April 2013 — Over the Horizon Market Commentary by David OfferApril saw the Australian share market more than recover the ground lost in March, rising 3.8% to close at 5,168, with theconcerns mentioned last month such as the Cyprus (bank) haircut, North Korean tensions and worries over Chinese andUS economic growth all fading away in relevance to investors.The current overwhelming driver of share markets globally are Central Banks competing to stimulate economic growththrough unprecedented monetary policy easing to make borrowing money cheap and to devalue respective currencies tomake their countries more competitive. While a late starter, since the Bank of Japan commenced its super-easymonetary policy late last year, the impact on the Japanese share market and currency has been extraordinary.Chart 1: Japanese share market - Nikkei indexChart 2: Japanese Yen and US Dollar cross rates. For the US consumer, Japanese goods have become 30% cheaper in justthe last 6 months..
Australia’s Central Bank, the Reserve Bank of Australia (RBA), has belatedly entered the currency devaluation contest withanother 0.25% rate cut announced on Tuesday, 7th May. With our official interest rate now just 2.75%, this is a rate thatone would historically associate with a severe recession. However, the RBA believes that the Australian economy will growa bit below trend in 2013 and return to average growth rates in 2014. The primary reason for this rate cut was toendeavour to create weakness in the Australian dollar.While on the day of the announcement there was a small drop in the exchange rate, this was fully reversed two days laterwith the release of lower than expected unemployment numbers. This made the RBA’s actions appear futile.However, a day later, our dollar along with many other currencies was suddenly sold off strongly to almost trade at paritywith the US dollar. This was caused not by the RBA cut but rather by the US Federal Reserve talking of ending stimulatorypolicies due to the ongoing economic improvement being experienced in the US.This illustrates that the future level of the Australian dollar will be determined more by US Central Bank action, currentlythe Fed’s QE3 programme of buying US$85 billion worth of securities every month, than any action the RBA endeavours todo.We view a lower Australian dollar as vital to improve the overall health of the Australian economy and reduce the effects ofour current ‘two speed economy’ where there are clearly defined economic winners and losers. Accordingly, the health ofthe Australian economy depends to a large extent on the health of the US economy. If US growth picks up more stronglythan expected, the US dollar will rise and the Australian dollar will fall. This will be beneficial for nearly all Australianindustry.The following chart of the Australian dollar is starting to paint a positive picture for a potentially weaker currency goingforward.At the current time, rumours are starting to circulate of large hedge funds starting to take short positions in the Australiandollar, suggesting we may be at the beginning of a sell side trade. A break below 95 cents against the $US would confirmthis. If such a momentum trade eventuates, we may all end up being surprised about just how far and quickly theAustralian dollar falls.A key reason behind this hedge fund trade is a growing view that the resources boom is coming to an end. As mentioned inprevious monthly commentaries, we have viewed the resource boom as the rapid rise in employment that occurred withthe construction of new mines and we share the view that this is coming to an end due to the exorbitant costs of buildingnew mines in Australia. However, we don’t believe it necessarily means an end in favourable commodity prices or profitsfor established Australian miners. It is likely we are now entering a period of consolidation, cost minimisation and focus onreturning capital to shareholders.Woodside is an example of this, having recently changed its dividend policy to now pay out 80% of underlying profit. Themarket’s endorsement, reflected in the shares rising 14% post announcement, of Woodside’s decision to abandon near-term growth options in favour of returning capital to shareholders shows scepticism towards the potential returns onfuture large-scale growth projects in the resources sector. If BHP and RIO Tinto followed Woodside’s lead, they couldtheoretically generate FY15 dividend yields of 10% and 8% respectively, versus WPL’s 5%.
As exporters, resources companies will be cheering for any weakness in the Australian dollar. They will also bebeneficiaries of an improvement in global economic growth should the current global Central Bank intervention besuccessful. Accordingly, we are comfortable adding key resource shares to portfolios, particularly when contrasting the lowvaluation multiples they trade at versus the higher priced multiples of more defensive shares. As per the chart below,there is plenty of scope for these shares to play catch up at the current time.While share markets are currently being driven by Central Bank stimulus policy and a general lack of investmentalternatives, we need to remember that share markets will ultimately trade at what they are worth. As an indication ofaverage value of worth, over the last decade, our market has traded on an average Price Earnings (PE) ratio of 14.5times. Recently, we have risen from a low in May 2012 of 11.7 times to now currently trade at 15.7 times. While a marketaverage PE of 15.7 times is not excessively expensive, within our market, there is a wide disparity of valuations. Forexample, healthcare, as a defensive sector, is trading on an average prospective PE multiple of 23 times versus materials ona relatively low PE ratio of 11 times. Our view is that there is nothing defensive about having to wait 23 years on currentearnings to get your money back on an investment.As a final point, if Central Bank intervention is successful and global growth resumes, at some point interest rates will rise.If this eventuates, returns from other asset classes such as cash will improve and this will provide a head wind for thoseshares recently driven up in price primarily for the income they provide.To this end, we remain comfortable to building the cash component within portfolios, particularly having benefited fromthe strong rally that has occurred to date.
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