12 Sep August Market Commentary

Monthly Economic & Investment Market Commentary

August 2012

In today’s world where such a vast amount of information is so readily available, one needs to be vigilant towards succumbing to confirmation bias, that is the tendency to seek out information and sources that support the views you already hold.

We have consistently spoken of two major themes which we expect to dominate the investment landscape for many years to come. The first is that there is too much debt in the developed economies and that the necessary policy changes to reduce that debt will mean subdued growth in the “Submerging Nations”. The second is that the rise of the middle class in China and other Asian and Emerging Economies represents a phenomenal shift in the global economy that will continue for decades to come.

As we have quoted before, the most succinct summation of these trends comes from our macro economist Jonathan Pain, who says that in future “the Submerging Nations will spend less and save more, and the Emerging Nations will spend more and save less. Yes, it really is that simple.”

Generally speaking there is less conjecture about the quantitative aspects than there is about the qualitative aspects. So before we embark on the discussion we promised last month about China, Emerging Markets and the Australian economy, and in the interests of guarding against confirmation bias, let us first lay out some of the major arguments of those who disagree with our views.

• Growth in the Chinese economy has been inflated by unsustainable government directed investment in fixed assets and infrastructure, including building ghost cities, bridges to nowhere and empty airports and shopping malls.
  
• Demand for our commodities and artificially high prices, has masked the underlying weakness in the Australian economy. When China has its inevitable “hard landing‟ the Australian economy will plunge into recession.
  
• Australian banks are reliant on overseas funding, which can be withdrawn at short notice, and would require emergency support from the Reserve Bank of Australia to ensure liquidity.
  

ASIA AND EMERGING MARKETS

Images of empty new apartment blocks, public buildings and shopping malls, indeed entire cities that have been built with no current inhabitants, make a seemingly compelling case for those arguing that such spending is wasteful and of no long term benefit. These stories have been told for many years by those who say the Chinese economy operates under an unsustainable model, what are much less prominent are the follow up stories such as the Wall Street Journal’s “Shanghai’s Pudong, Once Soulless, Rises Up”¹ which says: “Pundits once mocked Shanghai’s Pudong district, a purpose built version of Manhattan, as overdesigned and under occupied, evidence in steel and glass of a property bubble of historic proportions.”

The article tells us that more than double the office space in Manhattan has been built in Pudong since 1995, some 120 million square metres and 70 skyscrapers. Real Estate Agent Jones Lang La Salle says vacancy rates are slightly lower and rents are slightly higher than is the case in Manhattan. Pudong now has a population of more than 5 million people, but perhaps this may be just an isolated example, and the more recently completed construction will remain ghost cities.

Our view is that this will not be the case and that the urbanisation of the Chinese people as predicted by the Organisation for Economic Co-operation and Development will mean that the current infrastructure spending will support this long term internal migration from rural areas to cities. By 2030, the OECD predicts that a further 300 million people – roughly the current population of the United States – will be added to the urban population.

As to overall infrastructure spending, we refer again to The Economist², which makes the point that assessing current rates of spending doesn’t really tell us whether there has been too much or too little spending. Rather we should consider the value of all past investment, the capital stock, which is shown on the right in the adjacent chart.

What is clear is that there has been a big increase in the capital stock per person in the last decade in China. What stands out even more is how far behind the Chinese are in comparisons of this measure with the United States, Japan and South Korea.

Stephen Roach was formerly Chairman of Morgan Stanley Asia, and recently wrote that urbanisation is not phony growth, rather it is an essential ingredient of the “next China‟ and noted that urban per capita income is more than triple the average in rural areas. The rebalancing of the Chinese economy will drive development for decades.

Over relatively short time frames, the progression of the Chinese towards spending more and saving less will not be the smooth projection shown in this chart, taken from an Australian Treasury paper3 published earlier this year, though over longer periods we are confident in the rising trend.

AUSTRALIA

So to Australia, where in the just completed reporting season BHP Billiton’s decision not to proceed with the proposed expansion of their mine at Olympic Dam in South Australia received a lot of attention. BHP management has decided to evaluate less capital intensive options for accessing the copper resource at Olympic Dam than the intended underground mine, and naturally current market conditions including lower prices and higher costs were a consideration in this decision.

They believe the long term outlook for the copper market remains strong, and this view is supported by the following charts that come from same Treasury paper mentioned above. As GDP per capita expands, so does demand for commodities.

Our view is that this relationship will hold for China (the red line in the bottom right hand corner) as it has done for the other more developed countries depicted, though we will have shorter term fluctuations particularly in prices, as part of the longer term trend.

The other headlines to come out of the company reporting season were the inevitable headlines about bank results. There are some differences in reporting periods, but ANZ and NAB announced cash profits of $4.5 billion $4.2 billion for the nine months to June, Commonwealth Bank had $7.1 billion for the year. Interestingly, in the back of the 150 page analyst presentation was a chart from Commonwealth that was clearly designed to respond to some of the sensational headlines.

This chart shows the apportionment of the bank’s income, with the yellow and light blue slices making up the $7.1 billion profit figure mentioned above. Among the largest 100 companies on the ASX, the CBA ranks 2nd in terms of overall size and the size of the dividends paid to investors, and third in the amount of tax paid to the government.

However, it ranks lower when measured by Return on Equity (31st) and lower again on Return on Assets (82nd). The banks produce large headline profits, but relative to their size are not pricing super profits.

It is easy to make the claim that bank profits are too high, yet none who do so go on to outline whether lower profits should come from lower dividends to investors, fewer people employed or lower taxes paid to the government. Let us conclude by addressing the concern about the composition of bank funding, and particularly the reliance on overseas funding.

During the depths of the Global Financial Crisis, credit markets around the world froze as banks became unwilling to lend to each other, and our banks were certainly part of that environment. In the end, emergency liquidity measures were provided by Central Banks and gradually lending resumed.

The chart from the RBA⁴ at right shows that the way banks fund themselves has changed since the crisis, with a marked increase in domestic deposits and a similar decrease in short term funding. Expectations are that this trend will continue, though at present a repeat of some external shock of the magnitude of the GFC would certainly be felt in Australian Banks.

With the likelihood of a disorderly breakup of the Eurozone seemingly much diminished in recent times, and China moderating its growth in a controlled manner, we remain confident that Australia banks will continue to provide attractive, stable returns.

ASSET CLASS VALUATIONS

The table below shows our long term (10 year) expected returns from three asset classes; Australian shares (represented by All Ordinaries index), international shares (S&P 500) and listed property (ASX 200 Property). The four valuation ranges, represented by the different colours, are determined by comparing the return we forecast, to a risk free rate of return (Term Deposit rate).

SOURCES:

1. James T Areddy, “Shanghai‟s Pudong, Once Soulless, Rises Up” – Wall Street Journal. 21-Dec-11.

2. Free Exchange, “Capital Controversy” – The Economist. 14-Apr-12.

3. Brendan Coates and Nghi Luu, “Economic Roundup” – Department of the Treasury. Issue 1, 2012.

4. Statement on Monetary Policy – Reserve Bank of Australia. August 2012.

About Reuben Zelwer   Reuben Zelwer established Adapt Wealth Management in 2011 to help time poor clients achieve financial freedom. For over 15 years, Reuben has helped professionals, executives, business owner and those approaching retirement make the most of their circumstances by making good financial decisions. Reuben’s professional practice is complemented by substantial voluntary work, which has included setting up financial literacy and savings programs in the local community.