Clime Weekly Market Themes
What are central bankers thinking?
Hours after US President Trump finished his State of the Union address, boasting about the “unprecedented economic boom” across America, the Governor of the Reserve Bank of Australia, Philip Lowe, warned of an “accumulation of downside risks” — including trade skirmishes between China and the US, rising populism and Brexit. In addition to these offshore pressures, Lowe highlighted the declining housing market in Australia. In a U-turn from previous statements, he said that the next move in interest rates could be down, instead of up.
Indeed, central bankers in the UK, India and other countries are in the process of joining Australia in their retreat from plans to tighten monetary policy. The most significant policy change was of course the decision by Federal Reserve Chair Jay Powell on January 30 to shelve plans to lift rates further because of possible risks to US growth.
One year ago, optimism about synchronised global growth was keeping markets buoyant. The IMF hailed the broadest synchronised global upsurge since the GFC, with 120 economies enjoying a pick-up in growth. But now the optimism is fast disappearing.
An update from the IMF last month highlighted the “backdrop of weakening financial market sentiment, trade policy uncertainty, and concerns about China’s outlook”. Growth in advanced economies will slow from an estimated 2.3% in 2018 to 2.0% in 2019 and 1.7% in 2020, it said.
Global manufacturing activity is at a two-and-a-half year low.
Why the big change in sentiment?
Policymakers were overly bullish last year. The Fed over-reached by signalling four increases in interest rates for 2018 when the global economy was still fragile. Its new-found caution is providing “cover” for other central banks to mark down their own rate expectations.
The turning point came in the December quarter, when markets woke up to a swirl of headwinds, including the possible transformation of a trade skirmish into a full blown trade war between the US and China. Other headwinds: the Fed still raising rates in late December, Brexit uncertainty, slowdowns in China and the eurozone, US government shutdowns, the list goes on.
The US domestic economy has continued to put in a robust performance, with the number of new jobs in January coming in ahead of Wall Street expectations and wage growth running comfortably above inflation. But corporates in the S&P 500 index, which generate over a third of their earnings overseas, are warning of faltering overseas demand in markets including China.
The Fed, which led the world’s major central banks in beginning to tighten in 2015, has been at the centre of the recent outbreak of dovishness. Powell presided over the 0.25% increase in rates on December 19 to 2.5%, but his attempts to couple that rise with reassurance about future moves fell flat. The danger sign came when equities sold off after the chairman said the reduction of the Fed’s balance sheet will run on “automatic pilot”.
Wall Street’s negative reaction to his guidance underscored to policymakers just how fragile market sentiment had become. On January 30, Powell changed his tune and shelved plans to lift rates further. With US inflation low, the Fed has set aside worries about economic overheating, focusing instead on downside risks. Rate rises are, for the time being, off the agenda. Were trade talks between the US and China to break down altogether, accompanied by full-blown hostilities with Europe over trade, some commentators are saying that there is a 1 in 3 chance that America could be pushed into recession. With the information currently available, that analysis is probably somewhat pessimistic.
Fed’s dovishness migrates to Australia
The RBA has shifted to a more cautious outlook amid concerns that steep falls in house prices and the slowdown in China could choke off domestic growth. Unemployment in Australia fell to 5% in December, its lowest rate since 2011. But there are growing concerns that a weakening housing market is hitting household consumption, with retail sales unexpectedly falling by 0.4% in December, compared with the previous month. Evidence of the deteriorating housing market is reflected in poor auction rates: only 40% of homes put up for sale by auction in December were sold. Prices in Sydney and Melbourne have fallen 12% and 9% respectively from peaks achieved in 2017, with expectations of further falls to come. The RBA will be keeping a beady eye on employment levels in coming months: any marked increase in unemployment levels will likely be followed by a rate cut.
Europe looks weak, getting weaker
The European Commission has reduced its eurozone growth forecast for 2019 to 1.3% from 1.9%, marking down outlooks for the major economies including Germany. It is predicting the weakest expansion in Italy for five years. The European Central Bank has sounded the alarm about the impact of trade tensions and Brexit, only weeks after it stopped expanding its quantitative easing program.
European governments are worried by the decline in the industrial sector, and starting to rev up support, such as raising further debt for investment and infrastructure projects. Fortunately, with European rates so low, the cost of borrowing remains extraordinarily cheap.
Industrial production growth falling sharply
Indeed, the threat of deflation is returning to Europe. All the eurozone’s biggest economies have seen inflation expectations fall in the last few weeks as measured by “break-even rates” in the bond market. See chart below, which shows how forecasts for inflation over the next 10 years have shifted in France, Germany, Italy and Spain based on the difference in yields between inflation-linked and conventional bonds:
US Government shutdown, part 2
The United States is facing another possible government shutdown later this week. Budget talks between Democrats and Republicans ground to a halt over the weekend in a dispute over immigration policy and building the wall. News emerging on Tuesday suggests some progress might have been made in talks. But risks remain that a repeat of the 35-day shutdown that started before Christmas could cause hundreds of thousands of federal workers to again be furloughed.
The British economy grew 0.2% in the final quarter of 2018, compared to the previous three months, according to data published Monday. The rate of expansion for the full year was 1.4%, down from 1.8% in 2017. Economists said that uncertainty over Brexit was a major factor in the poor performance, with business investment falling for the fourth consecutive quarter. With less than 50 days to go before Brexit, Prime Minister Theresa May has still not identified an exit proposal that is acceptable to both the European Union and UK parliament. The drag on growth from Brexit uncertainty suggests there is little hope of a rebound early this year.
Stock of the week: GUD Holdings Ltd by Vincent Cook
GUD Holdings Ltd (ASX code: GUD) is Australia’s leading provider of automotive parts to the trade sector, with strong brand positions including Ryco. The business has been able to successfully grow through acquisition of other small suppliers, where GUD is the natural owner and often uncontested purchaser. GUD has a market cap of $1.08 billion.
GUD is a cleaner, higher quality business now than in past years following divestments. GUD had a number of new products coming to market at the end of last half, which should support the current half year result.
- GUD’s share price has recently come under pressure following weakness in vehicle related stocks given the fall in new car sales, the general equity market correction and a modest miss at the 1H19 result.
- The stock is down >20% from August 2018 levels, compared to the Small Ordinaries down 8%.
- However, GUD is not servicing new vehicles but all vehicles in operation in Australia (18.6m cars vs ~1.2mpa of new car sales). Most of their business is for cars aged 5-10 years.
- GUD’s products are predominantly used in vehicle servicing, which is largely non-discretionary. GUD benefits if cost-focused consumers move away from OEM mechanics towards independents. Lower new car sales means an older fleet, resulting in increased servicing requirements. In summary, exposure to weak consumer sentiment is muted.
- GUD has traded on a forward PE of 17-19x over the past two years, but is now trading on 16.4x.
- Management note long term earnings drivers of 2% car numbers growth, 2-3% pricing growth, 0.5-1.0% market share gains and an unquantified benefit from new products.
- This has resulted in automotive organic sales growth averaging 7% per annum over the past 3 years, with 5% delivered in 1H19.
- This is supplemented by acquisitions.
- The combination of organic and M&A activity should be able to deliver high single digit EPS growth into the medium-long term.
- Management see a significant pipeline of opportunities; they are often the only bidder on transactions, as their scale and national distribution makes them the natural owner.
- Resellers such as Repco and Bapcor will not typically acquire these businesses given a significant % of the target company’s sales are through a competitor.
- GUD can achieve cost savings on freight and procurement for acquired businesses. They also typically find opportunities to expand the product range and better manage pricing. Overall this can result in a material uplift in margin over time, from ~15% to ~20%.
- Near-term consumer environment in Australia is weak. Consumers could limit servicing to the bare minimum.
- However, car servicing is largely non-discretionary, and management indicates that consumers have not neglected maintenance in the past when times have been tough.
- A key medium-term risk is increased penetration of private label brands.
Valuation and recommendation:
- Our price target implies a 15% total return, including a 4.8% (12 months forward) fully franked dividend yield.
- This price target translates to FY19/20/21 PEs of 19.4/18.0/16.4.
- GUD is a high-quality business (Clime Quality Score of 100%) with defensive characteristics and a sound long term growth outlook.
- We have initiated purchases of GUD for a range of core portfolios.
Cartoon of the Week: from AFR …