Investment & Economic Review April 2021

This ultra-stimulatory policy position of the RBA infers that there will hardly be an interest rate on cash, term deposits or even mid-duration bonds for another three years. Meanwhile, share and property prices are feeding off this munificence, and risk asset valuation metrics are being enhanced by the low rates. Notwithstanding these actions, in the long-duration market, (i.e., the component not controlled by the RBA), interest rates are actually rising – perhaps suggesting an element of disbelief in the likelihood of the RBA sustaining their position.

Of course, this policy does not come without a cost – the RBA having loaded up its balance sheet to nearly $400bn, more than twice the pre-pandemic amount. Does this matter, one might ask. Well, it doesn’t matter much whilst inflation risks are low, and our overall financial condition is strong – public sector, private sector and household. The real risk is that the RBA or some other central bank (they are all adopting similar strategies - lemming like) takes these policies too far, from which it will be extremely difficult to retreat. Such circumstances would precipitate considerable market volatility, though this is thankfully not on the near horizon.

Domestic economic activity is rebounding strongly. Disposable income growth is higher than pre-pandemic (partly due to last years consumption decline), household savings are strong, unemployment declining, and consumer confidence has regained all that was lost in 2020. And the drought has broken. Australian household wealth (mostly real estate and financial assets, less liabilities) has reached an all time high. These conditions are enhancing a recovery in corporate cashflows and earnings, which together with the RBA’s actions have created more favourable conditions for share and real estate markets.

Australia’s public authorities and citizens have managed the pandemic fairly well, which should assist us in the recovery phase, though the need to accelerate the vaccine rollout is an important consideration for 2021.

The Australian stock market, as measured by the S&P ASX200 Index, rose by 3.1% in the March quarter continuing the market recovery which began in earnest last November. Dividends were mostly higher than the previous half, as concerns eased about the extent to which the pandemic and resultant economic downturn might affect corporate cash flows.

When dividends are included, Australian shares have recouped all of the declines suffered last year.

The recovery in share prices has been driven by a combination of a quick rebound in corporate earnings, the ongoing stimulatory actions taken by governments and central banks globally, and an acceptance by investors that more traditional market analytical ratios can be stretched a little due to the pervasive low interest rates.

Benign credit conditions have increased the attractiveness of share buybacks and other capital management initiatives. Buybacks have become commonplace as businesses take advantage of ultra-low interest rates to bolster corporate valuations. The concept of a buyback is straightforward. The company simply buys its own shares, usually via the public stock market, then cancels them. The effect of this is that there are less shares on issue so the company’s profits and assets per share are higher when divided into fewer shares.

If well managed a buyback can be an effective use of funds, particularly if the company has excess capital, borrowing costs are low, and there is a dearth of other business investment opportunities. However, buybacks increase corporate debt, and if the company pays too high a price for its own shares the strategy can backfire. Also, its sometimes perplexing that a business management cannot find anything better to do with shareholders’ funds but to buy their own shares. Boral is a current case in point, having just announced a large on-market buyback using proceeds from their divestment of their US based USG joint venture. Now Boral is a building materials business, so surely their management can find better operational expansionary opportunities than buying their own shares at a two-year high price. Perhaps another purpose is to reduce outstanding capital, so their largest shareholder Seven Group automatically increases its percentage ownership. Construction company CIMIC seems to be following a similar strategy.

Financial accounts were reported by most companies during the March quarter and were a mixed bag, though generally better than expected. The banks reported sharp improvements in their customer loan deferrals, allowing CBA for example to report a half-year profit of $3.9bn and pay a dividend of $1.50, higher than the previous Covid affected $0.98. Bulk commodity company earnings surged due to high volumes and prices for iron ore, allowing significant dividend increases across the sector. Telstra reported a solid result and provided more guidance on their business separation plans, agricultural company Costa surged due to better growing conditions, health stocks Sonic and Ansell had good results and strong share prices, and energy stocks Woodside and Santos bounced back from the struggles of last year.

The market outlook is satisfactory. On one hand the recovering economic and earnings cycle and low interest rates should underpin stock prices, but on the other the present valuations are fairly full, with some spots of overvaluation. It is possible that the inevitable but gradual withdrawal of the sugar hit provided by the central bank and governments will weigh on economic activity and create some market unpredictability. Given this, we expect the market trend ahead to be modestly higher, but not without a couple of bouts of sharp volatility.

International stock markets continued their recovery in the March quarter, with the MSCI world index rising by 4.5% in US dollar terms. The continental European markets were the standouts, France up by 9.3% and Germany up 9.4% for the quarter, whilst the Singapore market rose strongly by 11.3% helped by an economic rebound and the partial privatisation plans for CapitaLand. The only market with a negative return for the quarter was mainland China, which fell by 0.9%.

The US large-cap Dow Jones index outperformed the technology heavy NASDAQ in the March quarter, reflecting an investor rotation from the higher priced technology and healthcare sectors to more economically cyclical sectors including industrials and banks, but notably the NASDAQ index has still performed materially better over an extended period.

One of the challenges post pandemic is to seek to stem burgeoning sovereign debt. There are various strategies emerging, mostly focused initially on shifting stimulus from the monetary policies of central banks to the fiscal responsibilities of governments. In the United States, President Biden’s US$1.9trn package includes US$1,400 direct payments to certain citizens as well as large financial assistance to health services, education and local government. No sooner than the ink had dried on this fiscal generosity, a further US$2trn was mooted to be offered as an ‘infrastructure’ package, with more to come. Enormous fiscal deficits are inevitable, necessitating an increase in debt or the creation (printing) of more money.

Equally necessary is the raising of revenue via higher taxes or levies. In Britain’s recent budget, their Chancellor announced an increase in their corporate tax rate from 19% to 25% with effect from April 2023, and in the United States President Biden is promoting a tax increase from 21% to 28%. Each will raise billions and help arrest the blowout in sovereign indebtedness, but also have a detrimental effect on bottom-line corporate earnings and market valuations.

The International Monetary Fund has upgraded its economic forecasts, particularly for the United States for which it now expects economic output to surpass pre-pandemic levels by 2024. Heavy fiscal stimulus, a successful vaccine rollout, and consumers spending pent up savings are the likely causes of the surge. US stock prices are benefitting from widespread corporate profit upgrades.

Most international stock markets have returned to or exceeded their pre-pandemic levels, making value investments a little more difficult to find.

The unit prices of Australian Real Estate Investment Trusts (REITS) fell by 1.1% in the March quarter, underperforming the broader stock market. The primary reason for the decline was an uptick in bond yields from about 1% to 1.8%. Higher bond yields affect property valuations, because the present value of future cash flows (mostly rent) is lower when the factor by which they are discounted (the bond yield) is higher.

Furthermore, the property trust components of REITS are required by their tax structure to distribute their income to unitholders. This requirement diminishes their retained cash assets and necessitates REITS to raise capital via debt or equity should they wish to acquire further property or expand. It is this constraint that hastened the transition of many property trusts to stapled securities in recent years. Take for example GPT Group, which rightly presents itself as a vertically integrated diversified property group. The security you can buy on the stock market is no longer a property trust, in fact investors who buy their shares are actually buying a General Property Trust unit, and a GPT Management Holdings Ltd share, stapled together. The point being that the performance of REITS is not just the ups and downs of their property values and rents, but also the operational accomplishments of their property development and management businesses.

The key consideration when assessing REIT investments is their core cashflow, defined as funds from operations. This represents real cashflows such as rent, and excludes property revaluations, interest expense and depreciation. The pandemic disruption to discretionary retailers such as cafés, restaurants, hospitality, and tourism, and to the commercial workplace via lockdowns and remote work trends have placed considerable pressure on some REITS’ funds from operations, perhaps for a few years. The response has been to relax rental pricing pressure, allowing more generous rental abatement and fit-out incentives.

Residential property markets have been strong, almost everywhere. The existence of ultra-low interest rates, high household savings ratios and a shift towards suburban and regional residencies has existed in most countries and caused rampant demand at a time of relatively low supply. Some countries are attempting to slow demand by regulatory intervention. New Zealand, whose house price surge has exceeded Australia’s, has introduced a range of tax measures to curb investor speculation, and favour first-home buyers, but domestically the regulators are yet to consider any meaningful actions.

The rapid uptick in long-term interest rates was perhaps the most notable financial market event of the 1st quarter of 2021. Whilst central banks flexed their muscles to hold short- and medium-term rates down, the market forces had a contrary view, causing long-term rates to spike due to positive economic activity, and an expectation of increased inflation.

Bond prices fell, as they act inversely to rate movements, so many duration-based fixed interest assets and benchmarks suffered a negative return for the quarter. However, the anchoring of short-term rates at close to zero has helped contain bond rate increases, such that bonds now offer a better relative investment proposition.

Activity in the bank hybrid market included new issuance by CBA and Macquarie, both priced at skinny margins which reflect the strong credit conditions and heightened investor appetite for anything with yield. These two will be amongst the first to shed some capital value next time there is a credit spread blowout. Bank hybrids are now relatively expensive, mostly offering only a moderate return for the risk contained.

The outlook for interest rates remains subject to the Reserve Bank’s policy stance. Their stated position of no increases to the cash rate till 2024 is bold and dramatic, but few really believe that the RBA can or will hold this aggressive position for so long. Therefore, it is widely expected that interest rates will rise before 2024 which will cause the yield curve to flatten. This is actually an encouraging scenario as it would reflect some price and wage inflation, which in moderation is economically positive.