Harbour Monthly Commentary: Stronger global growth signals

A transition continues to cyclical and growth stocks

Friday, January 11th 2013, 10:19AM

by Harbour Asset Management

December seemed to mark the month of further transition to cyclical and growth stocks in both Australia and New Zealand. The New Zealand equity market returned 25.9% in 2012 – outperforming the World MSCI index, which rose 9.4% in New Zealand dollar terms. The Australian ASX200 index was up 20.3% in Australian dollars for the year, and up 15% in New Zealand dollars.

Extremely low interest rates will create challenges for investors. Initially, in hindsight it may be obvious that investors will chase yield. But yield alone has limitations; sometimes companies face declining growth opportunities and the prospect of dividend cuts in future years. Eventually, as clarity on future growth improves, investors seek better longer term growth investments. Companies that will grow earnings despite of various headwinds and those that may benefit from the cycle ahead become sought by investors.

Additionally, although corporate profit growth expectations are generally low, valuations of equities relative to cash and bonds look cheap. This is why many defensive yield investments are giving way to both secular growth stories and well placed cyclical recovery opportunities.

Global investors remain cashed up , and US households are said to be under weighted to equities . We think that relative to cash and bonds there is still relative upside in both equities and real assets.

Further clarity on the 2013 growth outlook may provide investors with the confidence to move allocations back into equities.

Longer term, investors are still likely to see value in equities relative to alternatives. For instance in the US the Equity Risk Premium is over 500bps or 5%, showing equity valuations to be stretched relative to bonds. This stretch may say more about the level of bond yields than the absolute cheapness of equities; however, at the margin, investors may be motivated to continue to rebalance portfolios into equities.

One interesting feature of the recent behaviour of markets is how stable bond yields have been. Despite strong economic data, QE4, further monetary easing in Japan and the prospect of more in Europe and the UK, bond yields have only backed up somewhat. The slight worry is that inflation expectations continue to rise, and through 2013 inflation trends will need to be monitored closely. Nevertheless, there is nothing at the moment in the behaviour of bond markets to suggest a near term sell off that may harm the relative valuation of equities.

For bonds to stay well behaved, markets probably need to see economic data improving gradually.
Too much growth momentum – for instance US employment growth topping 300,000 a month – would bring forward expectations of a cessation in quantitative easing and potentially interest rate rises. Markets also need to see inflation indicators staying well behaved. Currently most price indicators are still comfortably showing very little credit led inflation but a key indicator to watch in 2013 is inflation expectations.

The global data continues to improve
Housing, and general business indicators have improved in both the US and China. For instance, real estate monthly floor space sold jumped by 30% in China, and new building starts rose 6%. The closely watched power generation rose 7.9%, while crude steel production lifted 15.2%. Iron ore imports are up 8.3% in the 11 months to November on last year. The analyst range for average iron prices for 2013 is $110 to $130. The current spot price is $150, up sharply on the low of $85 in August 2012, and at this rate analysts will have to upgrade. We expect that process to begin in the next week or so, Credit Swiss upgraded iron ore prices and Rio Tinto’s earnings and target price.

This upgrade cycle has broader ramifications than just for Rio Tinto and BHP Billiton – both strong performers in the portfolio in December. Stronger iron ore prices lift the terms of trade for Australia, and may keep the Australian dollar firm. In turn this is likely to keep up pressure on the Reserve Bank of Australia to ease. We expect a further cut in interest rates sometime in the first quarter this year.
Many investors have shied away from Australia – given its poor earnings momentum, and concerns regarding Chinese growth. We think that sentiment is changing and the resource cycle is likely to bring investors back as a broader cycle of growth emerges in Australia.

Already there are signs that investors are anticipating the earnings turnaround in some stocks.
Lend Lease was up 7.9% in December after announcing it had been selected as the preferred bidder for the Sydney International Convention Precinct. However, some stocks also rose on little news flow – Suncorp, Computershare, CSL, Amcor and Seek were all up more than 2%.

In the US, the closely followed business confidence indices were stronger than expected with forward orders and employment components showing good momentum. The actual US payrolls employment data was also good – with 155,000 new jobs created, and the ADP employment report was stronger. Many other US indicators released were also on the positive side – and the upswing in momentum seems to continue with markets now sanguine regarding the outcome of fiscal negotiations. That said, commentators will still worry about future US fiscal negotiations and market volatility is likely to rise from current lows; however, the housing story in the US and rising cost effective domestic energy output are key positives to drive growth.

In Japan, a market and country we have all ignored for decades, there are signs of life. We should expect further efforts to weaken the Yen and bolster nominal growth.

Finally, European indicators have continued to grind modestly along; credit spreads have continued to fall especially in the periphery. Despite this improvement, Europe should still be on the watch list for key market risks.

2013 – Momentum for New Zealand still focussed on Christchurch

On balance most of the major trends in the New Zealand economy remain intact.

Housing is leading the recovery, with reconstruction of Christchurch now getting some significant momentum. We think analyst expectations for dwelling consents are still too low. There is some evidence of an improvement in household spending, with consumer confidence up slightly – and electronic billing data for November much stronger and anecdotal electronic data up more significantly for the post-Christmas sales.

However, there is no evidence yet of any real credit growth, and broader business confidence (outside construction) remains at the more subdued levels established in the September quarter.

It seems likely that NZ monetary policy will stay on hold this year, with a bias towards higher rates either late in 2013 or early 2014. The consensus for NZ economic growth for 2013 remains unchanged at a respectable 2.6%, a slight improvement on 2012. Furthermore, corporate profit announcements in February are likely to again support the equity market. Although absolute valuations in New Zealand are no longer cheap, the Equity Risk Premium (ERP) for NZ remains elevated suggesting attractive relative returns.

A key question is do high ERPs signal further equity out-performance?

There is a strong relationship between macro trends and equity risk premiums. Goldman Sachs finds a high correlation between the bunching of equity returns (the risk-on risk-off trade) and ERPs . A high ERP has reduced the value of growth stocks relative to stocks with stable and or more certain sales growth (utilities and other defensives). Importantly, a high ERP has also been associated with the under-performance of cyclical stocks. Financial and resource stocks have also under-performed in periods of rising ERPs. The reversal of high ERPs globally could see a very large dispersion in returns and significant advantages to active management relative to passive strategies.

The outlook for the Equity Risk Premium is a key question we will be exploring in research to be published in the next few weeks. We have some confidence that both growth and cyclical stocks are beginning to perform, but less confidence in strong returns for the overall NZ equity market.

New Zealand was close to the best performing market in the developed world in 2012, bettered only by Germany (and Greece!). Moreover, the New Zealand equity market is over-extended versus shorter term moving averages. For instance only 6 out of the top 50 stocks were trading below their 200 day moving average in December. In addition, some digestion of new issues and placements may have required funding, and also the New Zealand Commerce Commission’s announced draft UBA pricing for Chorus was met by a negative down draft across stocks considered to be in regulated sectors. Chorus itself fell at one point 21%, before recovering slightly, to be still lower by 13.5% in the month.

In our opinion, the Government needs to back up their pre-Christmas rhetoric and move decisively to bring about legislation and change the directive for the Commerce Commission to ensure both less volatility in draft decisions and to encourage investment in much needed infrastructure. Global investors continue to be an important part of our market and policy stability is highly valued. New Zealand needs foreign capital, to develop broader industry capability, for jobs growth and to rebuild Christchurch.

We think it unlikely that New Zealand equity returns top 2012’s 25%+ performance in 2013, but we still view the equity market positively, in part because of momentum in Christchurch. The housing market more generally is likely to have some enduring momentum for corporate profits and global investors appreciate the certainty of New Zealand’s economic growth outlook.

Turning gradually toward Australia
The consensus for Australian 2013 GDP growth at 2.9% is a little stronger than that for New Zealand. However, business and consumer confidence in Australia remain very weak. This highlights the continued reliance on the mining sector for growth.

The very recent Australian equity rally appears to have been driven by global factors – in fact the beta of the Australian market to both China and Japan looks poor in December. Australian equities were up only 3.4%, whereas Chinese and Japanese equities were up 18% and 10% respectively. The somewhat subdued reaction of the Australian market is more likely to reflect the fact that consumer and business confidence both fell in December, despite the RBA’s further cut to rates. Housing finance has yet to improve, and corporate news on balance remains negative. While many Australian stocks are trading above their 200 day moving average, the proportion is a lot lower than in many markets. (133 out of 200 Australian stocks are trading above their 200day moving average stock price).

Like the rest of the world, the Australian equity risk premium remains very elevated. This suggests more upside to the equity market. Despite cuts to corporate profits, Australia’s equity risk premium is still well above long term averages. Clarity on global growth, particularly in China, Japan and the US, will be most important for Australia. Further cuts to rates will also most likely improve sentiment.

Outlook
On balance, we consider that the NZ equity market may be over extended on several measures and that better opportunities are emerging in both global growth stocks and in cyclical stocks exposed to cuts in interest rates in Australia. Nevertheless, NZ equities still look good value relative to bonds.

CSL, Fisher and Paykel Healthcare, and Mainfreight are key examples of stocks in our portfolio that are likely to perform in most environments. Smaller companies like Diligent, Pacific Edge Biotech and A2 Corporation provide exposure to very strong potential earnings growth.

Balancing these longer term growth stocks are significant portfolio positions in Fletcher Building, Rio Tinto, BHP Billiton, Lend Lease, and a number of financials (National Australia Bank, Westpac, Computershare, Suncorp).

Best wishes as we start 2013 on a positive footing.

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