Steward Wealth monthly review April 2015

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Written by James Weir

James specialises in the theory and best practice of portfolio construction and management. His success within national and international investment banks led him to become a Co-Founder of Steward Wealth and he is a regular columnist for the Australian Financial Review.
May 1, 2015



Australia has always been good at digging stuff out of the ground and sending it overseas. When times are good in commodities markets, times are normally good for the country as a whole, and when times are bad, it’s like they’re never going to turn around again. Of the many commodities Australia produces, there is no price more important to our export earnings than iron ore, which collapsed from $180/t in 2011 to recently hit $47/t – ouch! (see the chart below)

Iron ore

But just as the news could hardly have sounded worse with the government warning of a $30bn hole in the budget, billionaires proposing collusion to control excessive production, and listed iron ore producers tumbling into receivership, lo and behold, the price bounces 25% in a month. What was the catalyst? Maybe it was seeing iron ore executives lining up outside receivers’ offices, or maybe it was BHP announcing it will slow its expansion plans in the Pilbara.

Is the worst over? Who knows. Back when China was throwing everything into growth, the margins for iron ore miners were running at close to 80%. Not surprisingly, the global giants (the likes of Rio Tinto, BHP and Vale) rolled out plans to massively increase production. When China’s growth slowed, which it was always going to do, the production plans didn’t, and the seven largest iron ore producers went from producing 520mtpa in 2008 to 1.13bt now. That’s about one-third of today’s global supply.

Rio can produce a tonne of iron ore at a total cost of $17 and sell it for about $47 and BHP’s margins aren’t far behind, so they’re still making plenty of money. China produces the most iron ore at 1.55btpa, but at an average cost of about $100/t, so they’re mothballing production. It’s how markets work: high cost producers will fall away, reducing supply, until the price reacts and a new equilibrium is found.

Will we see another cycle like the last one? Looking at the chart below of the real iron ore price (that is, adjusted for inflation) over the last 115 years, you’d have to say it’s unlikely. You can see just how extraordinary that burst of Chinese demand was. Likewise, will we see $30 iron ore and the Australian federal budget fall in a heap? That looks unlikely too. Are we glad we avoid exposure to cyclicals like these? You bet.

Real iron ore

We had more interesting developments this month from the world’s most influential commodity price: oil. The price for West Texas Intermediate fell from $106 per barrel in June last year to a low of $44 in January after the Saudis tried to squeeze high cost producers, particularly the U.S. shale oil producers. Then came the reports of doom: oil stockpiles in the U.S. hit a record (see the chart below) and those shale frackers pushed U.S. crude production in March to the highest in 42 years, which all added to the biggest supply glut since the 1930s.

Oil stocks

Then reality caught up: because of the lower oil price the contracting of drilling rigs in the U.S. has plummeted from about 1,600 in October 2014 to less than 750 now. The chart below illustrates again when you get an extraordinary situation in a market, in this case a sharp increase in production reflected by the massive increase in the rig count, the price will respond. Crude production has peaked and is now expected to fall away, just as it has from some other high cost oil producers.

Drill rigs

As a result, the oil price has jumped more than 30% from the January lows (see the chart below).

Oil price

Will oil go back to where it was? Maybe one day, but it won’t happen in a hurry. The frackers haven’t forgotten the recipe, and some of the high cost producers simply couldn’t afford to shut down, or even slow down. And conspicuously it’s been confirmed that in 2013 a turning point was reached: the world added more renewable energy capacity than coal, gas and oil combined.

China hit the headlines after reporting 1Q GDP growth of ‘only’ 7%, once again (surprise, surprise) bang in line with what the government had guided, but well below what the markets, desperate to escape this low growth environment, had hoped for. It was the slowest rate of growth in six years and came with all kinds of headline grabbing numbers: steel output fell for the first time on record; cement output growth fell to minus 20%; coal imports down 45% year on year and total exports also down 15% for the year.

The thing to keep in mind though is the Chinese economy is slowly changing, just as the government had planned, from shipping to shopping. Fixed asset investment, which was by far the main economic driver over the last 30 years was at a record low in the March quarter, instead the services sector is now 46% of GDP (which is a good sign the economy is maturing) and retail sales in the world’s second largest economy rose a lazy 10.2%.

Again, not surprisingly, the property sector has been targeted by the government after running red hot for ages. No namby-pambying around with parliamentary commissions, they just changed some of the rules with the result that residential land sales fell 46% over the past year and construction starts were down by more than a third, with prices dropping 6.1% year on year. Reflecting how important the property sector has been to the economy there is still a huge inventory of unsold housing hanging over the market (see the chart below) which is what the government is keen to address.

Unsold Ch housing

Not to be held back from a good punt though, Chinese investors have flocked to the stock market instead. Recently the government allowed punters to open up to 20 accounts with different brokers, with the result that in one week there were more than four million accounts opened! What could possibly go wrong? In a classic case of what came first, a rising market or increased interest from retail punters, the Shanghai index has more than doubled since July last year! (The chart below illustrates both points.) China’s 23% weighting in the MSCI Emerging Markets index accounted for a big part of its phenomenal 7.5% rise this month. Notably though, the EM index is still on a prospective PE of 11.5x compared to the All Countries Index of 15.9x.

Shanghai index

Another significant Chinese milestone this month was the government allowing a state-owned firm to default on its debt. There has been much angst over the total level of Chinese debt, which at more than 200% of GDP is certainly high. However, something to bear in mind is that a lot of the accumulated debt went into building capital assets and infrastructure, which will return an economic yield for years to come. That’s a very different proposition to the typical western government that has been building debt to pay for its welfare obligations, which do not produce a return. The Chinese economy is undergoing a transition which will inevitably involve a few speed humps, like a property correction and a slowing in the rate of growth, but that is essential for a more stable long-term.

In the U.S. a string of tepid economic data has the market still breathlessly debating when the Fed will start to raise interest rates; the so-called ‘lift off’. The Fed has said it will be guided by the data, but the March employment report was about half what had been expected; manufacturing growth fell to the slowest in two years, presumably not helped by the sharp rise in the U.S.$ we talked about last month, and worryingly, a small business survey showed optimism had fallen to nine month lows. Throw in weaker than expected 1Q real GDP of 0.2% and inflation still below 2% and altogether it’s hardly inspiring for a rate rise, reflected in the market’s pricing of a September tightening falling from 100% not so long ago to only 40% now (see the chart below). We still feel the Fed would like to raise rates before the end of the year even if by just a token amount, but it’s not going to be aggressive at all because of the high U.S.$.

Probability of rate hike

That’s not to say it’s all bad news out of the U.S. One survey showed job openings hit a 14 year high at more than five million, unemployment claims hit a 15 year low and the closely related consumer sentiment numbers rose to the second highest level in eight years. Plus, a real milestone was passed during the month: the NASDAQ, which was ground zero of the dotcom boom, finally reached a new all-time high after 15 years (see the chart below). Naturally there were the doomsayers warning we’re in another bubble, but a simple comparison of the PE ratios tells you we’re not. In 2000 the index was trading on a PE of 70x, compared to about 20x now and technology was 65% of the index back then whereas it’s 40% now. If nothing else, it’s a salutary reminder of the risks of buying into overvalued markets – 15 years to get your money back is a long time.



In Australia, the Reserve Bank held off on another rate cut in April, observing the responsiveness by the public to a rate cut is “unusually uncertain”. House prices certainly seem to be a big part of their considerations, but Governor Stevens was careful to point out a balance needs to be found between Sydney housing and the other 80% of the economy, with the biggest terms of trade adjustment in 150 years pushing hard in the opposite direction. It’s odds on the RBA will cut rates again, and probably soon given the A$ has popped back up to about U.S.$0.80 again, but Stevens pointed out yet again that governments are placing too much reliance on monetary policy to do the heavy economic lifting.

Despite the local media painting the economic glass as half empty, as it is wont to do, Australia too is far from falling into a big economic hole. Unemployment is traveling at 6.1% with job vacancies at a three year high; inflation is low at 1.3% but that’s not unexpected, and growth is firmly positive. Whilst we’re still adjusting to the mining party finally being over, you’d have thought it would be a great time for a government to exploit the lowest ever bond yields and issue super long-dated bonds and go out and build a heap of infrastructure. Paranoia about debt levels is misplaced if the debt is productive – it’s a lesson we could learn from the Chinese, instead we focus on the U.S. and Europe as our benchmarks.

The good stuff

German elevator company ThyssenKrupp plans to release new MULTI elevators in 2016 that run on maglev technology rather than ropes, that’s the same technology that some high speed trains use. It means the lifts won’t run on big, heavy steel cables that currently limit how high a building can go. It also means the lifts will be able to travel sideways.

It could open up new architectural possibilities: buildings could be much higher, like two kilometres(!) and with smaller footprints. The lifts would be smaller, take up less space and have less waiting time. Whilst they’ll cost more, ThyssenKrupp reckons the pay back will be about ten years.

This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product. You should also obtain a copy of and consider the Product Disclosure Statement before making any decision on a financial product. You should seek advice from Steward Wealth who can consider if the general advice is right for you.

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