Predictably, the aggressive interest rate policies adopted by central banks has had some effect. The policymakers’ intention was to temper inflationary forces by subduing the purchasing capacity of the consumer. However (at least to date), consumption patterns have been less affected than anticipated, and it is the financial system itself that is bearing the brunt of central bank tightening.
Now, the Reserve Bank (and its global peers) don’t have a lot of choice, as one of the few effective tools they possess is interest rate settings, a very blunt tool indeed. In Canberra, treasury is (politically) instinctively defending the rapid rise in government debt and is seemingly now oblivious to any common-sense budgetary constraint. Indeed, annual budget deficits of about 2% of GDP are forecast for the foreseeable future. This is a dreadful outcome, considering the unambiguously positive terms-of-trade that Australia has enjoyed in recent years, thanks to the coincidences of strong commodity prices and demand, and a favourable agricultural La Niña climatic cycle. Governments need to understand that piling up debt only serves to worsen the reckoning when it arrives.
There is much talk about the refinancing cliff, being the rollover of mortgages and other loans from low fixed rates to much higher variable rates. This is a genuine concern, but so too is the cliff the Australian federal and state governments face when they seek to refinance more than a 1.4 trillion dollars of debt at double the interest rate.
Given the scenario of rapidly rising rates and unquenchable debt it’s no surprise that financial markets blinked first. This took the form of large failures in highly geared entities in the crypto space, then a more widespread malaise in credit and risk appetite, manifesting in a mini banking crisis. Whilst the banking industry is now stabilising, the more leveraged corporates in construction, retail and other sectors have a tough road ahead, so more failures and bankruptcies are likely.
The immediate global response was for central banks to come to the rescue yet again – the US Federal Reserve increasing its balance sheet assets by more than US$300bn. Markets welcomed this sugar hit (shares up, bond yields down) but it is a short-term measure, with more market volatility likely in the coming months.
It won’t be easy for treasury in Canberra to arrest government indebtedness as they will find it difficult to tighten their purse strings at a time profound societal inequality.
Indubitably, higher taxes and levies are coming.
An interesting market development in March was the decline in longer term interest rates, which are now lower than short-term rates. For example, in Australia the 90-day bank bill rate is 3.7% yet the five-year bond is 3% and ten-year bond 3.3%. This is known as an inverted yield curve and can be interpreted as an indicator of an impending economic downturn.
So, the path ahead is clouded by a deteriorating economic outlook and other consequences of higher interest rates. Add to this the ongoing conflict in Ukraine and the United States’ breach of its legislated debt ceiling. This latter subject will surface regularly during 2023 as the US reached its $31.4trn debt ceiling in January and has made no progress towards resolution. The ceiling breach has led to significant and belligerent bickering between the Democrats, who want the ceiling raised and are reluctant to reduce spending, and the Republicans who are emboldened by their newly won majority in the House. Inevitably a solution will be found, but the possibility of this being 11th hour might add to credit and financial market volatility and risks in the coming months.
Australian Shares
The Australian stock market, as measured by the S&P ASX200 Index, rose by 2% in the March quarter, continuing the upswing from late 2022 but not without a hiccup, notably a rapid fire 9% decline from the February peak before a more recent recovery. The market rose by 3.5% for the quarter when dividends are included.
The corporate financial reports released in February were largely satisfactory, profits and dividends mostly higher and large company balance sheets in good shape. Significantly larger profits and dividends were declared by the mining and energy companies, representing a probable peak in their present earnings cycle. Banks reported modest expansion of their net interest margins and a (almost unbelievable) low quantum of customer arrears. Australian bank share prices however had a bad quarter, falling in sympathy with more strained credit and banking conditions in the United States and Europe.
There has been a noticeable defensive preference in Australian shares recently, with consumer sectors such as food retailers and healthcare performing well; investors preferring these due to their lesser sensitivity to weaker economic and consumption growth.
Perhaps the biggest area of concern is the construction industry, which has been beset by the dual impositions of higher material inflation and labour shortages. There has already been a disturbing increase in sector bankruptcies, some citing an inability to complete fixed-price construction contracts. Shares in the construction and property development sectors are now priced for a bleak period ahead.
Having now assessed the December-half financial reports, and considered the economic outlook, we have downgraded the profit growth projections for the ASX200 stocks by about 5%. Part of this is a reversal of the post-Covid earnings bounce back and part a reflection of a softer economy. We use a valuation process that applies an ‘equity risk premium’, this being a methodology that seeks to determine that a share investor is being adequately compensated (by way of an acceptable projected return) for the risk taken. The outcome of this assessment is not too concerning – we see company profits and dividends as sufficiently sustainable to adequately compensate investors, though the extent of stock market upside is tempered by the restrained outlook. Thankfully dividends have improved from the pandemic lows, helping justify our sanguine market outlook.
Global Shares
In the March quarter the MSCI world stock market index was unstable but ultimately rose by 7.3%. The recovery was bolstered by central bank actions which caused bond yields to fall, thereby assisting the relative value of equities. Unsurprisingly, the very same sectors and stocks that were punished last year as rates rose received a positive fillip in March.
The dominant event of the quarter was a liquidity squeeze in the global financial system that caused tremors firstly in the US regional bank sector then Swiss bank Credit Suisse – both events quickly countered by government and central bank interventions. These events need to be viewed with some alarm, as a lack of liquidity in the global financial system can very quickly escalate, causing credit spreads (borrowing costs) to rise, reducing funding to business, and accelerating an economic downturn. Hence the central bank interventions are welcome, though will come at a cost, as money supply and government indebtedness were increased so dramatically for COVID relief and subsidies that there is very little further room to move.
The ructions in the financial sector caused bank shares to tumble worldwide on fears of contagion and memories of 2008’s financial crisis. Thankfully, the financial buffers held by banks is much improved in recent years so the fall in bank share prices should be seen as an opportunity to buy.
The United States’ stock market has a high representation of technology sector shares, and it is this sector that benefited from the recent decline in bond yields, the reason being that a lower discount rate was applied to projected future cash flows. Hence the technology heavy NASDAQ index rose by an outstanding 16.8% in the quarter and the broad-based S&P 500 index rose by 7%.
European markets were mixed but mostly positive for the quarter. Britain, which contains a large component of banks, eked out a small gain of 2.4% whilst shares in Germany had an excellent quarter, up 12.3%.
Asian markets were also positive, Japan up by 7.5% and Hong Kong up 3.1% whilst the market in Singapore was flat.
Property Securities
The prices of listed Real Estate Investment Trusts (REITs) fell by 0.2% in the March quarter, erasing some of the gains achieved in late 2022 and early 2023. The property sector bore the brunt of the market liquidity fears with renewed speculation that commercial real estate valuations would tumble, despite little supportive evidence to date.
The property sector of the stock market remains at odds with the transactional evidence. Some security prices are 20% to 30% lower than net tangible asset values suggesting the market has no faith in the sustainability of valuations. There is merit in this view due to higher financing costs and a weaker commercial rental outlook, which will weigh on receipted funds from operations (the key valuation metric). Hence the sector has some more investment headwinds, notwithstanding the seemingly low security prices.
The commercial property sector has been the weakest (but is also the cheapest), particularly CBD and regional offices, which are struggling to achieve occupancy and rental growth. Prime properties such as those owned by GPT, Charter Hall and Dexus are managing better than lower grade properties as many tenants are taking advantage of high lease incentives to upgrade their premises.
Large format retail centres have been resilient and are enjoying record visitation and tenant sales and high occupancy. Part of this is due to post-COVID rebound spending, and part due to the generally sound household financial position in Australia, notwithstanding multiple interest rate raises.
The property development industry is struggling to counter high costs, shortage of labour and amortisation of losses from some fixed price contractual work. Some smaller developers have failed which has cascaded through the industry and economy. The large developers such as Lendlease are also suffering lower margin but are poised to emerge with more significant market share.
Residential real estate prices have fallen modestly, though nowhere near as much as predicted by some commentators. Approvals for new housing have fallen sharply, exacerbating a general undersupply and adding to a very tight rental market.
Interest Rates
The recent instability in the global financial system might cause the Reserve bank of Australia to pause their interest rates upcycle but they remain wary of inflation risks so will probably raise rates from the current 3.6% by one or two more increments of 0.25% in the coming months.
Bonds have been particularly volatile, surprisingly falling in yield recently in reaction to global events, central bank actions and an expectation of deteriorating economic output. Consequently, bond prices have risen, much improving the poor performance suffered by bond investors last year. The movement in bond yields has been longer duration focused, with shorter dated bonds less affected. This caused a flattening then an inversion of the Australian interest rate yield curve, an uncommon event that is normally reflective of stressed economic conditions.
At present sovereign interest rates of all durations are between 3% and 4% and will probably stay in this range for a while. It is not likely that the Reserve Bank will increase the cash rate materially above 4%, and it is equally unlikely that long bond interest rates fall below 3%. Hence, we can expect a relatively stable interest rate environment for a few months, which is a good thing.
Term and bank deposits have re-emerged as an appropriate investment destination. Banks had been partially funded by an ultra-cheap Reserve Bank initiative called the term funding facility. This facility is now maturing, so banks need to replace the funding elsewhere, including from customer deposits. Banks are also tapping the financial market, particularly tier 2 securities, some of which offer investors excellent rates.
Tier 1 hybrid securities have come under the spotlight recently due to the value collapse of Credit Suisse’s hybrids. Australian bank tier 1 hybrids are strongly capitalised and have very little default risk, but investors need reminding that such securities carry some risk, and could conceivably suffer material losses. To be clear, Australian banks would need to suffer very substantial losses, for example arrears arising from a widespread 30% decline in house prices, for hybrid defaults or equity conversions be triggered. This is not our expectation.
An area of greater concern is corporate and high yield debt, especially associated with real estate construction activity and other volatile industry sectors. There are seemingly attractive interest rates on offer, but we are cautious due to increasing default risk. There is little merit in taking on risk to get an 8% interest rate without any capital gain potential, when (for those with a risk appetite) some good shares offer excellent dividends and capital growth.
Because of changed rates the fixed interest sector has become a more straightforward proposition. Investors can achieve a decent return with low risk by focusing on a mixture of cash and term deposits, sovereign bonds and some well-capitalised bank and corporate loans.
Outlook
Last quarter we presciently warned of likely market volatility in 2023. The shudder in the global banking industry last month and the heightened risk of constrained financial liquidity serve as a warning that all is not well. There is a slowing global economy in 2023 at a time that government and central bank capacity to help is constrained by their previous munificence.
Expect more market volatility as 2023 progresses, but also be watchful for opportunity in the stock market as prices already reflect a degree of uncertainty. Shares and bond prices will react quickly to events and news, both positive and negative, so we suggest holding some investment liquidity but be prepared to take advantage of the expected buying opportunities ahead.
Yours sincerely,
Malcolm Palmer
Joseph Palmer & Sons