Another month with geopolitical noise constantly appearing in the press – Brexit, US/China Trade War, Middle East oil attacks and Syria. Let’s attempt to distil what really matters:
- The major geopolitical issue are the impediments to trade. The world owes its current standard of living to the growth in global trade. Impediments to open trade should lead to lower GDP growth.
- A synchronised slowdown across almost 90% of the world economy dominated talks at the International Monetary Fund and World Bank’s annual meetings in Washington on 19th October.
- Slower GDP growth will be reflected in the earnings of corporations.
- For those corporations where slower global growth impacts on earnings growth, valuation multiples e.g. price/earnings are likely to contract.
- The investment strategy of carrying 10-20% in cash and looking for “good buys” based on independent research is a competent strategy.
- In the current low interest rate environment, the TINA effect i.e. There Is No other Alternative, will act as a compensating upward draft to companies which experience slower earnings growth.
The Central Bank authorities are somewhat all over the place, which isn’t helping the markets. Since November last year, there have been a number of conflicting strategies from the Reserve Bank of Australia. Last month they were talking of lowering interest rates further and initiating an Australian version of quantitative easing (QE). Our concern was that this strategy would spook consumers and instead of spending the personal income tax cuts, they would save these funds by paying off mortgages or parking the money in their mortgage offset accounts. Given weak retail sales numbers in Australia last week, which lead to the failure of the proposed Latitude IPO, there is some evidence that this is exactly what Australian consumers have done. So in the last few days we have seen both the Reserve Bank Governor and the Australian Treasurer talking up the economy and downplaying the need for further interest rate cuts. This in turn has seen the Australian 10 year Bond recover from a low of 0.86% on the 10th October to 1.17% on the 22nd October, a material change (+.51%) in a short time.
The consensus remains however that longer term interest rates will stay lower for longer and that investment strategies should take this into account. What is more risky is to assume that the 10 year Bond Rate will fall further. It was only last November that the consensus was for the 10 year Bond to rise materially from its 2.7% level!
The discussion at the IMF and World Bank’s annual meetings in Washington noted that central banks aren’t maxed out, but they are close to it. Delegate after delegate warned on everything from the side effects of negative interest rates to the diminishing returns on lowering interest rates. That means fiscal authorities will need to pick up the growth baton, probably with some coordination with their central bank colleagues. Combining government spending along with monetary policy and structural reforms to juice growth was a main theme of the meeting. IMF CEO Kristalina Georgieva stated “slower growth requires that monetary policy remains supportive, but we all recognise that it cannot do the job alone… Fiscal Policy must play a more active role.”
Some governments were more receptive to the message than others. US Treasury Secretary Steve Mnchin said all tools, including Fiscal Policy, need to be used as space for monetary easing diminishes. Japanese Finance Minister Taro Aso said the Government has Fiscal options.
Still not everyone saw the urgency. German Finance Minister Olaf Scholz argued his government is already investing heavily, while Australian Treasurer Josh Frydenberg said his push for a budget surplus and sustaining a record expansion aren’t mutually exclusive. Your diarist’s view is that the above discussions are setting the scene for increased Fiscal Stimulus over the next 12-18 months. Already a number of programs are being implemented by various governments. Those governments who choose to borrow at the extremely low 10 Year Bond Rates, negative in a number of countries, to replace ageing infrastructure and capital works should see a firming of the 10 Year Bond Rate. So there is some chance that we have seen the bottom of the long term bond cycle. Aggressive investors may choose to buy fixed rate long dated securities such as Commonwealth Bonds, whereas the less risky strategy is to invest in floating rate securities with attractive margins such as senior debt. Australian senior debt margins have increased from 0.25% to 0.85%, attractive on a risk return basis for the Not-for-Profit and Fixed Interest portions of portfolios.
Keynesian economics suggests that when economies are slowing, borrowing to replace ageing infrastructure can be a useful public investment. At the October Market Outlook Breakfast, Sarah Shaw, our speaker showed photos of ageing infrastructure across the developed world, noting the trillions of dollars required to be expended on infrastructure over the coming decades. Defensive assets with revenues relatively stable across economic cycles were preferred. These are in two categories:
- Regulated Assets:
- gas/electric transmission and distribution
- waste water
- User Pays and Contract
- toll roads
- railway supports
- towers and satellites
- contract generation
During an earlier advisor presentation in our offices, in response to a question about the timing of investing in infrastructure, Sarah responded that the internal rate of return on their universe of projects was 16% with a threshold for investments of 8%. In time of low interest rates, infrastructure may well develop as a separate asset allocation class.
Yin & Yang 3 - Banks
In the June Blog, it was noted that while the dividend yield driver is positive for the banking sector, regulatory issues including remediation are negative and analysts are forecasting a cut in dividend payments. Since that time, we’ve seen ANZ, NAB and Westpac move to recognise remediation costs approximating $2B. This is of some concern, as it is by no means clear that the process is in anyway complete. Other negatives including lower interest rates are negative for bank margins both because the cash rate is only a part of the funding costs leading to political criticism and also that banks are unable to make the margin from borrowing short and lending long. The Bank of Queensland results are likely a leader for a subdued banking reporting season. So the negatives and the positives on the banks are as follows:
Property Returns Fall
As the 10 Year Bond has fallen so too has the capitalisation rate for properties. Remember that as the capitalisation rate falls, the value of the property increases. For example, if a property earnt $500K in rent and the capitalisation rate was 10%, the property is worth $5M. Whereas if the cap rate is 5%, the property is worth $10M. A number of the listed property trusts have been trading at 15-30% premiums to their net assets, with the net assets already trading towards highs given the low cap rates.
The unlisted property space is exhibiting the same characteristics. ISPT, the industry super fund’s property trust, reported a return for the June 2019 year of 3.3% being income of 6.06% less a 2.42% capital loss. This compared to 13.3% in the prior year and a 5 year annualised return of 11.54%.
Again, the lesson in the property market is to be careful of valuations and to be selective.
Yin and Yang 3 – the Oil Sector
To conclude on a positive note, the July blog noted that the major energy stocks are of interest at current levels with Santos quarterly production exceeding that of Woodside for the first time in many years. During October Santos scored a trifecta with the offshore Dorado WA oil discovery flowing at exceptional rates, oil and therefore LNG prices are benefiting from geopolitical issues in the Middle East and the announcement of the Connoco Phillips acquisition of the Darwin LNG plant and Bayu Undan oil discoveries for $2.2B. RBC commented that the acquisition had compelling strategic merit and the price was reasonable. So both Woodside and Santos are on target to their announced trajectory of 100M barrels of oil equivalent (MMBOLE) by 2025.
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