INVESTMENT ARITHMETIC FOR 2015: 2 + 2 = 4
In 2014 my Australian Equities mandate returned 15.1%, but the S&P/ASX200 Index managed only 5.6%. Share prices in the mining sector dropped as iron ore and coal prices fell to levels not seen since 2009. Repeated downgrades to Chinese GDP growth forecasts added to the negative sentiment. In the second half of the year oil prices halved, causing share prices in the energy sector to join the miners in their slide. Things were worse in Australia than overseas: the US S&P 500 index returned 13.6% in CY14, and although European share markets had a mid-year attack of nerves, they have risen by 20% since mid-October.
In the wake of such experiences, many investors are now gun-shy, if not shell-shocked, and fearing more of the same in 2015. We believe that outlook can be summarized very simply:
- the two big trends of last year – low oil prices and a high US dollar – will continue to operate in 2015.
- the two long-term macro events which we write about almost every month – slowing GDP growth in China, and the eventual normalization of US interest rates – are still in place, and they will drive bond and equity returns over the next three years.
- these two sets of two factors just mentioned will trigger four sources of risk in 2015 – junk bond defaults in the US energy sector, defaults in US dollar bonds issued by non-US corporations, defaults in low-quality sovereign debt, and “covert defaults” by second-rank Chinese companies.
So that’s how we get 2 +2 = 4. The four sources of risk originate in the credit markets, but their effects will spill over to the equity markets. There’s nothing like a default in the portfolio next door to incentivize a fund manager to re-evaluate the risk in his own portfolio. Before we jump to investment conclusions, let’s look at all eight items in detail.
The halving of oil prices is a spectacular positive for oil importing countries, not only because it improves their balance of payments, but also because it reduces petrol costs for the average consumer, increasing their ability to spend on other things. (The impact of low oil prices was discussed in detail in our 19 December 2014 Commentary.) The US is a good illustration of the point. As its high-cost oil producers will go out of business over the next two years, states like Texas and North Dakota will suffer economic damage, but the effect on the US as a whole is positive because of the widespread benefits of lower petrol prices for consumers and lower input costs for downstream users of petroleum products. Petrol is a big expenditure in the budgets of US consumers because 86% of US commuters travel to and from work by car every day (according to Commuting in America 2013, from the American Association of State Highway and Transportation Officials). Because of the lags in oil supply, we expect oil prices to remain low for the next five years.
The rise of the US dollar against most other currencies reflects the resurgent economic strength of the US and in particular the fact that its growth rates are speeding up while other countries are decelerating (e.g. China) or stalled (e.g. much of Europe). The primary cause of this divergence is the end of the resources boom. From 2003 to 2012 resource producing countries such as Australia, Brazil and Canada prospered because resource consuming countries like the US had to pay higher prices for resources. Over the next decade, however, as commodity prices decline or stagnate, the resource consuming countries will prosper. Hence we do not expect that the rise of the US dollar will reverse in the near term, although it will undoubtedly have fluctuations and retracements. Students of history will recall the relentless rise of the US dollar in the early 1980s, which was halted only by the combined efforts of five central banks (the Plaza Accord of 22 September 1985). The rise of the US dollar is similar to the rise of the Chinese renminbi, which is now 51% above its real effective value in mid-2005 when it was unpegged from the US dollar: its appreciation against the rest of the world reflects the faster growth rate of its economy in the long term, despite the persistence of capital flight as Chinese elites smuggled their money off to safer jurisdictions. (That said, the Chinese renminbi is expected to depreciate in CY15.)
The big macro trend of China’s slowing growth is now part of the conventional wisdom. CY14 GDP growth was 7.4%, the lowest level since 1990. The slowdown is partly driven by tighter monetary policy and partly by structural change in the economy, so we expect that CY15 and CY16 will be slower again. The emerging economies which have profited from supplying resources to China are already suffering the pain of lower prices and lower volumes. For Australia, the China slowdown is an ongoing negative influence because a third of our exports go to China.
The eventual normalization of US interest rates seems likely to begin this year, if recent comments from the US Federal Reserve are any guide. The process of restoring cash rates from zero to their historic averages of 3% to 4% will take a year or two, and its speed will depend on how healthy the US economy is over this period. Higher cash rates will tend to push up term spreads and credit spreads in US bond markets, with flow-on effects to business financing and mortgage affordability. The key point here is the Fed is only concerned with the health of the US economy. The impact on the rest of the world economies doesn’t matter, because the rest of the world doesn’t vote in US elections. Because the Fed has been talking up the rate rise for some months now, it is likely that the first 0.50% of the rise is already priced into US credit markets.
The two big trends of 2014 interact with the two long-term macro events to produce our four sources of negative events for 2015.
The first source of risk – a rash of junk bond defaults in the US energy sector - is the inevitable outcome of lower oil prices. For high-cost producers, lower prices mean that operating costs can’t be covered and interest obligations can’t be met, i.e. they default. The financial consequences of these defaults will fall on bond portfolios and bank loan books. It is likely that many banks in the energy states will fail without Federal assistance. (Connoisseurs of banking crises may like to read Mark Singer’s Funny Money, which chronicles how oil-exposed banks collapsed in the 1980s.) The real-world consequences include insolvencies, unemployment and a slump in oil sector capex. Although these events will attract media attention (just as they did in the 1980s), the damage will be localized to the energy states.
The second source of risk – defaults in US dollar bonds issued by non-US corporations – is the result of the appreciation of the US dollar, reinforced by slowing Chinese growth and the normalization of US interest rates. Companies which do not have the natural hedges of USD assets and revenues will find themselves exposed to higher interest and principal obligations in their home currencies, and some of them will be pushed into default by high gearing or other misfortunes. This source of negative events will be more widespread than energy sector defaults and harder to predict.
The third source of risk – defaults in low-quality sovereign debt – is what happens when countries get into the sort of difficulties which force companies into insolvency. A country can’t go bankrupt, but it can certainly stop paying its creditors, and there are many examples over the last three decades. The usual solution is some form of “restructuring”, which means extension of maturity, partial forgiveness of principal, reduction of interest rate, etc. The main effect of sovereign defaults is on the bond portfolios which were foolish enough to own these securities, but they also provoke a re-evaluation of risks and a lot of media noise.
The fourth source of risk – “covert defaults” by second-rank Chinese companies – is a subset of the second source, but it needs to be considered separately because it has different consequences. Chinese companies are by no means immune from over-borrowing, but important Chinese companies enjoy the benefit of an implicit government guarantee. In the handful of near-defaults by Chinese companies over recent months, some arm of government has usually managed to arrange a last-minute rescue so that actual default does not occur. It is conceivable that these heroic interventions spring from the Chinese Communist Party’s deep concern for the welfare of investors. It is more likely that some level of government has a more direct motivation for averting an outright insolvency, such as the potentially disastrous impact on the local economy. In short, the only Chinese companies which will be allowed to go bust are the unimportant ones.
What do the four sources of risk mean for Australian investors? The sovereign and corporate defaults will have little direct impact on Australian bond or equity markets, but their impact overseas will increase the volatility of global capital markets. In this context, it is important to remember that, because Australia is small compared to the US, our capital markets function like a derivative of US capital markets. Or, to put it more bluntly, when the US sneezes, we catch cold.
The collapse of US energy companies will not be paralleled in Australia, because 160 years of resource booms have taught most Australian banks and investors not to lend money to mining and oil companies. Over the next two years, the listed mining and oil sector will shrink sharply.
The “covert defaults” by Chinese companies will reinforce the negative impact of slowing Chinese growth. A company which has just been rescued goes into work-out mode, not expansion mode, so it will not be importing more raw materials from Australia. This phase will be how the Chinese central government deals with the over-capacity which has been built up in many industries as a result of low interest rates and other investment incentives. Factories and plants will quietly shut down, and modest pensions will be paid to the laid-off workers, following the precedents set when the government shrank superfluous state-owned enterprises in the 1990s.
The net effect of our 2+2=4 is to bring the Australian and US share markets closer to their next correction. Because we expect higher volatility in 2015, we suggest that, from March onward, investors should either take out derivative protection against downside risk, or reduce their exposure to equities.