Provision Newsletter

1. Price of iron ore has fallen dramatically

The price of the steel-making ingredient iron ore has been on a downward trend since 2011. The impact of this for Australian share investors is that a decline in commodity prices negatively impacts the profits of miners and adversely affects share prices.

2. China cools down

Concerns of inflated property prices have recently hit the headlines after a strong run up in prices and seemingly unceasing construction across China. The surge in prices and a threat to affordability saw Chinese policy makers implement measures to cool down property demand. This included controls such as limiting domestic housing purchases and raising down payment minimums. Another key factor in cooling the property market involved tightening monetary policy in China, which was aimed at slowing credit growth and lending for new properties.

China’s slowing economic growth is also a significant influence with some releases of economic data raising concerns that China’s economy may struggle to hit its +7.5% growth target in 2015. These factors translate into less ‘end-user’ demand for iron ore in China.

3. Significant ‘new supply’ is entering the market

To add to the complexity, there is a large amount of new supply of iron ore hitting the market provided by large miners such as BHP Billiton, Rio Tinto and Fortescue Metals as all the mining investment of the last few years has manifested in the completion of new mines. Less demand and more supply has driven a fall in the iron ore price and has weighed on the share prices of miners.

What does this mean for investors?

Large miners are better placed to weather suppressed commodity prices relative to smaller miners as they are better capitalised and have lower costs. An environment of depressed share prices for miners and balance sheet difficulties could set a backdrop for more mergers and acquisitions.

Corporate activity led by Chinese investors could be a support for many miners. For example, the last few weeks saw Chinese steel company Baosteel and Aurizon Operations offer a joint takeover to acquire 100% of the ordinary shares of Aquilla Resources.

The strength of balance sheets and average costs of production will be an important factor in determining the health and potential survival of miners.

About the Author  Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital's diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note: While every care has been taken in the preparation of this information, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This information has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. Certain information in this website has been obtained from sources that we consider to be reliable and is based on present circumstances, market conditions and beliefs. We have not independently verified this information and cannot assure you that it is accurate or complete.

1. Compare this year’s annual report with last year’s annual report.

Check that the activities detailed in the current annual report are the same as what the company said it was going to do in the previous year's report. Consider whether the company has achieved the goals it set out for itself, and if this is a reason to be concerned about the company’s future.

2. Cash flow trends.

There can be a significant difference between what a company says it earned, using accounting standards, and the cash flow it generates. Cash is money in hand, not the result of accounting measurements and judgment calls, as is the case with earnings and net income. This line item is particularly important when making investing decisions. When a company's net income is much higher than cash flow, investors want to be aware and find out why.

Reflecting on the most recent reporting season, Michael Price, Portfolio Manager, AMP Capital Equity Income Fund said: “One of the key surprises was significantly stronger cash profit growth and thus high cash conversion rates, which were utilised to drive significantly stronger than expected dividend growth.”

 3. Earnings and revenue growth.

If you invest in a company, you want to know how much the company earns and whether it's boosting its sales. This can tell you whether a company is on a growth trajectory or in decline, key factors that determine how much the company is worth. A company's earnings and revenue can be compared with its stock price to tell you if a stock is expensive or reasonably-priced.

According to Phillip Hudak, Portfolio Manager/Analyst, Small Cap Equities at AMP Capital, Australia’s August reporting season saw a widening divergence in earnings growth rates being delivered across the market: “Many domestically-focused companies continue to find operating conditions difficult given Australia’s economic recovery remains sluggish. However, a number of offshore exposed companies outperformed due to the more advanced recovery of other developed world economies relative to Australia.”

4. Debt load.

It's critical for investors to understand how much debt a company has and how that debt compares with its ability to pay. This requires examining a company's balance sheet and income statement. Debt isn't detrimental for a company, so long as it can generate ample cash flow to service the debt payments.
There is so much information on financial statements because these documents are the most critical pieces of information investors will get from individual companies. Reading these documents closely is one of the best ways for investors to evaluate the performance of the company and gauge new developments that may affect its performance in the next few years.

Important note: While every care has been taken in the preparation of this information, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This information has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. Certain information in this website has been obtained from sources that we consider to be reliable and is based on present circumstances, market conditions and beliefs. We have not independently verified this information and cannot assure you that it is accurate or complete.

1. Compare this year’s annual report with last year’s annual report.

Check that the activities detailed in the current annual report are the same as what the company said it was going to do in the previous year's report. Consider whether the company has achieved the goals it set out for itself, and if this is a reason to be concerned about the company’s future.

2. Cash flow trends.

There can be a significant difference between what a company says it earned, using accounting standards, and the cash flow it generates. Cash is money in hand, not the result of accounting measurements and judgment calls, as is the case with earnings and net income. This line item is particularly important when making investing decisions. When a company's net income is much higher than cash flow, investors want to be aware and find out why.

Reflecting on the most recent reporting season, Michael Price, Portfolio Manager, AMP Capital Equity Income Fund said: “One of the key surprises was significantly stronger cash profit growth and thus high cash conversion rates, which were utilised to drive significantly stronger than expected dividend growth.”

 3. Earnings and revenue growth.

If you invest in a company, you want to know how much the company earns and whether it's boosting its sales. This can tell you whether a company is on a growth trajectory or in decline, key factors that determine how much the company is worth. A company's earnings and revenue can be compared with its stock price to tell you if a stock is expensive or reasonably-priced.

According to Phillip Hudak, Portfolio Manager/Analyst, Small Cap Equities at AMP Capital, Australia’s August reporting season saw a widening divergence in earnings growth rates being delivered across the market: “Many domestically-focused companies continue to find operating conditions difficult given Australia’s economic recovery remains sluggish. However, a number of offshore exposed companies outperformed due to the more advanced recovery of other developed world economies relative to Australia.”

4. Debt load.

It's critical for investors to understand how much debt a company has and how that debt compares with its ability to pay. This requires examining a company's balance sheet and income statement. Debt isn't detrimental for a company, so long as it can generate ample cash flow to service the debt payments.
There is so much information on financial statements because these documents are the most critical pieces of information investors will get from individual companies. Reading these documents closely is one of the best ways for investors to evaluate the performance of the company and gauge new developments that may affect its performance in the next few years.

Important note: While every care has been taken in the preparation of this information, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This information has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. Certain information in this website has been obtained from sources that we consider to be reliable and is based on present circumstances, market conditions and beliefs. We have not independently verified this information and cannot assure you that it is accurate or complete.

1. Price of iron ore has fallen dramatically

The price of the steel-making ingredient iron ore has been on a downward trend since 2011. The impact of this for Australian share investors is that a decline in commodity prices negatively impacts the profits of miners and adversely affects share prices.

2. China cools down

Concerns of inflated property prices have recently hit the headlines after a strong run up in prices and seemingly unceasing construction across China. The surge in prices and a threat to affordability saw Chinese policy makers implement measures to cool down property demand. This included controls such as limiting domestic housing purchases and raising down payment minimums. Another key factor in cooling the property market involved tightening monetary policy in China, which was aimed at slowing credit growth and lending for new properties.

China’s slowing economic growth is also a significant influence with some releases of economic data raising concerns that China’s economy may struggle to hit its +7.5% growth target in 2015. These factors translate into less ‘end-user’ demand for iron ore in China.

3. Significant ‘new supply’ is entering the market

To add to the complexity, there is a large amount of new supply of iron ore hitting the market provided by large miners such as BHP Billiton, Rio Tinto and Fortescue Metals as all the mining investment of the last few years has manifested in the completion of new mines. Less demand and more supply has driven a fall in the iron ore price and has weighed on the share prices of miners.

What does this mean for investors?

Large miners are better placed to weather suppressed commodity prices relative to smaller miners as they are better capitalised and have lower costs. An environment of depressed share prices for miners and balance sheet difficulties could set a backdrop for more mergers and acquisitions.

Corporate activity led by Chinese investors could be a support for many miners. For example, the last few weeks saw Chinese steel company Baosteel and Aurizon Operations offer a joint takeover to acquire 100% of the ordinary shares of Aquilla Resources.

The strength of balance sheets and average costs of production will be an important factor in determining the health and potential survival of miners.

About the Author  Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital's diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note: While every care has been taken in the preparation of this information, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This information has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. Certain information in this website has been obtained from sources that we consider to be reliable and is based on present circumstances, market conditions and beliefs. We have not independently verified this information and cannot assure you that it is accurate or complete.

With share valuations in emerging markets looking relatively cheap compared to those in developed markets, we explore what investors need to look for before taking the plunge.

Be selective

While emerging market shares are relatively cheap, the current health and future prospects of individual countries within this segment can differ significantly. Therefore, while we expect investors will benefit from general exposure to emerging markets over the long-term, the short-term picture requires investors to be more discerning and pick and choose based on individual country and company fundamentals.

For example:

• Argentina’s problems are well-known and its ‘default’ reflects a problem with a hedge fund rather than broader emerging market debt problems.

• Tougher sanctions for Russia will harm it more than the West. However, Russia is unlikely to cut off gas supplies to Europe given the long-term damage it will do to what is a key export-earner for it.

• The softer trend in commodity prices is good for Asian emerging markets (as commodity users) unlike South America and Russia (commodity producers).

• China is looking relatively cheap at the moment and India is looking expensive however the reform-oriented Modi Government in India bodes well for the future.

• The Indonesian President is also reform-minded but there is uncertainty over the election results.

• Brazil is a bit problematic given the populist approach of the Dilma Government so a change in government would be required before we become more optimistic on Brazil.

Consider debt levels

Investors in emerging markets should focus on current account surplus countries as they are less vulnerable to foreign capital flows, for example China and Korea, and therefore less susceptible to volatility when the US Federal Reserve decides to start raising interest rates again.

Final thoughts

While a recession in emerging market countries is unlikely, we are likely to see slower growth than we have witnessed over the last decade. The trend in commodity prices is softer (working against Russia and South America) and the last decade has seen some backtracking on economic reforms.

After posting solid returns since May, emerging markets have improved since the start of the year. However, emerging markets still have a lot of catching-up to do on the ground lost to developed markets since 2010. More broadly while they are cheap and still have some catching-up to do, investors do need to be more selective than was the case, say a decade ago regarding the emerging world.

About the Author  Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital's diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note: While every care has been taken in the preparation of this information, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This information has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. Certain information in this website has been obtained from sources that we consider to be reliable and is based on present circumstances, market conditions and beliefs. We have not independently verified this information and cannot assure you that it is accurate or complete.

Drivers of recent volatility

Our view for this year has been that shares would have positive but more constrained returns than seen over 2012 and 2013 and that volatility would increase. Our basic reasoning was that with shares no longer dirt cheap, investors would have to depend more on earnings growth for share market gains and this would be more constrained and uncertain. Until recently it has been relatively calm though despite a range of worries and deep scepticism amongst many commentators. Lately though, it seems the worry list has intensified and this has been reflected in increased volatility.

The list of worries includes the following:

• Top of the list has been unease about the gradual shift at the US Fed towards eventual monetary tightening. Ultra easy Fed policy has been a key source of support for the global economy and investment markets. Investors are naturally concerned about what will happen when this ends with the Fed’s third round of QE set to end later this month and the Fed talking about raising rates next year.

• The global economic recovery has proved yet again to be fragile and uneven: with the Eurozone flirting with deflation; Japan struggling after a sales tax hike; the Chinese economy going through another soft patch; and emerging markets generally remaining subdued.

• Meanwhile a range of geopolitical threats are causing nervousness including: the escalating involvement of the US and its allies in the conflict with IS in Iraq and Syria; the conflict in Ukraine; the protests in Hong Kong accentuating concerns regarding China; & the worsening Ebola pandemic in Africa & the arrival of cases in the US.

• A range of “technical” concerns regarding US shares have added to these worries including: the absence of a “decent” correction since 2012 and low levels of volatility (or VIX) leading to fears investors may be complacent and the narrowing breadth of the US share market rally.

• Finally, we have been going through a seasonally weak period of the year for shares. The September quarter is historically the weakest quarter of the year.

Source: Bloomberg, AMP Capital

While US and global shares have had only modest pullbacks of around 3 to 4%, Australian shares have been particularly hard hit with a fall of 7% reflecting the overlay of global concerns along with:

• A sharp fall in the iron ore price and commodity prices generally on China worries;

• Increasing talk that Australian banks will be forced to increase their capital ratios; and

• Foreign investors retreating to the sidelines as the $A falls. They are 30-40% of the market and it’s quite normal for them to pull back as the $A falls as they fear a double hit to the value of their investments. Indeed $US based investors lost 12% in Australian shares last month.

The correction in shares could go further: US shares, which tend to lead global markets, are only off slightly so far whereas corrections often go to 5 to 10%; nervousness is likely to intensify in the run up to the end of QE3 later this month; nervousness in Europe may well continue until uncertainty is cleared up around banks with the ECB to announce results of stress tests later this month; and finally seasonal weakness often runs into October. However, we view this as a correction, not the start of a new bear market.

A correction, not a new bear

There are several reasons why what we are seeing is likely a correction, rather than a bear market. First, valuations are not extreme.

Source: Bloomberg, AMP Capital

This is evident in the previous chart which is based on a range of measures including a comparison of the yield on shares with that on bonds. Recent share market weakness has pushed valuations well into cheap territory again.
Second, the global economic cycle is a long way from posing a major threat to shares. The global economy is growing, but it’s uneven and sub-par. This is a blessing in disguise:

• While the US looks to have recovered from a soft patch early this year, growth in Europe, Japan and China is dragging the chain. Europe is unlikely to slide back into recession with the ECB doing just enough to support growth but weak credit demand and a reluctance to ease fiscal policy growth will remain constraints. Meanwhile, China is doing better than most other regions but its stop/go approach to supporting growth in the face of pressure for long term reforms is likely to see growth stuck around 7%.

Source: Bloomberg, AMP Capital

• As a result global spare capacity and excess savings remain intense so inflationary pressures remain tame and bond yields low.

• In many ways the world resembles the 1990s after the early 90s recession with the US being a growth leader, other regions lagging and disinflationary pressure keeping a lid on inflation.

• The overall result is that global growth is strong enough to boost profits but a long way from the boom conditions that cause escalating inflation. In other words, the global growth cycle is still in the “sweet spot”.

As a result, global monetary policy is set to remain easy.

• While the US is edging towards monetary tightening, Europe, Japan and China are a long way from tightening and if anything are likely to see further easing.

• This means the US dollar will likely remain under upwards pressure, which in turn will have the impact of importing low inflation into the US and delaying/limiting the extent of US rate hikes once they do start to get underway (as occurred in the second half of the 1990s).

• Finally, although the Fed will likely end QE3 this month, a 15-20% fall in US shares as we saw in 2010 and 2011 with the ending of QE1 and QE2 is unlikely as the US economy is now on a much sounder footing.

Finally, we are still a long way from the sort of investor exuberance seen at major share market tops. It seems everyone is talking about share market corrections and crashes. In Australia, the amount of cash sitting in the superannuation system is still double average levels seen prior to the GFC and Australians continue to prefer bank deposits and paying down debt to shares and superannuation. There is still a lot of money that can come into equity markets as confidence improves.

Source: Westpac/Melbourne Institute, AMP Capital

So absent a left field shock the most likely outcome is that, while shares could see more downside in the next month, this is likely to be limited with the bull market to continue.

The threat from geopolitics and pandemics

 Perhaps the main potential source of left field shocks are the current geopolitical threats, but our reading is that these are unlikely to pose a fundamental threat to global growth:

• The Islamic State seems unlikely to threaten oil supplies and while a terror attack is a risk, it’s worth noting that the progression of such attacks last decade seemed to have less impact on markets as investors got used to them.

• The threat from Ukraine may be receding.

• The protests in Hong Kong are certainly a risk to China, but there is a good chance that they will peter out as the people of Hong Kong grow frustrated at the disruption they pose to their ability to go about their business.

• The “arrival” of Ebola cases in the US and Spain is worth watching, but our base case is that it should be easier to contain in western countries with modern medical facilities and higher standards and ease of hygiene.

What does this mean for Australian shares?

 If global shares have more short term downside then so too will Australian shares. However:

• The Australian share market is now quite cheap again with the forward PE now back below 14 times.

• The fall in the $A will further help the economy avoid recession as mining investment slows and provide a boost to corporate earnings as each 10% fall in the $A adds around 3% to earnings.

• Interest rates are set to remain at generational lows with inflation pushing back towards the low end of the RBA’s target range according to the TD Securities Inflation Gauge and the RBA looking at using credit controls to slow investor demand for housing rather than rate hikes.

As such Australian shares are likely to see a strong rally into year end. Just bear in mind though that Australian shares are no longer the relative outperformer they were last decade. This decade is likely to see continued underperformance versus global shares as the commodity price super cycle is now going in reverse resulting in a headwind for the local share market and the falling $A (which we see heading down to $US0.80 or lower) will boost the value of offshore shares.

Concluding comments

The rough patch we have seen in shares lately could go a bit further. However, the bull market will likely remain intact thanks to a lack of overvaluation, the benign economic cycle, easy monetary conditions and a lack of investor euphoria.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.