Issue: September/November 2008
Equity Prospects - Resources vs Financials?
Trustees could be forgiven for feeling particularly confused about equities right at the moment. Much of the confusion concerns one's view on the prospects for resource and financial stocks. Asset managers have been particularly vocal and quite extreme regarding their positions. This article aims to provide some insight into the conflicting arguments, while at the same time suggests that both may actually prove to be right.
Mr Goldfinger and Mr Bond are fictional characters, both have plausible investment scenarios, highlighting the complexities of current market dynamics as well as the opportunities and risks that investors currently face.
Mr Goldfinger believes that the market is not fully pricing in the secular case for commodities and that the global economic backdrop is one that supports resource stocks relative to financials, notwithstanding the apparent value offered by financial stocks. Mr Bond counters that commodity prices are rolling over, triggering a revaluation of financial stocks as investors adjust their portfolios, taking comfort as the sub-prime crisis looks set to dissipate and interest rates peak locally.
Domestically, investors are broadly divided into these two camps. It’s worth exploring the relative merits of their arguments and, in this light, the two were asked to provide further support for their views.
Question: Commodity prices have experienced significant recent declines as global growth concerns mount. Are you concerned that the seven year commodity bull market is now over?
Answer: (Mr Goldfinger)
There is a strong case that a tipping point has been reached in the development of these economies, to the extent that I’m convinced that their future development has strong underlying momentum. Structural reforms and lessons from past crises leave policy makers more in tune with the required policy mix to support continued growth. Substantial foreignreserves, strong external balances and improvements in terms of trade provide a further underpin and protection against external shocks. In particular, trends in commodity demand per capita in the industrialisation of Japan and South Korea suggest that China and other emerging markets still have plenty of scope to lift commodity demand.
The emerging economies increasinginfluence is illustrated in the continued resilience in many commodity prices despite the severe slowdown in the US and other developed regions. In previouscycles, post the industrialisation of Japan and Europe after World War II, a moresignificant decline in commodity prices ensued. History suggests that emerging regions, lead by China, are set to providea structural underpin to commodity markets similar to the one that accompanied the rebuild of Japan and Europe.
Another factor supporting commodity prices is the long lead time and significant capital costs required to increase capacity.A shortage of skills and equipment has only exacerbated the situation. I think the slow supply response also shows how sceptical producers have been on the secular story. This is particularly acute in the oil market, with oil producers having shown reluctance to reinvest their windfall profits. Increased capacity will not be realised overnight and current low spare capacity and probable supply disruptions suggest that oil prices will remain relatively firm.
Inflation is on the rise globally. Admittedly this is most pronounced in developed regions, but I believe that negative realinterest rates across many regions pose further risks as do continued elevated oil prices. Manufacturers and retailers will inevitably adjust prices and employees will demand higher wages, unleashing coreinflation measures. This risk will increasewhen the US economy and other regionsagain accelerate, taking up the slack provided by the current deflationary forces of falling house prices and employment. I also believe that the deflationary impact of cheap Chinese goods is ending on the back of surging input costs for Chinese manufacturers, an upward revaluation of the Yuan and elevated freight rates. Commodities arethe ideal inflation hedge.
Question:Resource stocks have been volatile since the end of June. Are you not concerned about further weakness, may be significant in coming months?
Answer: (Mr Goldfinger)
Anglo American and BHP Billiton aretrading on single digit P/E ratios after recent declines and earnings releases and on low single digit PE’s on our forwardearnings estimates. Producers continue to generate phenomenal cash flows and the possibility of special dividends cannot be discounted in the next year or two. More recent weakening in the rand will provide further impetus to margins. There are also notable signs of volume expansion in the diversified miners. Analysts have been caught by surprise and have been adjusting their earnings forecasts higher. The market will begin to price these positive fundamentals into stock prices as volatility subsides.
Question: You think there is deep value in financial stocks, but stocks continue to languish despite some recent tepid gains. How do you explain this?
Answer: (Mr Bond)
Conversely, resource stocks have incredibly strong earnings momentum and until more recently seemed to offer far better prospects based on the fundamentals. Recent developments signal that both these factors could soon favour financials over resources.
The relative merits of commodities will decline as stability returns to the US housing and financial markets. US banks have been recapitalised, and most of the sub-prime losses are now behind us. We have not yet seen this point but, once it occurs the markets will be quick to respond, punishing expensive resource counters and bidding up US banking stocks.
Renewed stability and improved growth and interest rate differentials will support the Dollar pulling commodity prices lower. I believe that oil could be particularly vulnerable given the large speculative element of demand, which has to unwind at some stage. A correction in prices will be further supported as demand destruction follows current elevated prices and inflation undermines emerging market growth prospects. Financial stocks will then receive renewed investor focus. Lower commodity prices, especially oil and food, will allow local inflation to surprise on the downside, providing policymakers flexibility to reduce interest rates.
We might not be quite there yet, but current valuations of financial stocks, leave investors with a large margin of safety, as well as upside potential when prospects improve in the next up cycle.
Question: What are the risks that dividends could come under threat from declining earnings.
Answer: (Mr Bond) This is a low probability event, and should not be given too much weight. My numbers still suggest positive earnings growth in the next two years. The inflation/interest rate backdrop has improved, with no further tightening needed. Indeed, some are of the view that the Reserve Bank has already done enough and will be forced to reverse its latest rate hikes as domestic demand slumps, pulled lower still by surging fuel prices.
While economic growth is set to moderate, consensus projections of 2.5% to 3.5% in GDP growth still provide a positive slant to the economic backdrop. I simply do not see bank earnings collapsing in this environment.
Mr Goldfinger and Mr Bond both seem to have compelling arguments. Will events transpire as Mr Goldfinger predicts or will Mr Bond be vindicated? The truth probably lies somewhere between their two bipolar views, and the challenge is forecasting whose view to give more weight.
RMB Asset Management is currently underweight equities as a whole, given the threats posed by elevated global inflation, high oil prices and the risks continued losses for US and global financial institutions pose to the global economy. Within equities, we are overweight resource stocks on analysis of global macroeconomic fundamentals similar to Mr Goldfinger’s arguments.
The strong earnings momentum of resource plays should provide a solid underpin to stock prices. We also take comfort, that though stock prices have retreated, resource counters included, commodity price strength has for the most part remained intact.
Domestic plays include an overweight position in financials and an underweight position in industrials, especially more cyclical stocks, which would be vulnerable if local fundamentals were to surprise on the downside. Financial stocks have experienced significant declines, flailing under both higher inflation and interest rates, and the negative spill-off of weak global financial stocks brought about by the US sub-prime crisis. Local financial institutions, however, have for the most part not been too exposed to sub-prime losses, and balance sheets remain fundamentally strong. Significant declines have left them on attractive valuations. Taken together with forecasts of uninspiring, but still positive earnings growth, financials appear to have little downside from current levels and potentially solid upside once signs emerge that the interest rate cycle is turning and the gloom afflicting global financial stocks lifts.
*The positions quoted are an indication of the average positions across RMB Asset Management portfolios' relative to peers. Actual positions in any one single portfolio may differ.