16 Feb 2016
This is an edited excerpt from that debate with Cornell, PPB chairman Steve Parbery, Ferrier Hodgson managing partner Steve Sherman, McGrath Nicol executive chairman Peter Anderson, KordaMentha senior partners Mark Mentha and Michael Stiassny, Deloitte partner David McCarthy, Moelis & Company managing director Colin Richardson, Houlihan Lokey managing director Nicholas Rowe, Borrelli Walsh managing director Cosimo Borrelli as well as ANZ chief risk officer Nigel Williams and chief economist Warren Hogan.
" I think in our industry we've probably been the quietest we've been in 20 years. But if there's a wave coming at us, I don't think it's going to slap us in the face very soon."
Steve Sherman, Ferrier Hodgson managing partner
Cornell: It would be useful, I think, to get everyone's thoughts on the macro picture for 2016. Where are the stresses? What sectors? Could it be a political risk? Where are you starting to see some cracks?
Parberry: There's no doubt there are headwinds and people are uncertain. We've seen real stresses and oversupply of capacity in mining services. That affects drilling equipment, rental accommodation and the like. Some of the equipment has been redeployed in our CBD areas, causing prices to drop, so it's having a little bit of a knock-on effect in that regard.
In property, we've seen some uncertain signs about growth. Where we've been getting inquiries is on presales and the ability of some of the foreign investors to complete those. So not stress but signs of noise. Does it slow down the growth and is it going to affect people's expectations on value?
The other area we have seen, and there's obviously quite a bit of agitation on it, is agriculture. Agriculture is not a huge part of the economy but it was expected there was going to be opportunities. The banks at the moment are seeing stress in part of the agriculture industry in the far north. It's nearly, I suppose, a concern about recovering some of those moneys.
So it's certainly not going to heighten people's view to spend or lend money to those sectors. In the far north we've got drought but we've also got stock levels at record lows. So when the drought comes off how are we going to fund that? How are we going to fund future growth?
Obviously oil and gas also. Most of our competitors are doing a lot of work in energy in the US. We don't think it's going to be impacted as much here but it's obviously one to look at.
Sherman: I think the obvious stress for Australia would be the manufacturing sector. I don't think Australia manufactures well but when you compare it to the capital investment in manufacturing I think we have been very slow to move away from that.
I agree the car industry is dead but we haven't seen the fallout downstream. It sort of died a natural death. There will be businesses that just can't modify themselves quickly enough and will fall away. Others will survive but they're going to have to through innovation and movement into other areas.
Property is an interesting one. In Sydney if you're within 10 kilometres of the Sydney CBD you're probably laughing but elsewhere you're not.
There are certainly stressful areas we're not seeing yet. I think our industry around this table we've probably been the quietest we've been in 20 years. But if there's a wave coming at us, I don't think it's going to slap us in the face very soon.
Cornell: You're not seeing a rising swell on the horizon?
Sherman: No, not really. It's hard to see where it's going to come from.
Mentha: I agree, there's not a lot to say, other than maybe reflect on the fact we're probably in the restructuring market the quietest we've ever been, which is reflective of the banks' provisioning.
So I think we have to adapt to that market. We're obviously very busy in South East Asia as well, Indonesia, Papua New Guinea, China, those sorts of places. We too need to put our resources elsewhere, like into data analytics.
Williams: One of the things concerning me at the moment is on the one hand infrastructure, private equity firms and pension funds are in the halo of any asset with an impression of yield on it. Yet on the other side we're seeing operating companies pretty squeezed for cash.
It really doesn't matter whether it's the Australian version in resources or the New Zealand one in dairy; they're all affected by commodity prices into Indonesia or China.
On one hand you've got a lot of money chasing assets but on the other things look a little bit more sanguine. Then you go to financial markets where for the first time in 30 years we have US swap spreads under treasuries and we've got CDS trading through the bond market. I don't understand why but what it says to me is financial markets are paying a huge premium for liquidity.
On the other hand you've got fund managers and pension funds really searching for any asset that moves, as are a lot of retail investors, and so that to me seems like a disconnect. How it transpires in 2016, I don't know whether that's an early thing or whether it's actually going to take a while to unwind.
Hogan: One of the biggest stress points everyone is talking about is emerging market and corporate debt and of course we need to watch that. But we did this a few years ago as the Asian financial system opened up.
A lot of the increase in debt reflects a more sophisticated financial system and a larger economy rather than a runaway cyclical debt binge. There's no doubt we will see some problems arise but we should look at the stress points as idiosyncratic rather than an overall macro problem.
In Asia there's this idea the economy is slowing, there's a trade recession, there's all these stresses. The reality is Asia is actually performing quite well compared to other emerging markets.
Look at the countries going through a disaster. They're right at the matrix of the stress points of emerging markets and commodities, like Russia, Brazil. Then on top of that you've got some pretty bad policy and politics sitting there as well.
Here in Australia we're only halfway through the contraction in mining investment spend. In the last couple of years the effect of that on the overall economy, on our ability to generate enough growth to keep unemployment at a reasonably acceptable level, has been about the growth in housing construction.
Anderson: I think the essential question is do you care about the growing level of debt around the world and, if you don't, is there a level of debt you do care about? If you do care, how on earth does it unwind? Isn't the world artificially awash with liquidity?
You can put your crappiest asset on the table and 25 hedge funds will come and have a look. Ten years ago they wouldn't even have walked in the door. So at the moment banks have an exit. You had that pre GFC also, banks had the ability to get rid of stuff which they probably shouldn't have. What exit mechanisms will be available when the liquidity cycle turns?
Warren's telling us investors are going to get a 2 or 3 per cent return if they're lucky in the current environment because we're completely awash with artificially induced liquidity. By definition people have to get a lower return and they're going to get that until the liquidity dries up.
Hogan: Am I worried about it? Yeah. The world economy has seen a substantial increase in debt following the global crisis of 2008. Some estimate the increase at $A57 trillion over eight years.
If the GFC was a debt crisis we have responded to it by putting more leverage into the system. The governments of the advanced economies have only recorded higher debt levels at times of war.
The debt is supporting asset prices via the forced reduction in long-term rates of returns. The problems is if the underlying income streams supporting those asset prices falls short of expectations, we will have a significant valuation problem.
Am I worried about it in Australia? Not at all, although the government does need to be very careful. The tolerance level for debt in Australia is a lot lower than most other countries because we have much higher household debt but the reality is our government has very low debt levels compared to income.
Stiassny: So if you're looking at a risk there, which is what I think we should be doing, how do see what's happening with ISIS, Turkey and Russia?
Hogan: I can't factor in geopolitical disturbance because I can't forecast it. I'm not forecasting economic distress but I'm sure you will all agree it wouldn't be too hard to get a downturn. We're probably due a downturn.
Stiassny: Let's just talk about tourism. Increasing prospects of terror attacks will change how most people think about travel, obviously.
Hogan: I would not disagree with that and tourism is a critical global industry. In an aging wealthy global population tourism is the one thing people will spend their money on. They're not going to buy a lot of cars.
Stiassny: The most fundamental issue we have is funding, available funds kill or hides a lot of the issues. So we are facing one of the quietest years we've ever had. It's simply about the fact there is always an alternative funder available. So you look at even city councils, short of money, selling assets. In New Zealand the rich are turning up to buy in big numbers. There's always someone around who can't find a home for their cash. I think that changes the whole world.
Agriculture is a basket case but has been hidden so well. So the commodity issues are really big. We have never adapted in New Zealand, so we're getting hit really badly. It's the farming 50/20, if you take five farmers, one is bleeding to death. Three are just surviving and one is sitting there with so much money in his pocket waiting to pillage the other four. That's kind of the model, isn't it?
McCarthy: They're very rational observations you've made but, if we think about it now, every tradeable commodity is in massive oversupply and it got there because of the enormous investment and debt that piled into all these places around the world on the assumption steel consumption/production would continue to grow at 20/25 per cent.
What didn't we know between 2006 and 2013 we know now? Why did we think or why did educated large companies think it was going to keep going like this when you've got very rational observations and you seem to have a good amount of data, particularly around China? What made people think that was going to continue?
Hogan: The bulk commodity producers turned out to be a bit too ambitious about steel production and demand. At this stage it looks manageable from a coal and iron ore perspective. That of course assumes China remains on track over the decade. There is little scope for a significant drop in the demand for steel from here.
Williams: On a lot of that commodity stuff, don't forget out of GFC China had the biggest financial stimulus of any country. So the demand curve for that commodity was very rapid and then supply and response takes a bit longer to actually come on.
Fifty per cent of the New Zealand dairy debt is in 20 per cent of the farmers but there's a large number of farmers who are still profitable in dairy prices where they are and there's a number of the iron ore producers profitable here.
Coal, there are number of companies and projects that still look good. If you take the pay arrangements, they're a lot more difficult.
I've got one other issue which I'm a little bit concerned about and that is it comes back to this idea about where money is actually going and the ability for liquidity to be withdrawn. You just look at this last 12 months of banks which have come out and said they are reducing the size of their balance sheets because they are not getting sufficient return on capital.
Standard Chartered have a targeted return on equity by 2018 of 8 per cent. They are going to do that by reducing risk weighted assets. All these reductions add up to something like $800 million when you throw in a few other banks. It's quite easy to see there's a trillion dollars of assets in what are Asian-type markets actually being reduced. That's huge.
Richardson: But you've got the alternative finances coming in, of course.
Williams: Absolutely, but that's coming from the US and Asia.
Richardson: The issue is it's going to cost you more. The price of the money is going up. I think in terms of 2016, we're playing the same game. We're all, in our industry, salivating over what might happen as money gets tighter. So there's going to be quite a lot of work to do.
At Moelis we're thinking of opening up an office in the west because we think there's going to be a restructure coming our way. It all sounds a bit negative doesn't it? I think the saviour will be the currency. If the currency is not in the US60c range by end 2016 I will be very surprised.
Rowe: I think there will be a reckoning. It's often the boards who don't always appreciate the options available to address the problem. They want to wait until it goes over the cliff and you restructure from the resulting base position, as opposed to manage it in advance.
I think our view of restructuring in this market has been it's preferable to solve a problem when it's apparent, as opposed to solve a problem when the capital stack itself becomes difficult or impaired and you can't turn that around.
Boards often don't see a time imperative or they're unsure how to address the capital structure. I think boards and management often leave it too late. Once it has gone past that point, it's hard to restructure when it's broken.
Cornell: Cos, could we get a Hong Kong perspective?
Borrelli: if you look at where we work, Hong Kong and China to us are effectively one business. Singapore and Jakarta are effectively one business. When the GFC came along China came to a stop. Hong Kong's role as a merchant came to an end and everything suffered around that.
Hong Kong has been struggling with the sharemarket and Singapore at the same time took a bit hit from the commodities market. The shipping industry, which was very, very big in Singapore, has created a huge mess.
Indonesia is really suffering because of what's gone on with commodities and manufacturing in China. But what we've really seen recently is the impact it's having on construction.
For some reason cash in construction just isn't there. The impact it's having on the retail markets is huge. We've had a busy five years, a really, really busy two years, but nothing like the last weeks of 2015 and that was primarily from the smaller commodities businesses out of Indonesia.
Something has happened with the coal industry in China. The bankers and the government decided to let the professionals have a look at, whereas they have been trying to contain it beforehand. I'd call that a reduction in government support from the industry.
The next BlueNotes debate will look at the fallout from digital disruption across the economy.
Andrew Cornell is manging editor at BlueNotes
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
16 Feb 2016
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