Oils aint Oils – Hidden Sharemarket Risks

The 2011 outlook is modestly positive for Australian shares supported by the lack of a double dip, growth in emerging economies and ample global liquidity (low global interest rate environment and second round of quantitative easing). But increased Australian inflation and costs (oil, commodities) will reduce margins in key sectors, capping the potential for sharemarket growth this year. We describe key investment strategies to benefit from these issues. Investors and advisers will have to work hard to generate real returns in the next part of the cycle.

We’re not past the GFC mess yet

For those that like to skip to the end of a good story, we show in this research piece that:

China’s growth story (which for domestic socio-political reasons is likely to remain on track for an extended period of time) is:

	Good for Australian resource companies and their shareholders;
	Good for Australian workers who are in the resource sector or related industries;
	Good for Australian GDP growth;
	Bad for Australian interest rates;
	Bad for Australian inflation;
	Bad for Australian exporters;
	Ugly for Australian consumers not employed by companies in the resource sector or related industries;
	Ugly for Australian companies exposed to consumers not benefitting from the resource boom (ie the “two speed economy”);
	Ugly for Australian companies, employees and related goods or service providers, that are in mature industries under pressure from the massive structural change occurring in the Australian economy.

That’s why today’s media headlines (3 March 2011) read: “Shares flat as investors shun risk,” when only 2 weeks prior, companies like BHP were reporting massive profit increases (normally the sign of the start of a bull market)!

China, china, china

China is the great driver of the global commodity supercycle, but the topsy turvy global macro-economic confusion coming from this provides the greatest challenge to global economic health since the bottom of the GFC. Consider the following:

(Chinese wage pressures, asset bubbles) China’s inflation rate remains high, around 6% - 8% pa (depending on who is measuring), and this poses internal problems for Chinese authorities (food price inflation drives food prices up, provoking unrest from the urban and rural poor; this feeds into higher wages and higher prices for exported goods, and fuels asset price bubbles in the property and corporate sectors);
(Slowing Chinese economy) China’s central bank and regulatory authorities were the first in the world to raise interest rates and impose lending and liquidity restrictions after the GFC, in an effort to rein in inflation. They continue to take measures to suppress inflation using a combination of these tools – but this is often perceived as a negative for global (including Australian) stockmarkets. Suppressing economic demand and activity has the obvious potential to reduce demand for Australian commodities, goods and services supplied to China;
(Rising cost of Chinese exports) Wages in China are rising - leading to an increase in prices of the goods it supplies to the rest of the world. This is a key point: although we have been used for at least the last decade to Chinese low cost goods being a deflationary input to western economies, as prices of exported goods begin to rise, this flows through into higher prices in Australian shops for these goods;
(Australian inflation) Chinese demand for commodities including oil continues to grow, driving prices up with at least 3 negative impacts on the Australian economy (which at least partially offset the benefits to the Australian economy arising from high commodity prices):

Rising commodity prices brings competition to Australian commodity producers, as more expensive/lower quality suppliers become more attractive,
Surging terms of trade (ie the Australian current account surplus) means the RBA will keep interest rates at the high end of the range for the foreseeable future,
Rising oil prices act like a tax rate increase, negative for consumer spending, industrial demand, GDP growth – and stock prices.

China – the good, the bad, and the ugly

Our national destiny is inextricably linked to China for the foreseeable future, but this is starting to play out in very unexpected ways. The RBA’s Glenn Stevens showed in his speech last November to the 50^th anniversary of CEDA, (http://www.rba.gov.au/speeches/2010/sp-gov-291110.html ) that the enduring boost to Australia’s terms of trade sets up big challenges to Australia, including how to respond to rising GDP growth and inflation. More recently, in his speech last month entitled “The Resources Boom” ( http://www.rba.gov.au/speeches/2011/sp-gov-230211.html ) he stated (somewhat ominously, when looking at the history of previous commodity booms in Australian history):

In short, these episodes were major externally generated shocks that proved very disruptive, not least because the country's macroeconomic policy framework was not well equipped to handle them. The high levels the terms of trade reached on some occasions were not permanent, but they did persist long enough to have a big impact on economic outcomes.

Glenn Stevens noted the other big by product of a massive terms of trade surplus – the strong exchange rate (great for imports and bad for exports):

A further thing we know about the boom is that it is associated with a much higher level of the exchange rate than we have been accustomed to seeing for most of the time the currency has been market determined, a period of more than 25 years (though, over the long sweep of history, the nominal exchange rate was often considerably higher than it is now). On a trade-weighted basis, it is 25 per cent above its post-float average.

This exchange rate is, of course, hurting our exporters and their share prices are reflective of that. Stevens concluded by acknowledging the massive structural change in the Australian economy:

there is going to be a non-trivial degree of structural change in the economy as a result of the large change in relative prices. This is already occurring, but if relative prices stay anywhere near their current configuration surely there will be a good deal more such change in the future.

So, China’s growth story (which for domestic socio-political reasons is likely to remain on track for an extended period of time) is:

	Good for Australian resource companies and their shareholders;
	Good for Australian workers who are in the resource sector or related industries;
	Good for Australian GDP growth;
	Bad for Australian interest rates;
	Bad for Australian inflation;
	Bad for Australian exporters;
	Ugly for Australian consumers not employed by companies in the resource sector or related industries;
	Ugly for Australian companies exposed to consumers not benefitting from the resource boom (ie the “two speed economy”);
	Ugly for Australian companies, employees and related goods or service providers, that are in mature industries under pressure from the massive structural change occurring in the Australian economy.

Given these strong and often contradictory forces, it’s no wonder that the Australian sharemarket can’t make up its mind about whether China’s day to day actions and policy measures are good or bad!

Oil – the real problem for 2011 and beyond

Ever since the GFC, a rising oil price has been somewhat welcomed, as an indicator of returning global activity and growth. But oil at US$116 per barrel – as it was today when I turned on Sky Business News – is a shocking dampener of activity, both here and abroad. It may not hurt as much in countries like the US where interest rates (such as home mortgage rates) are at an all time low. But in countries like Australia where home mortgage rates are high, and where real inflation is high as well (see above), high oil prices have a real – and damaging – effect on the economy. As Gerard Minack said in last week’s Eureka Report:

In my view, the effect of rising oil is similar to that of rising bond yields. While investors were worried about the sustainability of Western-world expansion, equity, rates and oil could move together. Improving macro data were good for all three. Consequently, all three have been positively correlated through most of the past three years.

This will start to change once investors factor in sustained growth (something I think is relatively close). From that stage, further gains in commodities or rates will be increasingly seen, in my view, as a headwind for equities.

Rising energy prices is one of the headwinds I see for developed market equities like the US in the second half. The rise in crude prices through $100 is, in my view, just another sign that the sweet spot for developed market equities is almost over.

While I think the market can move higher in the near-term, the second half of the year looks set to be much more challenging. Although I don’t have a precipitous decline as a base case, my view is that equities will probably make their year-high in the current half.

Where to from here

Commodity and oil prices are a mixed blessing for the Australian economy and sharemarket – as they are for other developed nations (many of which aren’t faring as well economically as we are). Rising prices indicate economic growth, and this is magnified in resource producing countries. But these price rises produce stresses in wide areas of the economy, in Australia, our “good,bad and ugly” matrix above shows how complex are the interaction of these forces. Even though the Australian economy and sharemarket is showing pleasing signs of post GFC strength, rising prices (oil in particular) will act to moderate economic growth, and to put a lid on the stockmarket growth for the foreseeable future.

Oh, and if you didn’t notice, Gerard Minack shares our house view that the growth in developed nation’s sharemarkets is probably at the end of its current cycle (watch out for any signs of withdrawal of QE2, which will hasten the slowdown). Ironically this makes a mockery of recent fund manager calls to move out of EM equities and into developed nation shares.

Australian shares seem to have developed a floor (at least those in sectors relatively immune from the stresses we identified above), and some will continue to grow their earnings and share prices strongly. But general market growth may not be at a very fast pace for the next year or so, with exogenous shocks like Libya a risk to the downside.

Investors and advisers will have to work hard to generate real returns in the next part of the cycle.