Reflecting negative global and domestic issues, the Australian equities market was down 10% in the 6 months to Christmas Eve 2018 with the ASX200 reaching a low of 5467. Since then, Australian equities have rallied by over 1100 points to hover at 6650. This will most likely result in Australian equity returns of 10% for the full year, a credible recovery from the Christmas lows.
The graph below shows the Australian ten year bond rate. On the 9th November 2018, the Australian ten year bond rate was 2.75%, whereas in late June 2019 the rate has fallen to 1.28%.
This fall follows the about face by the Federal Reserve in the USA from talking about three rate rises in November 2018 to now foreshadowing further cuts. The Australian Reserve Bank governor followed suit, reading from the same playbook. These are major falls in the ten year bond rate which is the cornerstone for valuing all assets including shares and property. The valuation question is how much of a premium is required to the risk free rate, i.e. the ten year bond rate in order to compensate investors adequately for the risk of the underlying investment. The rationale for the central banks rate softening is found in what economists debate as the Philips Curve. The Philips Curve is the relationship between unemployment and inflation. The conventional wisdom for many decades was that an unemployment rate around 5% was close to full employment and certainly by the time the economy reached unemployment of 4.5% or lower, an increase in inflation would be anticipated so central banks would be looking to raise interest rates. The debate amongst economists over the past 6 months is that there has been little or no inflation and the economists refer to this as “The flattening of the Philips Curve” i.e. central banks now believe they can lower interest rates further without leading to inflation in the current economic conditions.
Not everyone thinks that interest rates should be so dramatically impacted by a debate about the Philips Curve. Having cooled the Sydney and Melbourne property markets with responsible policies, some including your diarist query whether restimulating the property market so dramatically is good policy. There may also be other factors for example, when did bank depositors and other fixed interest investors cease to be customers? Surely those investing in fixed interest have a right to reasonable incomes for the use of fixed interest deposits.
The effect of the further fall in interest rates is to make income producing assets more attractive. For example Westpac shares are yielding 6.65% fully franked i.e. 9.52% gross. While this has not changed, what has changed is the differential between the Westpac dividend yield and the Australian ten year bond of 1.28% is enormous. If longer term interest rates had continued around 3%, one might have thought that fully franked shares in Westpac at around $28/$29 were appropriately priced. But given the differential between the dividend yield and the ten year bond rate, it’s not surprising to see the market gallop ahead to be within cooee of the 2007 high. It is possible that notwithstanding some of the issues of the banks including remediation costs and losses from the Sydney/Melbourne property boom, that we may see Westpac trading above $30 again. Another way to look at the impact of lower rates is to assume a company has a capital structure of 2/3 equity and 1/3 debt. If the required return on equity (roe) falls from 12%-10% and the cost of debt falls from 8%-6%, then the weighted average cost of capital (WACC) falls from 10.67% – 8.67%. This means corporations would accept all projects where the internal rate of return exceeds the cost of capital i.e. 8.67% and so one would expect such falls to result in greater economic activity as has occurred in the USA. These metrics are positive for equity markets, such that Australian investors will need to hold their nerve and let their shares run.
It is possible that term deposit rates may fall below 2%, so Australian equities with the fully franked yields over 4% and property trusts over 5% provide income in such a low interest rate environment.
In fixed interest, the task is to make a careful assessment of risk/return options. Wayne Matthews, head of Burrell’s fixed interest desk, has identified a number of such investments over the past 6 months.
The announcement of the G20 meeting in Japan in late June caused a flashback for your diarist to 2016 when the market lost 300 points in late June 2016 as a result of the BREXIT vote. Fingers crossed, but it looks as though the hard work in restoring returns for the June 2019 year will not be upset prior to 30 June.
The US/China trade war and the lack of agreement on BREXIT have impacted economic statistics. The understanding that the BREXIT negotiations with Europe are not a win Europe/lose UK scenario but a ‘lose/lose’ is slowly dawning on European politicians. However the argument is about sovereignty and such fundamental differences are not easily solved. In the meantime the European economy continues to weaken. On the 7th of June, the Deutsche Bundesbank cut 2019 GDP growth in Germany to 0.6% and 2020 to 1.2%. This is a substantial downward revision for the German economy. As commented in the May blog, a deal of this is to do with poor exports to Asia.
In the US, several of the sentiment indices had their worst prints since 2009. On the 17th June, the Empire State Manufacturing index measuring New York State manufacturing showed a dramatic reversal by 26 points to minus 8.6.
Julie Bishop, the former Australian Minister for Foreign Affairs, provided insight at a forum in Brisbane the morning of Wednesday 26th June. In her experience there was far too much hubris, aggression, stating of positions and lack of constructive solutions in the male dominated forums of foreign ministers. On the other hand, forums of female foreign ministers achieved constructive solutions and ‘go forward’ plans. There are certainly a lack of constructive solutions to some of the geopolitical issues. It is to be hoped that some of the posturing can be put to one side, so that the global economy can return to more normal trade flows and less disruption. Tariffs and trade barriers are a ‘lose/lose’ in the medium-longer term. Stock markets have been sanguine to this point around these two geopolitical issues, but it is likely patience will run out, particularly if such impact on company earnings growth. Conversely, a reaction to such geopolitical events in the September quarter may be a useful buying opportunity.
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