Australian Economy
Overview
The latest national accounts released on 2 March show that the economy grew by 0.7% in the December quarter and by 2.7% over the year. Growth was driven by a large increase in business inventories (stock on hand). An increase in inventories can either be a sign that businesses are confident of an increase in future sales or alternatively, a sign that business has over estimated demand. Only time will tell.
Of course much has happened since the end of December, including a string of natural disasters such as the Queensland floods, Cyclone Yasi and of course the horrific events in Japan. All of these factors are likely to provide a temporary reduction in overall output in the March quarter. This is likely to be reversed in the June quarter as the additional activity to rebuild and repair flood ravaged Queensland gathers momentum. Similarly, exports to Japan may suffer a temporary adjustment, but these too are likely to rebound in coming quarters as the reconstruction effort gets underway. Despite the near term impacts of these natural disasters, some very clear trends persist in other parts of the economy.
Firstly, the resources boom continues unabated. As noted in previous commentaries, the rise in demand has been largely driven by the industrialisation of China and to a lesser extent, India. To put this into perspective, the number of people living in cities in China and India alone over the past decade has increased by over 250 million (over 10 times the Australian population) , requiring an enormous expansion in infrastructure and housing. In turn, steel production in India has doubled and in China it has increased five fold. No surprise then that demand for iron ore and coal (in particular) has far exceeded supply, resulting in soaring commodity prices and a terms of trade about 65% above average. Resource exports now account for 57% of Australia's total exports. Australia is the world's largest exporter of iron ore and coking coal (used for steel production) and the second largest exporter of thermal coal (used to generate electricity). Based on known reserves (in Australia) and 2009 production output, iron ore and coal are expected to last another 71 and 98 years respectively.
Of course, any investment boom throughout history inevitably results in a supply side response. By 2015, the supply capacity of iron ore in Australia is forecast to almost double from 2007 levels, thanks largely to expansion projects totalling around $35 billion. Coal export capacity is forecast to increase by about 20% over the next 3 years while LNG capacity is forecast to increase by more than 150% by 2016, due to committed projects totalling some $72 billion. This supply response is being mirrored globally. Inevitably, a greater supply without any commensurate increase in demand will lead to lower prices. The boom will not last forever but in the meantime national income is materially higher as a result.
The second clear trend that has emerged since the onset of the Global Financial Crisis (GFC) has been the material increase in Australia's savings ratio. Australians are now saving a greater proportion of their disposable income than they have for many years. The savings rate has increased from almost nothing 5 years ago to around 10% of disposable income, much of which is being used to reduce debt and improve household balance sheets in the wake of the GFC. In the short term, this has been at the expense of retail sales and credit growth, both of which have been much more subdued in recent times (excluding Queensland, retail sales rose just 0.1% in February; sales in Queensland were higher as consumers begin replacing items damaged in the floods). Over the longer run, this savings trend is a positive development as it is should slowly increase the buffer available to individuals to meet the costs of living (by either getting ahead of mortgage repayments or providing a cash buffer), potentially cushioning the effect of the next cyclical downturn.
Conclusion
The mining boom and commensurate boost to national incomes has been difficult to reconcile for many Australians. This is because the boom has been largely responsible for higher interest and exchange rates. Higher interest rates have absorbed any increase in disposable income obtained by households with mortgages. In turn, the retail sector has been impacted by subdued consumer spending while the tourism and import competing manufacturing sectors have been impacted by the higher exchange rate. Nonetheless, unemployment remains low (at 5%), inflation remains contained (at least for now) and demand from China for the main bulk commodities (iron ore and coal) is not showing any signs of slowing. Although natural disasters may provide a temporary reduction in growth in the March quarter, we expect growth to recover to around trend (3% - 3.5%p.a) thereafter.
International Economy
Overview
In late January the International Monetary Fund (IMF) updated its world economic projections for 2011. Global growth is forecast to rise by 4.4% in 2011 and 4.5% in 2012. Growth in advanced economies is forecast to rise by 2.5% and growth in the emerging economies by 6.5%. These forecasts were made before the turmoil in the Middle East and North Africa (MENA) began to unfold and before the tragedy in Japan. The scale of the disaster in Japan is beyond comprehension. The clean up and timelines for restoration of infrastructure and housing remains uncertain. Further, the International Atomic Energy Agency continues to warn that the situation at the Fukushima Daiichi Nuclear Plant remains very serious. In an updated on 29 March, they said: "The crisis at the Fukushima Daiichi plant has still not been overcome and it will take some time to stabilise the reactors." As a result, we cannot yet be definitive about the financial impact of this disaster except to say that, assuming radiation is eventually contained, economists estimate that growth in Japan is likely to be materially weaker for about 12 months. That said, the eventual reconstruction effort is likely to provide a substantial boost to activity thereafter. On these assumptions, we do not believe global growth will be derailed, but certainly we expect it to be somewhat lower than the IMF forecasts suggest.
Certainly in our view the situation in the MENA region provides greater downside risk to the global economy as a whole. Oil is a major input of production and recent price rises have already had spill over effects in terms of putting upward pressure on prices. Higher prices without any commensurate increase in incomes inevitably leads to lower demand. It is true that the GFC has left much of the developed world with excess capacity, allowing some absorption of higher prices without unduly impacting inflation. But there comes a point when firms must pass on higher costs to stay in business. Economists estimate that a spike above US$120 per barrel would be enough to cause significant inflationary effects and lower growth. A spike above $150 for an extended period would most likely cause a global recession. With the oil price at $104 per barrel at the date of writing, we need to be alert but not yet alarmed.
United States
December quarter GDP in the United States came in ahead of expectations at 3.1%, thanks largely to Quantitative Easing Mark 2 (QE2) announced in November and an extended Fiscal Stimulus package announced in December. Recent growth has been underpinned by improved household consumption, much of which has been boosted by temporary government support. With household debt still high and house prices in renewed decline, asset values are unlikely to underpin any further resurgence in consumption. A sustained improvement will need to come from rising incomes (wage rises and/or rise in number employed). While job creation has improved somewhat in recent months, the pace remains uneven. Rising commodity and oil prices also present a growing threat. Not so much in terms of higher inflation, as excess capacity remains high, but more so in terms of slower growth outcomes. Fortunately corporate profits remain solid and it is here where the recovery is on a firmer footing. Ultimately though it must be remembered that the US economy remains on an unsustainable fiscal trajectory. Government debt continues to rise as does its unfunded future liabilities (e.g. future social security liabilities). Printing money will not solve the problem. At some point, the US needs to adopt sustainable policies that result in meaningful debt reductions. Fiscal consolidation of course represents a huge challenge. Reducing public spending will cause a recession unless private sector output is robust enough to take up the slack.
Euro zone
Growth in the Euro zone (EZ) has continued to exceed expectations due largely to the extraordinary growth in Germany. Germany is a large global exporter and demand for its products (including cars and electrical) has soared on the back of the much weaker Euro. Key trading partners, including France, have benefitted from the flow on effects. As long as global growth is not derailed, most economists expect modest growth in the region of around 1.5% to continue throughout 2011. Certainly, high commodity and oil prices present a growing threat. Of course it would be remiss of us to suggest growth in the EZ is broad based. Sovereign debt problems continue to plague the region. Greece remains in deep recession, Portugal looks set for a double dip recession and growth rates in Spain, the United Kingdom and Ireland are likely to stay subdued for an extended timeframe.
China
As China's presence as an economic powerhouse continues to grow, so too does the scrutiny over the state of its economy. Risks of China's economy slowing significantly due to higher interest rates or exchange rate imbalances appear overstated, at least for now. This is because we need really look no further than the Government's Five Year Plan to identify where their economy is headed. The Five Year Plan for 2011-15 makes for compelling reading. It will spend RMB$1.3 trillion to build 10 million low income apartments in 2011 alone (akin to housing roughly half the population of Australia in one fell swoop). Even if global growth stalls, the Five Year Plan is likely to underpin strong domestic demand for some years to come.
Conclusion
Despite recent natural disasters, the global recovery remains on track. Risks however are certainly more elevated than they were some months ago and so we would have to argue that global growth forecasts may disappoint.
Australian Equities
Overview
Over the quarter ending 31 March 2011, the ASX 200 Accumulation index rose by 3.23
The March quarter was characterised by significant volatility as investors attempted to digest the impact of the floods in Australia, the turmoil in the Middle East and the tragic events in Japan. The significant uncertainty saw an initial flight to safety, away from riskier cyclical stocks and into more defensive safe havens. This was unwound somewhat in the last week of the quarter as fears began to ease.
Outlook
Australians have very much adopted a more conservative outlook since the GFC. No longer are they borrowing voraciously against rising property values (partly because the rate of growth has slowed and partly because interest rates have risen) to fund consumption and as such we have seen a shift in spending patterns. Unsurprisingly, this has led to retail sales growth well below trend. Until asset values (property and shares) begin to rise again, or interest rates fall, this trend is likely to persist for sometime yet.
This certainly has had negative implications for the retail sector where revenue projections have had to be revised, and the banking sector where household credit growth expectations have reduced. Lower credit demand has also impacted the building sector where new building starts remain weak.
The rise and rise of the Australian dollar has also brought with it its challenges. Import competing manufacturing companies have been forced to reduce margins (hence profits) to stay competitive. Companies with large offshore operations have found those earnings materially lower when converted into Australian dollars and tourism operators have been impacted by lower overseas arrivals. Against this backdrop, profit forecasts in the resources sector remain at or near record highs. China's 5 year plan, which includes a massive housing project, should ensure continued demand for Australia's resources for some time yet. The energy sector too is benefitting from higher oil prices and expectations of even greater near term demand for coal and LNG following the nuclear energy disaster in Japan.
Conclusion
Based on earnings estimates for the year ending 30 June 2011, we maintain a fair value assessment for the ASX 200 of around 5,580. This represents an increase of 15% from 31 March levels. It is based on consensus earnings expectations for 2011 multiplied by a long term average market earnings multiple of 14.5. As such, we believe the Australian share market remains moderately undervalued and recommend a modest overweight position.
International Equities
Overview
Over the quarter ending 31 March 2011, the MSCI (ex Australia) World Index rose by 3.11%.
Over the quarter global equity markets experienced a heightened level of volatility due to a raft of incredibly significant events. These included the uprisings in the Middle East and North Africa that have sent the oil price spiralling upwards; the devastating earthquake, tsunami and nuclear emergency in Japan; NATO action in Libya; and the likelihood of a bailout in Portugal. Against this challenging backdrop, the global index still managed to rise.
Much of the gains were made in the United States, where corporate profits have risen strongly over the last 12 months, albeit off a low base. Standard & Poor's consensus earnings estimated for the S&P 500 (the main US share market index) for the 2011 calendar year are currently in the order of $95 per share. Using a multiple of 14.5, we estimate fair value for the S&P 500 to be in the order of 1,377. Consensus earnings estimates for 2012 are in the order of $98 per share, implying fair value of 1,421. As at the date of writing, the S&P 500 was at 1,328, only 3.7% below fair value for 31 December 2011. Given the global risks that persist, we would argue that the US share market is certainly no longer cheap.
Conclusion
Global risks remain unusually elevated at the present time, yet the main global index constituent, the share market of the United States, is now relatively fully valued. As result, we recommend maintaining a modest underweight exposure to international equities over the coming quarter.
Australian Real Estate Investment Trusts (Listed Property)
Overview
The ASX 200 A-REIT Accumulation index returned 3.80% over the quarter.
The February profit reporting season delivered results at or mildly above consensus estimates for the AREIT sector. Outlook statements were generally positive with a number of trusts marginally updating earnings guidance. That said, earnings growth prospects remain relatively modest with growth of 3.2% expected this financial year and 3.8% in 2012. The sector certainly displayed less volatility than the general market over the period, indicative of a sector that has reduced risk by significantly reducing debt (look through gearing is now in the order of 30%) and, to a large extent, refocusing on investing in properties that deliver investors a stable but growing rental income stream over time. Sector dividend yield expectations for 2011 have risen to around 6.4%.
Outlook
High interest rates and below trend household credit growth are likely to continue to make conditions somewhat challenging for those trusts that focus on residential housing development. Still, some will benefit from reconstruction of flood affected areas. The fundamentals for the office and industrial sectors remain broadly positive with employment growth and favourable business conditions likely to add to demand. As surplus capacity slowly continues to be absorbed, the potential for rental increases may not be too far away, at which time, the prospect for asset revaluations may be realised.
Conclusion
The sector is now trading at a 6% premium to its net tangible asset backing, but this is skewed by Westfield, Stockland and Goodman Group which are all trading at a premium. Most other stocks are trading at between a 5 and 15% discount. This discount arguably remains justified, especially for those stocks with lower quality assets, less certain income streams and higher levels of debt. In short, valuations are no longer compelling but selective value remains. Nevertheless, fundamentals in the sector continue to improve and so a benchmark position is recommended.
Fixed Interest
Overview
Fixed interest returned 2.04% over the quarter ending 31 March while cash returned 1.22%.Outlook Despite low unemployment and an unprecedented resources boom, consumer spending remains subdued and household credit growth below trend. By and large, the string of interest rates rises since the end of the GFC, coupled with very high levels of mortgage debt have begun to impact upon disposable incomes. This in itself would normally be sufficient for the RBA to consider a reduction in rates.
But these are not normal times. The RBA remains transfixed on the resources boom and the record terms of trade that has resulted. The theory being that the impact of higher mining profits and higher incomes from those who work within or support the sector are expected to generate greater wealth, enhance demand for goods and services, putting upward pressure on prices and labour (hence the risk of inflation). Retail sales, in effect, are the conduit that can help spread the wealth from the mining boom across the broader economy – but only if interest rates don't offset the gains. An increase in retail sales leads to increased orders, driving manufacturing and service industries. The resultant pick up in activity enhances income via higher employment and wages leading to a virtuous spiral (multiplier effect).
The actual experience to date has been less obvious.
Shareholders have enjoyed higher dividends and miners much higher wages, the benefits of which have flowed trough to related service industries. Yet the sector is not a large employer and so the boost to incomes has been somewhat concentrated. Increased spending from miners and other sector beneficiaries (service providers and shareholders) has to date been offset by higher interest rates reducing the spending power of other groups (namely households with mortgages). In our view this is why retail sales have remained lower than expected
We are left in a position where the RBA's preferred inflation measure, the trimmed mean, now stands at2.2%, at the low end of the 2-3% target range. The RBA though will remain reluctant to reduce rates as they are mindful of the huge level of capital expenditure commitments in the resources and energy sectors that in time, will only further add to national income should commodity prices remain elevated. In a way, monetary policy is now hostage to the mining boom.
Conclusion
Despite subdued retail sales, we expect the Reserve Bank to maintain a mildly restrictive policy stance while the terms of trade remains elevated and the oil price remains high. On balance, we believe the RBA is likely to leave rates on hold over the coming quarter. We continue to recommend an overweight cash position and modest underweight fixed interest position.
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