by Harbour Asset Management
Firstly however, Harbour outlines why the recent global economic turmoil hasn't significantly changed its view that:
Amongst the commodities we prefer iron ore and coking coal, but can see how oil and copper prices could also recover. Gold in Australian and New Zealand dollars is a tougher call
So without belittling key global risks we start this strategy review by looking at Australia where the equity market continued to under-perform New Zealand in July.
Without mincing words, despite the "gift" of the commodity boom Australia appears to be in a period of wrenching structural and potentially political change. There have already been big winners and losers, and a large dispersion in potential returns looks set to continue. Domestic industrials, media and retail performance is poor and with a renewed inflation threat, and a higher Australian dollar, the influences look to intensify. As a result credit growth is weak; households and businesses don't need to borrow. And Coalition voters in particular are very depressed. Through all this the Reserve Bank of Australia seems still intent on raising interest rates.
As Macquarie strategist Goldstein-Morris points out: "the impact of the mining boom on the rising AUD, near zero productivity growth, rising inflation, a cautious consumer, and fiscal policy focused on other issues are leading to a deteriorating domestic operating environment. As a result, there is significant risk of further large downgrades for most domestic consumer related cyclical industrials."
Yet sitting in New Zealand these trends seem curious. Australia should be booming, shouldn't it? Unemployment is less than 5%, real wage growth is not yet negative, net Government debt is amongst the lowest in the world and their terms of trade are at a 150 year high. Why is the consumer so toxic about spending? In part the decline in retail sales is about the downturn in consumer confidence and real income growth.
But also Australian consumer's decisions to spend are about wealth and the general psychology of national well being. Falling house prices together with noxious politics are a poor recipe for the average Australian household. The average Australian has become more than a bit apocalyptic about the future – the well meaning, fashionable Koala has become a much unloved, and shunned, Goanna.
So is this a terminal problem for Australia? In our view hardly, but with the Reserve Bank of Australia still optimistic about the outlook and concerned about inflation, the catalyst for a change in recent negative growth trends seems some way off. Australia does not face the insurmountable debt of many other countries. Providing China continues on a path of industrialisation, Australia will still provide key resources.
In our view to break the negative economic cycle policy needs to emerge on how to manage the terms of trade boom, sooner rather than later and a change of Government or leadership (or even PR) can only be a positive step from here. It's not that carbon or mining super profit taxes are bad, instead we are more concerned that micro productivity trends are poor. Where are the Australian supply side reforms to de-bottleneck housing, the labour market, or improve infrastructure at the pace necessary to lower wage-price inflation trends?
Perhaps this is the domestic recession Australia has to have and investors face a troubled time picking the bottom for earnings, and sentiment. Moreover, the outlook for Australian resource companies will continue to reflect the economic trends in China.
So is there any update on Chinese economic trends? A key recent debate has related to burgeoning local Government debt. We think these concerns are not a "ticking time bomb". Local Chinese Government debt at US $1.7trn is not unserviceable and according to many commentators including CLSA is really a Communist Party, or state issue. The data does show a very large lift in local Government loans in 2009, however taken with general Government debt, China is hardly the most indebted nation even including regional Government debt.
If, Chinese non-performing loans rise sharply, the Chinese fiscal position is in a much better position to that in either Europe or the US. Whilst all this may not be good for sentiment, the actual background is that industrial production growth in China is 15%, consistent with power production growth of 16% in the year to June. Consumption growth is even stronger, with retail sales growth of 18% in the last year. We think that while the supply of copper and coking coal remains constrained and we would expect prices to remain relatively high.
What are we worried about most? The US or Europe? Actually both. This is because the more we look at the policy responses, the more we agree with our colleague Christian Hawkesby when he says that, they have just "kicked the problems into the long grass." The real problems of ageing populations, rising welfare and healthcare costs and mountains of debt can only be solved with full on revenue and expenditure programmes like those embarked upon by both Sweden and Canada in the 1990s.
The real risks to these debt debates are further damage to the fragile jobless recoveries. In the US at least, corporate seem to be delivering strong earnings announcements, with almost 70% of those reporting earnings in the last month coming up with stronger than expected numbers. In contrast in Europe a majority of those reporting have delivered poor reports. We should expect downgrades to both US and European growth estimates in coming weeks.
Against that backdrop we are more cautious on global growth exposures. We have sold our positions in Computershare, AMP, Nuplex, and lowered our weighting in Brambles in response to falling expectations of growth and earnings expectations.
However, a soft landing in China probably sets the scene for better relative returns to commodity exposures relative to Australian domestic exposures. We are staying invested in selected iron ore, coking coal and diversified exposures, in preference to Australian banking, media and retail opportunities, although we admit this is becoming a finer call given the underperformance of retail and media in particular.
Strength continues to emerge in New Zealand. As we wrote last month, in New Zealand it's all coming together. This is not surprising:
Against this background economists have been falling over themselves to upgrade the economy and businesses also see a brighter future with the National Bank business opinion survey recording a further improvement in July, with the net balance edging up to 47.6% over the month from the 46.5% level recorded in the previous month. In addition, the reliable leading indicator of forward GDP - firms' own activity outlook assessment - moved up to a net balance of 43.7% from 38.7% in June. Older data also provided a positive surprise with the March 2011 quarter GDP growth was significantly stronger than expected.
We think domestically oriented companies are well placed and we have bought further exposure to companies such as Fletcher Building, Sky Network TV, Sky City Entertainment, and smaller companies like NZX, and PG Wrightsons. Much of the funding has come from export oriented companies and global exposures.
The major risks to a more positive growth profile in New Zealand are a deep slowdown in Australia and a continued appreciation in the NZ dollar. We do expect a 0.5% rise in interest rates in coming months, and a further rise in the first quarter next year. This may continue to place a bid tone under the New Zealand dollar which is why we remain significantly hedged into New Zealand dollars.
Overall in the portfolio our largest active positions are in the resources, energy and healthcare sectors where we see longer term positive secular forces.
We look forward to reporting further portfolio matters in September.
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