April 2015

Market Perspective

CVF News

Market Perspective

Gary Hui

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:

Where are we bullish?

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