Market indices are made up of large and capital-intensive businesses, dependent on old technology. These businesses have performed well in the past due to historic economic tailwinds, including lower interest rates and quantitative easing. Looking forward however, our view is that a changing world is likely to create headwinds which will negatively affect returns from these businesses and sectors over the medium to long term.
Here we take a deeper look into the sectors which make up the bulk of the Australian index, and take stock of the challenges they face.
Australian banks dominate
Financials are the largest sector of the Australian stock market by value, dominated by the four major banks – CBA, Westpac, ANZ and NAB.
In the decades leading up to the global financial crisis, banks benefitted from strong credit demand, which was funded to a significant extent by foreign debt. As a result, Australia’s external debt as a percentage of GDP increased from around 43% in 1988 to 117% in 2017, and household debt followed a similar path, increasing from around 40% of GDP in the 1980s to 122% in December 2017.
Much of this household debt was used to buy residential real estate, and banks were the major lenders and therefore beneficiaries. Consistent double-digit system credit growth was the norm, as Australian households invested more and more heavily in the housing market.
House price boom
Residential house prices rose significantly and consistently as a result of easy credit, loose lending standards, declining interest rates, robust foreign investor demand, and strong population growth in major cities. In fact, the market has remained remarkably resilient over the past decades, with the result that there has been a general view that it will always rise.
We would argue however, assessments by banks of household income, and potential growth in household income have been unrealistic for some time, and that overly simplistic and optimistic affordability assumptions by banks are in part responsible for rises in both the price of residential real estate and credit growth. The net result is that many households have taken on too much debt, and the market now exhibits at least some of the characteristics of speculation.
Looking forward, credit growth is likely to be weaker
Increased scrutiny and stricter lending standards for banks as a result of revelations from the Royal Commission are likely to negatively impact the availability of credit, and this will naturally flow through to property markets.
In addition, the longer-term outlook for credit demand in Australia is also poor due to a number of economic and social factors, including high levels of household debt, the likelihood of future wage growth remaining modest, an ageing population, and high residential property prices.
If, as we expect, demand for credit weakens, then the major banks’ ability to grow their revenues and profits will be curtailed going forward. Bad debts are currently at low levels but they will rise over time, particularly as wage growth continues to come under sustained pressure. If residential real estate prices come off, then this could also place additional pressure on highly-geared households and result in higher loan defaults.
Finally, the banks have extremely high levels of financial gearing and will be forced to raise substantial amounts of equity at low prices when the next economic downturn occurs. This will result in a significant increase in the number of shares on issue for the banks and materially dilute future likely returns.
Australian materials and energy face headwinds
The materials industry sector currently represents approximately 17% of the S&P/300 and energy comprises an additional 6% of the index, so combined these two sectors account for around 23% of the total index.
In our view, these businesses are unlikely to offer investors predictable earnings over the long term given that the prices of commodities are inherently volatile, companies cannot consistently control the volume of production, and operating costs are variable.
In addition, commodities-based businesses have relied very heavily on China as their primary source of demand. This is partly because historically the Chinese economy has used large fixed income programs as a form of economic stimulus. In fact, as of 2017, gross fixed capital formation accounted for around 44% of GDP, twice the average for most major countries globally.
A large part of this fixed investment has been debt funded. Government gross debt was 48% of China’s GDP in 2017, up from less than 30% ten years ago. Household debt in China increased to approximately 48% of GDP in 2017, up from less than 20% in 2008. Corporate debt in China has also grown significantly over the past decade as well and is now approximately 156% of GDP, compared with the U.S. where it is approximately 71%.
These figures are important, because growth in debt and fixed investment are heavily linked and high debt levels are normally associated with lower future economic growth.
At present credit growth is continuing to expand at rates above overall economic growth, and while higher gearing brings forward consumption and investment in the short term, it generally signal lower growth going forward. In addition, the Chinese economy is in the process of transition towards a more consumer and service-based economy, less reliant of gross fixed capital formation over the long term.
Renewable energy threatens fossil fuels
The cost of renewable energy generation and storage is decreasing, in some cases at double-digit rates, which means there likely to be a significant and structural decline in demand for thermal coal and oil over the very long term – the next decade and beyond – as a result.
Not only is solar and wind energy renewable, it has close to a zero-marginal cost, whereas thermal coal has a significant marginal cost that is unavoidable. Old world energy companies will struggle to compete with renewables, as the combination of distributed energy arising from the improving economics of rooftop solar and home batteries as well as large commercial solar and wind farms and commercial battery storage improves. It is also likely that future governments will act to impose costs for carbon emissions.
Oil producers are likely to experience long-term declines in demand for oil as electric vehicles displace traditional internal combustion engine motor vehicles.
Transport accounts for over half of global oil demand and the cost of electric vehicles has been declining in recent years as battery technology has improved, and the overall cost of production has declined. Over the next few years, it is likely that affordable, long-range electric cars will start to enter the major car markets.
In addition, many of the businesses currently operating in the materials and energy space could face declining demand from the technology-enabled trend towards the dematerialisation of society, as well as the increasing awareness of the economic cost of climate change and the environmental damage from carbon emissions.
The key Australian equity indices are dominated by the banks and commodity stocks, which in our view are likely to face lower earnings looking forward for reasons outlined above.
In our view, investment managers who focus on long-term business economics rather than benchmark weights are those likely to outperform. Businesses with high structural growth within their investable universe – those which are modern, innovative and disruptive and have strong and sustainable value propositions are the ones which will succeed into the future. On the other hand, mature, low-growth, legacy businesses are likely to be disrupted by new technologies and continue to face ongoing struggles.
Mark Arnold & Jason Orthman, are CIO and Deputy CIO of Hyperion Asset Management.