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Following on from last week’s Part (1) – ‘Top Ten Themes’, as noted in Part I1 we believe it is key to maintain perspective above all the daily noise that is occurring in the markets currently.
Below we consider what will likely determine the US Presidential election result later in the year. We revisit the outlook for China and suggest why the world’s second largest economy will be likely to experience a soft landing.Emerging markets, gold and resource stocks have all been under varying degrees of pressure this year, but we continue to believe that the bull markets in each are far from over.
1. The US Election
The US election in November is shaping up as a referendum on Barack Obama’s first term as President.
Republican candidate Mitt Romney has emerged from a bruising battle to become the presumptive challenger to Obama but he has hardly been embraced by his own Party’s core voters let alone ignited excitement with mainstream America.
We noted that Obama won the Presidency during the height of the GFC in January 2009 making the economic challenge ahead extremely difficult.
Unemployment has been the lightning rod for the electorate’s satisfaction with his handling of the economy. But although the unemployment rate has come down from its peak, it remains stubbornly above 8% and historically at least, no incumbent has been re-elected with such a poor mark on his record.
We believe Obama will have his work cut out for him over the remaining 6 months of the year. President Reagan is the only president to have been re-elected since World War II with unemployment above 6 percent, so this will be the central issue at the next election.
Obama has removed the Iraq and Afghanistan wars from the agenda by bringing American troops home and severely cutting the Defence Budget. And as we have remarked although tensions are heating up again over Iran, it is highly unlikely any action will be taken here before the election.
He has also had a victory by finally getting passage for the controversial healthcare reforms.
Otherwise, he has been hamstrung in trying to deliver his policies ‘for all Americans’ by a Republican-controlled Congress and a slim majority in the Senate.
So far, the polls show an expected close split between Obama and Romney but this is likely to simply reflect Democrat versus Republican core voters. We expect Obama’s superior oratory ability and charisma to carry him past Romney’s blandness.
This will be a Facebook election – which candidate is better ‘liked’ by the public.
As usual, voter turnout will be an important factor as the US seemingly always has a high apathy factor. In 2000, when George W. Bush snatched victory from Al Gore by just 300 votes (thanks to the US Supreme Court ruling in the Florida count), only 65.6% of the eligible voters bothered to exercise their democratic right. About 56 million citizens failed to vote.
And should the economy continue to improve at snail’s pace, this could well be enough to allow Obama to stay put in the White House.
2. China : Hard or soft landing?
At the start of the year we suggested that the question of whether China’s pace of growth will glide to a so-called soft landing, or nose dive into a hard landing would be largely dependent on ‘policy’. We also noted that the shift by national authorities away from a monetary tightening would help ensure the hard landing scenario does no eventuate.
We pointed out that the growth could well slip below 9% this year, but also highlighted that Beijing would defend its growth target of at least 7.5% annually.
We also noted that there would be plenty of scope for policy shifts to maintain growth above 8% if external factors conspire to increase the potential for a more rapid and de-stabilising slowdown. And as the year has gone on this scenario has certainly played out, with the Chinese central bank certainly showing it is up to the task, and surprising some in so doing, of facilitating a soft landing.
The first major move came just over a month ago with China’s surprise 25 basis point rate cut – the first in four years. Benchmark lending and deposit rates were cut to 6.31 and 3.25 percent respectively.
This went some way to raising the belief that the government and central banks were committed to ensuring growth would come back to more sustainable levels. As a result we expected more from the Bank of China, and we didn’t have to wait long.
Later the same month we saw another ‘surprise’ cut by the Chinese Central Bank to its benchmark deposit rate by another 25 basis points, and lending rate by 31 basis points. To foster credit, the central bank also declared that it would allow banks greater leeway in setting lending rates at a discount (up to 30% now) to the benchmark.
Certainly a strong signal, particularly when considering that many aspects of the economy are not performing that badly.
The export driven side of the growth story does certainly not need any help at the moment. China’s exports rose in May at more than double the pace many had expected, up 15.3 percent on a year earlier. The follow on in June was, whilst not as stellar, also strong, up 11.1 percent year on year.
Recent domestic side data however has been less positive. In May iindustrial output gained by less than 10 percent (coming in at 9.6 percent though, hardly a disaster) for a second month and retail sales increased the least (still 13.8 percent) in almost six years.
However it is worth noting that these numbers are actually not that bad – or at leastthey do not suggest China is going to fall off a cliff any time soon. It is only in the prevailing climate that they are viewed through a negative prism and be grist for the bears’ mills.
Recent data, which was soft, but not disastrous, combined with the clear policy stance of the Bank of China, means that a soft rather than hard landing is likely in our view. And China has plenty of capacity to further stimulate its economy.
Certainly it has ample flexibility in terms of inflation which fell more-than-forecast to 2.2% in June from 3% in May.
And one problem China will never have is deflation, and unlike Japan, population growth and demographics will not be an issue for many decades. With an urbanisation rate of around 51 percent, which is still well below Western countries, there is plenty of room for the economy to continue growing over the next 5 to 10 years.
The country also has clearly has the financial capacity to stimulate further. The fundamentals of China’s economy have shifted, particularly with respect to its huge accumulation of foreign capital over the last decade that has given it the world’s largest store of foreign reserves, worth $3.3 trillion.
It is also worth noting that the amount of stimulus thrown at the economy remains significantly below the 2008 GFC.
Politically it remains the best option to ensure a soft landing as well. The slowdown raises the risk of job losses and unrest at a politically awkward time for the ruling Communist Party as the older guard look set to hand over the next decade of younger leaders.
All this said, we do not expect the China story to keep going at the same pace. The last three decades have delivered double digit expansion, lifted 600 million people out of poverty, and turned China into the world’s single biggest source of economic growth, number one exporter, and second biggest economy.
Much is made of the Chinese ‘property bubble’ and we have all seen the pictures of empty towns that have been built. However the government is also being highly proactive in attempts to cool this, putting curbs on mortgage lending as an example.
Mind, by the same token there is much to suggest that the demand for property in China will catch up with supply. China’s urbanisation rate of around 51 percent is well below that of the West (around 70/75%) and therefore assuming these rates converge over the next 3 decades, around 250 million people will be looking for new homes in cities.
Looking at the local stock market itself the Shanghai Composite is in key territory.
If we take a broader look at the bubble that formed in Chinese stocks between 2005 and 2007, the SCI remains well down from the all time highs of 6000. However we do believe there is the strong possibility of a meaningful reversal to the upside in Chinese equities sometime this year or in 2013.
One concern is the Shanghai composite index which has made a new near term low, but in our opinion this is due to rising fears of deflation, given the underlying inflation rate has declined sharply.
The obvious catalyst for an upside break in the SCE would be for the China’s equity markets to see through the current slowdown to when the economy begins to pick up on the back of induced stimulus measures. We are not at that point yet, but given the significant range of stimulus options that China has, this point could be reached within 3 to 6 months.
3. Emerging markets shaken, stirred but not broken
At the start of the year we noted how the previous 12 months had been particularly brutal for emerging market equities as a broad asset class. The index, as measured by the MSCI Emerging Markets ETF was down almost a quarter on the year.
We commented that it would be likely that emerging markets would regain favour at some point in 2012. And despite market volatility it is certainly possible to claim that emerging markets have gained ‘some’ favour – The MSCI Emerging market gauge has added around 2 percent in 2012.
Certainly the first quarter of the year saw emerging markets pick up as confidence in the global economic recovery and associated appetite for risk, increased. The reversal of this confidence was equally responsible for gains that were given back in the second quarter.
Many emerging markets remain a leverage play on global growth, and will continue to bear a positive correlation with the overall level of investor confidence. Specific causes of angst centre will tend to centre around China (itself an EM), the Euro zone, and commodity price volatility (with many EM’s resource heavy exporters).When volatility and levels of angst increase emerging markets are always likely to suffer more than developed markets in the ‘risk off’ trade.
However as we have noted in last week’s review the situation changes entirely if governments and central banks are able to successfully engineer reflation of the global economy.
At that point there would likely result a substantial rally in emerging markets, particularly given relatively modest valuation levels. The key index of emerging markets trades at around 9 times earnings – this compares to the average for developed markets is around 12 times. Currently Emerging markets are trading at a 15 percent discount to their historic valuations.
Within the emerging markets themselves there are notable pockets of value. The Russian market for example is trading at around 6 times the prospective earnings of its constituents. The market suffers from an habitual ‘corruption and political risk’ discount but as a play on energy prices has also been impacted by declines in the oil price.
Other constituents of the BRIC economies are also heavily resource focussed, particularly China and Brazil. And so again here the fortunes of these will be heavily determined by the performance of hard commodities (discussed in section 5).
However there are several other tiers of emerging markets which also hold significant potential should the global growth story hold together, These include other commodity stories, but also other areas, with Taiwan and Korea key examples in the technology sector.
Other emerging players are benefitting from being on the geographical periphery of developed markets. An example here is Turkey – the fastest growing economy in Europe last year, the second fastest globally – and is showing signs that it may be approaching ‘soft landing’ territory. GDP for this year’s first quarter came in at 3.2%, a far cry from the 11% of last year’s first quarter.
In addition, the country has improved it public debt position which now sits at around 40% of GDP, significantly lower than the 70% of 2002.
As with many nations in the emerging category, Turkey’s population is young and growing; currently 75 million, the United Nations estimates that it will reach 92 million by 2050. And although income per head has tripled in less than a decade – to around US$10,000 – the Turkish are still playing catch up with the Western world.
However these markets cannot grow in isolation. Turkey and others are heavily influenced by goings on in the West. Nearly half of Turkey’s exports for example go to the EU, three quarters of Foreign Direct Investment comes from Europe and three quarters of the country’s tourists come from Europe.
In summary, emerging markets are likely to remain challenged in a ‘risk off’ environment, but that is not denying the incredible value on offer given the compelling growth prospects still in place for many in this category.
Despite a slowdown emerging markets are still forecast to account for up to 70% of global growth over the next few years. The biggest players (Brazil, Russia, China and India) are set to account for around 50% of global growth by 2020.
We continue to favour having some exposure to emerging markets, whilst recognising these will more likely perform once market angst has subsided. However the rewards will be more than commensurate with a risk-on environment likely seeing a rapid re-rating of emerging market equities.
4. Opportunities in gold miners
The gold market has rolled into the second half of 2012 with the gold price closing the mid point of the year at US$1,598 an ounce. Over the six months to 30 June 2012, gold managed to hold onto a small gain of 4.4%. As the following chart shows, following a rapid climb early in the year with a peak in February of US$1,781 an ounce, gold has been on a downward, but volatile trajectory since.
For Australian gold miners the first half of 2012 finished where it started, with the ASX gold index rising a meagre 0.11% in the first half of 2012. The pronounced lag in the performance of Australian gold stocks in 2011 was propelled into the first half of 2012 as the gold price continued to rise.
As we suggested at the start of the year in our Top Ten Themes for 2012 it is not unusual for gold stocks to be sold off during times of equity market stress. The sector is part of an equity class in its own right, along with being part of the resource sector at large. This gives the gold sector a unique high risk profile within the broader equity asset class.
The valuations for Australian gold miners as a whole in the first half of 2012 were relatively unchanged. Investors remained steadfastly unwilling to translate the robust gold price into higher valuations for the gold miners.
With the fall in valuations however, for patient investors the gold miners have become significantly less risky, as the robust gold price has put them on relatively low historical multiples. Investors appear sceptical of the sustainability of the gold price, hence the reluctance to price valuations higher.
We maintain a favourable view on gold in 2012. Long-time Members will know we have held a bullish stance on gold for some time. A view we believe that has been vindicated by the current positive move in the gold price in the first half of 2012.
Going forward, we continue to hold to our long-term outlook on a positive pricing environment for gold.
Normally gold stocks are leveraged to the movement in gold prices in either direction.Our favourable outlook for gold should generate plenty of scope for a future upward rerating in gold miners. While the gold price has moved upwards in the first half of 2012, the miners as a group have remained stationary. The following chart shows the ASX gold index for the first half of the year.
A compelling factor in our Top 10 Themes for 2012 was the high margin environment we believed gold miners would enjoy as a result of robust gold prices. Although, operating costs have continued to pressure the gold sector and gold prices have eased back, margins have remained buoyant.
In summary, with the gold price at current levels gold miners can continue to deliver robust free cash flows. Cash flows that will aid in the funding future growth opportunities and lead to further share price rerating.
We view the risk to reward profile for many gold miners as attractive for the remainder of this year. Especially as we continue to hold a positive outlook on the price of gold.
5. The Resources boom: Still on?
All eyes have been on China over the past six months as the resource boom in Australia was predicated on the commodity demands of the Asian region and in particular China.
As we remarked earlier there is no doubt that over the first six months of 2012 that the Chinese economy has cooled. China’s first quarter 2012 Gross Domestic Product (GPD) was up 8.1% when compared with the same quarter a year ago after growing by 8.9% in the December quarter of 2011. The quarterly increase was the slowest pace of growth record by the Chinese economy in nearly three years. GDP was up 1.8% from the previous quarter.
However we continue to believe that a ‘measured’ slowdown will still provide ample fuel for the commodities bull market to continue many years yet.
The National Bureau of Statistics (NBS) indicated that activity during the March quarter was ‘still in a reasonable range.’ At the same time, the NBS warned of outstanding problems in the economy, including the difficulty in stabilizing exports, on-going inflationary pressures and falling industrial profitability. It cited the need of balancing the support of growth with controlling inflation.
China’s March 2012 quarter GPD number is due to be released on 12 July 2012. Market consensus is for the annual rate of growth to again be markedly slower at 7.6%, compared to 8.1% annual growth for the March 2011 figure. Global economic chaos in the European Union, China’s major exporting destination, has likely taken a toll on the Chinese economy.
China in its most recent five year plan for the country forecast economic growth of 7.5% to maintain stable geo-social conditions within the country.
Inflation has gone out of the Chinese economy with the most recent figure for June 2012 coming in at 2.2% annual change. In 2011 Chinese inflation was running at plus 6% annual change. Exports remain a problem for China as economic conditions in Europe remain unchanged. Profitability of Chinese companies have also softened over the past six months.
As we remarked earlier the on-going European situation and softer corporate profitability have led to a key change in the monetary policy stance by the Peoples Bank of China. The Peoples Bank of China has lowered the Credit reserve ratio required to be held by banks in China and has now also cut the official interest rate. China’s cash rate has been cut twice from 6.56% to now be 3.0%.
The impetus behind these policy moves is directly to stimulate internal economic activity. We do not have to travel to far back in time to see what a strongly performing Chinese economy can do to the commodities world both in pricing and volume.
The speed of the intended positive impact of these chances in monetary settings on the Chinese economy, should be substantially quick than seen in the European Union and the United States. Why? China does not have the deep seated sovereign debt problems or a reliance on government programmes as most western countries do, to generate growth.
With China now stimulating its economy the outlook for commodities and the resource boom in Australia could once again look a little rosier.
The Australian Federal Government has meanwhile put some internal impediments into the resources boom equation, including the Minerals Resource Rent Tax (specific to iron ore and coal only) and the Carbon Tax that may have slowed the decisions by miners to push ahead with projects in the near-term, but likely not stopped them.
The resource boom in Australia has slowed as evidenced by our two biggest miners in BHP and RIO recently announcing the rescheduling of capital projects, but is certainly far from over.
Whilst the commodity sector will also remain under pressure in a risk-off environment, global economic reflation in the second half of the year will certainly see money flow back into the sector in our view.
We believe that policy makers are getting their acts together to address the sovereign debt issues in Europe and globally central banks remain at the ready to stimulate should growth falter. Meanwhile the biggest single customer of the commodities sector, China, remains on course for a soft landing in our view.
Whilst often a volatile place to be the relatively modest valuations across the sector do little to dissuade us from retaining a positive view on high quality resource companies.