This quarterly update provides an eight-minute overview of the macro-economic landscape and our view of the two scenarios we anticipate playing out in response to continued reductions in interest rate. We provide specific investment commentary and finish off with how we are adapting our client portfolios to accommodate the changing economic conditions.
Key Data
Reserve Bank of Australia (RBA) cash rate at 0.75%
Economic growth sits at 1.4%
Inflation remains below the 2-3% RBA target range at 1.6%
Unemployment sits at 5.2% with participation rate at an all-time record high of 66.20% (August 2019)
G7 GDP growth is 1.6%
US Federal Reserve cash rate is at 2.0%, down from 2.5% in June, with growing pressure for further easing
Economic Commentary
Global markets continue to remain sensitive to interest rate policy settings. Monetary policy settings, somewhat in line with broader consensus, are in the medium-term likely to continue to ease globally. The RBA has again lowered rates to a new record low 0.75%, with another rate cut expected and quantitative easing attracting increased discussion.
Markets had already priced in the lowering of rates, resulting in fixed interest and infrastructure assets rallying over the first 6 months of 2019. This has reduced the medium-term upside for these asset classes and results in a lower rolling yield (expected income over 12 months) for both asset groups. Infrastructure remains more attractive than bonds, and cash becomes the best haven for truly defensive investment capital.
As Warren Buffet says “interest rates are the gravity of markets” – that is, when interest rates are low, valuations move higher, and vice versa.
It is very difficult to predict how global markets will react to continued central bank interest rate reductions. However, we speculate that the most likely path forward is one of two scenarios:
The traditional ‘Philips curve’ relationship. In this scenario, cheapening money increases demand for capital resources (including labour), leading to an increase in the cost of resources (not asset prices). This generates inflation, reducing the need for prolonged central bank easing. This will limit the depth of central bank interest rate reductions and prompt a quicker return to more normalised interest rates. In this scenario, inflation is a catalyst for markets to more conservatively price future earnings. This would result in a market sell off and a drop in asset prices.
Cheap money fails to increase capital resource prices. Central bankers have already expressed frustration in the limitation of monetary policy producing the desired increase in resource prices, as demonstrated in Japan and the EU and voiced in Australia and the US. This means inflation is unlikely to emerge and we may see the rolling average prices for US 10-year bonds at 3% (or even lower). This will result in a prolonged and slow grind upwards of asset prices.
Of the above two paths forward, we believe the latter is more likely.
In a recent interview, Hamish Douglas of Magellan Funds Group relayed his funds discussions with two macro-economic consultants. They are Janet Yellen and Kevin Warsh. Janet Yellen is the previous US Federal Reserve chair and Kevin Warsh is slated to be the next one. Short of getting inside information from the current US Fed Chair, this is as close a guide as you could get regarding rate expectations for the future. They voiced the likelihood that US 10-year rates will reach 3%, but don’t rule out 0-2%. Easing has begun, but as yet inflation has not.
This lack of transmission of low interest rates into inflation, we believe, is partly associated with a change in capital investment by businesses. Resource constraints required to fulfil the Phillips curve relationship do not exist in capital light businesses (technology service businesses). This is because there are negligible costs to meet additional consumption. Another emerging trend is that an ageing population appears to be constraining spending as they save for long term funding needs (as outlined in recent internal RBA research).
These factors, among others, have blunted the ability of monetary policy to influence inflation. This means rates are likely to continue down and the discount rate used to make a fair value estimate of income streams reduces also. It follows that, all other things being equal, income streams increase in value and asset prices rise.
As discount rates are adjusted down, the valuation of many companies with modest to robust earnings growth looks attractive. In fact, should the risk-free rate continue to fall, a company with modest long-term earnings growth may find itself, on a discounted valuation basis, being of ‘infinite value’. This is known as the Petersburg paradox. Obviously, common sense ensures that reasonable constraints on valuations prevail, but this extreme outcome/paradox helps demonstrate some of the challenges in thinking about investing.
In a scenario where we see rate settings move towards zero, investing in companies that generate organic growth becomes more important than being seduced by companies with relatively attractive dividends, but with poor growth prospects. Mature businesses have already seen yields fall as their valuations grew (even though underlying earnings haven’t grown). This limits investment returns to income only and should inflation rise, the value of static returns falls and so too company valuations. Companies with earnings growth will recover from this valuation fall, those without earnings growth will not.
Selecting investments has always required an appreciation of the opportunity set of alternatives available and not an investment decision based on historic precedents. This has led to the acquisition of investments at higher valuation multiples than historical norms, but relative to the alternative, they remain attractively priced.
As Mike Tyson says – “everyone has a plan until they step into the ring and get hit in the face”.
In the event scenario ‘1’ eventuates, and inflation creeps back into markets, investors globally will get punched in the face (our investment portfolios included). However, the investments which recover from this blow will be the ones that, because of fundamental earnings growth, ‘get back up’. The same is not true of ‘over-valued’ businesses, without earnings growth. Once ‘punched’, they will stay down.
Another ever present risk is the massive and growing US government debt. Nobody seems to discuss how this unwinds, and what effect it will have on the US and other economies. We’ve shared our thoughts on this in previous quarterlies, subtitled the elephant in the room.
Investment Commentary
The good, the bad and the ugly
The Good. Businesses that provide consistent earnings per share with organic growth prospects (preferably double digit, but even modest growth is attractive) at a reasonable valuation. Businesses like:
Microsoft
Alphabet (google)
CSL – albeit valuation does get stretched
CPU
Macquarie Group (albeit earnings were lower for FY19)
Ping An insurance group
Alibaba group
Visa
AMEX
The Bad. These can be newer growth stocks, trading at very high or seemingly unreasonable valuations. An added layer of risk occurs as often new businesses have homogenous ownership. That is, they have a 1/3 founders, 1/3 growth investors and 1/3 quant traders (like passive funds) as investors. However, the investors that invest on the inherent value of a business sold their shares long ago based on their perception that the shares were overvalued. This means there are few or no ‘natural’ sellers left. With no natural sellers, the market for these shares has become homogenous, leading to a breakdown of efficiency in pricing the asset (discussed in greater detail two updates ago here). This can lead to wildly inaccurate stock prices, which may or may not be sustainable. We think this may exist in businesses like:
AfterPay
Wisetech
Xero
Amazon
Netflix
Some of the above businesses are incredible (Xero and Amazon). We are not saying that these are not terrific businesses, we are saying that they are valued at difficult to understand prices.
The below businesses are sometimes called value traps. These are often older businesses that look attractively priced with reasonable dividends. This may reflect historical earnings, but they are now structurally challenged businesses, or, they lack longer term earning potential:
AMP
TLS
ANZ, NAB, CBA, WBC
A comment on banks. Many of the banks have had zero earnings per share growth since 2011/2012. Yet, over the same time their share price value has grown as interest rates reduced. Although lower interest rates squeeze bank margins, the relative effect of a reduction in the discount rate in valuing the income stream, outweighs reduced profitability. There may be some near-term opportunity in bank stocks (as rates are likely to continue to drop), but we believe the risk of a rate increase surprise and lack of any prospect of recovery outweigh the short-term opportunity.
The Ugly. Ugly businesses have a proven track record of losing money. Have no material pathway to making money and often have opaque or questionable business processes and management. They are critical of criticism made about them and typically (but not all) are newer listings.
Tesla – Tesla doesn’t make money. It has sold some of its core assets to an entity controlled by its CEO at a discount. Shareholders are presently suing the company. It also has an opaque board, including Elon Musk’s cousin, Kimball, who as a chef has been paid $6.4m to be on the board. One hedge fund analyst values Tesla’s asset’s at less than outstanding debt, so has a target share price of $0, vs. current share prices of $238.
WeWork. The first people to lose their jobs are freelancers and contractors. Already failing to make money, the slightest downturn will see revenue bleed further. An unprofitable real-estate broker priced like a technology company.
Uber. 30% of your Uber fair is funded by venture capitalists…
Lyft.
Cash and infrastructure, with some limited international high yield credit are the better places for ‘safer capital’. The bond market has been compressed so tightly that careful selection of equity positions provides a better ‘risk adjusted’ source for returns. However, this also results in higher nominal portfolio risk.
In formulating the above commentary, and listing the above companies, we do so knowing that some of these companies might in fact fare very differently to what we or others predict. It is impossible to predict every decision or change in direction a company may make or a change in the marketplace that may occur.
When making a prediction we are reminded of the quote by Canadian economist John Kenneth Galbraith; “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know”.
Portfolio Commentary
It remains important to periodically review investment portfolios to ensure they have the best chance of maximising.
There is no dramatic change required to portfolios, but some slight shifts across a few asset classes should be considered:
Reduction in low-yield and short dated bond positions.
No change to higher yielding floating rate bond positions (predominately through the Bentham Global Income Fund).
Increase weighting in cash.
Modest increase in infrastructure assets (where client portfolios are more defensive)
Reduction in exposure to low or neutral earnings per share (EPS) growth businesses, unless there is a specific client requirement for larger dividends in their portfolio.
Increase investment in favourable EPS organic growth businesses, where valuations are fair. This may see a further concentration in existing favourable businesses.
For Australian businesses, this happens to correlate (or perhaps is causal) to domestic businesses that have global earnings.
A shift to the east. Although dark clouds remain around opaque Chinese credit markets and trade uncertainty persists, there remain attractive valuations for organically growing large cap businesses, like Alibaba and PingAn insurance, for the investor with the right risk appetite.
A reduction in passive investment exposures.
Investment limitations
Credit markets require far greater diversification than equity markets. This reflects the idiosyncratic nature of credit risk. Default typically arises from an unknown event, often management fraud or unscrupulous behaviour (think VW diesel) and the best way to manage this is to diversify out what you cannot see. As such, we usually access credit (i.e. fixed interest) through an investment manager with many hundreds of underlying exposures.
For smaller portfolios we will not take direct international positions but use a manager for this role. Where scale allows, we strip out investment management costs allowing direct investment in large “blue-chip” global equity positions.
For smaller and mid cap market positions, in addition to emerging markets, we prefer to use the expertise of specialist fund managers.
By Matthew Vickers BEc, Dip MFBM, MAppFin, CFP
Financial Adviser | Snowgum Financial Services
Disclaimer
Any advice contained in this update is of a general nature only and does not take into account your circumstances or needs. You must decide if this information is suitable to your personal situation or seek advice. Prior to investing in any particular product, you should read the Product Disclosure Statement.
Snowgum Financial Services Pty Ltd (ACN 603 703 859 is a Corporate Authorised Representative (Corporate ASIC AR number 001001581 ) of Peter Vickers insurance Brokers Pty Ltd (Australian Financial Services Licensee (AFSL) No 229302 & Credit Licensee (ACL) No 229302 ǀ ABN 68 074 294 081).
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