Macro. The sheer complexity of macro makes it fascinating. It can be very helpful in deciding which sectors to avoid. That said our focus is on finding cheap stocks. No matter what the macro outlook is, we focus on finding under-appreciated or neglected stocks with under-appreciated earnings upside. If we do this, then even if our stocks multiples contract during some macro gyration, provided the earnings deliver, the stocks will in time as well.

Because we get asked a lot, here is our very crude take on the macro at this juncture:

The Australian equity market is expensive when viewed on an historical basis. The same applies to most (but not all) equity markets globally. Earnings multiples for most stocks are elevated relative to their historical trading ranges. Recent Australian market performance has more to do with the expansion of valuation multiples than the delivery of earnings growth, in aggregate.

This is despite Australia experiencing something of a nominal income shock. A commodity price bubble is in the process of correction (it is not over yet). Commodity price declines are driving declines in investment and a softening of employment conditions, such that nominal wage growth is weak.

Unconventional monetary policy in Japan, Europe and the USA has driven a shortage of high quality collateral and a compression of sovereign yields. As central banks buy bonds from bond mandated investors, those investors tend to use their cash to buy… more bonds, which drives the price of the bonds up and the yields down. When central banks buying of sovereign debt is greater than their host governments issuance of that same debt, there is a shrinkage in available supply – a squeeze.

The US Federal Reserve has actually experienced a small shrinkage of its balance sheet of late, and the topic of rate rises is firmly on the agenda in the world’s largest economy. Australia and the US currently traverse highly asynchronous paths. This is relevant for the Australian equity market because over any meaningful time period Australian equity indices are most correlated to US equity indices and its worth bearing in mind that equities don’t always behave when rates rise, even if they can’t rise too far given the high levels of system leverage in developed markets.

The RBA is providing accommodative but conventional monetary policy to cushion soggy domestic demand. A deleterious consequence of this is housing valuation; some home buyers appear to be plugging all time low interest rates into their home loan affordability calculus and borrowing heavily. Given supply of houses changes very slowly yet the value of housing stock in some regions has been rising strongly for some time, there is a self-reinforcing circular reference at work; as the value of collateral rises, banks can lend more, home buyers can pay more, and thus the value of collateral rises again and the feedback loop continues. One famous investor would call this reflexive.

The market is not expensive when viewed relative to bond yields. However, for perspective, the 10 year Australian Commonwealth Government bond’s yield to maturity is ~2.5%, an all-time low and a thoroughly miserable return unless you’re counting on deflation.

We believe commodity prices have only experienced their initial phase of correction. This is why we excluded companies in the GICS metals and mining index from our mandate in late 2014 when we were drafting our IPO prospectus. Commodities can be a highly profitable area in which to invest, it just comes down to cycle timing and cycles in this sector are long. If we look at iron ore as the poster child of the commodity boom:

• In the year to 31 March 2015, China produced approximately 812 million tonnes of crude steel1. This was an increase of only 8 million tonnes over the prior year.
• Net exports from China of crude steel over the same time period increased 35 million tonnes2. That is, ex net exports and inventory adjustments, apparent Chinese steel consumption declined 27 million tonnes, or approximately 3.7%. The driver here is the Chinese property market and specifically pricing trends and their effect on raw materials demand.
• Historically, perhaps the best analogue for Chinese steel is Japan. Japanese steel production peaked in 1973 at approximately 119 million tonnes and then declined, with the production level of 119 million tonnes not seen again until 2007; Japan produced 110 million tonnes of steel in the year to 31 March 2015. The USA produces approximately 87 million tonnes of steel a year and behind China and Japan is the world’s third largest steel producer. China cannot export away its surplus. We think it very likely Chinese steel production has peaked and that a long adjustment has begun (we also wonder what someone looking down on Port Hedland from space must think, seeing three duplicate rail systems for transporting iron ore).

Where are we bullish?

• AUD depreciation winners (in the near term given extreme positioning, we may well see the AUD bounce; but our currency view mirrors our commodity view).
• Under appreciated business models.
• Out of favour businesses that aren’t directly exposed to mining or housing.

1 International Steel and Iron Institute data
2 Customs General Administration, People’s Republic of China