After years of incredibly easy monetary policy globally we are finally amid a synchronised global economic recovery the likes of which we have not seen in over a decade.
Leading indicators of future economic activity like the US Purchasing Managers Index (PMI) or the German Manufacturing Business Climate Survey are at decade or multi-decade highs. The number of economies globally that are currently in recession is at the lowest on record. This strong economic growth has been translating into strong corporate profitability, or the expectation of it at least, which has led to surging global equity markets over the last 2 years.
The Australian economy has fared less well owing to low wages growth and decelerating discretionary consumption as a result of higher energy and other non-discretionary costs for Australian households. This slowing growth has been largely offset by the timely acceleration of infrastructure spending in Australia and higher commodity prices brought about by stimulus and supply-side reform in China.
The closing of excess steel, aluminium, coal and other uneconomic manufacturing capacity means that China has gone from exporting goods deflation to exporting inflation in many basic materials. This inflationary pulse is still widely underappreciated and will likely have meaningful positive impacts on western world industry and the prices they achieve for their basic materials. It could also contribute to the re-assessment of current emergency level monetary policy settings in the global economy.
“We expect strong economic growth to persist”
For the year ahead, we expect strong economic growth to persist, which will support corporate earnings and likely push equity markets higher over the course of 2018. Global central banks are still incredibly cautious about raising interest rates, despite very good economic data, and continue to err on the side of too lax rather than too tight monetary policy. This is good news for equities.
How we’re positioned
At Paradice, our Australian Large Cap portfolios are positioned to take advantage of this economic upswing by owning companies leveraged to stronger global economic activity. This includes companies in the materials sector like BHP, Sims Metal and South32. BHP and S32 have benefitted from stronger commodity prices during 2017 which has facilitated significant earnings growth and, in the case of BHP, balance sheet repair.
“Investors can expect an elevated level of cash returns”
Free cash flow yields for both businesses are above 10% using conservative commodity price assumptions highlighting that investors can expect an elevated level of cash returns in the year ahead. Sims Metal is a significant beneficiary from the supply side reform in China and the resultant closure of close to 200 million tonnes, or 20%, of the Chinese steel industry. These steel mill closures have reduced the flow of steel exports from China leading to an increase in rest of world steel production and a resultant increase in the demand for scrap steel. We believe this change to be structural and likely long-lasting given the Chinese governments’ commitment to reducing pollution.
We also think the energy sector is attractive owing to favourable valuations, strong free cash flow generation and an under-appreciated tightness in global energy markets. Oil market supply and demand balance in 2018 is reliant on Shale oil producers in the USA adding at least 1 million barrels of additional oil production.
“The Shale oil business model is broken”
Shale oil producers have not made money in the last decade nor generated free cash flow irrespective of the oil price being $100, $70 or $50. Additional production from Shale has been reliant on equity and debt raisings to fund future production growth as the companies have not been able to generate sufficient cash to reinvest in growth. We believe that the Shale oil business model is broken and that oil production from Shale in 2018 will disappoint.
If production does disappoint, oil markets will tighten fasten than current market expectations which will boost earnings for companies like Woodside Petroleum, Santos and Beach Energy. These companies are also leveraged to Liquified Natural Gas (LNG) demand which has been incredibly strong in the second half of 2017. China’s environmental restrictions have again played a part as coal to gas switching has been much faster than most anticipated leading to a 50% surge in Chinese LNG imports in 2017.
Financial companies of the likes of Macquarie Group and Computershare should also benefit as an acceleration in economic activity in 2018 leads to greater mergers and acquisitions activity and higher yields on cash balances.
The risks to markets heading into 2018 are as always many and varied and largely unpredictable, especially if geopolitical in nature. The key risk we focus on is the current market narrative that “inflation is low and will stay low as there is no wages growth”. Such a view is currently being priced into many defensive assets and long bonds and requires one to believe that this cycle is unlike every other cycle before it. In previous cycles inflation always turns up but often at unexpected times and in unexpected places. We think this cycle is no different and are already seeing evidence of cost inflation from Chinese supply side reforms, wages growth troughing and energy prices pushing higher.
We expect this economic cycle to end like every other economic cycle before it with higher interest rates spoiling the party. We aren’t there yet.
Written by Troy Angus, Head of Large Caps, Paradice Investment Management.
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Paradice Investment Management, Australia's first boutique firm specialising in smaller companies, was founded in 1999. It is privately owned with a team of 34 people, including 18 investment specialists, who manage over $15 billion in AUM.