The 5% devaluation of China's currency dominated financial markets in this past week. The China bears seem to garner most of the headlines these days, and so it was again: according to the pessimists, the devaluation confirms that the economy is in dire straits and that the government is desperate to boost net exports and so ameliorate the ongoing weakness in consumption and business investment. To many commentators, China's devaluation represents the latest chapter in the ongoing saga of 'currency wars' waged amongst the world's central banks.
Devaluation yes, but after many years of appreciation
What seems to have gone under the radar in much of the press and commentary is that the Chinese Yuan (CNY) has undergone a significant appreciation in recent years. Because it has been broadly pegged to the US dollar, the CNY effectively had appreciated by 25% against a basket of its major trading partners. As a result, the devaluation only returns the CNY's trade weighted index back to levels that prevailed as recently as November 2014 (see chart).
The bears are right to argue that the devaluation is a signal that the authorities remain concerned about China's future growth prospects. But they have good reason to: manufacturing and industrial production remain in a funk, disinflation is widespread (with pockets of deflation), the recent sharp fall in Chinese stocks has rattled confidence, and many residential and commercial property markets are suffering from a glut of inventory. Against the backdrop of a weakening economy in recent years, the CNY would likely have depreciated if it had been a floating currency. The PBOC has not put up the white flag; it is right to seek to re-align the currency with the economy's fundamentals.
In fact, the devaluation of the CNY - together with the recent relaxation of reserve requirements, cut to official interest rates, and (at times clumsy) efforts to support the stock market - has brought the PBOC in line with other central banks, that have eased monetary policies which has been designed to address the global shortfall in aggregate demand. When the ECB and BOJ adopted more aggressive monetary stimulus at various stages in the past year, financial markets welcomed those moves.
Yet the PBOC is derided as irresponsible when it seeks to also address the classic symptoms of a domestic cyclical downturn. This is not to deny China's many structural challenges, including much needed reform of the financial system and re-balancing of growth towards consumption. Such structural reforms are necessary to help China achieve sustainable growth over the medium term. But China - along with most other economies - is currently suffering from deficient demand and the best solution is more aggressive monetary stimulus.
Record low wage growth in Australia a signal that labour demand remains weak
In Australia, the clearest sign of an economy that is also suffering from a shortfall in aggregate demand was continued absence of wage pressures. The private sector wage rate (excluding bonuses) is 2.2% higher than a year ago, which represents the slowest annual growth since the inception of the wage price index in the late 1990s (see chart). In a speech delivered during the week, the RBA's Christopher Kent confirmed that record low wages growth reflects weak demand for labour, and this is consistent with animal spirits remaining dormant in the corporate sector.
The much anticipated handover from mining capex to non-mining capex remains elusive and continues to be a source of frustration to the RBA. In another speech from the central bank delivered during the week, Mr Phillip Lowe acknowledged that while this transition continues to drag on, it is appropriate that the household saving rate decline further; that is, it is reasonable to expect consumption to grow faster than disposable income to support growth at time when the corporate sector was showing little appetite for taking on investment projects.
As long as the 'economy is expected to operate with a degree of spare capacity for some time' (in the RBA's own words), institutional investors should have an overweight in some of the richly valued defensives that have strong earnings predictability. Based on Evidente's proprietary earnings predictability scores, stocks that have ranked highly on this measure have outperformed significantly since 2011, coinciding with the peak in global commodity prices (see chart). Other stocks that rank strongly on Evidente's earnings predictability measure include: ASX, Ramsey Healthcare, AGL, Amcor and Coca Cola Amatil.
Investors have now digested the major banks' capital raisings, but expect EPSg to revert to low single digits
At the sector level, banks continued to dominate the reporting season, with CBA being the last major to announce a capital raise (a rights issue of $5 billion). Certainly significant considering that they reported a full year after tax net profit of $9 billion. Encouragingly, the lift in bad & doubtful debts announced by ANZ in the prior week (citing renewed risks in agriculture and mining) does not seem to have been shared by either NAB or CBA.
Given that the bad & doubtful debt cycle is likely to have troughed, EPS growth for the sector is likely to revert to low single digits, consistent with growth in nominal GDP. This was reflected in CBA's growth of 5% in NPAT for the full year. Balance sheets across corporate Australia in aggregate, remain in excellent shape. But pockets of stress pose risks to the majors, particularly low and declining yields for commercial property, which continue to be characterised by rising vacancy rates, particularly in Perth and Brisbane.
Upside to EPS growth is limited and the sector is trading on multiples that are at the high end of historical norms, suggesting limited scope for valuation expansion. Nonetheless, I continue to recommend that investors have a small overweight position in the sector due to sustainably high payout ratios and strong predictability of earnings. Higher capital requirements will dilute their ROEs but the banks have the flexibility to eke out more efficiency gains and drive their already low cost to income ratios even lower. Stronger capital buffers will also help the banks to better cope with adverse exogenous shocks, such as renewed weakness in property markets.
Macro-prudential measures to curb credit growth to housing investors - Avoid REA
The ongoing strength in residential property markets in Sydney and Melbourne helped Realestate.com (REA) to report a 24% lift in NPAT for the full year. The CEO's presentation slides highlighted the penetration of premium listing products, investment in high growth markets and boasted the size and engagement of its audience. The CEO also devoted no less than three slides to that old chestnut, innovation.
But there was no mention of the two key macro drivers of the stock: turnover of the housing stock (which governs listings) and new lending commitments (the two are strongly correlated). House lending has been on an upward trend for the past three years, lifting from 14% to 18% of the stock of housing credit, underpinned by lending to investors, while lending to owner-occupiers has stagnated (see chart).
The key risk going forward is that lending to investors slows as the lift in investor lending rates and more stringent LVR restrictions take effect. The RBA and APRA are clearly determined to engineer a moderation in credit growth to this segment to sub-10%. Lending to owner-occupiers is likely to pick up the slack only if the majors loosen their LVR restrictions to this segment (unlikely) or the RBA eases policy again (likely, but not for a while). In the meantime, expect growth in total lending commitments to slow and turnover in the housing stock to plateau or decline. To achieve growth in listings in these conditions, REA will need to win market share from Domain, which could spark renewed price competition. Investors should avoid REA while this dynamic plays out.
Ansell: The dark side of global diversification
The earnings torpedo delivered by rubber glove and condom manufacturer Ansell last week highlights the dark side of global diversification. Investors - who marked down the stock by 16% on the day of the result - clearly didn't believe the CEO, who cited adverse currency moves, currency hedging gone wrong and disappointing economic performances in many key developed and emerging markets. The Chanticleer column in the Australian Financial Review wrote an excellent piece this week on the poor performance of a number of complex, multi-national businesses, with assets located in multiple jurisdictions, including Ansell, Orica, QBE and NAB. The poor returns from ASX listed global conglomerates demonstrate just how difficult these businesses are to manage for Australian based CEOs.
Evidente has updated its model of firm complexity, based on five factors, including product diversity and geographical dispersion. According to the model, the most complex stocks include: Seek.com, Qantas, Worley Parsons, AMP and Computershare (Ansell ranks in the top quartile of complexity). If history is any guide, the risk is that these stocks can invariably deliver earnings torpedos, particularly for those that have poor quality management and weak governance structures in place.