23 July 2012
The 2011-2012 financial year has been marked by significant domestic and global economic challenges. John Campbell, Avoca Investment Management's Managing Director and Portfolio Manager, discusses these challenges, and shares his thoughts on the impact of the broader economic environment on the Australian small caps sector.
US economic concerns, fears about China's slowing growth, and the sovereign debt and banking crisis in Europe are the three key themes that have been plaguing the global economy over the past 12 months. Will the 2012-2013 financial year suffer from more of the same uncertainty?
The European sovereign debt crisis is not likely to be resolved via a quick monetary or fiscal fix. Central bank balance sheets have already expanded significantly across Europe, and the European Central Bank's (ECB's) interest rates are now very low by historical standards. See ECB refinancing rate chart below. Accordingly, the ability of central bankers to apply monetary stimuli is now severely constrained. Likewise, government-driven fiscal options are similarly constrained.
Source: Morgan Stanley
Quoting the Bank for International Settlements' 2011 Annual Report, "both conventional and unconventional accommodative monetary policies are palliatives and have their limits". In our view, the crisis will only be solved by hard micro-economic reform, fiscal and taxation reform, and more generally, countries starting to live within their means. Whilst this may translate into lower growth than what was previously thought possible, this might be the inevitable outcome of decades of European socialism and ‘big government'.Positively, there is a growing realisation throughout Europe that this type of reform is a necessary precursor to recovery. To paraphrase Churchill, one might say that although it is not the beginning of the end of the crisis, perhaps it is the end of the beginning.
Unlike Europe, the slowing Chinese economy still has massive potential for stimulatory measures if required. Although China's economy is maturing, and double digit growth is no longer likely in our view, healthy growth of 7 to 8% is sustainable for the medium term, especially as China's middle class expands to Western levels of affluence and consumption. The chart below details Chinese real GDP growth since 2000.
Source: Morgan Stanley
In the medium term, we anticipate continuing growth out of China will be a key driver for the Australian economy. That said, we expect growth rates more in the 7-8% range than the double digit rates enjoyed in the first half of the 2000s. Whilst still positive for the Australian economy, we do not believe such growth will be sufficient to see a return to the record hard commodity prices of 2009-2010.
The US arguably entered the economic crisis earlier than the rest of the world and could therefore potentially emerge earlier. Data coming out of the country over the past 18 months has generally been quite positive, with housing markets in many of the worst hit states looking brighter than at any time over the last few years, and unemployment now below 9%. Whilst the US also has its share of fiscal imbalances, we believe its political structure will allow it to adjust its fiscal settings on a more comprehensive and responsive basis than in Europe.
Global macro-events will inevitably affect the Australian small caps sector more than the large caps sector. This is mainly because the small caps universe tends to be more economically cyclical than is the case across the top 100 stocks. This in turn is largely due to a heavy composition of resource stocks within the small caps benchmark (36% for the S&P/ASX Small Ordinaries Index versus 22% for the S&P/ASX 100). The chart on the following page illustrates the downward movement of the S&P/ASX Small Resources Accumulation Index.
Small resource stocks have underperformed small industrial stocks by over 40% since January 2011. The Bennelong Avoca Emerging Leaders Fund has been well underweight small resource stocks and continues to be so. That said, with small resource stock valuations looking more attractive than at any point over the past year, the case for a large underweight is diminishing.
Source: Avoca Investment Management
Given the uncertain macro-backdrop, formulating investment strategies is challenging. Investors not surprisingly remain highly risk averse in the face of an unknown endgame in Europe. The possible outcomes are many, but we believe, at best, negative growth across the Eurozone for the next few years is likely. The question as to whether this will lead to weaker growth across the US and Asia remains unanswered, and will certainly haunt the 2012-2013 financial year and impact the Australian investment landscape.
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