This Quarterly edition from Snowgum Financial Services provides you with a 7 minute digest on all things economic, investing and markets.
Please feel free to forward this digest to clients, colleagues and friends who can in turn subscribe to it.
- Australian unemployment at 5.5%. Bucking the expectation that last quarter’s lower unemployment rates were an aberration. Unemployment has been consistently low since September 2017.
- Aus Inflation stubbornly low at 1.9%.
- Wage growth stable at 2.3% (Note. Latest data available from ABS is only from November 2017).
- Aus Economic growth at 3.1% for the 12 months to March 2018.
- US unemployment is 4.1%. Its lowest level since 2000.
- Market volume down 40% during World Cup games | Investors like football.
Tighten your belts… except Australia
- A rough estimate of the Quantitative easing being attempted to be unwound from global markets is 18-20 trillion dollars.
- US Federal Reserve target cash rate is 1.75% vs the RBA target rate of 1.5%. Not such a big difference.
- US Expected. Federal Reserve rate by end of 2018 is expected to e 2.1%, with a further 3 rises in 2019 to 2.9% and an expectation of 3.4% by 2020 (Bloomberg).
- Aus Expected. RBA cash rate to remain unchanged, not just through to the end of 2018 but, based on RBA forecast inflation of just 2.25% by 2020, the earliest potential rate rise is mid-2019… a big difference to the US.
- Chinese economy slows. Trade war fears are the official ‘reason’. Unofficially, the concern is that the volume of hidden or undisclosed debt might be suffocating growth.
The biggest economic issue on investors’ minds is the unwinding of quantitative easing and the ‘normalisation’ of underlying cash rates. If it isn’t the biggest issue, please let us know what else it might be!
With central bank rates at or near historical low rates, a whiff of inflation was enough to entice the US and EU into a tighter approach to monetary policy. (i.e raise interest rates and/or curtail the QE stimulus). In Australia, no such whiff has wafted past the noses of policy makers.
Nearly ten years of quantitative easing and loose monetary policy has resulted in two things;
1. Cash has been a dismal place to be for investors.
2. Any investment producing an income (i.e. property, equities and bonds) has been pursued by yield hungry investors.
As investors were forced to move capital into bonds, property and equities in their search for yield, they have been ever more willing to pay a premium for this yield.
With underlying rates finally starting to rise, resulting in improved cash and government bond returns, capital is beginning to rotate out of property and equities. This is reducing the premium demanded for these income streams, resulting in a fall in some of the most over-bid asset prices.
What can we learn from history?
In 2004, the US Fed rate was 1.25%. It was hiked by 400 basis points (4.0%) in a two-year period to 5.25%, partially to curb overzealous residential property borrowing. The higher rates started to bite in 2006, with a slow down in residential property. We all know what happened when this debt became unserviceable and was exposed in 2008.
In 2018, we now have twice the debt we had in 2006. Much of it issued at near zero (0)%. The US Fed Reserve has signalled that they expect to raise rates by up to 165 basis points (1.65%) by the end of 2020. If further rises continue from then, care will need to be taken to avoid the pain of 2008.
While investment returns have been terrific (for most of those investing outside of Australia), caution is needed as the debt heavy global economy is highly sensitive to changes in interest rates.
We are keeping an eye and ear out for a canary tweet from either specific economies or sections within economies that may struggle to cope with the rising cost of capital.
The difficulty with any idiosyncratic event that provides a catalyst for market disruption, is that it is largely unpredictable. With that in mind, if we had to flag an early concern with any specific economy or section of the market, it would be economies or sections of the economy with the largest debt burdens. Two good examples are;
- China, with its opaque lending standards; and
- Closer to home, heavily leveraged sections of the Australian residential property market
With the long running low cash rate, the capital value of income orientated investments will fall as interest rates rise. When there is little-to-no earnings growth, whether it be in property, equities or bonds, an investment yield of only 5% or less is poor compensation for any but the most secure and low risk of investments.
We are at the end of a 30-year bull market for bonds.
With rates positioned to go in one direction (up… not the band), bonds are a tough place for investors to generate substantive positive returns. Opportunities are available, but in our view, focus should be narrowed to floating rate bonds, short dated maturities or alternative debt arrangements - such as direct corporate loan structures with their own separately negotiated covenants or security.
We think ‘hybrids’, those ubiquitous capital notes offered by banks, are to be entered into with great caution. As a capital note investor, you get all the downside and none of the upside of being an equity investor. There is still some attraction for the short to medium term investor with a strong appetite for only income. For everyone else, you may as well buy the bank equity (although read our thoughts on equities below).
The increase in share market valuation (i.e. expansion in the multiple on earnings paid) was brought about by the high ‘opportunity cost’ in leaving capital in cash. With returns on money now increasing, this is set to reverse. In any tightening environment, the tide of capital flows will eventually turn (and in economies like the US, may have turned some time ago). This is no dire outlook for equities as the impact of monetary tightening on equities is a lagging one, with flow through effects on the broader economy taking up to 18 months to play out.
Until recently, many blue chips were able to hide poor earnings growth behind increases in their share price.
In the context of a tightening monetary environment, we are cautious of:
Businesses that trade like bonds. i.e. high yielding, low growth businesses where we expect to see the relative value of their income streams contract.
Businesses holding high levels of debt, as they are set to face increasing funding costs.
Businesses with high-payout ratios, many of which fall into point 1, whom we expect to struggle to keep pace with fast changing industry conditions.
Many of your domestic ‘blue-chip’ stalwarts, like Telstra, the big 4 banks, IAG & Suncorp, Woolworths & Wesfarmers and retailers generally, fall into at least one of the above categories.
As the impact of changing monetary conditions trickles through the economy, we expect to first see increasing volatility, followed by contractions in the share price of yield orientated equities/infrastructure. On a positive note, based on the RBA’s recent comments, Australia looks set to lag much of the rest of the world in uplifting interest rates, slowing a potential slide.
Telstra, with its particularly challenging industry environment, are first cab of the rank to see the value of their income stream deteriorate in both notional terms and in the eyes of investors.
Big 4 banks remain heavily leveraged to a saturated residential mortgage market and given their noted failures to expand internationally, we cannot see where growth will come from.
With the valuation correction already playing out for the big four banks (as shareholders over the last couple of years will attest), beyond the continued dividend yield, which is still valuable, capital upside is hard to see. Any overweight position in the big four banks now substantially increases the risk of capital loss, contrary to the 'investor psyche' of five years ago.
In the mature financial and insurance services sector, agile entrants are starting to nibble at incumbent’s market share. Where there is at first a nibble, a much larger bite will follow.
Australia is not without some terrific growth stories, Macquarie Bank and CSL being the market darlings, in a broader and generally sadder story for the large cap Australian businesses. CSL particularly has been a stand out, with price now front-running its earnings growth story. With investment opportunities limited at home, it is important to look further afield.
International developed markets largely appear fully priced, been more exposed to cheaper money than Australia. This in particular makes passive investment exposures unsuitable.
We appear to be in a late-stage bull cycle, which may continue to produce some good returns through to 2020. As such, it's to big a risk to simply sit on the sidelines. In portfolios we manage, we are scaling-back passive Asian region exposures, and complementing these with more active strategies.
While the markets north of Australia provide prosperous rewards for investors, professional guidance is more important than ever to target this region.
We’ve searched and failed to see clear guidance on what is happening in the Chinese economy. Some evidence suggests that growth has been lower this year than last year’s apparent mini-boom. Although if you ask the Chinese, it’s been a steady 6.5% the whole time.
The largest concern in this area of the world is uncertainty about Chinese debt; who has it? can they afford it? and how much is out there? Given that uncertainty, we still fall back on rule no. 2, diversification. Allocations of capital in targeted opportunities in Europe, the US and Australia.
We like the saying “You can’t see what you can’t see”. Which is why, regardless of the opportunity in plane sight, you must diversify the risk of the unknown.
In case your wondering… Rule no. 1 is don’t succumb to emotional bias.
We are not property experts, there are plenty of those making predictions.
On the one hand Morgan Stanley states that the property outlook is the worst in 30 years. More here. On the other hand, in the same article ANZ economists suggested the east coast had already passed the worst of the correction. A month later it looks like ANZ has fallen in line with an updated lower and longer outlook for property.
If you are looking for early canaries, smaller developers appear to be scaling back or even exiting their business as margins all but disappear on property developments.
With development activity in the apartment space, particularly east coast capitals, slowing down materially, not even first home buyer support will soak up what might now look like an over-supply.
Right at the coal face, even gun-slinging real-estate agents are sounding the warning. More here.
From left field, government policy has shown a rare turn of pace to support a soft landing to the construction boom, with planning changes introduced simplifying the construction of terrace and middle density living. More here.
Whatever the size of the downturn, there is a consensus that prices are unlikely to move anywhere material for at least a couple of years in east coast capital city markets.
By Matt Vickers BEc, Dip MFBM, MAppFin, CFP
News at Snowgum
We’ve recently partnered with Paul Levy. Over the coming year together we will transition his clients across to Snowgum Financial Services. Paul has worked passionately for 40 years advocating on behalf of his client’s financial interests.
We are fortunate to be able to learn from Paul’s experience and honoured to be entrusted with the responsibility of continuing this advocacy on behalf of his clients. We look forward to catching up in person with Paul’s clients over the coming quarter.
Snowgum Principal Adviser Matt Vickers has run his traditional World Cup Tipping competition. Front runner tipster's Johnny Warren and Tsdheo are nearly over the line, but a French win will see tipsters 'Widdles' & 'Kelv Brown' pip them at the post. Should Belgium claim a historic win, Mr S. will leap into the minor places. Taking out the coveted wooden spoon is Jonas, a woefully dreadful tipping outing for a former competition winner.
For comprehensive Tipping comp information, visit the tipping comp page here.