AMP announces its themes for 2014 for the Australian market.

As the country prepares to mark Australia Day, AMP Capital has identified the key themes investors in Aussie equities should celebrate and those they should look out for this year.

AMP Capital Co-Head of Fundamental Equities Michael Price said: “Australian equities are a key component of many investors’ portfolios and there are reasons for investors to be positive about the asset class this year. There are signs M&A activity is increasing in response to a rising market while housing construction is also recovering.

“On the flip side, investors should be aware mining capital expenditure is continuing to be rolled over and this may have an impact on the economy more broadly and companies that service major miners in particular. Australian retailers’ supply chain management will also be an issue to watch.

“Aussie equities are a popular investment because they offer the potential for capital growth and income, tax advantages such as franking credits and liquidity in a market most local investors understand and feel comfortable with. They are often the first choice for investors ready to return to financial markets at a time when share valuations are still reasonable.”

The key themes are:

The return of M&A activity

After three to four lean years, mergers and acquisitions (M&A) activity in Australia looks set to increase along with the local equity capital market (ECM). There is a healthy initial public offering pipeline in place for 2014 with signs suggesting the return of contestable M&A. Periods of rising M&A and ECM activity are typically associated with rising margins for those companies linked to such activity. With both rising revenues and improving margins, Australian companies linked to capital markets are set for a strong year in 2014.

Housing construction recovery

Interest rate cuts have taken longer than normal to trigger residential activity due to concerns among consumers around job security and a desire by households to pay down debt. But the pick-up in demand the Reserve Bank of Australia (RBA) has been looking for is finally occurring in a coordinated manner across Australia. House prices are rising, finance approvals are picking up and housing start numbers are at levels consistent with previous peaks. A significant increase in demand for products such as concrete, bricks, plasterboard, glass, steel and concrete roofing, combined with the high fixed-cost nature of building product manufacture, should ensure a housing construction recovery translates into a large leap in profit for most operators. An improving housing market should also support hardware and electronics retailers.

Retailers to face increased sourcing costs and scrutiny on supply chains

Australian retailers’ supply chain management and supplier factory standards will continue to be scrutinised this year and laggards might face brand damage. In addition to margin impact from potential weakness in the Aussie dollar, retailers’ margins could also be impacted by continued wage inflation in Asia, most notably in Bangladesh where minimum wage inflation has lagged China. Emerging sourcing locations, such as Cambodia, also pose brand and operating risks.

Australian mining capital expenditure to continue to roll over

Investors should be mindful of the decline of mining capital expenditure, which is likely to impact companies providing services to the major miners. Factors such as uncertain demand from China and a lower commodity price environment are resulting in project deferrals and cancellations, and the rolling over of mining capital expenditure. Current market forecasts for many of the companies providing services to the major miners, notably those exposed to iron ore mining capital expenditure, continue to look too high and further downgrades are expected during the next 12 months.

All eyes to China

AMP Capital’s view is that Chinese growth will be around 7.5 per cent this year but it is the composition of this growth that is of particular importance. For example, if investment as a percentage of GDP dropped from 50 per cent to 30 per cent it would have a much bigger impact on resources demand than a change in GDP growth from 8.0 per cent to 7.5 per cent. Demand for copper and steel are still high by traditional standards, driven by a similar set of end-use sectors: infrastructure, construction and manufacturing. However, investors shouldn’t necessarily expect more of the same in China. Credit growth has slowed considerably during the past two months and the government appears determined to tighten liquidity conditions this year and in particular the growth of the shadow banking sector. We should expect demand growth to weaken from credit intensive sectors later in the year especially sectors that are highly carbon intensive as environmental controls tighten.

LNG will be a focus

The most interesting development in the Australian energy markets will be the commencement of the huge Gladstone liquefied natural gas (LNG) projects. While this could be a boon to the Australian economy, there are a few things to consider. LNG from the east coast of Australia is sourced from coal seam gas, which carries higher operational costs and potentially lower profits meaning tax revenues from these projects may not be substantial for many years. Also, if the new volumes of LNG being sold were to buoy the terms of trade considerably as some expect, the Australian dollar could be more supported than the RBA would like, providing a conundrum for interest policy.

Executive remuneration and governance in the spotlight

A number of companies have received their first strike since the introduction of the ‘two strike’ rule and a continued focus on executive remuneration is likely in 2014. As a result, companies that continue to have remuneration structures poorly aligned with shareholders’ interest and/or poor disclosure on remuneration details as well as companies with poor overall governance structures might see significant ‘against’ votes in 2014.

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In an age of instant communication in which investors have become drawn into the daily contortions of financial markets, it pays to stand to back and consider some of the longer-term themes.

Many of the most rewarding investment returns in the last two decades have been the product of the most compelling and intuitive narratives.

The emerging markets became a bone fide asset class and the “BRICs” moved from marketing gimmick to a serious engine of economic growth.

The term “commodity super-cycle” was coined to reflect the resource hungry demand of industrialising emerging markets. Rallies in finite resource sectors such as oil and metals, or in internet stocks, or in gold in an age of money printing have all garnered investor attention based on persuasive premises. 

Investors have always been drawn to compelling narratives. Turning points in markets are often associated with the emergence of a new story or the widespread adoption of an existing one.

Change is afoot
The world today is barely recognisable from 1980. The developed world is likely to see slower growth rates for some time due to the multi-year deleveraging required to reduce the high debt burdens created by the financial crisis. The outlook for growth in emerging markets remains far in advance of the developed world and the gap has been exacerbated by the ongoing effects of the financial crisis.

The cornerstone concept of ‘risk free’ is being reassessed in the light of the Eurozone debt crisis and has significant implications for investors. Meanwhile, recent developments in the energy space are significant, with the commercial exploitation of shale gas & oil discoveries likely to make north America a net exporter of hydrocarbons. Investors must take stock of these shifts and consider whether they have adequate exposure to the fastest-growing parts of the world.

Long-term themes for investors to consider
Here are some of the most prominent multi-year themes that are likely to have a significant impact on investment returns.

A ‘two-speed’ world with a shifting balance of power: Emerging economies are benefiting from a multi-year shift in the global balance of economic power.  The investment universe is becoming increasingly polarised between low-growth, mostly developed world economies and higher-growth, mostly emerging economies. The fallout from the credit crunch is a multi-year hangover as developed economies face macroeconomic headwinds.

The US dollar’s position as dominant reserve currency will be challenged: The loss of the US sovereign’s triple A rating and the rebalancing of economic power will support calls for a new reserve currency system, particularly as the Chinese renmimbi (or Yuan) is increasingly internationalised.

Do not underestimate demographics: Demographics are perhaps the least understood, yet most significant of multi-year trends for economies and investment markets. Some countries have already consumed their demographic dividend; others are now reaping the benefit of young and productive working age populations.   

The reassessment of “risk-free”: The conceptual cornerstone of risk-free assets in the shape of triple-A rated government bonds has been shaken to the core, due to the sovereign debt crisis. Investors will be forced to reassess outmoded ideas about risk. In a developed world characterised by low bond yields, investors are likely to embrace income as a means of boosting total return. This will mean a move up the risk spectrum in order to get yield, with equity and property playing a greater role in providing income. 

The age of the emerging market consumer is here: Consumption in emerging markets is growing strongly and this theme has the power to support equity investment in companies based in emerging and developed markets who can take advantage of this growth.

Don’t write off the US just yet: The US may have lost some of its dominance but the obituaries are premature. Despite the rise of the BRICs, the US remains a dominant economic and consumer power, well ahead China and India in per capita growth terms, and with a long track record in creating in creating shareholder value.

Energy shake-up: The discovery and commercialisation of extensive shale-based hydrocarbons in North America are a game changer in the natural resource landscape that will have a significant impact on the balance of power in energy markets.

Watch out for the “disruptive” technologies: The impact of disruptive technology is one of the most powerful forces in the corporate sector, creating billion dollar companies like Apple, Google, and Facebook, while relegating other firms to obscurity. Distinct ages in technology are now apparent – 1990s was the decade of desktop internet; the 2000s moved into mobile internet; and the 2010s seem set to become the decade of cloud computing.

Time taken understanding the narratives driving current and future investment thinking is invariably time well spent.
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