Beware the index! (Part 2)

Part 1 of our article “Beware the index!” took a general look at the composition of market indices. We concluded that most broad-based indices contain a large number of low quality businesses that have benefited historically from economic tailwinds, including the trend to lower interest rates and quantitative easing. Many businesses within the key benchmarks are heavily dependent on old-world products and technologies with capital intensive business models and significant debt levels. Part 2 of “Beware the index!” takes a deeper look at the key sectors that make up the S&P/ASX 300 and their outlook. We have identified a number of reasons to be cautious on banks and commodity-based businesses over the long term.

Australian banks need credit growth

Financials represent the largest sector of the Australian stock market by value, with the sector dominated by the banks. In turn, the banking sector itself is dominated by the four major banks (CBA-AU, WBC-AU, ANZ-AU, NAB-AU). The banks enjoyed strong credit demand for several decades leading up to the Global Financial Crisis (GFC), mostly funded by foreign debt. Australia’s external debt as a percentage of GDP has grown over the past few decades from 43% in 1988 to 117% in 2017. [1]

Over the past few decades, the level of household debt in Australia has increased substantially. Household debt to GDP has increased from approximately 40% in the 1980s to 122% in December 2017.[2] The rise in household debt was a key driver of the robust double-digit system credit growth that was experienced in the decades prior to the GFC. A material amount of this debt was used to buy residential real estate. Decades of easy credit availability, loose lending standards, declining interest rates, robust foreign investor demand and strong population growth in the major cities has pushed residential house prices significantly higher.

Figure 1: Credit and Broad Money Growth

Sources: ABS; APRA; RBA

Residential prices appear to have been heavily influenced by simplistic and optimistic borrower income and expenditure (affordability) assumptions, employed by the banks over the past few decades, rather than more sophisticated valuation mechanisms. This means the residential property market exhibits at least some characteristics of speculation. A strong belief in rising property values, easy credit, strong population growth and globalisation has resulted in a very resilient residential property market over a long period of time. Going forward, the banking Royal Commission is likely to have a negative impact on the availability of credit as lending standards are tightened. We believe the household expenditure benchmarks that domestic banks have historically used to assess applicants debt servicing ability were unrealistic and optimistic. They are likely to have resulted in many households taking on too much debt given their likely future income.

Figure 2: Debt to GDP (%) – Australia

Source: Bank for International Settlements; Hyperion Asset Management

In our view, the longer-term outlook for credit demand in Australia is poor. The key headwinds for future credit growth include: elevated household debt levels; likely modest future wage growth; an ageing population; tightening lending standards; a continuing hollowing-out of the middle class; high residential property prices and low levels of housing affordability.

The weak outlook for credit demand will severely restrict the major banks’ ability to grow their revenues and profits going forward. Bad debts are currently at very low levels and are likely to rise over time, particularly with sustained pressure on wage growth and the displacement of middle-income jobs. Potential future declines in residential real estate prices may place additional pressure on highly-geared households and result in higher loan defaults. Australia has not experienced a recession since 1991. This is unlikely to continue indefinitely given the high levels of financial gearing across households, businesses and government (much of which is owed to foreigners) and a heavy reliance on commodity prices for national income. The high inherent financial leverage of the banks and their broad exposure to households and small businesses will result in significant losses as bad debts increase.

Share count dilution during the next economic downturn will be large

Banks have high levels of inherent financial gearing and thus their profitability is severely affected during economic downturns because it only takes a small percentage of the loan book to default to cause significant losses. During difficult economic times, banks are likely to be forced to raise substantial equity capital at depressed prices in response to increasing bad debts. Highly dilutive equity raisings will result in material declines in the banks’ earnings per share. During the late 1980s, early 1990s and the GFC, Australian banks raised significant equity and increased their share counts substantially. The large level of dilution from additional shares for the bank sector is shown in Figure 3 (below).

Figure 3: Change in the number of shares on issue for the banks

Sources:  Macquarie; Hyperion Asset Management

In summary, the long-term return profile for the domestic commercial banks is modest given the weak long-term outlook for credit growth. Furthermore, if there is a material economic downturn, the return profile deteriorates as expensive equity raisings permanently dilute long-term earnings per share.

Capital intensive companies will need to issue shares in a downturn

Similarly, the dilution caused by substantial share issues at depressed prices during economic downturns is also a key long-term return headwind for the non-banking sector. This dilution was evident during the GFC, as shown in figure 4 below. Dilutive share issues are typically undertaken by capital-intensive businesses with low returns on invested capital, cyclical businesses and highly acquisitive companies that have high levels of debt.  Nervous creditors normally force these highly geared companies to raise equity at low prices during economic downturns.

Figure 4: Growth in the number of shares for All Ordinaries (indexed) and key market sectors

Sources: UBS; Hyperion Asset Management

Figure 5 below, shows the highly dilutive impact of equity raisings on highly geared businesses that were forced to raise expensive new equity during the GFC. The overall market share count rose by 7.2% and 10.7% in calendar years 2008 and 2009, respectively (Refer figure 5, below).

Figure 5: Annual change in the number of issued shares for the All Ordinaries Index

Sources: UBS; Hyperion Asset Management

Australian materials and energy sectors

The materials industry sector is the second largest component of the index and currently represents approximately 17% of the S&P/ASX 300 index. The energy industry sector comprises an additional 6% of the index. Combined these two sectors represent 23% of the total index and, in our opinion, are generally businesses of low predictability and quality. They have low levels of predictability because of the volatility of the price of the commodities they sell, the inability to consistently increase their volume of production, the finite nature of their resources, the uncertainty of finding new deposits and the variable nature of their operating costs.

In addition, many of the businesses within these sectors could face declining demand over the very long-term from the technology enabled trend towards the dematerialisation of society and the increasing awareness of the economic cost of climate change and the environmental damage from carbon emissions.

A large component of increased global demand for key commodities has been the emergence of several very large fixed investment stimulus programs by the Chinese government since the GFC. Chinese economic growth over the past decade has benefited from a series of large infrastructure spending programs. The Chinese economy historically has been heavily reliant on fixed investment with gross fixed capital formation representing a large percentage of GDP. In 2017, gross fixed capital formation was 44% of GDP, approximately double the average for most major countries globally.[3] This large level of fixed investment has been partly debt funded. Government gross debt was 48% of China’s GDP in 2017, up from less than 30% ten years ago.[4] Household debt in China increased to approximately 48% of GDP in 2017, up from less than 20% in 2008.[5] Corporate debt in China has grown significantly over the past decade and is now approximately 156% of GDP, compared with the U.S. where it is approximately 71%.[6]

Figure 6: Total credit to the non-financial sector as a % of GDP – China

Sources: Bank for International Settlements; Hyperion Asset Management

Growth in debt and fixed investment are heavily linked. High debt levels are normally associated with lower future economic growth. The trend towards higher gearing levels continues with credit growth in China continuing to expand at rates above overall economic growth. Higher gearing levels bring forward consumption and investment but in the long term normally mean lower levels of future growth, particularly if the investment is misallocated. Given the massive size of capital investment programs that China has undertaken it is likely there has been significant misallocated capital investment. High and increasing debt levels tend to have a declining influence on economic growth because excess use of a factor of production, such as economic capital, tends to be associated with diminishing returns to GDP. In addition, China is likely to move towards a more consumer and service-based economy that is less reliant on gross fixed capital formation over the long term. Therefore, it is likely that the rate of demand growth for commodities from China will decline over the next decade and the support for commodity prices should be adversely affected.

There has been a cyclical increase in global economic activity in recent years because of continuing debt-funded fixed investment by China and some improvement in general economic activity in the U.S. and Europe from stimulatory monetary and fiscal policy. However, liquidity is now being removed from the global economic system as the U.S. Federal Reserve continues to raise short-term interest rates and reduces the size of its balance sheet. The implications of high gearing levels globally and the Federal Reserve tightening monetary policy is that the demand environment for commodities is likely to become more difficult.

Impact of renewable energy

Given the ongoing declines in the cost of renewable energy generation and storage there is 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).

Thermal coal producing companies are facing major disruption in terms of their traditional role in producing electricity. One key problem is that solar and wind energy has close to a zero-marginal cost, whereas, thermal coal has a significant marginal cost that is unavoidable. Going forward it will be difficult to compete with renewables given the capital cost of solar and wind continues to decline at double-digit rates. Thermal coal demand will be adversely affected by the combination of distributed energy arising from the improving economics of rooftop solar and home batteries and large commercial solar and wind farms and commercial battery storage. Traditional peaking power generation will eventually be displaced by large scale battery storage and the combination of rooftop solar and home batteries. In addition, it is likely that future governments will act to impose costs for carbon emissions. Much of the current reserves of thermal coal will never be extracted from the ground because of reducing demand over the next decade.

Oil producers are likely to experience long-term declines in the demand for oil as electric vehicles displace traditional internal combustion engine motor vehicles. Transport accounts for over half of global oil demand (refer to figure 7). 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.

Figure 7: Segmental breakdown of current oil demand

Sources: International Energy Agency; Oil price.com; Hyperion Asset Management

At times, earnings from oil and gas has been over 20% of global benchmarks. As discussed, there is inherent risk in this source of earnings in the benchmark particularly given the recent recovery in oil and thermal coal prices.

Figure 8: Percentage of MSCI AC World earnings – Energy (oil, gas and coal)

Sources: UBS; Hyperion Asset Management

Conclusion

The key Australian equity indices are dominated by the banks and commodity stocks. The banks face a poor growth outlook with weak demand for credit, increasing government regulatory risk and the risk of significant earnings per share dilution when a recession finally occurs in Australia. The Australian indices’ large exposure to low quality materials and energy stocks is likely to be an earnings detractor over the long term as China’s economy slows due to its increasing debt burden and as its economy changes from one dominated by fixed investment to a less commodity intensive service and consumer-based economy. In addition, the Australian market indices have a large exposure to legacy non-bank industrial companies that are mature, capital intensive, heavily reliant on economic growth and are likely to be disrupted over the next decade by new entrants with better products. Outside Australia, the major stock market indices, although higher quality than the Australian market because of a higher weighting in innovative technology-based companies, are also likely to produce lower returns than achieved over the past few decades because of multiple structural headwinds.

Hyperion’s investment philosophy is not based on benchmark stock weights but instead is focused on the long-term business economics. We invest exclusively in the highest quality, structural growth businesses available within the relevant investable universe. These businesses are modern, innovative and disruptive with strong and sustainable value propositions to customers and other stakeholders. We avoid mature, low growth, legacy businesses that are likely to be disrupted by new technologies. We believe a low growth world suits Hyperion’s high quality, structural growth investment style and presents a favourable environment for long-term alpha generation.

 

Mark Arnold (Chief Investment Officer) and Jason Orthman (Deputy Chief Investment Officer)

 

[1] CEIC

[2] Trading Economics

[3] The World Bank

[4] Trading Economics

[5] Trading Economics

[6] Bank for International Settlements

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