A strong rebound in the last quarter of 2015 for Australian equities masked some wild price swings during the period that included a late Christmas rally of 8% as end of year buying and short covering saw the S&P ASX 200 index post nine straight days of gains as stocks prices were ramped higher.  The rally has however been short lived as 2016 started with eight straight days of losses, wiping out all those gains from the “Santa Rally”.

While we didn’t see the need to address the “rally”, it’s important to consider some of the reasons market commentators and media analysts have suggested for the sharp decline experienced so far this year. Some of these issues are important for markets going forward, but others we feel are simply short term market obsessions which won’t impact company profits and distributions in the medium term.

“China is Slowing”

What does the market commentary around China really mean when analysts and articles state “China is slowing”?  The rate of growth in China is indeed slowing, but the economy is still growing, albeit at a more sustainable rate.  In 2007, GDP in China was $US 3,524 billion and growing at an unsustainable 14.2%, while in 2014 growth had “fallen” to 7.3% but the economy had almost tripled to $US 10,352 billion.  Officials are targeting growth of 7% for the current year, but even if it grows by “only” 6-6.5%, the increase on a $US 10 trillion economy is much greater in absolute terms than 14% on a $US 3 trillion economy.

As China has progressed from a developing economy to being the world’s second largest, policy makers are looking to transition the economy from one driven by construction and industrial production to a more balanced developed economy where the consumer and services sectors make up a much larger proportion of overall economic activity.  This has been a deliberate and sensible policy, one followed by other countries as they transitioned from developing to developed economies – the US, Japan, Taiwan and Korea are all good examples.  Perhaps more important than the numbers above, in 2007 GDP per capita was $US 2,675 which by 2014 had risen to $US 7,591.  This is an important investment thematic for us as we see the increased wealth and spending power of the middle class in China as being a key driver of growth going forward.  If your wealth tripled in seven years, you would be a lot more confident and inclined to spend and invest.

While the mix of Australian industries benefiting from the rise of China will change to increasingly  include sectors like education, financial services, property and tourism, our low cost minerals and energy producers will continue to participate from the development of a much larger economy.

“Rising US rates will derail markets”

On a total return basis in Aussie dollar terms, the Australian S&P ASX 300 Index actually outperformed the US S&P500 in 2015.  Despite perceptions that rising interest rates in general are a negative for asset prices, in the US, interest rates are going up because sustained growth has returned (albeit at relatively low levels) and economic conditions are normalising.  We see both the increasing robustness of the US economy and the return to a more normalised interest rate environment as a clear positive.  While a rising rate environment will make things more difficult for companies within the US, a strong and growing US economy is a much needed lynchpin for global growth as a whole.

In the post GFC environment, we think people have forgotten how large an impact the US economy has, and the impact on the world economy as a whole of a return to more robust US growth (and given policy settings are still very accommodative we see increasing growth as likely) may have been underestimated.

“The Oil Price is Collapsing”

Oil is already down 15% this calendar year and shows no immediate sign of turning around.  While this is obviously a negative for energy stocks, low cost producers, such as Oilsearch and those with strong balance sheets like Woodside, will benefit from the removal of high cost producers from the market.  What has driven the extreme fall in the oil price has been the reluctance of low cost producers such as the Saudis to reduce their production in conjunction with the delay in high cost US and Canadian production being shut down.  OPEC and the Saudis in particular are looking at protecting market share.  The low cost of capital and the relatively healthy balance sheets of US shale producers going into the drop in prices has also meant that they have tried to hold on and keep producing longer than many expected, despite prices dropping below their cost of production.

Contrary to many reports (particularly around China), oil demand has continued to increase to record levels, but it has been outstripped by supply.  We are already starting to see this correct, as the number of producing wells in the US has been falling since May.  This is expected to start hitting production numbers in Q1, 2016 and we expect oil prices to stabilise and recover when this occurs.

On the flipside, it is important to also remember that a low energy price is hugely beneficial for the rest of the economy, particularly the consumer.  Studies have shown that with a lag, consumers do spend their extra disposable income after fuel prices fall.  This windfall should start to benefit retailers and consumer companies over 2016.

Elston’s philosophy

The big winner in terms of investment style in 2015 was momentum investing, with share price movements becoming the major driver in investment decision making.  This style is also inherently short term in its horizon.  At Elston, our investment philosophy is driven by the ultimate value of companies, on their earnings prospects in the medium and longer term.  We believe that as the economic cycle progresses, this creates opportunities to buy quality companies at cheap prices for the benefit of investors as market conditions change.  This means at times, we are investing against the consensus and we will experience periods when performance relative to the market suffers as we ignore the trendy trades that often end poorly when the music stops.  However, we strongly believe that this method of investing will create value for investors over the long term.

If you would like to speak with one of our advisers for more information please contact Elston on 1300 ELSTON or email info@elston.com.au and someone will be in touch.