2011 Market Outlook...By James Gerrish
At the start of each year we’d all like to have a clear, concise and accurate picture of where the stock market will head over the next 12 months. We’re all human after all however the market is a place of differing opinions, dynamic forces and above all, fear and greed of those who participate in it.
These forces make predictions difficult and those that tell you otherwise, are probably just salesman. What we can do is offer a logical outline of where we think the money will flow and what the catalysts for this flow are likely to be.
We can then search out quality companies, with sound fundamental drivers of value and buy them when their price action is attractive. Sounds simple, but do we really need to overcomplicate it?
Last year, much was written (and spoken) about the outlook for commodities. Anyone following my Morning Notes and discussions for the Finance News Network and Sky Business will know that I’ve been very bullish on the story of emerging markets growth. Investing in companies with a direct link to new world economies and this obviously means including a high concentration of commodity producers in a portfolio.
Looking across the broad spectrum of base & precious metals, Energy’s, Softs and Grains it shows that a combination of rising demand, supply constraints in some cases (Copper comes to mind) and a need for physical assets to hedge against a falling USD combined to send prices sky rocketing.
To give you some context of how this translated to our local market, the Material Sector rose by 13.3% against a broader market gain of 1.9%. To highlight this theme, you can take a look at the performance of my Emerging Markets Model Portfolio which has returned more than 24% since inception last year. (Please contact me if you;d like a copy)
What we need to concentrate on now is where money is likely to flow in 2011. Will it continue to find its way into commodities or will China and other growth centres slow? What impact will US monetary policy have and will Europe become a never ending story of bailouts?
I think China is the main beast we need to make a call on followed closely by the likely direction of the USD. These two factors will have the biggest bearing on commodity prices and in turn the fate of our market. There are of course other factors that will come into play and I’ll cover these regularly in my Morning Notes throughout the year.
China
China has been growing at near 10% in 2010 with greater Asia clocking growth rates of 8%. This incredible growth in China (and Asia) has led to inflationary pressures which have prompted moves to tighten policy. This will be a major theme in 2011 and I’d expect that further measures will be used including interest rates rises and increasing capital requirements for banks. Will this have a significant impact on Chinese growth? In short, no.
Why?
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Chinese policy makers don’t want their economy to slow significantly. I think at times we view China’s status as the emerging super power though rose coloured glasses. The fact is there is still a high degree of poverty in China and the growth of the middle class is still a work in progress. If China slows dramatically, the social implications would be dramatic.
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The speed and scale of industrialisation and urbanisation is unprecedented. At no other time in history have we seen such rapid expansion on such a significant scale.
Extract from RBA Speech in September 2010....”
As the countries of Asia have urbanised and industrialised, the demand for infrastructure has grown very strongly. When people move to the cities, new dwellings need to be built, and as living standards rise, so too does the quality of dwellings constructed. The growth of urban centres also requires the building of communication and transport networks, with the demand for roads, bridges, railways etc rising.
All this development requires raw materials. In particular, it requires steel to build the apartments in which the new city dwellers live and to build the infrastructure that supports those cities. For example, a typical 90m2 apartment in China requires about six tonnes of steel, and 10km of metropolitan subway requires around 75,000 tonnes.
On average, every tonne of steel that is produced requires around 1.7 tonnes of iron ore and over half a tonne of coking coal, and Australia is in the fortunate position of having ample low-cost, high-quality supplies of both. And with higher energy consumption also a feature of industrialisation, we are in the fortunate position of having large reserves of natural gas”.
Many companies in Australia are betting big on this phenomenon. Rio Tinto for example announced massive plans for its Pilbara expansion increasing its Iron Ore capacity by 50% at a cost of $3.9 billion. Fortesque Metals is in a similar camp spending almost $4 billion on its expansion plans.
However there are risks that need to be considered. We know there is some chance of a double dip although only remote. We know there is a possibility that China may tighten too aggressively and stifle growth, but its only small or European issues may spread more aggressively and the EU may be forced to dissolve. These are obviously important things to consider however they are outlier events – this means that they have only a small chance of occurring. I’m more conscious about the impact of the USD on underlying commodity prices.
The recent surge in commodities was brought about by two main things:
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Strong physical demand from growth in emerging markets
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A desire to hedge against a falling USD with physical assets
On the demand side, emerging markets are still growing strongly and although they may slow marginally based on a tightening policy bias in China, the recovery in the US that we’re starting to see is likely to take up the slack. After all, the US is China’s largest export market and we all know consumption there has been weak (but is likely to improve).
I think the impact of the USD will be biggest threat to the commodity markets and indeed commodity currencies in 2011. The US Federal Reserve unleashed an unprecedented level of Quantitative Easing in 2010. This essentially means they printed money and bought back existing Government debt. This increases the amount of dollars in the system and invariably, each dollar becomes worth less.
The most recent stimulus program that is underway has a total value of $600 billion. At the moment, the fed has spent about $170 billion so this means that the program still has a long way to play out and the pressure on the USD will remain.
From what I’ve read, it seems that the stimulus may come to an end in June of this year which would be a catalyst to buy the USD. When you think about it, by then the US should be well into recovery mode, we may even be seeing a strong, positive move in the labour market and the Government may stop printing additional dollars.
This would be a positive for the US currency and a negative for commodity prices. There would be no need to hedge a falling USD with physical assets as we’ve seen in the last 18 months.
How does this translate into an equity strategy?
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For early this year, we retain our view of backing the growth in emerging markets. We want to be long commodities that China and other countries are physically short of. This includes agricultural commodities as food security becomes a more pressing issue. I firmly believe that M&A activity that started to show signs of life late last year, will intensify at the start of 2011. This will be further amplified by significant capital available through private equity.
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As the year progresses we must be more conscious of the recovery coming from the US as they begin to pullback stimulus measures. The main data set to monitor in respect to this is the employment situation. Stimulus will remain active whilst unemployment remains high.
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If stimulus is wound down, the US Dollar may find support which will reduce the appeal of commodities and commodity backed currencies such as the Australian Dollar. This will be further amplified when the US moves closer to raising rates – potentially in 2012.
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As the US improves, we want to reduce our overweight call on commodities and start to gain some exposure to an improving US economy and currency. Companies that are listed in Australia that generate earnings from the US should benefit here.
I firmly believe that in 2011, being active in the market will outpace a passive strategy. Invest towards a longer term theme with the comfort that we can be active during shorter term market trends. I also feel it’s important to think outside the box a little. This can involve using Option Strategies or taking part in corporate activities such as capital raisings and private placements. My clients will have access to these strategies throughout the year.
In 2011, the market is at a precipice. 2009 was a great year for equities. In 2010, the market has been volatile but on a net basis has moved very little. After a year of consolidation, it’s often the case that we see a larger move - I believe that move will be to the upside.
Happy New Year.
James
