Australian Market Summary – 10 June 2016
Markets are broadly flat this week and frankly continue to trade with the same indifference they have for much of the last few months.
In the last 6 weeks, the ASX200 has traded a mere 3% range.
Pessimists, including myself, worry that the market looks fully valued for the growth outlook on offer.
As yet, however, there has been little bang for one’s buck in being cautious, since the ongoing rally to record low bond yields, continues to offer ballast to equity relative valuations.
This is the current purgatory we remain mired in for both local and foreign equity markets.
Put simply, the economy & corporate earnings continue to struggle, but that struggle is ensuring an environment of ever diminishing interest rates on fixed income products.
Were we in an ‘ordinary’ monetary policy cycle that involved less or no ‘QE’ or money printing so to speak, the extremes in asset class valuation wouldn’t be occurring, but as it stands, global investment markets are awash with ‘liquidity’ and desperate to achieve a return or in need of a ‘home’, so to speak.
Hence, we now live in a world where over US$10tln of global sovereign bonds now trade with a NEGATIVE YIELD – that a negative return is still seen as a safe relative place to be says it all.
These low interest rates in turn make the case for equity valuations to shine brighter, even if the outlook for corporate earnings is muddy at best.
It’s all a big circular and self-referencing relative cycle and playing the game demands knowing when the self-perpetuating relative cycle ends.
For our lot, we are happy to be sitting on maximum cash because we can’t possibly tell when the spoke in this cycle catches a branch. What we do know however, is that the outlook for underlying earnings continues to worsen and it is this that will ultimately be the final arbiter for equity prices.
So we sit and await, pretending not to be annoyed by the seemingly interminable momentum for certain assets.
LOW INTEREST RATES & LOW GROWTH
The RBA chose to leave interest rates on HOLD this month, entirely as expected they would in the middle of an election campaign.
The market is saying another rate cut will be forthcoming in either July or August and I, wholeheartedly agree.
However, it was indeed interesting to see the RBA referencing the recent re-acceleration in local housing prices this autumn. If the RBA are highlighting this, then it does suggest the RBA are keen to ensure further distortion of asset prices is avoided if interest rates fall further – in short what this means, is the bank lending standards will be tightened up again.
Sadly, it seems increasingly notable that the Australian fixed income market has come into line with the rest of the world economy in now suggesting that lower interest rates will do little to boost growth.
The shape of Australia’s yield curve has FLATTENED significantly in recent weeks, indicating far less confidence in future economic growth.
The yield curve is a wonderful predictor of future economic conditions as it depicts the yield required by investors over different points in time – the lower the future rate, the less confident investors are in future growth and hence the more willing they are to receive a lower rate of interest for their investment.
LOWER INTEREST RATES IMPACT PROFITS OF BANKS AND INSURERS
In a practical sense, lower interest rates regrettably have a negative bearing on the profitability of banks and insurers.
Banks ‘borrow short’ and ‘lend long’. In simple terms, they fund much of their longer-term borrowing from short-term deposits that yield zero or negligible rates of interest. Obviously when rates are higher, the banks can make greater returns from taking these low-cost deposits and lending them out.
It’s vice versa when rates are falling.
This is precisely why European and US bank earnings forecasts have consistently disappointed for the last 2 years and why, in spite of dividend yields of 6-8% in Europe, the banks have still underperformed the broader market.
This is an important point for investors in Australia to understand – yield is not the first thing to consider when looking at the banks, because yield is a function of earnings and if earnings forecasts are being cut, then so too are dividend assumptions.
Yield is not going to be the salvation for bank investors that they think it is, which is why we continue to advocate for portfolios to get back to market-weight or less for the coming 12 months in Australian Banks.
In the same way that banks struggle to make margin as rates fall, so too do insurers, but for different reasons.
Insurance companies hold enormous amounts of capital on behalf of policy-holders and alongside underwriting profits (where they exist), insurers make profits on investing policy premiums. When interest rates fall, the ability to generate investment income diminishes.
Lower interest rates will impact on the likes of QBE (QBE), Insurance Australia Group (IAG), Suncorp (SUN) and AMP (AMP) in the coming 18 months and this is another reason why we continue to monitor very closely our position in IAG with a view to taking profit.
IAG this week declared that the cost of the recent east coast storms would fall well inside their tolerance, coming in at $100m pre-tax.
With Australian bond yields falling to record lows this week (Australian Government 10-year yields under 2.15% and LESS THAN A 3-MONTH TERM DEPOSIT RATE), Australian Real Estate Investment Trusts (REIT’s), infrastructure names such as Sydney Airport (SYD) and Transurban (TCL) and mid-cap, ‘growth’ names such as the hospital stocks, REA Group (REA), CSL (CSL), Magellan (MFG) and NAVITAS (NVT), just to name a few, all continue to rise to new highs day after day.
The force is strong in these ones.
But valuation in the vast majority of these shares is far from compelling. Far from it.
I would argue that in the case of listed-REIT’s, current valuations and dividend yields in the high 4% to low 5% range (unfranked) look full and that there is a sensible case to be made to shift from the listed space to unlisted property – we would advocate for the AMP Capital Wholesale Australian Property Fund, which yields just under 7%, carries a spread of office, retail and industrial property and is ungeared.
Basically, you are switching from the listed space which trades at a substantial premium to valuation, into the same assets AT valuation.
On the hospital and infrastructure stocks, the valuations are equally uncompelling. Ditto the ‘growth’ names listed above.
I am happy to walk through individual thoughts on the above names on a case-by-case basis, should anyone be interested, but the point here is that whilst momentum is still strong, the fundamentals underpinning the rise are almost exclusively interest-rate driven, which leaves me uneasy.
THE MARKET THIS WEEK
Oil stocks finally caught a bid this week (finally! Sigh…), leading the sector performance charts.
Miners weren’t far behind.
Oils entirely deserve the bounce as we have highlighted in recent weeks and irrespective of the market, have more gains ahead of them.
Miners on the other hand do not and the recent spike higher in BHP (BHP) particularly just seems another gilt-edged opportunity to sell out of it.
I remain convinced BHP ends up in the $14-16 range and stuck there for sometime.
Telecoms and banks were ‘tail-end Charlie’ this week, with Telstra (TLS) a recent cause for frustration given the stock should be benefiting from the collapse in local bond yields. Friday’s trade points to TLS finally recognizing the bond market move, but let’s see if we can see some strong relative performance in the coming weeks.
Have a great weekend.
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