Lukasz de Pourbaix: One of the biggest things that has happened recently is the massive stimulus announced by China a couple of weeks ago. This is the biggest stimulus since 2015 and China is Australia's biggest trade partner. Run us through what are some of the key points from that stimulus package and what the ramifications then for Australian markets?
Casey McLean: It's a major change in tone that we've seen from Chinese regulators. Over the last two - three years, since China reopened post COVID, they've put in numerous measures into the economy, but I see there more support measures. This ground of announcements is clearly stimulus rather than support.
It started with what is effectively an interest rate cut. The mechanism in China is a little bit more complicated than Australia, but there were various measures to ensure that existing mortgage holders get lower rates, new mortgage holders get lower rates, and banks have the capital to do that by lowering their reserve requirements. That really is dealing with the supply side of the economy, the liquidity.
So, whilst they're injecting liquidity into the economy, which is great, you also need the demand side to come to the party. And just the very next day after the interest rate announcements, they had a Politburo meeting, which is a quarterly event. The September one doesn't usually deal with economic issues, this time it did. Very meaningfully, they came out at 1pm local time (AEST) and gave an announcement which was that we're going to do anything moment. They said they're going to make counter-cyclical adjustments, have large fiscal spending issue, ultra-long bonds, put in measures to stabilise the property market and also help support capital markets, the equity markets as well. We're yet to see the numbers behind this, they will come in time. China's a holiday period during October as well, but likely sooner rather than later we're going to see numbers around this. Hopefully that's big enough to really support the demand side of the economy.
Even before they went on holidays, you did see further measures in the property market. Some of the tier one cities relaxed or even totally eliminated in the case of Guangzhou, all home purchase restrictions as well. Tier one cities are important in the property market, it generally leads all cities throughout the country as well. We're going to look back and I think it will be a pivotal point.
LDP: This too has had ramifications for the Aussie equity market. What have you observed, from an Aussie equity perspective, on the back of that stimulus announcement?
CM: The most obvious impact has been a big rotation. The rotation has been into resources, which is the traditional play in Australia on Chinese growth, not unexpected. The funding
source has been the banks. We've seen selling in the banks, consistent selling actually, even when resources have had sort of pullbacks, you've still seen that selling continue in the banks as well.
Within the resources segment, it is backed by the fundamentals as well. Commodity prices have gone up since these announcements. It remains to be seen whether this is trader driven or whether it is supply/demand, and it's probably the former. It's a bit too early to see demand impacts yet. I think generally commodities are focused on the present rather than forward looking. So, it's a good sign that fundamentals are improving and the outlook has improved.
LDP: Certainly, a lot of people have been talking about the Magnificent Seven for some time and valuations, so it's interesting to see that rotation. One of the stocks that we spoke about in a little bit of detail was Bega, which I thought was interesting. It is related partly to this Chinese theme as well. Talk to me about that.
CM: It is an interesting company. Speaking with our analyst in Sydney who covers the
stock, he's become more positive because the milk prices in Australia have declined.
If you look back just recently, Australian milk prices have been at a premium to
global prices and that's really because the milk supply has been steadily ratcheting down over the years and there's been an excess of downstream bulk milk processing capacity, while at the same time your global prices have been very low.
So, you've seen Australian prices higher than global. It's meant imports have come into Australia and affected the market that way. But more recently, a couple of large players in the milk processing industry, the downstream, they've exited. So, now there's a bit of an excess of supply on upstream raw milk and prices have come down a lot and that helps Bega in terms of their bulk milk processing business.
When I was up in Hong Kong just a few weeks ago and speaking to our analyst there, Teddy, who is looking at the Chinese dairy companies, he's seeing quite a different picture, that the milk prices in China are at record lows. There is a demand element to that as well, but it's supply driven. From his visits out to farms in Mongolia and the like, he has seen that the dairy companies are taking action, they're rationalising their herd, which should increase Chinese prices and perhaps even flow through to global prices. If this eventuates, you could see a case where now Australian prices down, global prices rising, global being higher than Australia, and it's a pretty good environment for bigger bulk milk processing capabilities.
LDP: It's a great test case for an Aussie company, but having that global analyst reach and interacting with those analysts is so important to get the full picture, on a company like Bega.
If we move to Australia and the bigger picture, the number one topic has been rates and the RBA as to will they cut rates, when will they cut rates, all the rest of it. But we saw that in the announcement, they kept rates on hold, obviously pointing to continued sort of sticky inflation, continued strength in the labour market.
What are you seeing from a company perspective? Are companies, from a bottom-up perspective, cautious in terms of where rates are at? Is it business as usual? What implications do things like rates have on some of the
companies that you're talking to?
CM: Well, I think, generally speaking, companies' balance sheets are in pretty good shape. They've been relatively conservative in terms of how much leverage they've been able to take on and were helped out by some governments of handouts during the COVID period as well. There are some more leveraged sectors in the market, naturally leveraged sectors like property rates who do run high gearing levels throughout the cycle. We have seen those companies start to outperform the market as well.
There is a scattering of companies, I think, who do have overleveraged balance sheets. They're somewhat sceptical of how bad this cycle can be or how long the down cycle can last, and you have seen them raise equity to sort of shore up their balance sheets. Fletcher Building in case in point. They're more leveraged to the New Zealand economy, which is in a
worse shape than Australia, but generally they're in the minority and I think the company balance sheet looked pretty good now.
But when we think about the impact of the rate cycle when Australia cuts and US has obviously already entered into that rate cutting cycle, but the difference to me with this cycle is really the starting point where we're at. If you look at both Australia and the US, we're actually at the highest valuation ever prior to a rate cutting cycle and that's probably because
we're not in a recession currently as we usually are when we're entering into a rate-cutting cycle.
It also shows up in unemployment. It's pretty rare to be cutting Interest rates so potentially an aggressive cycle like the US is potentially doing when you're close to full employment levels as well. So, stepping back you have to think, well is this going to be the normal
sector rotation that you see in an interest rate cutting environment? I don't think so. I think this time could be different to normal recessionary interest rate cutting cycles.
LDP: The main thing I take from that is that a lot of the companies are looking at a pretty resilient balance sheet. Recession risk there, but probably low risk, that would be my key takeout?
CM: I think that's right. I think we've been of the view that a recession, at least in Australia, is unlikely throughout this whole period. I think, although Australia hasn't started cutting
rates yet, the US has, and Australia will at some point. That reduces the recession
further. But what's clear is growth is slowing and inflation is reasonably sticky but
the risk of a hard landing continues to sort of abate and there is a cycle on the
other side coming if you know there's a lagged impact of interest rates.
LDP: Probably the other area which is quite interesting is the construct of the Aussie market because a lot of the market has been commentating for some time around the US market and the concentration of the market, particularly around those magnificent seven stocks, those well-known tech AI related companies.
But one of the things you pointed out, which I thought was quite interesting, that if we look at the Aussie market, roughly 70 % of stocks of the drivers of the market can be attributed to six stocks. So, you could argue Australia almost has its own little ‘Magnificent Six’, so to speak. Talk to us through that because I didn't actually appreciate how concentrated our market has been in terms of performance.
CM: Australia has always been a pretty concentrated market with the big four banks and two miners, but you're right. I think it's year-to-date (up until mid-September), around about 70% of total market returns were driven by just six companies. It was the four major banks, plus WesFarmers and Goodman Group. Another way to look at this is if you compare the market
cap weighted index, the ASX200, that you see quoted on the news, versus an equal
weighted index, the market cap is outperformed by about 5% year-to-date as well.
So yes, we do go through periods where the major companies, the big companies drive
returns, but usually you do see a rotation back into other areas of the market as
well. I think that's a likely outcome as this is economic situation. The rate environment does change as well because I look at those six companies that driven those returns and I think it's hard to justify the performance of the banks on fundamentals. Earnings are flat to moderate, modestly up or down, and that's the likely path for the next couple of years.
You've seen a significant re-rating. Pretty much every bank is trading at record multiples in absolute terms and record multiples relative to the rest of the market. Whereas, if I was to compare contrast with Wesfarmers and Goodman Group, I think their performance, although some of it is from re-rating, a lot of it is driven by the fundamental improvement that you've seen in those businesses.
WesFarmers is in a pretty good environment at the moment. Their Kmart business is benefiting from trading down. The Anko brand that they've developed over the years has been enormously successful and a big part of that success as well. Bunnings obviously
just continues to grow as the behemoth in that sector. Goodman Group, they're in the two best asset classes within property, in logistics, which is leveraged to e-commerce and the growth of that, and data centres is a new entry.
So, I see them fundamentally driven, whereas the banks have potential to see rotation out of them into other areas of the market.
LDP: You run a very concentrated, punchy portfolio. When you think about taking positions in stocks, you've got to have a high level of conviction in those stocks because you are writing a concentrated portfolio outside of those six stocks. What are the areas that you're seeing opportunities in at the moment?
CM: Well, I think the first one is really the materials / resource sector. That rotation, particularly if the Chinese policies come through, I think potentially has legs, but you need to be a bit selective. I think within commodities there are some that are over supplied and potentially getting worse, like lithium, whereas others that have tight markets and are potentially tightening as well over the years to come.
Another area that's attractive is this is structural growth for quality growth companies in the market, mainly centred around the tech and some in the retail segments of the market. You do need to pay up for that growth, but they are structural growth companies in some cases and can probably grow, continue to grow strongly, even as the macro weakens as well, the growth slows down in the economy.
I think probably the final one that does look attractive from a medium-term point of view is more the industrial, cyclical type businesses. You've seen whenever there's improvements in the PMI and global macro, these companies in Australia do very well. There is an upcycle coming on the other side where growth accelerates and I think these companies which are generally smaller cap by nature will perform pretty well over the medium term as well.
