The Year in Review & Looking into 2016

Good afternoon everyone,

It feels only like yesterday I was writing a similar note to you all summing up the events of 2014 and hanging our hopes on what 2015 may bring. Now I’m back here 12 months later, in what seems now a year where all we did was jog on the spot.

I’m not one for Cliché’s but it was really a year of two halves. We opened with a real bullish theme fueled by Quantitative Easing measures out of Europe and Japan. Our index knocked on the door of 6,000 several times but was unable to crack that magical mark. Our highest closing mark on the ASX 200 was 5,982.70 on the 27th April. This was a stellar +10.6% on the year. Even by the end of the fiscal year we were still holding up around 5,600, however it seemed the rot had set in by then.

Investor smiles have since turned to frowns as the index has since plummeted to 4,909.6 earlier this month. As it stands today we are at 5,116.7 (22/12) which is -5.4% from where we started earlier in the year. In fact from our highs in April we are off a staggering -14.5%. This puts us well into bearish correction territory.

So we can see what the index has done over the last 12 months, but what were the common themes that drove the market so close to that 6,000 mark and then smacked it back down below 5,000 once again?

China

Our largest trade partner was a major cause for concern for the greater part of the year. To start with it provided much hope and optimism. At the end of 2014 the Chinese government somewhat opened their share market to International investors for the first time via a link system through the Hong Kong exchange. Investors piled in and new broking accounts were being opened at an alarming rate. It pushed their index to a high of just over 5,100 in July after starting the year at the 3,000 mark. It was roughly a 70% return in the matter of 7 months. If you go back even further to November of 2014 when the index sat at 2,400 the returns are even more astonishing. However since then it has cooled to sit around the 3,500 mark. Investors were of the initial view that due to years of being so closed off and insula the Chinese market was grossly undervalued and presented a unique opportunity. Those views gradually turned negative as the year went on as the pitfalls of an immature market where discovered and the Chinese economy slowed.

Chinese year on year growth slowed to +6.9% after sitting at +7% for many years. This is as the Chinese economy transitions from an Industrial/Manufacturing domination to a more services based one as we have here in Australia. People questioned the legitimacy of these figures and cited they had slowed even further. Retail, Industrial and Investor numbers continued to soften during the year in correlation with the headline GDP figures. However the last set of numbers did beat forecast and provided a bit more hope their economy had stabilized for now.

A booming property market also cooled off causing much concern for investors. The main worry is there could be a property crash which would bring to head the massive amounts of debt that had fueled the corresponding boom over the last few years. As of today this hadn’t occurred but still looms as a concerning possibility.

USA

The US story for 2015 was neither here nor there. The economy didn’t boom and it wasn’t a bust either, it continued to meander along the whole year. Like the Chinese market the Dow Jones performed astoundingly well to start the year and hit record highs of over 18,000 on the index. The S&P 500 followed suit and also hit record highs of over 2,100. This was fueled by strong EPS growth and large amounts of on market share buy backs. This was all in part due to record amounts of cash being held by US companies.

EPS growth was soon tempered by a strong US Dollar which softened export numbers. The stronger USD came about from a solid recovering economy where unemployment had dropped to 5.0% as of November. This brought about the question of when the US fed would start raising rates from their current 0% levels. The market began to factor rate rises in and the DJ and S&P fell modestly for the remainder of the year. Higher rates meant a higher USD. This would make the US market more expensive for International investors to invest in, hence why it was tempered.

As we all know, last week the Fed, decided to raise US rates by 0.25%. They also signaled that further rates increases would be gradual and it was expected they would raise rates by 1%, or 0.25% per quarter, in 2016 and then replicate that in 2017, all things being equal. The market initially rallied on the back of this as it had factored in these rate increases. However the rally was more due to the fact that the fed was going to do this gradually and there would be no sudden acceleration of rates.

Commodities

Partly in correlation with slowing Chinese economy, a strong USD and a massive oversupply, commodity prices took a big hit in 2015. Iron Ore & Oil particularly felt it the most. Iron Ore started the year around $70 US/t and has since dropped to sub $40 per ton. This was due to companies such as BHP, RIO, Vale and Fortescue bringing new production on over the last couple of years and also the anticipation of major new mines, such as Roy Hill, coming online in 2016.

Oil also suffered from the same fate as Iron Ore. It also started the year at roughly $70 US/b only to trade as low as $35 per barrel recently. Once again massive over supply is to blame for the rapid decline. Middle Eastern countries ramped up production, along with Russia, in the hope of sending US shale producers to the wall as they saw them a threat to their world energy domination. This looks set to continue throughout the foreseeable future as US shale companies remain more resilient than first thought and oil tankers sit full off the coast of many countries as there is now nowhere else to store the oil. We also have a case of Iranian sanctions being lifted in 2016 which could also bring on an extra 2.2-4.4mill barrels of oil per day by 2017.

Copper also had a bleak year in 2015. It started 2015 at $2.70 US/lb, only to hover around the $2 mark of late. However it’s not as bleak for copper as Oil and Iron Ore. It is thought that within the next 5 years we will see a deficit in supply for the commodity. This is as some older mines wind up and no major new mines are due to come online.

Australia

Despite many headwinds the Australian economy performed admirably for 2015. In the recent September Quarter figures the Australian economy grew at +2.5% year on year. Whilst this is below our long term trend of 3% it’s still a solid effort all things considered. Commodity prices have put a dampener on our economy, however this has been somewhat mitigated by the weak Australian Dollar. The weak Australian Dollar has also boosted sectors such as Tourism, Agriculture, Education and Financial Services. There are even signs that our manufacturing sector has seen better growth over recent months. Despite the falling commodity prices we are still exporting near record levels of Iron Ore & Coal which contribute greatly to our bottom line.

Our main stalwart for 2015 was the residential housing construction sector. This provided a cushion for the diminishing mining sector as some jobs were soaked up. Housing prices, mainly in Sydney and Melbourne, boomed throughout 2015, however they have seen some cooling of late. This is particularly evident in Sydney where new foreign investment legislation has tempered Chinese buying.

Despite some concerns early in the year that our economy was headed for a recession our jobs figures have stabilized and maybe even turned. Unemployment peaked at 6.2%, but now sits at 5.8%. Whilst jobs figures may not be reliable there is a trend that certainly is and that suggests that the employment market is growing once again.

The Market

Best performers for the Australian Market in 2015 were the Healthcare (+11.8%), Industrials (+11.4), REITs (+9.1) & Consumer Discretionary (+10.4) sectors. The worst sectors for the market were the Materials (-23.3%), Metals + Mining (-31.3%), Consumer Staples (-7.5%) and Energy (-34.3%).

Financials, such as the big four banks, struggled as underlying profit growth was tempered and EPS was diluted by large capital raising to meet new APRA regulations. Our biggest supermarket chain, Woolworths, met challenges from increased competition from overseas rivals and its new Masters chain continued to struggle. BHP, RIO, WPL and the like continued to struggle as profits were severely hurt due to falling commodity prices. These large caps, and what make up more than 50% of our market, forced us lower throughout the year and are the main reason we are at the levels we are at today.

Turning to the speculative end of the market. I, like many investors, like to dabble in the high risk end of the Australian market which saw some excellent gains and performers throughout the year. Top performers, like in 2014, mainly came from the IT/Telecommunications & Biotech sectors. It must be stressed when investing in such sectors you have to have rigid guidelines set and adhered to. This helps limit losses but also helps to teach you to take profits and money off the table so those all-important gains are not lost. This type of investing is also not for everyone. It is of a high risk nature and there is a chance you can lose it all.

Some of the best performing speculative stocks for us in 2015 were NOR (+384%), RNT (+126%), LAA (+70%), SMA (+225%), PRO (+300%), CVT (+150%), CNW (+100%), BPF (+88%), VEI (+43%), PPS (+68%), UML (+130%), AZY (+223%), OSL (+56%) amongst others*.

We saw a common theme of stocks back door listing via shell companies already listed on the ASX. These shell companies were often mining stocks with little to no assets left and with some cash. A group of investors would often bring an IT asset into the said company and then raise cash to help fund that acquisition and future growth. This was a lot easier than trying to list via an IPO on your own as there are far less stipulations and regulation around it.

2016 and Beyond

Obviously no one has a crystal ball and its near impossible to predict the future, but I always like to have a look at what could be the major themes going forward over the next 12 months or so.

All things being equal I would expect a positive year for the ASX in 2016. There is a proviso that the Australian economy continues to improve and we face no major headwinds. The market is always forward looking, so if it seems like the Australian economy does continue to be solid then markets will follow.

Like the US, if we continue to improve I can actually see a rate rise coming later in the year. The RBA would be keen to put some more ammo in the bank for turbulent times and to help temper any future inflation. I dare say we may see the Australian Dollar hit 65c against the US as they raise their rates further during the year. Once again this could be positive for our exporters and any company with a majority of its earnings denominated in USD.

Many commentators are predicting 2016 could be the year of another major global ‘Black Swan’ event. Where could this come from you ask? I see two possible scenarios.

The first comes from our biggest trading partner in China. It is no secret the Chinese have accumulated massive amounts of debt over the last 20 years and that the economy’s growth is cooling. If this were all to come to a head and that bubble burst it would send major shockwaves throughout the globe. We would also probably feel it the hardest.

Concerns are arising from the Corporate Bond sector in China, where once again massive amounts of bonds have been issued. The fear of a default from the payments of one of those bonds lingers and it would only take one major corporate to default and it could have massive ripple effects. The question is, is the Chinese Corporate Bond market sophisticated enough to be of concern?

As mentioned earlier Chinese property also troubles many. Many buildings sit vacant and unused throughout China. This suggests that properties are still grossly overvalued and of course we all know the massive amounts of debt associated with property in China. The sector has cooled over 2015 but many suggest this is just the pre-curser to the big event.

The above structural problems have been evident for some time in China. It’s just a matter how large they really are. The Chinese are masters are wall papering over the cracks in their economy. No one knows if or when they will come to pass.

The second scenario comes from our housing sector. Many have called for our property bubble to burst for years, but it has remained stable for some time. The Sydney and Melbourne markets have boomed over the last couple of years and only of late have begun to cool. It’s been 20+ years since we have since a major property crash here in Australia and many say it’s well overdue. However generally for property to crash unemployment must be high. Hence I don’t see this scenario playing out unless we see a ‘Black Swan’ event occurring overseas and in particular in China. This would obviously have a ripple effect for our economy.

However the thing about ‘Black Swan’ events. They often come out of left field and surprise global markets and hence many are left unprepared. This is what causes the aggressive sell downs, such as we saw during the GFC.

Back to the Australian market. Once again I see similar sectors outperforming in 2016 that we saw in 2015. Healthcare, Industrials, IT/Telecommunications should all continue to outperform. People should continue to seek stability in earnings and yield in these sectors. As the cash rate should remain low it will force investors to seek returns from our market. Companies with their earnings predominately in USD should also continue to perform strongly. As I mentioned above I wouldn’t be surprised to see the AUD sink to 65c. This increases these companies’ earnings when they are converted back to AUD from USD. Funnily enough many healthcare companies do earn a majority of their revenue in USD so look for that overlap in what could become a perfect storm.

The Australian IT sector is maturing, evolving and growing at a rapid rate. The Australian Government has recently announced initiatives to further boost this. This should translate over into our markets at some point. This is a high risk sector though, so a great deal of caution must be used.

The food staples sector should also see some positive movement in 2016. It’s no secret that the globe, and in particular China, crave our food products. From honey to baby formula we simply can’t produce enough to meet demands at this point.

I see the mid-cap space in all of the above to have greatest opportunity for growth. You need to be looking for that sweet spot where revenues are, or about to, grow exponentially, the company has little to no debt, substantial cash on hand and where the market hasn’t had the opportunity yet to push the price to exaggerated P/Es. I feel this is where you will find the best returns.

The big four banks will continue to struggle going into 2016. Underlying profit growth will be subdued and this will be compounded by further large raisings, which dilute EPS, to meet new APRA demands. I don’t see it being a bad year for the banks, and dividends still should yield 6%+, but I don’t see much capital growth over the next 12 months.

Anything resources or energy will also have a similar theme to 2015. We need to see commodity prices stabilize before we see the same in the stocks. Hopefully we will see their bottoms in 2016 and some sort of positive outlook going forward, however there is no point in trying to catch a falling knife. The sector remains an avoid for me still at this point. However keep it on close watch because when the time comes some great value could be extracted.

Well I think I have waffled on enough and this is as good a time as any to wrap things up. As always the beginning of any new year is a great time to sit back and review your portfolio and current investment goals and objectives. If you would like to do this feel free to contact me so we can sit down and discuss this and any other concerns you may have. Alternatively if you are looking to establish a portfolio and are looking to invest, now is also an excellent time to begin.

For my current clients and anyone I have had the pleasure of doing business with throughout 2015 I sincerely thank you for your support throughout the year. I wish you and your families all the best over the holiday period and wish you all a very Merry Christmas and Happy New Year. I look forward to catching up with you all in 2016 and let’s work towards another successful year.

‘Someone is sitting in the shade today because someone planted a tree a long time ago’ –Warren Buffett

Heath Moss

P: (08)8212-9632

M: 0413-799-315

E: heath@hlminvestments.com.au

*Gains on the mentioned stocks were calculated using the entry price when purchased and then the exit price when the last parcel was sold.