Fear: The comeback

There was a touch of irony in the title of last month’s Director’s Cut, The subsidence of fear, where we offered a six-step antidote to the then prevailing but misplaced optimism.

The image of a car about to drive over a collapsed road spelt it out—the danger had not passed. In the weeks since then, prompted by a series of tumultuous European elections, the investing public has reacquainted itself with the broken road.

From its conception the Euro, a political answer to an economic question, was flawed. The European Union however—a departure point for warring nations from centuries-long enmity—enjoyed a greater legitimacy.

Now even that seems challenged. From The Netherlands to Greece, governments that supported austerity programs are being thrown out. In local elections in North Rhine-Westphalia, even German Chancellor Angela Merkel’s Christian Democrats suffered a 30% drop in support. For the first time, politicians are openly talking of a Greek departure from the Euro and a breakup of the Eurozone altogether. 

The effect on local markets may not have escaped your attention. Last week, the ASX All Ords was down 5%. Even BHP Billiton, a long-time adherent to the supercycle theory, hints that if there was in fact a supercycle in the first place, it's now coming to an end. But the real trigger for the latest bout of panic lies not in Shanghai or the Pilbara, but in Berlin. 

Austerity fail

A formal challenge to German hegemony looms. François Hollande, France’s first leftwing president since Mitterand (yes, he of the Euro), intends to either renegotiate or ditch altogether the recent agreement that commits 27 European nations to run balanced or surplus budgets, with penalties for those that don’t.

German-inspired austerity is failing. Of the 17 countries in the Eurozone, eight are in recession. Spain and the UK recently confirmed they have ‘double-dipped’. Youth unemployment in Spain and Greece is close to 50% and in Italy is rising towards 40%. This is not the prosperous future Europe imagined for itself.

Germany thus faces an awkward choice: Accommodate the desire to move away from austerity with its attendant economic risks, or hold fast and deal with diminished political influence and a possible breakup of the Eurozone. That bleak choice lies at the heart of recent market falls and is why traders in London are ensuring their IT systems can deal with a return of the drachma.

The quagmire in which Europe wades is not just of a political making, either. Ever-expanding bureaucracies are taking a toll, too.

The public sector accounts for about 57% of French GDP and complaints of French pettifogging run so deep that upwards of 300,000 citizens have taken the humiliating and extraordinary step of emigrating to London. One presumes it is  not for the jellied eels.

The New York Times tells the story of Greek entrepreneur Fotis Antonopoulos, who wanted to start an online business selling olive oil. The odyssey began with mindless government form-filling and ended 10 months later with his board of directors being required to give stool samples.

Rogue trade

Meanwhile, less than five years after the depths of the Global Financial Crisis, JPMorgan Chase trader Bruno Iksil, on a mere US$100m a year, managed to lose the company $2bn.

Were it not for the fact that JPMorgan Chase enjoys a de facto government guarantee, this wouldn’t be a problem. But it does. As Matt Taibbi argues at Rolling Stone,

‘If J.P. Morgan Chase wants to act like a crazed cowboy hedge fund and make wild exacta bets on the derivatives market, they should be welcome to do so. But they shouldn’t get to do it with cheap cash from the Fed’s discount window, and they shouldn’t get to do it with money from the federally-insured bank accounts of teachers, firemen and other such real people.’

Suffocating bureaucracies, an ill-conceived European currency and a failure to address the conditions that led to the GFC are structural problems yet to be addressed (to say nothing of similar and long-standing concerns in China).

There is every reason to believe the pain has not yet been great enough for genuine reform to occur. The conditions that permitted—indeed encouraged—the GFC remain. European austerity and Iksil’s ill-conceived wager are merely symptoms of that fact.

Against this backdrop, the RBA recently lowered interest rates by 50 basis points. Australia’s structural problems are probably beyond the reach of a blunt tool that confiscates returns from savers to ease the stress of borrowers. They are deeper than that.

In a recent research report Dylan Grice of SocieteGeneral’s global strategy team offers the alarmist view: ‘What do you call a credit bubble built on a commodity bull market built on a much bigger Chinese credit bubble? Leveraged leverage? A CDO squared? No, it’s Australia.’

Grice bangs home his point with a few salient facts: Of the world’s 15 most expensive cities, five are in Australia (Adelaide is more expensive than London and New York); The ratio of debt to disposable income has risen from about 40% in the mid-80s to around 150% today (see Chart 1); and planned increases in iron ore exports will have almost quadrupled by 2016, with most going to China.

Grice then talks of Wuhan Iron & Steel and its move into pig farming, a subject close to the heart of our resources analyst, Guarav Sodhi (see BHP: Where the pigs fly high (Hold - $34.68)). If Australia’s commodity boom is based on the export of iron ore to make Chinese steel, and Chinese steel makers are getting into pig farming, where does that leave us?

Chart 2, which compares changes in US and Australian real home prices over the past 100 years, is equally sobering. No wonder The Economist believes Australia, with a market 53% over-valued by a rent-to-price metric, is in the midst of one of the world’s largest property bubbles.

According to Australia’s premier perma-bull stockbroker Charlie Aitken, such talk is ‘genuine scaremongering’. According to him, ‘Not only are Australian equities grossly, grossly cheap versus government bonds but there are clear catalysts for that value to be released.’

Of course there’s a case that the worst is behind us. We just don’t happen to think it’s a very strong one. The chances are that the next 10 years will be very differently to the previous 10. We’d like to ensure your portfolio is prepared for that probability.

Thus begins the recital of Bell’s Shibboleths.

It is almost impossible to pass research director Nathan Bell without being lectured on the dangers of debt, the need to diversify overseas and the advantages of cash, especially at a time such as this. [Those looking for a sermonic interlude might open the good book at Investing protection: Top risks for 2012 and Filling portfolios with cash from 3 Apr 12.]

Your analytical team has regularly urged caution about businesses like banks that rely on high credit growth and/or constant access to funding and credit markets. In the resources sector, look for exposure to volumes rather than prices and watch out for mining services stocks.

Nothing to fear

If you're buying businesses where the risk of permanent capital loss is low—and your analytical team focuses on high quality, stable businesses with pristine balance sheets, owner-managers and cheap valuations—you have nothing to fear from a general market fall. Those looking to make a start should check out Building a portfolio from our Buy list from 17 Apr 12.

Many of the businesses on this list should keep paying dividends and avoid the need for capital raisings should things get tricky. They also tend to increase market shares in a downturn and emerge in better shape. Any capital losses on the price you pay (provided you don't overpay) should prove temporary.

Over the past month or so we’ve taken the opportunity to fine tune that approach, selling out of stocks like Perpetual (see Tide going out at Perpetual from 30 Apr 12 (Sell - $25.62), Spark Infrastructure (Selling Spark Infrastructure from 20 Apr 12 (Sell - $1.42) and Woolworths Notes II from 7 May 12 (Sell - $106.18).

Happily, we’ve also been able to reiterate a number of buy recommendations, including Origin Energy, Santos, Sirtex Medical, Woolworths, Metcash, QBE Insurance, Sunland Group and Azumah Resources. Please see our Buy list for more detail.

For income investors, we’ve also uncovered an interesting opportunity in ALE Property (see ALE Property: Down in one (Buy for Yield - $2.08) from 2 May 12) with another prospect in the works.

This is hardly the work of genuine scaremongers. It is, however, an acknowledgment that Australia’s goldilocks economy has structural issues of its own and is more exposed to external shocks than many people accept. The recent rapid fall in the Australian dollar supports this perspective.

Investors not accounting for that in their stock sales and purchases are taking far bigger risks than is necessary or sensible. And that’s not a risk we want you to bear.