Carol Austin interview transcript

Carol Austin – Contango Asset Management – Mike Pascoe

CA The important thing with China is what’s happening in the construction side of the economy. Construction uses lots of things like cement and steel and aluminium and we make a lot of cement and a lot of aluminium so that’s very good for us so China’s overall growth is one thing but what’s happening on the construction side is a very different question and construction has slowed down sharply because the Government tightened policy and they’ve loosened policy and construction has taken off again. That second wind in construction is underpinning increased demand for steel, bulk materials, and is driving an upturn in prices of those goods.

MP So the overall Chinese economy is kicking on almost too strongly again?

CA No we haven’t seen pressure on interest rates. We haven’t seen pressure on inflation. The authorities are in the game of fine tuning which is a risky game but at the moment they seem to be successful.

MP So the implications for us, the China boom has further to run.

CA The China boom certainly has further to run but importantly the commodity boom has further to run. We saw steel prices come off quite sharply. We were going into a round of coal and iron ore negotiations off the back of falling steel prices. We’re now going into those negotiations with steel prices rising.

MP So it appears BHP and Rio have more upside than the market realises.

CA The market is now starting to get much more bullish on the outlook for bulk commodities. For iron ore in particular but also for coal. If steel producers are making more money by getting higher prices then they can be in a better position to pay higher prices for the raw materials.

MP Isn’t there a bit of a conflict here that while iron ore and coking coal prices are high and demand is high, is there a bit of a conflict here that while the prices of coking coal and iron ore are going to be high there is an oversupply of some types of steel in parts of the market aren’t there.

CA China is the major source of oversupply of steel. China is growing its steel industry at 20% a year. It is the biggest single producer in the world, so when the large producer grows at 20% there is a global glut but if China’s demand grows very rapidly and China’s demand for steel has picked up quite strongly in the last couple of months then that excess supply has been taken out in the home market and not flooding the global market, so China is absolutely the swing player in the steel market and as a consequence in the iron ore and coal markets.

MP So that 20 to 25 million Chinese are expected to move each year from the farm to the city are just having the inevitable impact.

CA Absolutely. The construction boom in China is going to go on. Urban migration is going to generate huge demand for housing, for offices, for roads, for schools, for airports. All sorts of infrastructure that need steel that needs cement that needs industrial materials. So as long as China’s demand is strong then you can see that we will see strong demand for these activities, but if it gets too strong and you start to get speculative price increases as we saw in the Shanghai property market the Government steps in and introduces measures to slow the growth and inevitably that slowdown can be quite acute and it has a direct impact on demand for steel. So we saw that in 2004. Steel demand fell away very rapidly with the slowdown in construction but now that’s bottomed and it’s actually taking off. In July construction activity was growing at 30% a year. That’s a good support for steel.

MP Is that a scary number. Does it sound a bit unsustainable.

CA We were looking at 80% growth in the height of the boom, so as long as it stays around current levels then it is good for steel demand. It is good for Australia. And importantly, it’s shifting demand back within China to domestic sources. One of the things that Australia has to be worried about is if China becomes too dependent on export growth because if that happens, then when the US slows, China slows and the world slows.

MP There’s a couple of things out of that. First of all though, does it have to reach a stage of maturing. I mean, growth of that level, the number of people coming into the city, urbanisation, does it have to reach a mature level where it stabilises. Still at a very high level of activity.

CA We’re a long way away from stabilising. China’s still at that take off phase and so as long as it can manage its imbalances, it’s internal imbalances it can have solid growth in infrastructure development for another decade and that would provide the demand that will keep prices high and we need that demand because Australia is expanding iron ore mines. Brazil is expanding iron ore mines. The same thing is happening in India. If we don’t have that solid growth on a continuous basis for the next decade, we’re going to go through the typical commodity cycle that we’re only too used to in Australia.

MP Before we get onto the impact on the Australian economy internally, what does it mean for investors. As an investor. As a wholesale funds manager, what are you doing about it.

CA Well we’ve been very bullish on companies like BHP and Rio Tinto. We think the demand in China that’s fuelling commodity prices in metals is also fuelling demand for oil so we’re also bullish on oil. Those resource sectors we think are going to continue to surprise on the upside.

MP Is it too early for a secondary kick on away from resources. Is there another value add available to us coming around the corner.

CA The companies in Australia that are benefiting indirectly from the resources boom are the construction companies. The mining companies are expanding capacity. They need new roads, new railways, new port facilities. They also need new mines so contractors that are supplying mining services, engineering services, they’re all doing very well. Anyone that’s supplying services to the mining sector is doing extremely well. The Governments have worked out that they haven’t invested in infrastructure for decades and they’re starting to spend on infrastructure. So that whole sector is going to do very well over the next several years.

MP The caveat there is that they price their contracts properly and allow for inflation.

CA Yes, this is true. This is true.

MP An expensive lesson for some. The other implication is the Australian economy itself. We end up having a dichotomy between the resources related and the consumer related?

CA Australia has had an extraordinary dream run for the last decade. Solid growth has been underpinned by very good increase in our terms of trade. Basically the world has been paying us a lot more for what we produce and we’ve been paying a lot less for the things we buy. Imported goods from Asia are falling in prices, the goods we’re exporting particularly resources are going up in price. That’s just a dream run and it’s not going to continue forever, but it’s underpinned. Good growth in profitability, strong employment growth. It has been extremely good for the Australian economy. The challenge going forward is when we don’t get that free kick from rising terms of trade to actually grow productivity and to increase wealth from our own activities.

MP Does the currency therefore swing on the higher side again. Does that begin to impact us?

CA The major moves in the currency are driven by the US dollar. If the US dollar is depreciating we will appreciate. If the US dollar is appreciating, we will tend to go down the back of it. The big moves in our currency have tended to be US dollar related. The only times when that hasn’t happened is when we’ve really sort of shot ourselves in the foot and gone through periods of depressed economic activity at home.

MP So our currency is not going to continue to move higher because of the trade flows.

CA We have managed to spend at a very great rate so that the mining boom hasn’t translated into large current account surplus as one might expect at this stage of the cycle. Our consumers have been spending at a very rapid rate so we are looking in Australia at a current account deficit that you would expect at the bottom of the commodity cycle, not at the top of a commodity cycle. So it is unlikely that we’re going to see the currency move up to high levels that you typically see the peak of a commodity boom because our consumers are dragging in imports at such a great rate that we’ve got balance of payments problems, notwithstanding boom conditions in commodity markets.

MP And the implications of that down the track.

CA The implications for Australia are the same as the implications for the United States. You’ve got to be able to pay your way. If commodity prices come off and consumers keep spending at the rate that they are, our current account deficit gets a lot worse and the way in which you adjust to that is slower domestic growth and a weaker currency. But hopefully the expansion of mining capacity means that we will be able to build our exports and rebalance our current account without those rather traumatic adjustments.

MP We also have a situation of a geographical split developing in Australia between the resources states and the rest. If that keeps going?

CA I think there’s every chance that that will keep going for some time. The resource boom looks like being a protracted boom. China is not a one year wonder. China is going to be a secular trend that affects Australia for the next decade and so you could expect to see increased expansion of mining capacity into the next decade which means WA and Queensland is set to do a lot better than the popular states of NSW and Victoria.

MP From an investors point of view, beyond real estate, is there a lesson in that. Is there something to be taken from it?

CA Well certainly the capacity of Governments to tax is dependent on the capacity of companies to make profits so one would have to believe that the mining states are going to be better positioned in terms of their capacity to generate revenue from their companies and therefore provide services locally. Which is always good for businesses in that area.

MP Now Contango is a wholesale funds manager. The average punter can’t invest there. What is your methodology. What is your pitch?

CA We believe that you have to understand what’s happening in the global economy before you pick stocks. So if we want to know whether to buy or sell BHP we analyse global trends. We look at what’s happening in China. We look at Government policies in China. We look at demand for steel. We look at demand for iron ore and coal and we take a top down approach to determining what we think is going to happen to individual commodities, commodity prices, demand for commodities and then we take that and analyse what it means for individual companies and we think that is a better way of approaching it than starting with the individual company and working out how that company is going to perform.

MP Can you give me an example of just drilling that down. Step by step.

CA Resource companies are obvious examples. Another area would be views on interest rates. We think that the outlook for interest rates is very important for thinking about what’s going to happen to property trusts. What’s going to happen to banks. Just generally any interest rate sensitive activity. So we spend a lot of time thinking about what’s driving global interest rates and how that will affect the Australian market and then with that top down view, we have a'¦ form a view about whether we want to be exposed to these sorts of things like property trusts.

MP And then once you do that, once you decide yes, resources are the go, or property trusts are or aren’t the go, what’s the next level in your process.

CA The next level we do what everybody else does, with that starting point we then look at individual companies and see whether the management is going to exploit those opportunities or whether it’s going to fly in the face of them and underperform. So the top down gives you an idea of where to go looking for the outperforming sectors and which sectors to avoid, that you’ve got to do the hard work of analysing individual companies to make sure that management can exploit those opportunities.

MP You raise an obvious question there. What is going to happen to interest rates.

CA The Fed is going to continue to edge up its rates but the bond market has been thumbing its nose at the Fed for the last year. It’s basically saying it’s going to run its own race. And we’ve been saying for some time that bond yields were range trade in the United States and the United States sets our bond market here, so we think they’re basically on a tread water for another 6 to 12 months.

MP And the cash rate in Australia? Reserve Bank policy? That doesn’t really matter so much?

CA There’s a lot of uncertainty in US at the moment. The US looked like it was going to pick up momentum but a few hurricanes have put paid to that idea but importantly they’ve also created a lot of noise in the system. The data coming out is going to be all over the place. Employment numbers are going to collapse, then maybe they’ll bounce back as people go to work. You’re going to have the growth numbers being impacted by the fact that you don’t have a job to go to because the company doesn’t exist. You’re going to see for the next 3 to 6 months really distorted numbers coming out of the US. And the Fed is going to have to grapple with those. It would be a brave governor in Australia that raised interest rates when there was a lot of uncertainty about the global economy.

MP In terms of domestic pressures, there aren’t any?

CA Surprisingly wage pressures have been quite modest in this cycle and I think it’s because a lot of sectors of the Australian economy are subject to global import pressure. If you’re in manufacturing you’re certainly not raising prices at the moment because you know that your.. the person you’re selling to can go down the road and buy a Chinese import at a much cheaper price so the challenge is to keep your existing contracts so I think global pressure is keeping wage rates down in a number of sectors. In the mining area certainly wage rates are going up but they’ve got the capacity to pay and they’re localised. It’s not likely that the pressures there are spreading across the whole of the economy.

MP If we have this big input as we do from the resources sector, how efficiently do those have to play through to the rest of the economy to consumers, to the average consumer. It doesn’t all just get stuck in Queensland, Western Australia.

CA It doesn’t flow through as well as it would, something that was more diffused across the economy but the fact is that business buy services. They make profits, Governments tax the profits that the make, so there is a trickle down effect. Having a business making profits is good no matter what sector it’s in.

MP So overall you’re an optimist about the Australian market.

CA I think the Australian economy is going to surprise on the upside going forward and I think the Australian sharemarket is going to surprise on the upside and it’s largely going to be driven off the back of resource sector and those sectors of the economy that are leveraged to the resource sector.

MP So is Contango fully invested. Have you got any cash.

CA We’re still fully invested.

MP Well just looking at your allocations, if you’re overweight on resources you must be underweight a whole pile of other things. What and why.

CA Well we tend to be underweight in the defensive sectors so things like bank, LPTs, those areas that tend to do well when the economy is sluggish, when interest rates are falling and when there aren’t a lot of growth opportunities in the market. It’s a relative position that you’re taking. It’s a question of if you think BHP and Rio are going to do particularly well, banks might do OK but not quite as well, you go overweight resources and underweight the banks.

MP And what about Telstra.

CA We’re underweight Telstra. We just don’t think that the growth outlook for Telstra warrants being exposed to that stock.

MP The banking sector itself though, even though there’s a bet resources will out perform, there’s still confidence in it down the track in the long term?

CA The easy [yards] are behind the banks. They went through a decade where they had tremendous cost cutting. They closed banks. They rode down declining interest rates and got benefits from that. Going forward interest rates will range trade or go up. They’re not going to have anymore branches to close. So all those easy gains are behind the banks. They’re going to have to struggle to outperform and to compete in a market where a lot of other companies are striving to generate productivity gains.

MP And the consumer sector retail. How does that fit into [ ].

CA Discretionary retail is getting hit very hard at the moment because of high petrol prices. If you’re an individual you’ve got to balance your budget and if the cost of petrol goes up, the amount of money you’ve got to balance your budget and if the cost of petrol goes up, the amount of money you’ve got left for discretionary spending goes down and so its things like dress shops and shoe shops and theatre, holidays, these are the things that gets squeezed in that sort of environment so we’re underweight discretionary spending.

MP Does Contango move its ratings very quickly. Is it a matter of constantly rebalancing or do you take a longer term [ ].

CA We take a longer term view, but sometimes an event can come out of left field and that will cause us to change quickly but generally these sorts of trends tend to evolve. We’ve had the view for the last 2 years that we were in a super cycle for commodities so we’ve had to structuralise our weight to companies like BHP and Rio Tinto. We have become more defensive on the consumer side as things like the last interest rate hike came through and petrol prices started to go up. So we do vary our exposure depending on changing circumstances but the themes tend to be quite long lasting.

MP What do you call long lasting in terms of a super cycle.

CA Well in the case of oil for instance, we think that for the next decade the world is going to struggle to come to grips with rising demand for oil out of India and out of China and as a consequence there will be cycles where oil will under perform but if you look at the next decade it’s going to be a period where being long oil is going to better than being short oil. But there will be periods and the periods could run for a year or two where there’s a cycle within the long trend.

MP You’re a fellow watcher of one of my favourite industries, the Baltic Dry Index, a measure of commodity shipping costs. What’s it up to.

CA Well the Baltic Dry Index is one of those things like the mine canary. It’s one of those early indicators that tells you that something is changing in the world economy and the Baltic Index dropped very sharply in the early part of 2005 and seemed to be suggesting that demand for commodities was slowing down and what we saw in August is the Index stabilised and it’s actually bounced back and has been rising for about the last 6 weeks and that bounce bank coincided with the bottoming of the steel market and a bit more strength emerging in metals markets so its telling us that demand out there for basic materials is a lot stronger than we were expecting.

MP The Baltic Index peaked in late 2003 when the financial markets suddenly discovered China. Was that an overrun. Was it too much or was it fundamental and there was a shortage of shipping that’s quite rapidly been sold.

CA The interesting thing about the Baltic [Frank] Index is it’s a combination of supply and demand. In the first instance when demand spikes it’s very hard to get new ships available to meet the increased demand so prices tend to spike very rapidly. That generated demand in new shipping and in the last six months or so we’ve seen a really large influx of new vessels coming onto the market and as a consequence we saw a very very rapid decline in freight rates. Given the fact that new ships are still coming on stream, they’re building a lot more ships, the fact that it’s bottomed and actually rising tells you the demand is actually quite strong. For prices to be rising against the background of strong supply growth, that tells you something very positive about demand.

MP Any X factors out there that worry you?

CA Oh, there’s lots of X factors. I mean these two hurricanes certainly added a new dimension to equity markets, to oil markets and to just the outlook for the US economy. Terrorism remains an issue that we all have to take account of. Bird flu is an X factor that would certainly create havoc on global markets, so no shortage of X factors.

MP But the investor has to power ahead regardless.

CA You look for leading indicators of changes in trends. Changes in demand trends and supply trends and you have to be guided by those.

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