Investors are living through abnormal times. At the macro-economic level, central banks are now unwinding financial stimulus and geopolitical risks remain elevated. Domestically, Australia remains heavily reliant on Chinese commodity demand and a housing cycle which appears to have peaked. Despite these challenges, we maintain our focus on the following enduring investment themes.
A US cyclical recovery drives interest rates upwards
The mid-2016 rebound in long bond yields from multi-generational lows was a critical marker for investors, with Trump’s promised US economic reforms accelerating market optimism since. Higher global interest rates will transmit into a higher cost of capital and lower asset valuations, which will challenge equity investors. However the same improving outlook for growth and inflation should also flow through into better corporate earnings, particularly for cyclical type stocks. It is for these reasons that we have been advocating a gradual shift in portfolios to having slightly less capital allocated towards defensive equities and slightly more to cyclicals.
Financials stocks are a key beneficiary
The financials sector is arguably the biggest equity market beneficiary of rising interest rates.
Banks benefit as a lift in the yield curve allows them to charge higher interest rates on customer loans. Meanwhile the cost of some bank deposit funding does not really alter with an upward move in the yield curve. Banks also hold excess shareholder capital, as required by the regulator, which they invest in fixed interest/liquid securities providing additional leverage to rising bond yields.
Insurance companies take upfront premium payments (known as a ‘free float’) and invest them in bonds while waiting to see what payments they must make for insured claims over the year. Similar to banks, insurers also invest excess regulatory capital in bonds. Higher interest rates thus benefit their earnings.
Share registries such as Computershare accumulate float balances through a variety of activities like processing and payment of dividends and trust activity, which sees them hold a portfolio of short-dated fixed interest securities as part of their regular operations.
Exposure to a potential resources resurgence
Commodities are clear beneficiaries of an improvement in global growth and we see strong sense in positioning for what may eventually prove to be the beginning of the next ‘mining cycle’.
Until early 2016, mining companies had endured a five-year downturn as the onset of new mining supply drove a correction in commodity prices. The miners adapted, often painfully and largely under new management, by cutting dividends and growth, while re-focusing on productivity, cost reduction and cash margins. Stretched balance sheets were repaired in protection against a potential prolonged downturn.
Some key commodities then enjoyed a surprise bounce in 2016 due largely to Chinese policy decisions (iron ore and coal). The major miners enjoyed significant bounces in both earnings and dividends. With balance sheets in far better shape, the majors’ rhetoric on capital allocation very much remains directed at sustaining higher shareholder returns (payout ratios, buybacks).
This is pleasing for shareholders, but also infers poor confidence in the trajectory of commodity prices, from the major miners, which should be noted.
We therefore don’t blame investors for having similarly mixed confidence in commodities, China and global growth. However we believe that several factors support an overweight sector exposure to resources:
- China is in robust shape, cycling GDP growth of ~6.5pc. With the mid-term leadership transition approaching in November, we think the risk of China’s economy being allowed to slip in 2017 is low.
- Upside to global growth – markets have already shown their responsiveness to Trump’s proposed US economic agenda. A stronger US economy would support stronger global growth which is in turn positive for commodities.
- Strong investor upside – traditional investors remain underexposed to commodities in general as the pain of the ‘bust’ remains fresh for many. We note that generalist investors are often late to any given commodity cycle.
We think that investors can safely position in our sector favourites, being BHP and Oil Search to gain exposure to a moderate upside scenario for global growth.
- Justin Still, Investment Adviser (Authorised Representative: 000279726) Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410.