Welcome to the first edition of the Burrell Blog for 2018.
Portfolio Settings to commence 2017/18 Financial Year
The purpose of this blog is to review the portfolios settings set in July 2017 for the current Financial Year.
In overview, the drivers identified in the July 2017 blog largely remain relevant, but the pace of change has been slow, with the exception that the US stock market has continued to reach new highs. The view that the Australian stock market remains better value and is delivering higher dividends remains current, with good Australian stock market performance in the December 2017 half year.
Dr John Edwards, Senior Economist and former Reserve Bank Board member was quoted in the Australian Financial Review Monday 8 January 2018 “The Australian 10-year government bond rate should be more than 4 per cent at the very least, way above its current level of 2.6 per cent, as the Reserve Bank pushes the official cash rate to a more neutral rate of at least 3 per cent from its current level of 1.5 per cent.” “I agree with the view that the risk is the increase in the bond rate is going to be quicker than the market expects. It hasn’t really priced it in, and if it is then there are lots of bonds that will fall quite sharply in their value.”
The table below shows how low the 10 year bond rates are around the world. Even the small increase in the long term bond rate in Australia in the June 2017 year resulted in the Australian bond benchmark 1 year return of only 0.2%! A greater increase in long term bond rates would likely result in capital losses on long dated bonds. This is a risk Burrells would prefer to avoid. The strategy that fixed interest investors should look at shorter dated securities less than 3 years on a fixed basis or floating rate notes continues to be preferred. The view is that the Australian bond market is heading towards a replay of 1993-94, when bond rates rose resulting in capital losses on bonds.
The second implication identified in July is that as the risk free rate is the key building block in valuing other securities including listed property trust (LPTs) and equities, the interest rate head wind means investors should be careful of LPTs and growth equities trading above intrinsic value.
90Day Bank Bill
UK 10Yr Guilt
The November blog considered the LPT sector in detail. In short the office sector appears vulnerable to increases in the long term bond rate, so caution continues to be warranted. The risk around the retail sector was justified in the December half year with falls in several retail shopping centre trusts. In fact this was over done by November which was part of the impetus for the November blog. The purchase of Westfield at what appeared attractive prices was well rewarded with the Rodamco takeover valued at $10 in December. Independent research indicates Rodamco may have an intrinsic value higher than its current price on the European exchanges and so while many Australian investors will not wish to hold a foreign property trust, those happy with international exposure may well accept the Rodamco scheme of arrangement during 2018.
The industrial sector was preferred by Burrells during the December half year with that sector providing 6-8% income yields, underpinned by the Reserve Bank of Australia’s view that overall growth in Australia is returning to trend. As domestic GDP sits at 2.8% and inflation at 1.8%, employment continues to edge up each month. The November unemployment rate was unchanged at 5.4%, participation was up 0.3% and the number of employed increased 61,000.
In conclusion, a selective security approach is justified in the Australian LPT sector, with caution around office and to a lesser extent, retail. The Westfield takeover has assisted returns in this sector for the December 2017 half year.
US Stock Market
Every day there are articles showing valuations in the US to be strong. For example again on Monday the 8th of January 2018, a Graph is included showing the 10 year average 12 month trailing price earnings ratio in the US is above 2007, although not above the 2000 tech bubble. The comment under the article follows; “The trailing 12-month P/E ratio for the S&P 500 is today just shy of 23, a level rarely seen over the past four decades,” wrote LPL Financial chief macro strategist Lenore Hawkins. “This level wasn’t reached once in the last bull market ending 2007. It was consistently above 23 during the last couple of years prior to the dotcom bubble bust, so we do have room to run, but let’s be clear-we are in rather heady territory.”
The US economy continues to edge ever closer to full employment, which should bolster wages and inflation. The US jobless rate in December 2016 was 4.7%; it was 4.1% last month.
The text book study in macroeconomics would suggest that the US tax cuts are a further stimulus to the US economy. Included in those tax cuts are lower tax rates to repatriate offshore funds, which in turn are an addition to the stimulus. With the economy at 4.1% unemployment i.e. basically running at full employment, one would expect the Federal Reserve to be concerned about inflation and so to raise fixed interest rates, both short term and long term, so as to provide fire power should the economy require slowing.
It should be borne in mind that inflation and wage growth are lagged indicators and appear towards the end of economic expansion. While there are many writing that it is different this time, usually that is not the case and so your diarist has the view that US wage growth and inflation will show their heads in calendar 2018 resulting in interest rate increases. Thus your diarist agrees with John Edwards that it is more likely than not for interest rate increases above the consensus to occur going forward, so that the fixed interest yield curves can return towards a more normal level.
So far the US stock market has shown scant regard for this logic. Nor has it shown any regard for the many commentaries from the Federal Reserve, economists and financial journalists as to valuations in the US. When Amit Lodha, Fidelity Global fund manager, visited from London before Christmas, he commented that the one factor that he believes will bring the overseas markets to heal is inflation allied with interest rate increases. In the meantime however, the tax cuts in the US have centre stage and may well continue to support the US market and US economic growth for a little while yet.
To the extent funds have been held back from international investing because of some of the concerns noted above to date that strategy has not been rewarded. Pending some correction in the US, investors should carefully look at fundamentals on US stocks and active fund managers. We may also see further investing from the US into Europe and Asia Pacific including Australia, as US fund managers become increasingly concerned about the valuations in their home market.
During the technology bubble in 2000, the US market moved well above the Australian market which continued at a modest trajectory. The result was that the Australian market did not move adversely during the technology bubble during the years 1998-2001, but incurred a modest fall during the 2002 year and some Australian stocks including Melbourne IT failed to deliver for investors who bought the stock with rose coloured glasses thinking the company owned the internet.
The Australian market has performed in a similar manner to that period, with value stocks such as banks, resources and manufacturing trading at modest valuations and producing satisfactory yields, in many cases fully franked. In Australia there is some concern around growth stocks trading on strong valuation multiples. Thus we’ve taken some profits from the Lithium sector in recent months which seems to be flavour of the month with overseas investors. One should always be careful of growth stocks when the market and analysts start to value stocks based on revenue multiples rather profit multiples. If a company has no profits, then a careful and realistic analysis is required of the growth anticipated by some investors.
The strategy to remain fully weighted to Australian equities continues on a risk return basis. The dividend yield driver is alive and well in Australia with strong dividend yields likely to continue to underpin the Australian market, such that no dramatic collapse is anticipated.
The banks now have a royal commission to contend with. The more likely outcome is that this will clear the air and result in better behaviour, without any large impact on valuations. The exception may be that Commonwealth Bank endures some pain around the money laundering breaches. The risk of the new capital requirements has now become a known and the major banks should meet those capital requirements in 2021 without great difficulty. Burrells continue to recommend a market weighting be held for the Australian banking sector, perhaps with some underweight on CBA compensated by an overweight on the other three major banks.
XFactors are geopolitical. Your diarist was taken by the observation that North Korea is the same distance from Beijing as Gladstone is to Brisbane. This factor indicates that the Chinese will deftly manage the situation to minimise military confrontation. The punitive sanctions imposed in December 2017 will hopefully result in a diplomatic solution.
Happy Investing in 2018
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This document contains general securities advice only. In accordance with Section 949A of the Corporations Act, in preparing this document, Burrell Stockbroking did not take into account the investment objectives, financial situation and particular needs ('relevant personal circumstances') of any particular person. Accordingly, before acting on any advice contained in this document you should assess whether the advice is appropriate in the light of your own relevant personal circumstances or contact your Burrell Stockbroking advisor. If the advice relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a Product Disclosure Statement relating to the product and consider the Statement before making any decision about whether to acquire the product.
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