We believe the Australian economy will see moderate growth in 2016, but we are keeping our eye on a potential road bump: the risk of a harder landing for the Chinese economy.
The slowdown in Chinese economic growth in the past few years has been an ongoing concern in Australia. China is a primary consumer of Australian commodities, particularly iron ore, the main ingredient needed to manufacture the steel that has been essential to China’s building boom of the last decade or so. Commodities comprise about half of Australia’s exports; iron ore alone makes up 20.2%.1
Recently, however, China’s annual rate of gross domestic product (GDP) growth has slowed from double digits in the early 2000s to less than 7% in 2015,2 and the country’s demand for commodities has declined along with it. In turn, the expectation for a continued slide in Chinese commodity consumption led the Organisation for Economic Co-operation and Development to cut Australia’s 2016 GDP growth rate from 3% to 2.6%.3
If China’s growth rate continues to slow in the year ahead, the Australian economy may experience a corresponding falloff, with the natural resources sector likely to bear the brunt of the decline. While the possibility of a hard landing for China cannot be ruled out, we believe large-capitalisation Australian resource companies may be cushioned by their position as low-cost producers, particularly in iron ore, and by the weakness in the Australian dollar that would likely accompany lower commodity prices.
We anticipate little price recovery in commodity prices in the immediate term. Excess returns in commodity markets in recent years have been removed by price falls in response to waning demand. Meanwhile, supply-side volume adjustments have been limited to date, and have resulted in a build-up in inventory.
At present, we do not see compelling broad-based value opportunities in the Australian resources sector. Where we do see value, our exposures remain scaled to reflect residual commodity price risk. That said, we are finding value in a number of energy, and oil and gas companies following significant share price underperformance. We are neutrally positioned on mining companies, but do see some selective opportunities. We remain cautious on the price of gold and gold-related equities.
Financials Meeting Regulatory Challenges
Looking to the Australian financial sector, new capital standards that were meant to bolster banks’ balance sheets have required the banking sector to raise money, and share prices are now at levels which appear to represent attractive long-term value. Whilst cyclical and regulatory headwinds for Australian banks exist, their relatively high pre-tax dividend yields, combined with modest earnings growth, have provided attractive total returns.4
Retail banks, which have benefitted from recent mortgage repricing activity, appear to us to be better placed to grow their earnings than more business-oriented or corporate banks. We believe the key risks for the sector relate to the pace of asset-quality deterioration from a multi-paced global economy, global regulatory agendas and the ability to contain costs if revenue growth moderates.
Our analysis reveals that the current return on capital within the life insurance sector is low by historical standards, and the near-term outlook for system growth rates (or total premium written) is subdued. In general, however, life insurance companies have taken actions that should improve returns over the next few years. Regulatory changes are likely to benefit returns in the medium term, although there is the potential for negative outcomes in the short term.
General insurance is volatile by nature, and the near-term outlook for that line of business looks uncertain to us. We think the healthy margins achieved over recent years in personal lines products are likely to move lower. Competition in these segments is intense, with smaller players gaining market share. The outlook for commercial insurance, both domestically and internationally, is also quite challenging with premium rates under pressure.
Within the broader wealth management sector, movements in equity markets will likely have a strong influence on future profitability. The flow of money into wealth products remains quite soft, and with the threat of yet more changes to Australia’s superannuation system—its government-mandated retirement plan—we believe this softness is likely to persist. Regulatory changes, whilst positive in terms of creating a higher-quality, more robust market structure, are introducing higher costs and placing pressure on margins. We currently find it challenging to find valuation appeal in this sector.
We also remain concerned with stretched relative valuation metrics in the infrastructure investment space (toll roads, airports, electricity and gas). Whilst we believe the majority of these companies are being managed and operated very effectively, prospective returns appear to have been compressed due to strong share-price outperformance during 2015. We recognise the durability of the expected future cash flows of these businesses in the current economic context; however, share prices reflect a high degree of investor certainty regarding future cash flows that we don’t fully agree with.
Meanwhile, valuations in the industrials sector have become unusually polarised based on a company’s perceived earnings. As a consequence, share prices of highly rated companies will likely be very sensitive to changes in earnings certainty. We would anticipate this polarisation to diminish in the medium to long term if interest rates revert closer to their historical norms.
By contrast, risks are arguably more than priced into some of the more cyclical stocks. Share prices of companies with exposure to the residential housing market appear to be anticipating a sharp reversal of fortunes. The market also appears to be fearing oil price volatility—for both oil consumers and oil producers.
While we monitor the daily vagaries of the market, our approach to investing in Australian equities is based on fundamental value over a medium- to long-term investment horizon. We pay little heed to short-term market noise or forecasts of near- term company earnings. When making investment decisions, our emphasis is on a firm’s business model and long-term earnings and cash-flow sustainability.
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