Abernethy’s 10 calls for 2014

The year ahead will be testing for Australian investors on multiple levels … and here are 10 key areas to watch.

Summary: A lower Australian dollar, a deteriorating domestic budget position, and a weakening in bond markets and potentially equity markets will be some of the hurdles confronting investors in the year ahead.
Key take-out: If bond yields go up as they should, it will be caused by a market that has independently lost confidence in the bond market. Should that occur, then it will certainly test the equity market.
Key beneficiaries: General investors. Category: Economics and investment strategy.


Graph for Abernethy’s 10 calls for 2014

In recent weeks I have been presenting my investment views at various investor briefings around Australia.

The list above outlines my major calls for 2014. Today, I would like to draw conclusions from these and examine how they affect various stocks in my Eureka Report portfolios and the Australian equity market in general.

1. Australian dollar

The weakening $A will be positive for our major mining companies, and particularly so for iron ore producers who will grow output further in 2014. Both BHP Billiton (BHP) and Mineral Resources (MIN) have a tailwind behind them, and the weakening $A will lift their profits, profitability and value in 2014. (BHP and MIN positive).

2. Federal Budget

The sharp deterioration in the Federal Budget has been well communicated to the market by the new government. The actual ballooning deficit is not the issue, but rather the response of the Government. Does the Treasurer let the budget slide without a significant response or austerity? Or does he adjust tax and revenue to cut the deficit by 1-2% of GDP in 2015? The later response would not be good for economic activity or the equity market. It would clearly hit consumer and business confidence.

In my view, the Government should not panic but rather drive public capital investment into a national infrastructure program. This would offset the significant decline in the mining capital investment cycle that is apparent for 2014. Such activity by the Government would be good for the economy and benefit each security in our portfolios. In particular, the hybrid security of Multiplex SITES (ASX:MXUPA) would be supported by stronger cash flows from increased construction activity.

3. Quantitative Easing

The tapering of quantitative easing (QE) in the US combined with its imminent and necessary introduction in Europe will create volatility in equity markets and will do little to support Australian economic activity. A weakening euro may well result in the United States slowing its QE tapering process. Today there continues to be much speculation as to the likely direction of currencies in response to central bank activity. This makes financial management and forecasting exceedingly difficult. These are not good conditions for making definitive calls on the equity market.

4. Debt Restructuring

In time there must be a renegotiation of the massive burgeoning government debt that exists across Europe, the US and Japan. We recently saw a forerunner to this when Portugal convinced bond holders with short maturity holdings to extend their term to redemption. I predict that we will see much more of this in the public markets as a mountain of government debt comes up for maturity. Without the extension of debt maturity, bond yields will rise and push down bond prices. The knock on effects in wholesale debt markets could be significant and affect the rates that Australian banks can borrow at in international markets. This is one reason that I believe suggests that Australian banks in general are fully priced at current levels.

5. Bonds Weaken

The weakening of bonds generally, and in particular the subprime bonds of Europe, seems assured. Weakening bonds and higher yields are not good news for equity markets unless they result from a lift in economic activity, and that increases inflation concerns. That is not what is on offer in Europe and the recovery in the US remains sluggish. Once again a weakening bond market will create challenges for the banking sector and this will lead me to reconsider our bank holdings in the New Year should they lift above current market prices.

6. The US Recovery

At this point I perceive that the US economic recovery seems overstated by most commentators. Whilst recovery is occurring, it has neither greatly improved employment levels nor lifted household income. The recovery of the US economy generally and the manufacturing base in particular will be greatly challenged by a strengthening US dollar. The flow on effects for economic activity would be significant and not to the benefit of Australian companies operating in the US market. Our portfolio exposure to Australian stocks operating in the US remains very low, although I admit that a weakening $A will translate into improved corporate earnings.

7. Japan’s Stimulus Program

The Japanese QE program dwarfs that of the US when measured in terms of a proportion of GDP. This policy was crucial to ensure that Japan neither defaulted on its debt nor suffered a destabilising lift in bond yields. However, the repercussions will reverberate across Northern Asia and could well cause a trade dispute in due course. This situation needs to be watched as 55% of Australia’s exports go to Japan, China and South Korea. The sharply weakening Japanese yen will result in responses which could be either political or trade based. Neither would be good news for the Australian economy.

8. China’s Currency Revaluation

China continues to slowly adjust its exchange rate and has revalued by 3% against the US dollar this year. Against the $A it has revalued by nearly 20%, and the inflation consequences of this move will be significant. For instance, retailers’ forward foreign exchange cover set at parity against the $US will roll off early next year.

9. Inflation Emerges

Inflation in Australia is clearly on the horizon in 2014, and our increasing 10-year bond yields are a good bellwether. Hybrid and yield investors should focus on floating-rate securities that are protected should cash rates lift with inflation (some examples are AAZPB, SWLPB, NABHA, MBLHB).

China’s decision to revalue its currency is driven by its desire to lift wages and to offset this with lower import costs. In particular, lower raw material and energy costs are essential to ensure maintenance of China’s competitive advantage. However, China will continue to revalue slowly against the $US to ensure that it maintains its massive trade surplus with the US. Australia sits meekly in the middle of international trade flows but at this point a strengthening Chinese currency will be good for our large commodity exporters such as BHP.

10. Equity Markets

The most confronting development for world equity markets in 2014 will be weakening bonds. Many commentators have claimed that this has not been a historically observable issue. However, they fail to understand that today’s bond yields (outside Australia) are held down by unprecedented monetary policy settings. Bond yields today do not acknowledge default risk, currency risk or inflation risk. Bonds trade under the tight control of central bank interference, which has worked in a period when demand for credit has been extremely weak. That is, QE has worked and not spiked inflation because of rising savings ratios, ageing populations, high unemployment and the fact that China has for a decade exported deflation to Europe, US and Australia. Therefore, if bond yields go up as they should, it will be caused by a market that has independently lost confidence in the bond market. Should that occur, then it will certainly test the equity market.


John Abernethy is the Chief Investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.

Clime Income Portfolio Statistics

Return since June 30, 2013: 8.92%

Returns since Inception (April 24, 2012): 36.84%

Average Yield: 7.34%

Start Value: $150,754.88

Current Value: $164,208.74

Dividends accrued since June 30, 2013: $4,394.92

Clime Income Portfolio - Prices as at close on 17th December 2013

Hybrids/Pseudo Debt Securities
Company Current Price Margin over BBSWRunning YieldFranking
MXUPA$83.503.90%7.77%0.00%
AAZPB$97.104.80%7.61%0.00%
MBLHB$80.331.70%5.34%0.00%
NABHA$73.501.25%5.22%0.00%
SVWPA$86.404.75%8.53%100.00%
RHCPA$104.994.85%7.11%100.00%
High Yielding Equities
CompanyCurrent PriceDividendGUDYFranking
TLS$5.02 $0.298.25%100.00%
AAD$1.96 $0.136.65%0.00%
CBA$73.93 $3.867.46%100.00%
WBC$30.87 $1.828.42%100.00%
NAB$33.40 $2.038.68%100.00%
SKI$1.58 $0.116.96%0.00%