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A Christmas fireside chat

As we wrap up 2014 and position ourselves on the blocks of 2015, it is worth considering how investors and consumers might behave. With Australia’s official cash rate already at 2.5% and having been there for 16 months, is another 25 basis point (0.25%) drop sometime next year going to get you off the couch? Our funds have performed well this year but it will be the more challenging months ahead that determine whether we can continue to deliver.

In simple terms you only need to know a few things. Will the economy grow faster or slower than the majority is expecting? Will inflation be higher or lower than most are currently expecting? And are high quality stocks with bright outlooks cheaper than our estimated valuations of them? These are the big questions because at other times there isn’t really any ‘variant perception’ to help generate easy outperformance.

Consumer confidence has crumbled in the last couple of months. It’s even worse today than when the last survey suggested confidence was at a three year low. CEO’s are telling us this. If low rates were going to stimulate anyone into action, they should already have done so, and another 25 basis point cut will not make any difference to consumer behaviour.

Let’s turn briefly to mining and mining services. As the iron ore price drops, thanks to increasing supply and declining rate of growth of Chinese demand (China’s rate of growth in GDP is forecast by the US Conference Board to fall to 5.5% and then to 3.5%) the impact is felt in job losses. As miners shelve projects and investing intentions slump, and as the higher cost producers close, workers are forced to start looking for work. Inevitably these new jobs will be on lower pay, as the mining boom saw salaries and wages soar for many workers.

And what are CEO’s telling us? We’ve had a car packaging company and a travel agent chain say that “it’s tough”, we had Rio tell investors the near term outlook was “challenging” and we’ve had rumours of Myer and DJ’s bringing forward their Christmas sales. This could reset consumer spending habits, and destroy the second spending boom that boosts retailers’ full year profits after the Christmas avalanche.

Hard to find compelling investments in most sectors

Why is it that low interest rates aren’t stimulating consumption? I think the reason is relatively uncomplicated. Those low rates have stimulated many to buy real estate, and irrespective of whether the purchase was for living or investment purposes, the consumer has geared up. And that’s a very different possibility to the usual ‘wealth effect’ we expect when house prices have been rising.

More recently John Borghetti at Virgin said: “Where there is uncertainty people go and hide in corners, and I think that’s what we’re seeing now in terms of spending … There’s not much hope out there at the moment.”

From an investment perspective, deteriorating prospects from the mining and material sectors has now infected retailing including travel. That takes out large sectors of the Australian equities market from our universe due to unattractive economics and prospects. The Financial Sector, dominated by the banks, may also be impacted in the near term, not only from weaker credit growth but also from the prospects of more punitive capital and mortgage risk weighting ratio requirements.

That doesn’t leave many other sectors from which to select outstanding investment candidates.

What about energy? The collapse of the higher-cost-junk-bond-issuing energy companies spreads volatility and fear further into the ‘high yield’ markets and then down along the risk spectrum. It's the first stimulus-infected bubble to burst and it is happening as we speak. Rates on high yield bonds were at just 5.6% only a few months ago when Janet Yellen said in Washington that she saw “pockets of increased risk-taking”. Today those junk bond yields have jumped to over 9%.

And it’s not just individual junk bond issues and their issuers that are being hammered. Entire countries are affected by the oil price slump. Venezuela, Nigeria, Columbia, Sudan, Iran and Libya are all impacted adversely. Evidently, Nigeria’s government revenues are funded by oil to the tune of 70% and oil represents half of Columbia’s exports.

Contagion. According to Goldman Sachs the high yield (junk bond) index is approximately 17% represented by energy debt issuers. This is significantly higher than the 4.4% exposure in 2006. Deutsche Bank reckon $550 billion of new bonds and loans have been issued by energy companies since 2010 and J.P. Morgan estimate that 12-40% could default.

Little scope to ease rates further

The longer the Fed holds its benchmark lending rate near zero, the greater the risk of more bubbles forming and then inevitably popping. Perhaps the most successful navigator of market and economic cycles has been Ray Dalio, who in early December 2014 noted that we’re currently in a “good environment” for owning stocks and that “we are in a mid-part of the cycle”, adding “We are long equities.” That is somewhat encouraging but in describing the signs to watch out for in the US he, inadvertently perhaps, warned investors in Australia what the next year or so might look like. Dalio noted that when the need for interest rate easing arose, already low rates would render few tools available to deal with it. At that point “asset prices are going to start looking top-heavy.”

And for Australia, that point might just be now.

 

Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’. The article is general information and does not address personal financial needs.


 

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