I am taking my own advice and selling in May and going away with my family for a few weeks. Hopefully, when I return, Australian equities will offer broader bottom-up value and we can deploy some of the cash we have built up over recent months at better risk-adjusted entry prices. On that basis today I offer a part 1 of a strategy note in which I will cover quite a few different macro topics that I believe will combine to drive the trading correction.
Still wary
As you are well aware I remain tactically cautious on Australian equities, looking for a trading correction back to the 5100 to 5200 index level range, where shorter-term technical support lies. So far that tactically cautious positioning since May has been correct (In fact the ASX200 is where it was nine months ago in Australian dollar terms and where it was three years ago in US dollar terms), but I tend to think the bigger move down at the index level will occur when I am on holidays (as it always seems to) as equity risk premium gets priced back into leading equities. The bigger correction has played out in the next few weeks for the last five consecutive years when the market is devoid of bottom up news.
Sentiment headwinds are building for Australian equities, not abating. That is why I am increasingly confident that my cautious tactical strategy will continue to prove correct in the weeks and months ahead.
Obviously with pure value hard to find, low volatility and low volumes, Australian equities are highly vulnerable to the slightest change in sentiment. I suspect at the top-down level the biggest risk to Australian equities, remembering the majority are being priced like fixed interest instruments (inverse to dividend yield), is from central banks. Yes, the same central banks that engineered the global yield compression trade.
While I think the RBA will do nothing on rates for an extended period (*refer to this week’s dovish RBA Board minutes [1]), last week you saw the Kiwi’s lift cash rates, the Bank of England Governor Mark Carney say “rate hikes could start sooner than markets currently expect” and you will also get notes from the FOMC that may also hint towards US cash rates moving up, or at least what mechanism the Fed will use to raise cash rates. US two-year bond rates have already started moving up. All I know is ANY bringing forward of central bank cash rate rises in the eyes of investors will be bad for equities, but particularly, any stock priced purely off its dividend yield.
Below are graphs of the US two-year bond yield and UK five-year guilt yield: note the spike in yields. This is a precursor to cash rate increases from the FED and BOE.
Don’t fight the FED, in either direction
This is why I am cautious on all forms of short US dollar carry trades, but particularly highly priced on P/E equity carry trades. What we all always underestimate is the amount of leverage being used in these carry trades, but particularly carry trades that have been successful for many years. Personally I think short US dollar carry trades are, in baseball terms, at the bottom of the Ninth innings and I continue to urge caution, particularly with the risk of central bank (ex ECB) cash rate rises increasing. Put it this way, it’s ok to leave a baseball game at the bottom of the Ninth innings when the score is 100-nil.
Flattening yield curves are also a concern for equities. That flattening yield curve has been 100% right in Australia predicting deteriorating East Coast consumer conditions (post Federal Budget) and I continue to feel that the divergent views implied by bonds and equities in Australia will converge in the weeks and months ahead in terms of price. Below is the three-year Australian government bond yield (green) versus the ASX200 (blue). A re-correlation would see the ASX200 in the 5100 to 5200 range.
AGB 3yr Bond yields vs. ASX200
We need to talk about China
But outside of interest rate expectations that could affect around 70% of the Australian equity market in terms of the price paid for dividend yield, the other 30% is either directly or indirectly China facing. Everything I look at as a macro indicator of Chinese economic activity remains sloppy. It could just be that the world is pricing in lower sustainable Chinese GDP growth rates, but just have a look at this overlay of price charts in China-facing indicators. There is a very consistent trend and I pay more attention to these indicators than any broker forecasts or “data” Beijing puts out.
In the chart below the spot 62% FE iron ore price, Baltic Dry ship index, Shanghai rebar steel price, milk powder index and fine wine index over the last six months. Very simply they have all headed from the top left to the bottom right corner of the chart.
These spot commodity price falls are clearly a result of the supply response from iron ore through to milk powder and fine wine, but it also indicates a broader reassessment of demand growth based off Beijing’s reticence to fire any “shock & awe” stimulus bullets. Interestingly over the same six-month period, the Renminbi (Yuan) has been allowed to trade in a wider (weaker) trading band to the US Dollar.
Lower sustainable Chinese GDP growth rates are a good thing in the longer-term, but in the shorter term they are clearly a problem for China-facing commodity producers.
What I worry about the most is not Beijing engineering a GDP growth slowdown, that’s ok, but could they be engineering a spot commodity price correction for their own benefit?
This could be an episode of The Empire Strikes Back after enduring a decade of record commodity prices. The China demand-growth driven low cost supply response has arrived in commodities and I can’t help but wonder whether the recent “inquiry” into commodity stockpile (port) financing is really an attempt to withdraw trader finance from the spot commodity markets, see forced selling of trader/warehouse/port inventories, and let the state owned enterprises deal directly with the major commodity producers in the spot markets. As the biggest marginal buyer of most commodities, China can become the price maker via reducing/eliminating “trader noise” in spot markets, particularly now the supply response has arrived and everything trades on spot price, not contract price.
Spot prices of copper and iron ore have already fallen further in response to the “inquiry” with industry commentary suggesting letters of credit and broader financing are drying up as Chinese banks become more cautious.
I am not a conspiracy theorist but this all needs very careful monitoring. The Chinese are long-term thinkers and they may well have put up with a decade of being a price taker of very high prices to get many decades of very low (stable) prices based off dramatically increased supply. I hope I am wrong, but the joke could be on us.
Quite simply, if Beijing can engineer a way to starve domestic commodity traders of finance, this could really unravel and all our (and the market’s) long-term assumptions on commodity prices are wrong (ditto stock valuations). I have written before that the super price cycle in copper and iron ore is over and the sidelines remains the place to be here in terms of pure plays. This is another reason I remain bearish on the Australian Dollar, a commodity currency currently priced as a yield currency.
We need to watch this space, but either way consensus FY15 earnings & dividend forecasts for the Australian mining sector remain too high, significantly too high. Ditto mining services/engineering.
100% of Charlie Aitken’s fees for writing for the Switzer Super Report are donated to The Sydney Children’s Hospital Foundation.
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Also in the Switzer Super Report:
- Charlie Aitken: Wait for the buying opportunities part 1 [3]
- Geoff Wilson: Why you need global stocks and how to get them [4]
- Staff Reporter: Buy, Sell, Hold – what the brokers say [5]
- Fundie’s Favourite: Buy a portfolio building block with James Hardie [6]
- Ron Bewley: Ron Bewley’s investment bucket list [7]
- Tony Negline: Super money for nothing – from the government! [8]
- Question of the week: How to buy US dollars [9]