For any investor, one of the most important portfolio considerations to make is asset allocation, and where and when to deploy capital. Depending on which stage of the investment cycle you’re in will determine your required weighting across asset classes. This has never been more important as weakening energy and resource prices, in conjunction with the introduction of the bank levy, lead to stagnating growth and reduced income in the Australian equity market. John and David sit down to discuss equities, resources, (un)employment, inflation and a potential services boom in relation to what it means for investors.
DW: Hello again everyone, David Walker from StocksInValue, I’m back with you this week for another video version of the View with John Abernethy. So John, as we record markets are down, oil prices are off again – walk us through what effect the weakening energy prices will have on the Australian economy.
JA: We flagged it earlier – I think of one things we’ve gotten right over the last year is the oil price going nowhere given the supply imbalance from America. I think that’s playing out and OPEC is a weak production consortium in terms of controlling price. The energy price is going to filter through to inflation, but we have low inflation around the world anyway. Unlike a normal cycle for Australia with a weakening currency, we’re not getting inflation coming through. So inflation is below normal and looks likely to continue not only in Australia, but also around the world. The offset of course is the energy crisis on the east coast of Australia, which is sort of government and policy induced. It suggests to us that inflation is in that 2 – 2.5% band for a while longer. In fact the NSW government budget said 2.5% is probably where it’s going to go for the next two years. That flags the fact that the Australian bond market is underestimating inflation. Even though bonds are at 2.3% to 2.4%, we’ve got inflation looking like it’s going to be above the bond yield for up to a few more years. We’ve probably got weakening bonds coming up for the next twelve months, not dramatically though. We’ve also got international events we’ll talk about in terms of interest rate cycle internationally, which Australia is probably going to watch for a while. In terms of the economy, we’re getting mixed readings – we’ll talk about that. The employment numbers are very strong coming out of last week but we need to see a bit more than that to get excited. In fact I’m surprised that it’s so strong because anecdotally that’s not correct – while the 3-month numbers for employment suggest a boom in employment, we’re certainly not going through a boom at present. Retail sales and wages growth also suggest we aren’t, so there’s a lot of conflicting evidence there. The Australian share market today as you noted was very weak – obviously that is resource lead, but we are getting bank tax effects coming through and that bank tax needs to be understood.
DW: Let’s walk through those topics. As commodity prices are softening, pointed out in today’s investment committee meeting, BHP, Rio, Fortescue and Woodside (large-cap go-to resource names) are all now slightly undervalued in StocksInValue and the dividend yields are just ok. Now, does that mean that large-cap resource names should enter the radar screen for investors?
JA: I’d first define investors and traders. I think it’s probably entering the trading range for an active part of the portfolio. But in terms of investing, because of the volatility they’d want to be a lot lower before we become confident of putting any of them into a long-term investment portfolio. The Chinese outlook is difficult to say at the least. Whilst we see growth in China, the growth trajectory is likely to soften substantially over the next 2 or 3 years. The tailwinds for commodity prices aren’t there in this cycle.
DW: China has to thread the needle between taking the heat out of its over-geared property market and keeping enough growth and employment to keep its population happy.
JA: We’d say China is potentially going to become a headwind in the next 12 months with commodity prices, and the forward curves are telling us that anyway. We don’t know why commodity prices spiked earlier this year and we now see that as an aberration. Will they fall much further? Probably not – we’re probably stuck at current levels, which ensure profitability for those companies you mentioned. So that’s the good point, that we see sustainable profits and sustainable cash flow enhanced by a weakening Aussie dollar (which is not happening) and that’s the other cruel feature of this market. I believe that the Australian market is falling more so because the Australian dollar seems stuck for whatever reason. Now whether it’s manipulation or whether it’s big asset managers or something else going on, given the commodity prices falling in the last couple of months the dollar should also be falling.
DW: Especially, also with the growing complaints about rising political risk in Australia. With the budget’s bank tax and the restrictions on gas exports, the large end of the business sector is starting to complain about political risk and I think that currency should be lower.
JA: Well, we had a headline last night from the energy sector, didn’t we, about sovereign risk.
DW: So what’s holding the dollar up?
JA: I think we’ll find out and it’ll be obvious in a couple weeks. Once we get past June 30th and whatever is happening in Asset Management land, and it is no longer needed, we may see the Aussie dollar fall quite quickly in the early part of the next financial year. But that’s just a suspicion I have.
DW: I just wanted to return to the employment data that you talked about. Over the last year the seasonally adjusted data has been volatile, especially in May, but the trend data shows ongoing moderate employment growth of 1.6% in total employment positions over the last year, with unemployment rates stable.
JA: I have a theory and I think there’s a long-term demographic. We are certainly in the cycle where we have an ageing population and the war babies are retiring at a greater rate. Some of the ‘job creation’ is really job replacement and I think we’ve got to be careful about how we view that. So we have to look at the absolute employment numbers, which clearly aren’t growing as fast as the job creation numbers and I think that tells the story. Now we won’t know for a few months whether it’s more full-time or part-time employment. We’ve got very conflicting evidence in the last six months, it’s swung back and forth. Until we get real numbers, my view would be that we’re seeing not great employment growth but still employment growth nonetheless. That indicates we’re not in recession or anywhere near recession but that the employment growth is more part-time than full-time and a lot of the job creation is, in fact, replacement.
DW: Do you agree with the Reserve Bank Governor’s glass half full take on the Australian economy expressed in his speech this week?
JA: The economy is ok at the moment. The transition from resources to wherever we’re going, whether it’s services or some sort of manufacturing base, that transition has been helped by the housing boom. But I think the transition, which is claimed to be occurring quickly, is not as quick as people suggest because the housing boom has meant that the transition has been less painful. It may become painful again in the next 12 months as the housing cycle pulls off. But there is some good news in terms of services growth within tourism, education and healthcare. I believe there are patches of the Australian economy that are benefiting, and will continue to benefit greatly, from a weaker Australian dollar. Certainly the kerfuffle going on in tourism, or the terrorism issues in Europe and America, must drive tourism to Australia. So that’s some degree of good news coming out of bad news, I guess.
DW: To finish, could we have a comment for our investors on portfolio management, especially how much cash they should have and how they should use it?
JA: I think you’ll see a driving temptation from asset consultants to push more money offshore. I think we talked about this off camera – the Future Fund is a very strong bet away from Australian assets and Australian dollars. I think you’ll find other asset managers move that way. We’ve had about 30-35% of our equity allocation in international. Depending on where you are in your life and your investment cycle that could be pushed up a bit if you’re more in accumulation mode. As for the Australian share market, the only thing going for it is yield. Over two years the Australian market is now pretty well flat again on capital growth – it’s all income. So it’s 2 years, it’s nearly up to 5 years and it’s definitely at 11 years, so it’s an income market. But we are seeing signs that income could fall in the Australian share market because of government intervention with the bank tax. I think we’ll see a re-basement of dividends – they’ll fall and be rebased then they’ll start growing again. But that’s a 3-year view and we’re hoping there’s not a housing cycle in between going against them. My view is that you would be downgrading Australian equities, upgrading international equities and, as you said earlier, maybe looking for a trade on the resources at some point in the next 6 months.
DW: Ok John, enjoy your break next week and thanks for contributing to this video. Thank you for watching. Please leave any comments in the section below this video if you have any macro questions and we’ll get back to you with answers. Thanks for watching and we’ll see you next time.