The Last Ten Trading Days of 2015
What a difference ten trading days makes! The December Blog written on the day of the US Federal Reserve decision to increase US cash rates by 0.25% indicated that we were surprised the Australian Stockmarket fell below the 5,000 level and it was more than likely there would be some form of relief rally when the Fed made its decision. From a low of 4,909 at the close on the 15th of December 2015, the S&A/ASX 200 index rallied 400 points to close the year at 5,295.
That December Blog noted that the fall in the Australian Stockmarket was not supported currently by falls in dividend yields. The income being paid by companies had not reduced, resulting in dividend yields at levels which seem not only attractive, but difficult to rationalise. The answer must be either the Australian market is not only good value, but under-priced on these yield stocks or, there is a significant threat to these dividend yields going forward. Bruce McLeary, Associate & Senior Analyst has a detailed spreadsheet by company of dividends actual for 2015, forecast for 2016 & 2017. The weighted average is 4.59% actual, 4.71% 2016 & 4.89% 2017. So while some company dividends may fall e.g. Woodside on average dividend income will be maintained on portfolios.
The best predictor of movements in the Australian market has been the dividend yield theme. It has dominated other themes and is the most likely the explanation for the rally since mid-December. “With the current dividend yields on quality banking and industrial stocks, it is difficult to come to any other conclusion other than the Australian market should move higher in response to the strong income currently available on the market”.
In terms of those bears on the Australian banking sector predicting falls in the return on equity for banking stocks, the reaction was one of scepticism from most quarters. The most common feedback is that housing is continuing as a strong driver, although with some consolidation, and with the additional bank capital raisings being required to support the existing loan book, the banks do not currently have excess capital under the new rules and so it is difficult to see significant headwinds to bank profits in such a strong housing cycle. The consensus view is that the Australian banks have a number of levers to pull to maintain high returns on equity. We’ve already seen a return to charging a higher interest rate on non-residential mortgage loans. This is a return to previous times when investment loans carried higher rates of interest. However over the longer term, it may be increasingly difficult for the major banks to maintain a 15% return on equity. But not in 2016!
The market is a great leveller. Lest your diarist, analysts or investors are feeling overly confident with their ability to predict the unpredictable, the graph below shows the resources sector of the Australian stock market. The index fell from 6,000 in September 2014 to 4,635 on the 1st of July 2015 and 3,155 on the 15th of December. This fall of 50% was dramatic and far exceeded consensus expectations.
Source: IRESS XTR.ASX
In the June 2014 Blog, your diarist noted “the possibility of sub-par Chinese growth raises the question of an underweight position for Australian resource stocks or alternatively option strategies to enhance value”. Over the ensuing 18 months, there has been a deal of lightening of resource positions across Burrell client portfolios. For Individually Managed Portfolios (IMP), selected sales of Woodside, Oil Search, RIO and Orica resulted in resources underweight the index. With the benefit of hindsight, the retention of holdings in BHP and Santos would have been better replaced by a decision to carry no resource or energy stocks. In the January 2015 Blog, and throughout this year, the supply/demand balance for individual minerals was seen as the best way of understanding commodities pricing, and in turn, stock prices. “Iron-ore is of more concern with some commentators predicting a global surplus of 35MT for the current year, swelling to 200MT in 2018. This compares to steaming coal, where the medium to longer term outlook is strong according to recent statements from the RIO CEO” (Blog January 2015).
The First Ten Trading Days of 2016
If the last ten trading days of 2015 saw the Australian market gain 400 points, the first ten trading days of 2016 saw all of those gains reverse. The purported rationale was the correction in the Chinese stock market and continuing weakness in the Chinese yuan against the US dollar.
Neither of these reasons bear much serious analysis. The surprising fact about the Chinese stock market is not that it is correcting, but that it rose to such giddy heights. Last April your diarist attended a Russell conference where the presenter noted that the Chinese economy had flatter growth, whereas the Chinese stock market was continuing to appreciate in leaps and bounds. His view was not to participate, as it was difficult to justify a stock market growing to such high valuation multiples, where the economy was only growing modestly.
The Chinese currency is pegged to the US dollar. The Australian dollar is not pegged and has fallen from $1.10 to 70 cents i.e. by approximately a third. The consensus in Australia is that this fall has assisted Australia in adjusting to the weaker commodity price environment and without the currency rate stabilizer adjustments, the Australian economy would be suffering weaker growth. So why is it surprising that given the Chinese yuan is pegged to the US dollar and its economic growth is slower than the USA, and that the Chinese seek what is only a minor devaluation?
A balanced perspective of China would see an adjustment from high infrastructure and capital spending to a modest growth level, while the Chinese economy makes a transition with services now growing more strongly. Chinese consumer activity measured by internal train travel, on mobile phones, international holidays etc., are all increasing. The Chinese consumer is no different to any other consumer seeking a better life and the services that support that life style.
As these Chinese issues are seen in a more balanced perspective, NAB at 7% fully franked i.e. 10% gross and other yield stocks must surely tempt Australian investors returning from the holiday season.
Australian Stocks/non resources and banking
Concerns with the resource sector and banking valuations have been a theme over the past 12 months. November 2014, the Blog included a notation on Resmed. This company specialises in sleep apnea, half its earnings in the strong $US, has no debt and $1B in the bank, owns its intellectual property with new airflow generators, masks and has low capital expenditure with production sourced in low cost countries. While the blog is more directed as a strategic and thematic document this example has been positive to date.
In December 2015, Seek was noted as a stock in this category, again with strong foreign earnings, digital presence second to none in its HR niche and now ranking number 1 in China.
The diversification of portfolios will continue as a major focus in portfolio reviews during 2016.
“A lesson of the past 18 months is that portfolios would have performed better by diversifying overseas.” (Blog July 2015). In the June 2015 financial year, the international markets were relatively flat with the MSCI (US) returning minus 1.09% and the Dow Jones in positive territory at 4.7%. However falls in the $AUD were a material contributor to international returns with the MSCI World (AUD) returning 25.22%. This currency weakness in the Australian dollar and strength in the US dollar has again assisted in the six months to December 2015, although at a much reduced level.
Themes for 2016
- Dividend yield driver
- Interest rate cycle headwind
- Central banks in different parts of the cycle
- Segment stocks in Burrell Universe into four segments
- Other high yield, but steady/lower growth
- High growth & sound business model, management, Balance Sheet, roe > 10%
- Adopt a realistic view on China, not a sentiment view
- Markets wholly reactive to China as a proxy to demand growth for energy & mineral resources.
- There is relatively well developed themes so looking for inflection points in calendar 2016.
- $US economy and the USD
- Digital disruption and competition
- Australia innovation stocks: medical appliances; commercial biotech
- Weaker resources sector = lower A$ = Mergers& acquisitions (M&A)
- Deloitte Fantastic Five: agribusiness, gas, tourism, international education and wealth management
- Possible X factors
A. US stock market valuations and possible correction
B. $20 oil
Dividend yield driver
The Global and Australian interest rates remain low. Term deposit rates are currently around 2.2% for 30 days, 2.6% for 60 days and 2.9% for 90 days per John Smerdon, Associate – Burrell Fixed Interest Desk. Moreover, the Australian 10 year bond probably bottomed in April around 2.23% and is currently at 2.63%. It is the difference between these risk free rates and the return on equities which is a key determinant in stock market prices. After falls on the Australian stockmarket in the first 2 weeks of January 2016, the dividend yield on NAB is shown as 7% full franked, a gross dividend of 10% including franking credits! While some headwinds exist for the banks, current attractive yields should lead to a recovery in prices. Likewise, good industrial shares with well-regarded management and proven business models will continue to attract inflows. In the April quarter of 2015, bank share prices bid up until the yields were 5% and quality industrials 4.4%.
Interest rate cycle headwind
The proviso to the preceding theme is that interest rates remain below the long term averages. For example the average Australian 10 year bond rate is around 6.5%, double the existing level. Despite all the talk of increased interest rates, the 10 year bond today is equal to its level 12 months ago. Given some weakness in the global economy and concerns around China, any return to long term average interest rates seems a long way off.
Overseas, the US Fed finally made its first increase in 8 years in December by 0.25%. While there has been discussion of a further two to four increases this year of the same amount that leaves US interest rates at low levels. Accordingly while increased rates would be a headwind to equity values, the more likely prognosis is for a slow and gradual set of interest rate increases in the USA which lag the continuing strength in that economy.
Central banks are in different parts of the cycle with Europe a weaker economy and the European Central Bank (ECB) more inclined to continue stimulus policy.
Segment stocks in Burrell Universe into four segments
- Other high yield, but steady/lower growth
- High growth & sound business model, management, Balanced Sheet, roe > 10%
The Burrell Universe comprises a subset of the ASX S&P 200 based on 5 quality focal points; sound management, conservative debt, quality of business, current earnings and red flag risks. The Burrell Universe has outperformed the S&P 200 index. It is helpful to segment those stocks into the four sectors above as those sectors have different attributes and performance characteristics.
The remaining themes will be discussed in more detail in subsequent Blogs.
Wishing you a Happy New Year and satisfying investing.
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