Crispin Murray

Head of Equities

2016 – the new year not a good year so far

New years often start with a type of reversion trade, as the laggards of the year just past bounce back. Not this year – the small rally in resource stocks in late 2015 has been wiped out, and then some, in the few weeks to date (despite Monday’s recovery due to a jump in the oil price and some promising words from the European Central Bank’s Mario Draghi).

Clearly the commodity and oil sectors lie at the heart of the volatility. Why? The market is enduring one of its periodic bouts of paranoia about China’s ability to maintain growth and avoid a “hard landing”. As was the case in August last year, there was no significant fundamental economic change prompting this episode.

Yes, structural changes in China’s heavy industry are seeing capacity cuts, and job losses are acting as a drag on growth. Yet the deflationary effect of China’s reform programme has been well telegraphed. We do remain wary on China – and on the resource sector as a result – yet we do not think that things are taking the negative turn that the recent market action would suggest.

The oil market is oversupplied and will remain so while ever the Saudis refuse to curtail production. Again, the only significant change here is the price of oil – the supply and demand fundamentals remain relatively constant. Near term the oil price will stay weak either eventually triggering a supply side adjustment and in turn a rapid bounce back or requiring demand to slowly claw away at the excess supply, which will lead to a more protracted period of low prices.

Weakness outside of commodities and oil largely reflects the fear of contagion. The market is questioning the solvency of resource companies at current commodity prices and is extrapolating this risk to the banks which provide them credit. The fear is that a tightening of credit by the banks could lead to a downturn in the global economy.

There are some comparing the current episode to 2007/2008 and forecasting further sharp falls in the Australian equity market. We believe the comparisons are not valid for several reasons:

  1. Australian equities have not performed well over the past 12 months. Unless you believe a recession is imminent – and we don’t – then the market does not look expensive and it is hard to get too bearish.
  2. The global economy is in reasonable shape. There is some momentum in the US job and housing markets, unlike 2008 where the latter was entering a prolonged downturn.
  3. Weaker oil prices are leading to consumer disposable income rising; retail sales for the most part seem in decent shape.
  4. The global banking system is much stronger now than was the case eight years ago. Banks may take a hit to earnings from provisions against resource exposure, but greater capital strength means it should not present a threat to solvency.

The main driver of market weakness in our view is the deteriorating liquidity environment as credit markets close up and certain sovereign wealth funds and central banks are required to sell assets to offset capital flows or fund fiscal needs. Equities due to their relatively deep and liquid characteristics represent a source of funds in this environment and as a result can trade below fair value for some time.

So where to from here? Ultimately the market mechanisms will kick in – low prices will deter some of the ‘forced selling’ and will also attract some of the sizeable amounts of cash sitting on the sidelines. Valuations are supportive and we believe that it would take a major negative – such as a recession – to see the market move down significantly from here. That said, we remain in a low-growth environment. In combination with concern over China it is hard to see a significant near-term re-rating from here.

We remain focused on stock-specific opportunities. These exist – even among the carnage of the past few weeks. For example, JB Hi-Fi is up 17.1% year to date (to last Monday’s close); likewise ResMed (+11.3%) and Metcash (+11.1%). It remains a good environment for active management.

 

 

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