Tuesday, 01 November 2016 08:01

Should investors participate in IPO's

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This article was written for SMSF Adviser online magazine.

 

With the avalanche of new listings coming to market, we consider the issue should investors participate in IPO’s (Initial Public Offers)?

When it comes to investing we all aspire to Warren Buffett, and yet at times investors act more like Gordon Ghecko, the fictional character portrayed by Michael Douglas in the 1987 film “Wall Street”. This is how it seems with the love affair investors have with IPO’s.

Every investors dream of course is to buy into a float, and then sell day one for a handsome profit, otherwise known as a ‘stag’.

We acknowledge how easy it is to fall in love with a new IPO, after all the prospectuses produced usually come complete with stunning pictures of celebrities such as Jennifer Hawkins who made the Myer prospectus worth flicking through. When Pacific Brands pitched to investors the images of Pat Rafter and others in their underwear may have been visually appealing, but certainly not instructive.

Aside from the pictures though, the prospectus almost always outlines a rosy outlook for the business.

The first question we would suggest investors ask themselves is – would they want to have this in their portfolio in 5 years time? If the answer is a clear no – then we suggest extreme caution.

Other than the normal set of investment considerations that investors think about when investing, such as price, management, gearing etc here are a series of additional points when thinking about investing in an IPO.

  1. Investors need to understand who is the vendor of the IPO. Private Equity funds have established a poor reputation for taking over businesses, loading them up with debt after stripping the company of other assets before selling back to unsuspecting investors via an IPO. Dick Smith comes to mind as a perfect example. We are not opposed to buying from Private Equity funds as such, but investors must understand that the vendors in an IPO have a far greater understanding of the business than the investor can gather from reading the prospectus, which puts the vendor at a significant advantage. Conversely the history of Government IPO’s has been a little friendlier for investors, other than of course Telstra II, which is still significantly underwater from its $7 plus offer price.
  2. Once investors have established who is the vendor, it is important to also understand whether the vendor is retaining any part of the company or if it is a full sale. If the vendor is retaining part of the business, investors need to understand if there are any time limitations around this ownership. We also believe that it is also crucial to understand what the IPO proceeds are being used for. Is the IPO simply to reduce debt, or for the vendor to sell out? Or are the proceeds being used to grow the business?
  3. Brokers are remunerated for selling the IPO. While this may sound obvious, it reminds us of the phrase “never ask a barber whether you need a haircut”. Brokers have to sell their services to the IPO vendor, which results in a research blackout on the IPO company. This simply means that it is virtually impossible to obtain unbiased investment research from the broking firm that is handling the IPO. And of course as the experienced brokers will tell you – “the best IPO’s you can never get enough of, and the IPO that you receive your full allocation for is generally the one you don’t want”
  4. One of the best pages of the prospectus is the “Investment Risks” section. In our experience, very few investors read much in a prospectus at all, and in particular do not read or understand the investment risks section. If it is one section of a prospectus that investors read, it should be this section.

So, should you invest in IPO’s? Our view is that while some IPO’s offer good opportunity, greater caution should be exercised by investors when considering IPO’s due to the lower level of information usually available.

 

Monday, 31 October 2016 16:47

Centrelink - Asset Test Changes - 1st January 2017

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This article provides a handy reference guide for the assets test changes effective 1 January 2017.

The quick reference tables allow you to look up the rate of annual Age Pension payable for various levels of assets under the current asset test rules (as at 20 September 2016) and the new asset test rules (as at 1 January 2017).

Singles

ASSETS TEST THRESHOLDS AS AT 1 JANUARY 2017

 

Lower threshold1

Upper threshold2

Homeowner

$250,000

$545,600

Non-homeowner

$450,000

$745,600

Assets test taper rate: $3pf for every $1,000 over the lower threshold.

 SINGLE HOMEOWNERS

Assessable assets3

Age pension: Current assets test4

Age pension:

New assets test as at 1 Jan 2017

Annual difference

$200,000

$22,313

$22,313

$0

$250,000

$21,463

$21,501

$38

$300,000

$19,513

$19,162

-$351

$350,000

$17,563

$15,262

-$2,301

$400,000

$15,613

$11,362

-$4,251

$450,000

$13,663

$7,462

-$6,201

$500,000

$11,713

$3,562

-$8,151

$550,000

$9,763

$0

-$9,763

$600,000

$7,813

$0

-$7,813

$650,000

$5,863

$0

-$5,863

$700,000

$3,913

$0

-$3,913

$750,000

$1,963

$0

-$1,963

$800,000

$13

$0

-$13

$850,000

$0

$0

$0

 

 

Couples

ASSETS TEST THRESHOLDS AS AT 1 JANUARY 2017

 

Lower threshold1

Upper threshold2

Homeowner

$375,000

$820,600

Non-Homeowner

$575,000

$1,020,600

Illness separated Homeowner

$375,000

$966,200

Illness separated Non-Homeowner

$575,000

$1,166,200

Assets test taper rate: $3pf for every $1,000 over the lower threshold.

COUPLE HOMEOWNERS

Assessable assets3

Age pension: Current assets test4

Age pension:

New assets test as at 1 Jan 2017

Annual difference

$200,000

$34,766

$34,766

$0

$250,000

$34,766

$34,766

$0

$300,000

$34,299

$34,299

$0

$350,000

$32,680

$33,487

$807

$400,000

$30,730

$32,674

$1,945

$450,000

$28,780

$28,916

$137

$500,000

$26,830

$25,016

-$1,814

$550,000

$24,880

$21,116

-$3,764

$600,000

$22,930

$17,216

-$5,714

$650,000

$20,980

$13,316

-$7,664

$700,000

$19,030

$9,416

-$9,614

$750,000

$17,080

$5,516

-$11,564

$800,000

$15,130

$1,616

-$13,514

$850,000

$13,180

$0

-$13,180

$900,000

$11,230

$0

-$11,230

$950,000

$9,280

$0

-$9,280

$1,000,000

$7,330

$0

-$7,330

$1,050,000

$5,380

$0

-$5,380

$1,100,000

$3,430

$0

-$3,430

$1,150,000

$1,480

$0

-$1,480

$1,200,000

$0

$0

$0

 

Note:

  1. Lower threshold as at 1 January 2017 as per Social Services Legislation Amendment (Fair and Sustainable Pensions) Act 2015

  2. Upper threshold is a calculated value assuming maximum pension at 1 July 2016 is indexed by 1.5% to 1 January 2017. The actual upper thresholds on 1 January 2017 may be different to those shown here.

  3. Assumes assets are financial investments subject to deeming

  4. Age Pension entitlement as at 20 September 2016 is calculated using the current taper rate of $1.50 pf for every $1,000 over the lower threshold. The Age Pension entitlement is the lower of the assets test and the income test. The maximum age pension is estimated by indexing maximum pension at 1 July 2016 by 1.5% and asset thresholds on 1 July 2016.

  5. Age Pension entitlement is calculated using the 1 January 2017 taper rate of $3 pf for every $1,000 over the lower threshold. The Age Pension entitlement is the lower of the assets test and the income test. The maximum age pension is estimated by indexing maximum pension at 1 July 2016 by 1.5% and legislated lower asset threshold as at 1 January 2017.

The information contained in this update is based on the understanding Colonial First State Investments Limited ABN 98 002 348 352, AFS Licence 232468 (Colonial First State) has of the relevant Australian laws as at 1 July 2016. As these laws are subject to change you should refer to a professional adviser for the most up-to-date information. The information is for adviser use only and is not a substitute for investors seeking advice. While all care has been taken in the preparation of this document (using sources believed to be reliable and accurate), no person, including Colonial First State or any other member of the Commonwealth Bank group of companies, accepts responsibility for any loss suffered by any person arising from reliance on this information. This update is not financial product advice and does not take into account any individual’s objectives, financial situation or needs. Any examples are for illustrative purposes only and actual risks and benefits will vary depending on each investor’s individual circumstances. You should form your own opinion and take your own legal, taxation and financial advice on the application of the information to your business and your clients.

Colonial First State is not a registered tax (financial) adviser under the Tax Agent Services Act 2009 and you should seek tax advice from a registered tax agent or a registered tax (financial) adviser if you intend to rely on this information to satisfy the liabilities or obligations or claim entitlements that arise, or could arise, under a taxation law.

22735/FS6613/0816

 

 

Monday, 31 October 2016 15:15

Why Deutsche Bank is no Hindenburg

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This article is an extract from Platinum Asset Management's September 2016 quarterly review

 

Bank's fail because they are 1) illiquid 2) insolvent or 3) both.

Deutsche Bank does not have a liquidity problem.  They hold EUR 200bn of highly liquid assets (12.5% of the balance sheet) which are enough to withstand a serious bank run.  But ultimately is doesn't matter, because the ECB can and will provide unlimited liquidity support to the bank, if needed.

The solvency question in more nuanced.  Normally banks become insolvent because they can't recover money from borrowers or counterparties, they don't have as many assets as they thought.  But the value of Deutsche bank's asset isn't being questioned.  Rather, its the value of their liabilities that has the market in a spin.

According to its latest disclosure Deutsche Bank faces 14 sets of legal actions.  These are contingent liabilities because Deutsche only has to pay if it loses a case.  Both the probability of losing those cases and the amount they would have to pay are unknown today.  Deutsche makes an estimate and has set aside EUR 5.5bn for these contingencies.  It recently emerged that the US Dept of Justice (DOJ) has offered to settle the largest of these actions for EUR 13bn.

Of the EUR 5.5bn Deutsche has provisioned for these contingent liabilties, EUR 3.5bn is thought to be ear-marked for this particular case.  This leaves Deutsche Bank EUR 9bn short.  It also raises the question of whether the EUR 2bn of reserves set aside for the remaining 13 cases is sufficient or if more will be needed.

Answsers are not forthcoming, most likely because they are unknowable.  Remember, this is a proposed settlement, not a penalty awarded by a court.  And the DOJ has a history of 'high balling' and then negotiating down.  For example Goldman Sachs was hit with a similar figure and ultimately settled for US $5bn.  EUR 9bn is therefore a worst case scenario.

Against this EUR 9bn claim and 13 other outstanding cases, Deutsche Bank has EUR 120bn of loss absorbing capital and, under basic assumptions, around EUR 4bn in annual earnings.  There is simply no reasonable chance that these litigation costs will cause a loss to the bank's depositors, clients or counterparties, let alone trigger a systemic crisis.

It is possible, however, that shareholders and the holders of some equity-like instruments may end up taking a hit.  This relates to a second problem.  While Deutsche meets its capital requirements today, the required level of capital will ratchet up each year until 2019, its a moving target.  By the end of 2019 the bank will need EUR 49bn of capital, and it currently has EUR 43.5bn.  This leaves a EUR 5.5bn shortfall that has to be progressively closed over three and a half years.

There are a lot of moving parts.  They may end up settling for well under EUR 13bn with the DOJ.  But equally, earnings are volatile in this business and may end up being significantly lower than EUR 4bn.  There is little in the way of a margin of safety, particularly where fear-driven clients choose to close accounts or cut relationships because of bad press.

However this is reflected in the stock price.  The shares are curently trading at roughly a 75% discount to book value.  This indicates that the market is pricing in a reasonably high likelihood of a dilutive capital raising.

Holders of some hybrid instruments are at risk if the bank's capital falls below a certain trigger level, which would trigger the automatic conversion of these bonds into equity.  This seems unlikely under current circumstances as it is hard to see how the issues described above would erode capital so much as to trigger a conversion.  However they are now vulnerable should the bank experience a second or third unexpected shock.

Hamish Douglass (CEO Magellan Financial Group) talks about 3 macro economic issues that investors should be thinking about at the moment.

Hamish believes that investors need to be thinking about rising long term interest rates, Italian financial system and China.

He is considered one of the best investors in Australia and his views are widely sought after.

He also talks about recent moves he has made in the fund he manages - Magellan Global Fund.

 

Media

Monday, 31 October 2016 14:21

Inghams IPO - we've chickened out!

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GEM Capital has considered applying for stock in the soon to be listed Inghams IPO, and had the opportunity through its investment bank contacts, but have decided not to proceed after careful consideration.

This article is simply to communicate the evaluation process that is undertaken when assessing investment opportunities.

Inghams is one of the largest vertically integrated chicken manufacturers in ANZ with a #1 market share in Australia (40% share) and #2 in New Zealand (34% share). Inghams runs its own stockfeed operations and controls every aspect of chicken growing and processing. Its closest competitor has a 33% market share in Australia and 48% in NZ.

Inghams Group sells to supermarkets (53% of revenue), fast food restaurants (17% of revenue), food distributors (8% of revenue), and ‘wholesale’ providers (butchers, etc, 7% of revenue). Although Inghams has a large number of customers, the top five accounted for 55%-60% of revenue in 2016. We have seen with companies like Coca-Cola Amatil Ltd that large supermarkets like Woolworths Limited and Wesfarmers Ltd have the ability to pass on a fair amount of pricing pressure to suppliers and Inghams will not be immune.

One of the most important aspects of assessing a new listing, commonly referred to as an IPO (Initial Public Offering) is to understand who you are buying from.  In the case of Inghams, the family has previously sold to a Private Equity firm, TPG Capital.  In our experience, rarely do private equity firms pass on gifts to retail investors. (or any investors for that matter)

It is interesting to note that TPG paid the Ingham family close to $900m for the business in 2014, and have since sold all the properties and leased them back, realising around $600m.  Now, two years after acquisition, TPG are selling up to 70% of the business to investors and are hoping to raise around $1.1bn at the upper end.  That means for an outlay of $900m, TPG will receive up to $1.7bn, pocketing a tidy profit of $800m while still owning 30% of the Ingham business.  TPG's remaining 30% stake is escrowed for 6-12 months, but it is unlikely they will be a long term owner of  this business.

If investors take a look at the sensitivity analysis from the prospectus, they will see that small movements in sales and pricing can have material impacts on profitability.

 

 

 

 

 

 

 

 

 

For a company forecast to increase profit by 18.9% to $98.8m in 2017, movement in average selling prices represents a significant risk should the supermarkets wish to use chicken in a discounting war.

While the price at the upper end of the IPO pricing would appear OK at 15.5 times forecast earnings, the price is higher than its smaller rival across the Tasman, Tegel Foods.

This is a low margin, high turnover business.  We don't mind the food production sector and quite like the chicken story, particularly with it's price advantage for consumers over beef.

We just feel that the easy money here has been made by private equity.  Therefore we are not participating in the IPO and will watch Inghams in the aftermarket, in the months ahead.

 

 This information is of a general nature only and neither represents nor is intended to be personal advice on any particular matter. We strongly suggest that no person should act specifically on the basis of the information contained herein, but should obtain appropriate professional advice based upon their own personal circumstances including personal financial advice from a licensed financial adviser and legal advice. Fortnum Private Wealth Pty Ltd ABN 54 139 889 535 AFSL 357306

 

 

 

Monday, 03 October 2016 09:50

European Refugee Crisis - last straw for the EU?

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Germany has taken in 1 million refugees in the last 12 months, and there are plenty of signs that the refugee crisis is taking its toll on social harmony in Europe.

A couple of months ago we spoke with Clay Smolinski on how the European refugee crisis is impacting investment decisions.

 

Here is a transcript of the video for those who prefer to read the interview.

 

Mark Draper: Here with Clay Smolinski from Platinum Asset Management and the Europeans have been through a lot really in the last decade and they’ve got plenty of coming up.

One of them has to do with the refugee crisis  there. So we just want to spend a couple of minutes looking at the investment aspects of the European refugee crisis. Can you just take us through your thinking on that?

Clay Smolinski: Yeah, absolutely. So the refugee crisis for me, the issue is – the risk of it is that it’s another challenge that the political will of the European Union needs to face.

For me the crisis alone probably wouldn’t be a huge deal for the union but the issue is that it comes on top of a lot of the problems, those individual – the union of countries has had to face over the last few years.

So we think about the union. Through the sovereign crisis, they got through the major battle, which was the economic battle needing to cut the budget deficits, needing to where – you know, that higher unemployment that that caused. From the economic perspective, we can fairly definitively point that that battle has been won. The economy is now recovering but that has left that political will far weaker.

Since then we’ve seen that in subsequent elections, more radical left or right wing parties have been voted in. Examples of this would be Podemos in Spain or Syriza in Greece. We now have major members like the UK going to referendum on deciding whether it’s an exit or not and now we have the refugee crisis and immigration is always a very politically-charged issue and it’s clear that the member countries have differed in their views on how to exit, on how to handle it. That just creates – it’s another issue. It’s another reason for people to get upset, the voting populous and maybe vote for an exit.

What is interesting for us as well and is a bit of mitigant to that is how Germany is – has behaved through this and certainly through the sovereign crisis, the response to that crisis was very much dictated by Germany and that has forced a lot of the other member countries to go through a lot of pain.

Now with the refugee crisis, they’ve really stepped to the fore and said, “We’re going to do more than our fair share to handle this. We’re going to take a lot of these people on to our soil. We’re going to provide additional funding to the others to work through this,” and I think it’s their way of standing up and saying, “Look, we know you’ve done your part and now it’s our time to really give back and to show solidarity in the union.”

Mark Draper: So a major risk here would seem political for that in terms of the uprising of hard left or hard right – well, probably hard right in this situation.

Clay Smolinski: It’s very hard to factor that back into a definitive investment decision but it’s certainly something that we need to keep in mind and often when you compare the European market to the US market, the European market does trade at a valuation discount. But I think at least some of that discount is warranted given the – I guess the more uncertain political outlook for that region.

Mark Draper: So be alert, but not alarmed at the moment. It’s a work in progress.

Clay Smolinski: That’s how we’re viewing it.

Mark Draper: Thanks for your time Clay.

Clay Smolinski: You’re welcome.

Media

Tuesday, 27 September 2016 10:37

Bull thesis on Woolworths

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Woolworths is "long on assets and short on market capitalisation" says Vince Pezzullo, Portfolio Mananger, Perpetual Equity Investment Company.

Perpetual started accumulating shares late last year and picked up the buying following first half results. Pezzullo believes management have shifted their focus from sales growth to efficiencly, with sales per square metre now a key metric.

Despite widespread investor concerns about losing market share to Aldi, Aldi recently lost East Coast market share for the first time.  "Our view is that Coles is run particularly efficeintly, if Woolworths is run particularly efficiently, which we think they're on that journey it will be hard for Aldi to grow."

With loss making Masters now closing, and the possibility of a spin-off of ALF Pub Group, the situation is also improving for Woolworths non-core busineses.

"We still like Woolies, we think it's a $30+ stock at some point".

Here are Vince's views on Woolworths, presented in September 2016.

 

 

Media

Thursday, 15 September 2016 19:54

Germany - Powerhouse or Powderkeg?

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Despite signs of economic recovery, Europe, indeed the developed world, has been engulfed by a wave of anti-establishment movements over the past year. What is going on? And why?


Charles Weule's on-the-ground report from Germany, the heart of Europe's immigration crisis, may help shed some light.  Charles was a former analyst at Platinum Asset Management.  We have reproduced this article with permission from Platinum Asset Management.

Preface - by Kerr Neilson (CEO Platinum Asset Management)

The present decade has been a tumultuous one for Europe. More than a handful of countries in the European Union went through a sovereign debt crisis in the aftermath of the 2008-09 global financial crisis and, at least for now, fiscal austerity and unprecedented monetary expansion continue to sit side by side as the twin pillars of economic policy.

A region that was already apprehensive from economic uncertainties was further shaken by the series of Islamic terrorist attacks and the influx of millions of immigrants and refugees en masse from the other end of the Mediterranean Sea and beyond.

The angst and frustration culminated in the vote of the British people on 23 June 2016 to leave the EU, but the chaos that ensued at Westminster suggests that ‘solutions’ and stability, if there were such a thing, are still some distance away.

Of these continual crises, last year’s refugee crisis has been one of the most trying on the cohesion and strength of the EU and was arguably a key factor that shaped the outcome of the Brexit referendum.

While politicians and bureaucrats wonder at the intensity and spread of anti-establishment sentiments and mainstream media busy themselves with denouncing the re-emergence of far-right nationalism, an on-the-ground, first-hand account of the daily interactions between the locals and the newly arrived immigrants may shed some light on the cause of the widespread discontentment and the breakdown of a precarious equilibrium and unity.

And so we present you with this special report from  Charles Weule. Charles is a former investment analyst at Platinum, who now lives and works in Germany. Equipped with a unique linguistic gift, Charles has travelled to and lived in many parts of the world. Having learned Japanese fluently, he went on to become totally proficient in Mandarin.  As with these two Asian languages, his use of German leaves him indistinguishable from a native.

Charles has been teaching languages in Berlin. In 2015 he joined the ranks of thousands of Germans to help – to work with – the one million refugees that have found their way to this new ‘Promised Land’. The seemingly trivial encounters relayed in Charles’ account paint quite a different picture to what one might hear from both Chancellor Merkel and her counterpart in the Alternative for Deutschland (AfD) party.

The picture is not one comprised only of lifeless children washed up on the shores of Greek islands and war-ravaged families marching through the perilous roads of the Balkans. Nor is it as simple as altruism versus xenophobia, good against evil, right versus wrong. Truth and reality is often drowned out by the voices from the two extremities of the spectrum.  

The multiple rounds of financial bail-outs extended to other EU nations did not much diminish the heroic status of Angela Merkel in the eyes of the German people. But when she decided to welcome the countless immigrants fleeing war-torn Syria and Iraq (and whoever else that saw it desirous to join them on the journey) with open arms, many turned against her and sided with neighbouring governments with less magnanimous policies.

The lack of consultation with Germany’s own citizenry as well as other European countries, the lack of consideration given to both short- and long-term consequences, and the sheer unpreparedness for what was to follow – which was so atypical of Germans – annoyed, frustrated and enraged many.

When large numbers of foreigners with different religions, different values and different expectations are suddenly imposed on communities, at least some of their concerns and displeasure seem natural enough. The issue of immigration is much more than economics and politics. It impacts on the collective sense of security, identity and sovereignty of a population, and is emotive at an individual level.

While we may observe from afar the geopolitical crises playing out in Europe and analyse the economic impact of the ECB’s negative interest rates, Charles’ report brings a broader and closer view on the situation in the region and gives us a rare insight into the thinking of ordinary German citizens. He also provides us with a historical perspective. Viewed in the context of the country’s past woes and vicissitudes, the generosity of the German people shines through as all the more extraordinary and their fear and exasperation all the more understandable. It helps to understand how governments’ mismanagement of sensitive issues like mass immigration could lead to popular revolts and irrational outcomes like Brexit, and this may in turn help us prepare for what may be lying ahead.

 To download the full report - which is a fascinating read - click on the download link below.

 

Thursday, 15 September 2016 19:43

New Technological and Machine Age

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Sir John Templeton famously said "The four most dangerous words in investing are 'this time it's different'."  As investors, we need to question whether we are entering a new technological and machine age over the next 10-25 years that could disrupt most businesses and possibly society as we know it.  In this regard, the new technological and machine age may be more important than The Industrial Revolution.  Quite possibly, this time it is different and whilst heeding Sir Templeton's advice, as prudent investors we believe it would be neglectful to ignore the technological developments that are almost certain to provide substantial threats and opportunities to business.

In a recent TED interview, Charlie Rose asked Larry Page (co-founder of Google) what is his most important lesson from business.  He said that he has studied why many large businesses fail and he concluded: "They missed the future".

According to Magellan Financial Group founder, Hamish Douglass, there is mounting evidence that we are approaching a tipping point of exponential technological advancement, particularly through accelerating improvements in artifical intelligence, 3D printing, genomics, computing power and robotics.

In his annual newsletter to investors he outlines what the future technological changes may look like and puts forward several challenges about how they may impact our lives, business and investment.

Click on the newsletter below to download your copy to read.

 

 

Wednesday, 31 August 2016 15:03

Megatrends impacting investment markets

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Key points

 

- Key megatrends relevant for investors are: slower growth in household debt; the backlash against economic rationalism &rise of populism; geopolitical tensions; aging and slowing populations; low commodity prices; technological innovation &automation; the Asian ascendancy &China's growing middle class; rising environmental awareness; and the energy revolution.  

 

- Most of these are constraining growth and hence investor returns. However, technological innovation remains positive for profits and some of these point to inflation bottoming.  

 
 
 

Introduction

Recent  developments – including the rise of populism, developments in the South China  Sea and around commodity prices along with relentless technological innovation  – have relevance for longer term trends likely to affect investors. So this  note updates our analysis on longer term themes that will likely impact  investment markets over the medium term, say the next 5-10 years. Being aware  of such megatrends is critical given the short term noise that surrounds  markets.

 

 

 

The super cycle slowdown in household debt

Household  debt to income ratios surged from the late 1980s fuelled by low starting point  debt levels, financial de-regulation and the shift from high to low interest  rates. But it's likely run its course as the GFC and constrained economic  growth have left consumers wary of adding to already high debt levels and banks'  lending standards are now tougher. This has seen growth in debt slow & households run higher savings rates.

 

Source:  OECD, RBA, AMP Capital

Implications – slower growth in household debt likely means slower growth in  consumer spending, lower interest rates and central banks having to ease more  to achieve a desired stimulus. Slower credit growth is also a drag for banks.

The backlash against economic rationalism

Its arguable that support for  economic rationalist policies (deregulation, privatisation and globalisation)  peaked over a decade ago. The corporate scandals that followed the tech wreck  and the financial scandals that came with the GFC have seen an increase in regulation, the Doha trade round has been stalled for years and now the combination of slow post GFC growth and rising inequality (see the next chart) in  the absence of the ability to take on more debt to maintain consumption growth are leading to growing populist angst. This is evident in the success of Donald  Trump, the Brexit vote and the recent Australian Federal election.  Of course this is just the way the secular  political pendulum swings - from favouring free markets in the 1920s to  regulation and big government into the 1970s, back to free markets in the 1980s  and 1990s and now back the other way with each swing ultimately sowing the  seeds for the next. But the risk is that the shift away from economic rationalist policies in favour of more populist policies will lead to slower productivity  growth and ultimately rising inflation as the supply side of economies are  damaged & easy fiscal policy is adopted.

 

Data  is after taxes and welfare transfers. Source: OECD, AMP Capital

Implications – populist polices could slow productivity and set the scene for the next  upswing in inflation.

Geopolitical tensions

The end of the cold war and the  stabilising influence of the US as the dominant global power in its aftermath  helped drive globalisation and the peace dividend post-1990. Now the relative  decline of the US, the rise of China, Russia's attempt to revisit its Soviet  past and efforts by other countries to fill the gap left by the US in various  parts of the world are creating geopolitical tensions – what some have called a  multi-polar world. This is evident in increasing tension in the Middle East between (Sunni) Saudi Arabia and (Shia) Iran; Russia's intervention in Ukraine;  and tensions in the South China Sea (which have recently been increased by a UN sponsored international court ruling in favour of The Philippines regarding  island disputes) and between China and Japan.

Implications –geopolitical tensions have the potential to disrupt investment markets at  times.
 
Aging and slowing populations

The  demographics of aging and slowing populations have long been talked about but  their impact is now upon us. We are living longer and healthier lives (eg,  average life expectancy in Australia is already around 83 years and is  projected to rise to 89 years by 2050) but falling fertility rates are leading  to lower population growth. The impact is more significant in some countries,  which are seeing their populations fall (eg, Japan, Italy and even China) than  others (eg, Australia, where immigration and higher fertility is providing an  offset) and others still where population growth remains rapid (eg, India,  Africa and the Middle East). 

Implications – at the macro  level this means: slowing labour force growth which weighs on potential  economic growth; increasing pressure on government budgets from health and  pension spending and a declining proportion of workers relative to retirees; a  "war for certain types of talent"; and pressure to work longer. At  the industry level it will support growth in industries like healthcare and leisure. At the investment level it will likely see an ongoing focus on strategies  generating income (yield) while at the same time providing for "more stable"  growth to cover longevity.
 
The commodity super cycle may be close to bottom

Since  around 2008 (for energy) and 2011 (for metals) the commodity super cycle has  been in decline as the supply of commodities rose in response to last decade's commodity  price boom combined with somewhat slower growth in China. However, after 50 to  80% peak to trough price declines and with supply starting to adjust for some  commodities (eg oil) it's quite likely that we have seen the worst (in the absence  of a 1930s style recession). This doesn't mean the next super cycle commodity upswing  is near – rather a long period of base building is likely as we saw in the  1980s and 90s.

 

Source: Global Financial Data, Bloomberg, AMP  Capital

Implications –  Low commodity prices will act as a constraint on inflation and interest rates but  the likelihood that we have seen the worst may also mean that the deflationary  threat will start to recede. In other words it adds to the case for a bottom in  global inflation. A range bound environment less clearly favours commodity user  countries over producers.  

Technological innovation & automation

The impact of technological  innovation is continuing to escalate as everything gets connected to the  internet. The work environment is being revolutionised enabling companies to increasingly  locate parts of their operation to wherever costs are lowest and increasingly  to automate and cut costs via automation, nanotechnology, 3D printing, etc. The  intensified focus on labour saving is likely good for productivity and profit margins  but ambiguous for consumer spending as it may constrain wages and worsen inequality and could ultimately hamper growth in emerging countries. There is  also the ongoing debate that with so many "free" apps and productivity  enhancements, growth in activity (GDP and hence productivity) is being underestimated/inflation  overestimated and consumers are doing a lot better than weak wages growth  implies. So fears around inequality and stagnant real incomes may be exaggerated. Time will tell.

Implications –  technological innovation remains a reason for inflation to stay low and profit  margins to remain high. But also a potential positive for growth.

Asian ascendancy & China's growing middle class

Low levels of urbanisation, income  and industrialisation continue to mean that the emerging world offers far more  growth potential than the developed world. While big parts of the emerging  world have dropped the ball (South America and Russia particularly), the reform  and growth story remains mostly alive in Asia – from China to India. Both China  and India are seeing a surging middle class, with China's growing from just 5  million people 15 years ago to now 225 million. This means rising demand for  services like healthcare, leisure & tourism.

Implications – favour non-Japan Asian shares (allowing of course for risk). Tourism and  services should benefit particularly from the rising middle class in China and  India.

The environment and social values

Concern about the environment is continuing  to grow and higher social standards are being demanded of governments and corporates. This reflects a range of developments including increasing evidence  of the impact of human activity on the environment, younger generations  demanding higher standards and social media that can destroy reputations in a  flash.

Implications – this will favour companies that adhere to high environmental, social and  governance standards.

The energy revolution

Renewables share of power production  will only grow as alternatives like solar continue to collapse in cost and  solar energy storage becomes mainstream. Likewise advances in battery  technology are seeing a massive expansion in the use of electric cars which  will feed on itself.

Implications – this has huge negative implications for oil and coal and along with the  impact of shale oil production will keep a ceiling on energy prices.

Implications

At  a general level there are several implications for investors

 
    • Firstly – several of these trends will help keep inflation  low, eg, slower growth in household debt, low commodity prices automation &  the energy revolution. By the same token if commodity prices have seen the  worst and government policy shifts towards stimulus we may have seen the worst  of deflationary and disinflationary pressures.
 
    • Secondly – several are also consistent with constrained  economic growth, notably aging and slowing populations, slower growth in debt,  the backlash against free markets and geopolitical tensions. This is not  universal though as increasing automation is positive for profits.
 
    • This is all still consistent with ongoing relatively low interest  rates (albeit we are likely around the bottom) and relatively constrained  medium term investment returns.
 
  • Several sectors stand out as winners including health care  and leisure but producers of energy from fossil fuels are potential losers.
Dr Shane Oliver 
Head of Investment Strategy and Chief Economist 
AMP Capital