8 September 2015, Stockholm, Sweden | News
The performance of China's economy is a concern for the stock market. But on the upside is Europe, which seems to be heading for improvement, plus strong domestic demand in Sweden. If the fears about China subside, it will be a good time to rebalance to a greater proportion of engineering in the portfolio towards the end of this year.
This is according to Ulf Strömsten, fund manager for Catella Hedgefond.
Company reports for the second quarter were reminiscent of the first quarter; large foreign exchange gains but not such impressive underlying growth. Overall, the reports were in line with previous forecasts, with divergence of a percentage point or so in sales and operating profit.
According to Ulf Strömsten, the focus this time was less on the reports themselves and more on what companies are saying about the outlook in China. The country's GDP growth during the first two quarters was 7 percent, although official Chinese statistics should be taken with a pinch of salt. This year saw a sharp rise in the Chinese mainland stock markets, with many companies assigned soaring values and p/e ratios, and in late summer there was a similarly dramatic decline.
"The reason for the upturn seems to lie mainly in the ease of borrowing on reasonable terms. In the same way that people borrowed and pushed up property prices two or three years ago, there has now been a surge in borrowing to finance share purchases. No one can accuse the Chinese central bank of sitting idly by– since November last year it has cut interest rates on five occasions, it has eased reserve requirements on four occasions and, on top of this, it has devalued three times. Each measure was initially welcomed by the market, and this fuelled the rise on the Shanghai stock exchange," says Ulf Strömsten in a conference call with Catella Fonder's Mikael Wickbom.
According to Ulf Strömsten, it can be difficult to analyse China through Western eyes. The country retains remnants of its old economy, mixed with a deregulated market. It is uncertain how individuals in China will react to what is happening in the country's economy, but if we look at the accumulation of wealth in property we can draw parallels with developments in Western countries, suggesting that in many respects the Chinese seem to reason and act the same as Westerners.
A hard landing for the Chinese economy is, however, unlikely. The country is centrally controlled and the government has large resources enabling it to intervene to prevent this. But whether or not China's stock markets have now fallen sufficiently is a different matter.
"We are still seeing intervention, with the government buying equities, so it is difficult to believe this trend has yet reached an end. I believe it will be important to see data evidencing that the economy has bottomed out and that the measures taken are beginning to produce results before we can speak with certainty of the stock market having levelled out," says Ulf Strömsten.
From a Swedish perspective, listed companies are not yet talking of falling sales in China, but they are talking of stagnation.
"I recently met with Autoliv, and China is its most important market. It is clear that the company is noticing a drop in demand for cars. Its view of China has not changed, but volumes are weaker in the short-term. Looking at the German car companies that have reported, BMW says that June was down and there are similar signals from other automakers. But in general the forecast for the full year suggests there will be growth of somewhere around 5-7 percent in automotive demand," says Ulf Strömsten.
Demand for consumer products such as cars and mobile phones has long been extremely strong in China. Exports as a percentage of Chinese GDP have been on the decline for a considerable period, and today account for a little over 20 percent, a decrease of 3-4 percentage points over the past few years.
China's ambition to rebalance its economy to being increasingly based on domestic investment and private consumption is happening against a background of declining competitiveness against other emerging markets. The country's increased prosperity over time has directed a large amount of money into private consumption of cars and mobile phones, and the downturn now occurring is taking place following a period of very high growth.
The United States is still focusing on if and when the Federal Reserve will begin to raise interest rates. Ulf Strömsten says that US full-year GDP growth of around 2.5 is still the expectation, but because the US economy is so largely driven by domestic demand, the country is more sensitive to interest rate changes than events in China, for example.
"But there is another uncertainty; if China seriously begins to stimulate by using real money to boost its economy. China remains the largest financier of the US budget deficit – does this mean it will become more difficult to finance the current deficit in the United States? And I don't mean difficult, but more difficult – the starting point is low. If this is the case, it could contribute to increased concerns in the bond and currency markets," says Ulf Strömsten.
Global GDP growth and economies are currently difficult to assess. There is no inflation to speak of, despite relatively good employment, which could possibly indicate that we are facing a normal slowdown – even though central banks are stimulating as if their economies were in acute crisis.
"Jan Häggström at Handelsbanken wrote an interesting article about this in the bank's latest economic forecast. The employment situation in the United States, Germany and, to some extent, Sweden is at levels where we really should expect much higher growth and inflation than we have. So the normal situation that we have strived to regain, with 2 percent inflation – if we can't achieve this when we actually have a labour market that is very close to where it should be during boom periods, what should we expect going forward? Perhaps normal growth in the future will not be above 3 percent, but rather 1.5," says Ulf Strömsten.
The stimulus measures taken by the ECB have nevertheless shown signs of boosting European momentum. Although growth is still low, the forecasts are higher than at the beginning of the year. China is certainly a concern, but the country is not a very big trading partner for the EU area.
Looking at the changes that have taken place in Europe, two countries have experienced an upward adjustment. Both Spain and Italy are showing stronger growth, and this has been the case in Spain for some time, which means that the prospects for the full year are fairly good. The problem in Europe continues to be France, where there are no visible signs of economic revival, but the European recovery is broader now than it was at the start of the year.
"It is clear that the EU, like the United States, can grow independently even if growth is slowing in China. But it is important to maintain confidence in the European economy if we are to see a virtuous circle. If this continues, Sweden, with the changes we have seen in the krona against the euro and with our export markets, will have better prospects for growth than the rest of Europe. And the conditions appear relatively positive for the final quarter," says Ulf Strömsten.
The Nordic countries face specific problems. The collapse in oil prices has hit the Norwegian economy hard, and expectations for the country's growth have been lowered to 1.1-1.2 percent for the full year. Although Norway generally has high production costs for its oil since it is offshore, Ulf Strömsten points out that many fields still have costs below the market price. This means it is still possible for Norway to make money, as evidenced by Statoil's decision to outsource major contracts for the operation and maintenance of its platforms.
The current crude price of around 50 dollars per barrel for Brent crude means that the price has recovered slightly from its low a couple of weeks ago. Ulf Strömsten says that OPEC's production costs average just below 40 dollars per barrel, which could serve as a kind of floor for the price.
The Catella Hedgefond fund has the ability to "go short", which means it can short sell assets when it expects a downturn, and it has done precisely that in Norwegian oil.
"At the same time, we should be aware that the trend has been weak, so I do not believe there is much more to take beyond what we have already made from these positions," says Ulf Strömsten.
Looking ahead, there is reason to keep an eye on what happens to oil prices. If we anticipate an upturn it will be a very interesting market to invest in, given the large declines we have seen. But Ulf Strömsten believes it is still too early – Catella Hedgefond is a low-risk product, and there is still too much uncertainty about oil prices to justify a long position in the sector.
Finland is in recession and the country is partly being hampered by sanctions against Russia and the weak performance of the Russian economy, and partly by the strengthening of the euro. Catella Hedgefond consequently has more short than long positions in Finland. The prospects for the Danish economy have been good, but the country's private consumption has been somewhat disappointing. One reason for this is that Danish households are highly indebted, which is a restraining factor.
Sweden is in many ways better off than our Nordic neighbours. Significant reasons for this, according to Ulf Strömsten, are the ECB stimulus package and signs that the European economy is recovering. Although China should not be ignored, growth in Europe, and especially northern Europe, is still the most important factor for Sweden. Exports to Norway and Finland are affected by what happens in those countries, but on the other hand things are looking brighter for countries such as Germany, the UK and the Netherlands.
"At the start of the year I predicted that the index would rise by 14 percent for the full year, and I actually still stand by this," says Ulf Strömsten.
As for the Swedish sectors and companies that are most interesting right now, we would avoid companies with large exposure to Asia in the short term. Sales in Asia average around 20-25 percent for Swedish industrial companies overall, so the region is important. Ulf Strömsten names Autoliv, Volvo and ABB as companies with a large share of sales in China and other Asian countries, while Trelleborg is an example of a company with lower exposure.
In the very short term, the conditions are best for sectors with little or no exports, such as banks, private consumption and real estate. These are sectors that have recently performed well on the stock market, but because the probability is still higher that European central banks will lower interest rates rather than raise them, the prospects remain good. Ulf Strömsten points out that domestic demand in Sweden is good – the July private consumption figure was very strong and the rainy summer has acted as a strong remedy for retailers.
"But if our scenario of stronger growth in Europe and a levelling out in China comes to fruition, we will at the end of the year rebalance from domestic sectors and move towards the more export-oriented companies. In that case it will be mainly engineering that is weighted upwards," says Ulf Strömsten.
He says that particularly attractive companies in a rebalancing would include ABB, which is in an interesting phase as many countries – not least China – are moving towards increased industrial automation. As China's exports have experienced decreasing competitiveness in tandem with rising costs, industry has been responding by cutting costs and increasing their levels of automation. Lower interest rates additionally make it easier to implement this kind of investment.
Autoliv is also interesting in the longer term.
"Autoliv has been hit very hard in the short term by the Chinese slowdown, but I believe that underlying demand has not changed at a pace to match the fall in its share price. So this is also a typical company that we should eventually switch into," says Ulf Strömsten.