Greece is the Word

1 July 2011

Greece is the word

by Andrew Fleming, Deputy Head of Australian Equities

Brinkmanship – the practice of pushing dangerous events to the verge of disaster in order to achieve the most advantageous outcome.

Brinkmanship abounded in May. Mr Sepp Blatter applied the central banker’s approach to crisis management, in stating his determination to “put FIFA’s ship back on the right course in clear, transparent waters”.  Euro brinkmanship receded the prospects for a neat resolution of the Greek debt crisis, seeing Europe as the weakest performing equity market globally through May.

Confronted with a crippling tax bill, Greek citizens are staring down creditors. Fear of the consequences this precedent sets is seeing banks weaken globally, including in Australia.

Thirdly, the US is within weeks of completing QE2, with most fundamental economic indicators in worse shape than when it began, eight months and US$850bn ago. Confronted with a weakening economy, financial markets are staring down the Federal Reserve, seeing non-$US assets continue to outperform.

And fourthly, in Australia, the Commonwealth budget presented a payments estimate this year of A$352bn, an increase of A$100bn in just four years.

In the face of gluttonous fiscal policy, the RBA in its May Statement on Monetary Policy highlighted that real national income growth has been driven by the terms of trade and not real productivity improvement through the past decade and that household saving is now back to “more traditional norms”. Globally and locally, inherently unstable economic systems are being confronted, and decision time, if not immediate, is imminent on all fronts.

We have previously expressed the view that macro factors are having a larger impact on the performance of the Australian equity market and its constituents than at any prior time we can recall. These four factors in May saw this ethos writ large, with all global markets off through the month, and generally by more than the 2% decline experienced in Australia.

The resilience of the Australian market is somewhat surprising to us on two fronts.

Even with the currency and input cost headwinds facing most industrial stocks, which has resulted in FY11 being the fourth year in a row of flat earnings, resource stock earnings continue at elevated levels such that we do not believe the Australian market as a whole is underearning. With high unemployment and low capacity utilisation, though, the case that profits are below a sustainable level (and hence warrant a higher multiple) is an easier case to make for offshore markets. Secondly, given both interest rates and market multiples are higher in Australia than elsewhere, clearly the equity risk premium being paid in Australia is far lower than elsewhere.

Again we are surprised this sees the Australian market outperform a global downturn. The miracle economy lives on!

Greece is the word. Globally, weaker bank stocks led markets down, reflecting the uncertainty a Greek sovereign default may cause for the banking system. It appears to us that of the three options available to address the Greek and other PIGS sovereign issues – austerity measures / fiscal reform, financial restructuring and guarantees from other EC members – the third measure, which has been most commonly used to date, is the least constructive. The resulting pushback from other member states is seeing the second option start to gain more attention, as is the consequent impact upon bank balance sheets, seeing bank shares weaken materially.

Good – if banks make a bad loan, shareholders should wear the cost. The moral hazard of “too big to fail” and socialisation of losses has reached a destructive point.

Even though the direct impact of Greek debt default, should it occur, is verging on irrelevant to the Australian banks, the emergence of the possibility of the precedent was a major factor in them being the standout sector through May, dropping 5%. Should current high teens returns on equity hold, the Australian banks are now being priced for low single digits growth.

This is hardly demanding, and so long as some pre conditions are met, the Australian banks are now cheap.

Firstly, they need to explain how shareholder return can decouple from asset growth, in a break from a 20 year pattern. We believe it is more than possible, but only if the least disciplined player in the oligopoly behaves in a manner seeking to optimise value rather than gain market share through discounting.

That is, the lesson of the UK system through the past decade, where a tragic lust for asset growth through discounting and M and A by what was the smallest of their four majors at the beginning of the decade (RBS) ended up being cheered by the equity market, belatedly copied by the competitors, and ultimately bringing a system asunder.

Currently, the market darling among the majors in Australia is, of course, the bank gaining market share through discounting.

The competitors are being forced to the dance, even in the face of a Valentine’s Day break up message by the provocateur. The night is still young but we hope this music stops soon.

As we wrote last month, productivity also needs to be aggressively focused upon by the sector. Just as Telstra is starting to reap the market rewards from years of productivity focus, forced upon it by a declining revenue environment, the same opportunity awaits the banking sector should they pursue that path.

For an industry to spend close to A$10bn per annum on IT in recent years and now be confronted with regular system failures, it is at best inexcusable and at worst management negligence. A robust IT platform is a pre condition to any material and sustainable productivity gains.

If the Greek debt crisis played its way into the Australian equity market returns through the performance of the banking sector, the resources sector again outperformed as the imminent maturity of QE2 loomed, with Fed Chairman Ben Bernanke stating it has left the economy and “moving in the right direction.” That’s arguable.

During QE2 tenure, Australian house prices have dropped 8%, economic growth has dropped from 2.6% through 1.8% and whilst full time job growth of 700,000 looks good, part time jobs have dropped by 600,000 and the participation rate has declined.

Commodity prices and resource stocks have been aggressively bid up through this eight month period, although with the program ending this month, and underlying growth weakening, it’s not surprising that weakness in commodity prices is emerging. This is yet to materially manifest itself in resource stocks in Australia, although we see this outcome as highly likely for high cost producers as the year progresses.

Apart from Banks, consumer discretionary stocks lagged the market in May. We agree with the RBA assessment that savings rates are now at “normalised” levels rather than the state of dissaving we experienced through most of the past decade. The implications on retailers are clear. They will continue to struggle to grow margin, and rents will need to decline over the next several years. One major retailer stated their intent was to drop rents by 5% through this period. Both retailers and Retail REIT’s are sectors where debt is best conservatively dealt with currently.

Portfolio outlook & strategy

Growth in the developed world is anaemic and slowing, with demand weakening and the financial system clearly needing further recapitalisation.

The major themes affecting the Australian markets of too much debt, albeit concentrated in the financial and household sectors, aging demographics, and commodity prices continuing to trade at levels well above what we consider long term sustainable prices, all remain on foot.

It remains imprudent for us to ignore what we see as the ongoing risks, which only become amplified the longer they remain unaddressed, even if the day of reckoning in several cases appears imminent. This balancing act has dominated the past three years and will continue to dictate our assessment of not just future likely returns, but also risks.

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