Welcome to the February edition of the Burrell Blog for 2018.
Finally a Correction
On Monday, 5 February the US Dow Jones Index was down 1175 points. The next day it closed up 2%, but with a range of 1167 points from low to high. On the 8th of February, the Dow fell a further 1000 points. To put this in perspective, the Dow is now back to the level it was at the end of November and the rapid gains in December and January are erased. The September 2017 Blog noted “The catalyst for a US correction is unclear”. However increases in the 10 year long bond rate together with inflation concerns were noted as the likely catalyst and this has proven correct. The September blog looked to two periods for insight and these may assist looking forward.
2000 Tech Bubble
The above chart looks at the technology bubble in 2000. The September blog saw parallel in the valuation multiples for selected technology stocks such as Facebook, Amazon, Netflix, Tesla and Snapchat. These are companies with large revenues, but low profitability and it is those stocks which corrected in 2000…and again this week. The technology bubble is not as pronounced in the US in 2018 as it was in 2000. Many of the leading technology stocks in 2000 now have reasonable earnings such as Microsoft, Intel, Google and Cisco. It is the more recent technology stocks noted above where the correction is occurring as the market has pushed up the prices of these growth stocks ahead of valuations on fundamental principles. Another feature of the 2000 adjustment was that Australia had not followed the US market up to nearly the same extent and so while the US market fell abruptly during the technology bubble, the movements in the Australian market were more muted. Burrells see a parallel to 2000 in that a number of stocks in Australia are trading at attractive yields eg, NAB reported well and is trading on a yield of 6.85% fully franked, the equivalent of nearly 10% gross with franking credits. In the absence of a fundamental deterioration in the Australian economy, which is not expected, one would have thought the dividend yields will support the prices of ANZ, NAB and Westpac. While CBA looks attractive cum $2 dividend, it is increasingly likely that CBA will be made an example of by the regulators in respect of money laundering and other regulatory breaches.
Analyst Shanny Lai at Burrells has undertaken a review of the 93/94 period. The reason for this is that during this period the 10 year bond rates increased by 2% in most markets around the world. Certainly this was the case in the USA, Australia, Germany, and Japan and there was also a strong increase in the UK. Blogs during 2017 raised issues around fixed interest. The September blog for example “with longer term bonds to be avoided and short term rates relatively unattractive when compared to listed company franked dividends”. With Australian long term rates having fallen from 6.5% to a low of 1.8% in September 2016, the concern was that as rates resumed an upward path to more normal levels, this basic building block for valuation of all assets would reverse the price appreciation. The main issues were in the USA where rates fell to under 1.4% in July 2016. The US markets have been in denial over rates for some time and a major impetus for the correction in the week commencing 5 February was that the US long bond rose from 2.4% to 2.8% in a fortnight. Burrells view for some time is that the long bond would breach 3% this year. This was an outlying call at the time, but with both the Australian 10 year and US 10 year trading above 2.8% currently, this results in losses in bonds and also in sectors which trade as a surrogate to bonds including property trusts. Moreover, it appears likely that a perfect storm may be appearing in the USA bond market. The US requires significant new raisings to fund the deficit with the estimate being US$1Trillion in the current year as compared to $US500B in the previous year. Notwithstanding the increase in the US 10 year rate, there was tepid demand for the three Treasury bond issuances this week. One reason for this is that of $US6.2T in treasuries, half is held by China, Japan and the Saudis. The Chinese have announced that their purchases of US treasuries are likely to reduce going forward (why would you buy treasuries if losses are likely to be occurred), Japan has its own issues, and the Saudis buy treasuries under an agreement from the 1970s where by the US undertook to buy Saudi oil if the Saudis then recycled the money back into US treasuries. In the past 24 hours there was an announcement that US oil production exceeds Saudi oil production, so the US requirement for Saudi oil is reducing.
Further driving future US interest rates is the fiscal position. The US economy is growing with US unemployment just above 4%. Into a strongly growing economy, the US government has injected a large tax cut. Economics 101 would suggest this will lead to inflation and the need for the economy to be cooled. The headwind from the 10 year treasury rate in the US maybe larger than many anticipate.
The more difficult question is around the extent to which the stock markets will adjust to the increase in long bond rates. Australia was in recession in 1992 and so a year later as the economy emerged from recession, there was strong growth in GDP also up by 2% in the world’s leading economies and this lead to the increase in interest rates. It also resulted in adjustments to stock markets of around 15%.
Action taken so far
Burrells have almost no long bonds in client portfolios, almost no downside option exposure from sold puts, have materially reduced property trust exposure and avoided increasing exposure to the USA stock market. Australian equities were seen as the best performing asset class in the year to June 2018. So far these portfolio settings have been beneficial to returns, with most portfolio returns in the period to December 2017 above benchmark. ”
Where to from here?
To the extent action has been taken per the previous paragraph, then in the context of rising overseas bond yields, many technical analysts will now see whether the fall in US indices tests the 200 day moving average. This would indicate a fall so that the Dow would be in a range of 20,000-22,000. Such a fall seems probable to your diarist.
Against this context, the Australian stock market has not moved up with the Dow and so logically should not suffer the same falls. While the common view is that we are highly correlated to overseas markets, in fact the correlation is .44 i.e. 44% of the movements in the Australian market are explained by overseas markets. The primary determinant of Australian performance is how Australian companies trade in the Australian economy. However we are an open economy and so commodities prices and events in overseas countries have more of an impact than they do, for example, in the USA, which is quiet myopic.
The speed of adjustment to some stocks is already rapid. For example in the property area Stockland has fallen under net assets from $4.70 to $4 at the date of this blog, while Mirvac with large profits anticipated from settlement in the forthcoming June half is trading at around net assets which means that one is paying nothing for the Mirvac business. These are but two examples of individual stock corrections which have quickly occurred. A number of clients also felt the fall in bank share prices was attractive, given the common view that the Royal Commission may clear the air on a number of matters, but will not fundamentally impact on the banks’ profitability. The history of “bargains” on the Australian markets is that they tend not to last long, so it is always a risky strategy to sit on one’s hands assuming one can pick up a bargain in some months. Your diarist can remember many articles after the March 2009 bottom post the GFC suggesting the market would stay there for a long while and there was no hurry. In fact all of the correction was largely over by September 2009 and this was to a once in 50 year event. So it pays to be attentive during these corrections.
Long term bonds remain risky and so the fixed interest strategy of staying relatively short and in floating rate securities appear sound. John Smerdon from Burrells fixed interest desk believes that some of the premiums on bank hybrids may disappear under the pressure of the higher US 10 year bond rate and so we are waiting a little for a buying opportunity in that sector.
Analysis of individual US stocks which we follow closely has not so far tempted Burrells to buy further. We are inclined to the view that there may be more to come from the US market. On the selling side, infrastructure stocks are interest rate sensitive and did not appear to have corrected sufficiently to our mind. Australian insurers after the GFC in tandem with the regulator were convinced to buy bonds to match their long tail liabilities and this strategy has proven fruitful during the last few years when bond interest rates were falling and bond prices rising. This strategy is over so clients may consider lightening for example IAG. There will be some relief for the insurers to the extent they hold inflation linked bonds.
The old adage of “buy in gloom and sell in boom” appears relevant. Burrell clients will do best to focus on valuations and research and not on market sentiment. While Burrells would be lower turnover than most competitors, the current markets will present opportunities both on the selling and buying side.
Happy Investing in 2018
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