unlikely. Everything we have seen in the recent times from the Chinese authorities suggests that they are proactive and targeted in their tightening measures.
In the West, we tend to ignore asset bubbles until they blow up and cause significant collateral damage; in China, the authorities are actively trying to nip the potential for real estate bubbles in the bud. And in doing so, they are not using blunt instruments such as interest rates which damage all the other sectors of the economy but instead the administrative tools directed specifically at the residential real estate sector in the regions where they have the more serious concerns about speculative activity. These policies will prolong the duration of China’s economic cycle and make it less prone to ‘boom-bust’ type volatility.
Looking at Europe, there is no disputing the fact that some member nations of the European Union (EU) need to repair their sovereign balance sheets. It would have been impossible for those Governments to implement steps needed to bring their fiscal deficits under control whilst under attack in the debt and FX markets.
The measures that the EU and the European Central Bank (ECB) announced a week or so ago are a short term source of stability in the government debt and FX markets which can then lead to longer term measures to repair the fiscal situation. These measures won’t be painless and EU members that need more drastic belt tightening will see a marked slowdown in economic activity as well as social unrest. But this is the price that will have to be paid for continued membership to the EU.
Furthermore, the EU aid package was a move that demonstrated unity amongst the member nations. The package was supported by the ECB with a commitment to undertake open market operations to bring stability and order back into capital markets.
The importance of these coordinated and unified measures in reducing the prospect of a contagion destabilising the global financial system cannot be understated. Leading into the announcements in Europe on 9 May 2010, we had concerns that disunity and domestic political agenda would take priority and that Europe may not take the steps that were taken in the US in late 2008 and early 2009 to stabilise the financial system.
This risk has now clearly passed and over time sovereign debt markets will normalise further and we can start debating the shape and duration of the global economic recovery again, instead of panicking about a prospect of another global financial crisis.
Future recovery
Overall, the recovery in the global economy has played out as expected. The markets went into a sideways trading pattern from October 2009. We have been expecting this pattern of range-bound trading to continue until the shape and sustainability of the recovery (especially in the US) became clearer. The recent market downturn, although sharper than we had initially expected, has not broken out of this overall pattern. The events in Europe have somewhat hijacked this scenario in the short term but we believe that European concerns will settle down and we will be able to focus once again on economic growth and corporate profitability in the second half of calendar 2010, and both these metrics look like they are improving.
Understandably, the Australian dollar has suffered as a result of the recent global events. It is a high beta currency and therefore a good proxy for global risk appetite. The current weakness in the dollar is a good reflection of the nervousness that has engulfed global investment community. More broadly, the Reserve Bank of Australia appears to have completed the process of neutralising the rates setting which has caused the carry traders to take the long AUD bet off.
At Platypus we think it likely that the dollar will recover as the macro concerns settle down and economic recovery comes to the front of investors’ mind, but predictions in this area are always fraught with danger!
Looking forward, the proposed Resources Super Profit Tax in Australia is likely to keep the resources sector under pressure until clarity emerges on the final form of the proposed legislation, and federal elections will play a big part in how this gets resolved. A federal election in Australia will be an additional source of uncertainty and may keep international investors on the sidelines for a few months.
Data flow out of China over the next few months that allays concerns about Chinese policy mistake may take some pressure off the sector as will valuation support validated by increased merger and acquisition activity.
The banking sector, which is the other large component of the market, is also consolidating gains. Bad debt cycle is playing out as expected but the market is starting to ask what happens next? How does the sector grow revenues from here if loan volume growth remains subdued and margin contraction recommences? Retailers have been on the nose since December 2009 and could become the stand out performers in the back half of 2010 if interest rates remain on hold for some time.
Overall, FY 2011 will be a year of picking quality stocks and then actively managing the portfolio – a buy and hold strategy may produce a disappointment.
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* Prasad Patkar is portfolio manager at Platypus Asset Management, an Australian equities joint venture partner of Australian Unity Investments.