A view from the Equity Market – AXA IM’s Tinker comments
After the October wobbles we saw a sharp bounce on Wall Street (S&P up almost 9%) before some technical activity retesting both recent highs and lows. Markets remain nervous but not panicky; the risk managers have done their bit and the fund managers have been allowed to sit back at their desks. It’s not so much business as normal as panic over.
This week sees the end of QE3 at least, if not the end of QE entirely, and doubtless the Economist newspaper has prepared several possible covers for this Friday with some sort of Halloween zombie theme with QE4 rising from the dead. There does seem to be some evidence of some value investors coming out of the woodwork, with a clear focus on sound balance sheets and good cash flows. As discussed in recent weeks, when there is a technical sell-off in markets that is then re-interpreted in terms of economics, then there is a likelihood that economically sensitive and cyclical stocks may find themselves overshooting to the downside. This is where the value investor can find opportunity.
The chart shows one of my favourite ETF’s the Dividend Aristocrat Index, essentially high quality US dividend paying stocks with an unbroken track record of paying or increasing dividends.
This has been one of the best vehicles for the buy and hold/add on the dip investor in recent years and made a new high once again this week as value investors stepped off the side lines to pick up equities with growth prospects and higher yields than bonds. Quality growth and income.
The Federal Reserve (Fed) looks to be sticking to its exit timetable this time (though some members like to talk of leaving the door open) but it is worth recognising that whereas in 2009 the fiscal deficit was 10% of GDP, it is now below 3% and nominal GDP growth is likely to be in excess of 4.5% for the next three years, whereas in the wake of the financial crisis it was basically zero. This is important to remember in the context of equity investments, especially when markets periodically ‘predict’ economic conditions from movements in bond yields. The US economy is basically in pretty good health. Not only has the US government managed to improve the health of its balance sheet, in the last six years, but so too have US households.
The chart shows US household debt as a % of personal income, which illustrates the steady deleveraging of US households since the crisis. At 90% of income, debt is now back to the levels it stood at in December 2002, just before the low interest rate policy of the Fed post the dot.com crash stimulated the housing debt bubble. Moreover, the current low levels of long term interest rates provide a further positive benefit as US households are taking advantage of refinancing opportunities to reduce the interest cost of their existing stock of debt.
In the meantime the corporate sector in the US appears to be increasing its balance sheet – US commercial and industrial loans are showing clear signs of growth, demonstrating an important driver to economic activity from the credit cycle. Some of this is undoubtedly associated with financial engineering – in many cases share buyback – but we can also see data series pointing to a pickup in capital investment by US corporates.
The headlines are all about how falling oil prices are ‘a bad thing’. For energy companies at least, but no mention of the benefit to energy consumers – essentially almost everybody else. Naturally, when oil prices were going up, we heard about how bad this was all going to be for energy consumers with no mention of how good it was for energy producers. As discussed in recent notes, there are a number of companies and a number of regimes for whom oil permanently below $80 would definitely not be a good thing, but it is questionable if this is really going to happen.
This continues to look much more like a short term supply spike rather than a long term demand collapse. However, if we add in the lower cost of gasoline – off a further 12c a gallon on average in the last two weeks which is basically $12 billion to be spent on something other than gasoline to lower mortgage rates – then the prospects for US disposable income look a lot healthier than many are willing to concede. Mortgages and gasoline act like a tax cut/increase for US consumers and right now both are positive, suggesting some positive potential surprises for companies exposed to the US consumer.
Oil has basically given up 38% of its rally from the end 2008 of lows, indeed the range $82-$110 that West Texas has traded the last 4 years is the Fibonacci range. This is not to get too precious – the numbers for Brent are slightly different, with the 38% range having broken and (presumably) traders targeting the 50% range, implying around $82 on Brent (currently $85). In my opinion the Fibonacci numbers are interesting because they suggest that the price of oil, along with other high profile prices such as Yen, Euro and gold have a large element of trader activity embedded in them.
The big news in Hong Kong this week has been the delay to the launch of the Hong Kong / Shanghai ‘through train’ project which was due to start this week. Some commentators saw conspiracies around the protests in Hong Kong, but more realistic is the fact that the time table was simply too tight to solve all the concerns raised by investors,particularly on the ’north bound’ train. As we noted back in April when the announcement was made, the six month timetable was pretty ambitious and the more we looked at the detail (we were not alone in having many different briefing meetings) the more obvious it became that while the ‘southbound train’ was simply extending current China practices to operating in Hong Kong, the north bound investors had many more concerns about a move in the opposite direction.
In particular, the current China policy requires a seller to deposit the securities they wish to sell the day before they actually do so – in effect telling the broker (and the market) the size of their position and their intention a day in advance! Western investors, who have spent years trying to prevent themselves being front run were horrified at the prospect, producing a rethink and a series of work-arounds, involving sub custodians and a variety of checks and cross checks. Somewhat clumsy, but likely effective and, crucially, requiring more time.
There is no doubt however that the Chinese authorities want this to happen; it is part of the ‘Rubik’s Cube’ of policy changes coming through that, while looking unconnected at first are likely to be revealed to be part of a carefully constructed multi-dimensional plan to open up China’s capital markets.
On the mainland this week we have seen more from the Fourth Plenum and its focus on the rule of law. While there have been none of the fireworks from last year, there is a clear sense of steadily advancing an agenda, with continued focus on anti-corruption and pollution, but also an underlying sense of a desire to improve the overall efficiency of the economy. There was talk of extending the free trade zones although someone in Shenzhen may be required to explain the old discrepancy between Chinese exports to Hong Kong and Hong Kong imports from China re-appearing before that can happen. Apparently the former are +34% while the latter are only +5.5%. Perhaps like QE, the shadow banking system isn’t dead quite yet?
Infrastructure spend is not dead either, despite the clear desire to increase consumption over investment. A big clue is the statement that the two railways companies (CSR and CNR) that were split off from the main state railway some time ago are now to merge together again, seemingly to improve the prospects for exports, but also presumably to capitalise on the big railway infrastructure push planned by China.This week sees the Asia-Pacific Economic Cooperation (APEC) meeting in Beijing at which there is to be discussion about the founding of an Asian Infrastructure Investment Bank, referred to after the World Cup as a BRICS bank. The idea is to allow China to be less directly involved in funding infrastructure projects in Asia, instead providing part of the capital along with other regional players such as India. Perhaps not surprisingly western institutions such as the World Bank are opposed to the idea and certainly the initial funding looks to be mainly Chinese as other countries stand back a little. Nevertheless the ambitious plans for a new silk route to the West based on advanced rail systems with China at the hub are a serious long term policy.
Elsewhere in China there is much focus on the headline real GDP number. On the one hand commentators are mocking the ability of the Chinese government to exactly meet their predicted number, while on the other hand claiming it is either tremendous or terrible if they beat or miss the number. The reality is that we are in the second or third year of a transition from investment to consumption and for equity investors this is all about finding the relative winners rather than obsessing with a top line number. As discussed in the last note, the base effect is very significant here; in 2012 China nominal GDP was around $8 trillion, half that of the US. This year it is forecast to be $10 trillion, against $17 trillion for the US. Over the two years it has been ‘slowing’, China has added the equivalent of another Italy, or 90% of the UK to total global output. The law of big numbers says that growth slowing can still represent a significant increase in demand.
Importantly while the macro can point us in the direction of positive economic tailwinds it is not enough to simply buy a basket of ‘consumer’ related products, there are many levels of consumption and most importantly we need to focus on cash flow and profitability. Merely being in the right place at the right time does not guarantee a return on capital.
The Chinese property sector is very much part of the old investment model and while instinctively we are not as apocalyptic as most, there is clearly a big inventory problem, especially in third tier cities. As David Murphy and his colleagues at CLSA’s China Reality Research point out, third tier cities are 70% of volume by square footage and yet 40% of them are now reporting a decline in population. As one property developer in Xi’an put it to CLSA; “There’s been 20 million square metres of property sold in Xi’an in the last 20 years, another 20 million square metres is currently under construction and only 180k/month are actually selling!” This is over 100 months of supply, and everybody is already long, with home ownership at 87% and 21% of families owning multiple homes. The real concern is that vacancy rates are now very high at over 22%. One can dispute the exact figures, but the order of magnitude is broadly correct and contrasts heavily with Hong Kong at under 5% and the US at 2.5%.
Finally we are never very far away from politics when looking at markets at the moment, because the policy responses that are having economic impacts are no longer those of the Fed with their monetary policy, but of politicians and their fiscal and regulatory policy. Another set of ‘tougher than the last guy’ capital requirements and bank risk tests this week for instance are far more relevant for banking profitability than any insight into a quarterly change in potential output might be. In Europe we had the rather amusing spat last week between David Cameron and the EU over a retrospective budget adjustment with an urgent demand to pay. The amusing thing of course is that the adjustments to the UK GDP were based on an inclusion of the black and grey economy – something that by its very definition is outside of the scope of government – and thus (theoretically) can hardly be increasing tax take. Meanwhile the French and Italians are trying to finesse the strict budget deficit requirements and the Swiss are proposing a referendum which if it passed would require Switzerland to buy back all of the physical gold is has sold off in the last few years (this has the gold bugs very excited as you can imagine).
The US have their midterm elections this coming week, while it would be fair to say that the markets were less excited by the politics in Tunisia and Brazil than they have been in India and Indonesia. While the victory by Dilma in Brazil was not unexpected, the market didn’t like the news. They were however more encouraged by a surprise increase in interest rates, which they regarded as an important step to get the economy back on track. In a mirror to the US, Brazil has falling growth, rising inflation and a growing budget deficit.
Finally it is interesting that now the restrictions are off on Alibaba the various investment banks are all coming out neutral to positive. The stock debuted at $68 before jumping straight to $90 and has edged up a further 10% since. The fact that it launched about 10 minutes before the recent market sell-off means that in relative terms it has been a fantastic relative performer in its first moth. Ultimately it is a two way pull between concerns on governance and control (the reason the float was in the US rather than Hong Kong) and what is now the biggest retailer in the world.