Investment & Economic Review July 2021

These strategies have collectively been called ‘stimulus’ and come in many forms including government handouts, job support measures, money printing programs, and huge swathes of debt. Most of these measures are categorised as ‘emergency’, meaning they would not have been invoked but for the pandemic. The test ahead is whether the economic consequences of the pandemic have merely been deferred by these actions, and how market and economic directions behave as the various stimulus packages are withdrawn.

A startling outcome of massive stimulus is the relationship between overall economic output and household wealth. Household wealth is statistically unaffected, and indeed has risen to record levels, as evidenced by significant cash balances and asset price appreciation. In other words, the governments are hemorrhaging whilst the wealthy sector of the populace are benefitting. Something must give.

Another economic aberration is the tightness in the labour market. Pleasingly, the Australian unemployment rate has fallen sharply, yet the Reserve Bank of Australia seemingly contradicts this by citing unemployment as being too high for them to relax their stimulatory measures. Much of the labour shortage can be attributed to border closures and restrictions, exacerbated in those economic sectors that have traditionally relied on migration and transient workers.

When the Reserve Bank meets on the first Tuesday of each month, they deliberate their monetary policy settings. Of late there has been a sameness in their pronouncements, that interest rates are unlikely to rise till 2024 at the earliest. Meanwhile, the financial markets are trying to grasp the concept of a neutral interest rate, being the appropriate short-term interest rate when economic activity is normal and inflation stable. It is unambiguous that interest rates have been trending to a lower plane for three decades, so the neutral short-term rate in Australia is probably in the 1.5% to 3% range. The reversion from todays controlled 0.1% setting is very much in the hands of the Reserve Bank, at least for now. Let’s hope they don’t overplay their role, as a market dislocation benefits no one.

Australia’s public authorities and citizens managed the early stages of the pandemic fairly well, though the need to accelerate the vaccine rollout is an important consideration for 2021 and beyond.

The Australian stock market, as measured by the S&P ASX200 Index, rose by 7.7% in the June quarter extending the market recovery which began in earnest last November. The dividend payout ratio also improved leading to slightly higher cash distributions, though it is noted that the average dividend yield of Australian shares of about 2.8% remains significantly lower than the long-term average of about 4%.

The steady rise in share prices has been assisted by a pleasing rebound in corporate profits and the ultra-stimulatory actions of central banks, both here and abroad. Valuations have tended to be enhanced by the low discount rate, and a resurgence in merger and takeover activity has boosted confidence. Strong markets have also caused fever-pitched speculation in peripheral assets such as some cryptocurrencies, digital tokens and special purpose acquisition companies. There’s a bubble forming that will burst spectacularly before too long, and investors are urged to be careful about buying securites with little or no tangible value, and to understand exactly what it is they are buying.

For the 2020/21 financial year many shares in the more economically sensitive and cyclical sectors performed very well. Australian banks, which suffered tremendously in the pandemic drawdown last March, were amongst the best performers in the recovery phase. Similarly, mining stocks such as BHP had a good year, bolstered by record iron-ore export volumes and strong commodity prices. Commodities were supported by government stimulus and troublesome supply chain bottlenecks, which combined to create temporary supply shortages and utopian pricing conditions.

Another consequence of ultra-low interest rates is an increased investor appetite for infrastructure assets with regular cash flow and yield. Telstra was able to monetise its mobile communication tower assets by selling 49% of its InfraCo Towers business for more than expected, and both Sydney Airports and Spark Infrastructure have recently received unsolicited takeover bids.

The Australian stock market outlook remains satisfactory. On our assessment, the recovery in corporate earnings will continue, and the effect of low interest rates remain positive, at least for a while longer. Our market forecasting tool analyses profit growth data, bond yield forecasts and applies an equity risk premium multiplier, the result of which is a projected fair value for the ASX200 index of about 7750 points, about 6% higher than the current level.

International stock markets were generally strong in the June quarter, with the MSCI world index rising by 7.3% in US dollar terms. The only laggard market was Japan which declined slightly in most of their industry subsectors. European healthcare stocks performed particularly well with the likes of Novo Nordisk, Roche and Sanofi all posting double digit gains for the quarter.

The United States continued to outperform, with a resurgence in the large-cap technology and consumer discretionary sectors, including record high prices achieved for many stocks including Alphabet (Google) and Microsoft. Our analytical process considers ten primary factors when assessing global markets, including past and future rates of GDP growth and inflation, ratios of earnings and dividends, credit and foreign exchange risks and interest rate forecasts. Our conclusion for the year ahead is that the markets in the US, China and Hong Kong have become fairly fully priced, with some downside risks apparent, whilst markets in Germany, United Kingdom, Japan and Singapore are undervalued.

After a stellar period, the Australian dollar has begun to wane, notwithstanding the continuing robust commodity prices and export volumes. The Reserve Bank’s interest rate interventions have helped arrest the upside trend in our dollar, which was an intended consequence.

One of the clear risks to all world stock markets is the timing and pace of the trend reversion of interest rates. At present stock markets are attuned to the stimulatory benefits of lasting low rates and are largely oblivious to the certainty that control mechanisms employed by central banks will be eased. On average, global markets are trading at a premium to their historic relativity of projected earnings versus bonds, primarily because investors generally have convinced themselves that the era of ultra-low rates isn’t ending any time soon. Certainly, this is a view with supportive merit, as the continuing pandemic will forestall any aggressive policy adjustments for some time longer.

One can’t comment on global markets without referencing the stupendous and escalating amount of sovereign debt, and the inevitability that the sheer size of these liabilities will weigh on economic society at some point in the future. Governments will simply have to rein in spending or increase revenue, or more likely both. As fiscal expenditure increases, budget deficits concurrently balloon, so the need for financial restraint becomes more pressing.

As most international stock markets have trended higher it is a bit more difficult to find pockets of value, however of interest are health care stocks, particularly in Europe, industrial automation businesses, and consumer staple companies with strong brands and market share.

The unit prices of Australian Real Estate Investment Trusts (REITS) had an excellent June quarter, up by 8.9%. Industrial property led the way, particularly Goodman Group which rose by a staggering 16.8% for the quarter, achieving successive record highs. Goodman’s vast portfolio of industrial property now exceeds $50bn with $10bn of development work in progress, much of it funded by co-investment partners, which has proved to be a successful strategy. Centuria Industrial also performed well, but BWP which owns Bunnings stores, performed in line with the market.

In the retail space conditions are much tougher, unsurprisingly. Scentre Group (Westfield) securities fell slightly in the quarter as did Charter Hall Retail and Vicinity Centres. Large format shopping malls have enjoyed a resurgence in foot traffic and turnover in their suburban stores, but their CBD stores are struggling mightily due to lockdowns and work from home protocols.

The large commercial and diversified REIT’s are performing satisfactorily, using their scale to achieve some efficiencies. Dexus, which owns a sizeable portfolio of office buildings, is performing surprisingly well on rental receipts, occupancy renewals, and commercial sales, considering the dire predictions for the commercial market. Stockland and GPT, both comprising a diverse mixture of real estate, have been able to mitigate some of the weakness in their retail and commercial operations with strong sales and growth in the industrial and residential sectors.

Thankfully, REIT distributions have recovered considerably, in most instances close to pre-pandemic levels. Scentre and Vicinity, which skipped a half-year distribution last year have recommenced payments. Dexus’ 51.8c annual distribution is their highest ever. Of course, very low interest rates have helped property stocks enormously, so investors will need to be wary of potential underperformance when rates eventually rise.

One key consideration for commercial property is the pace and timing of workers’ return to CBD workplaces. This is particularly relevant for office landlords and tenants, and the turnover for retail zones and large CBD based retail malls. The Property Council of Australia has assessed that Melbourne CBD occupancy had only returned to 26% of the pre-pandemic level by June, and Sydney 67%. The recent lockdown orders will set this back further, such that CBD occupancy will likely remain suppressed well into 2022

Residential property remains strong almost everywhere, and dwellings offered via auction are mostly selling quickly. A relative dearth of supply has exacerbated a market already driven by low interest rate fervor. Inevitably, supply will balance demand and prices will stabilise, probable sooner now rather than later.

There are two important interest rate topics at present. Firstly, short-term rates, as defined by bank bills or overnight cash, have been held stoically at close to zero. It is the aggressive actions of the Reserve Bank that have caused this rate to remain at close to zero, and their rhetoric suggests this policy will be retained for some time.

Secondly, long term interest rates, i.e., the ten-year bond (often cited as the risk-free rate of return), rose sharply in February, but in recent weeks has fallen just as quickly. This recent decline is coincident with the reemergence of Covid infections in Australia and consequential city and regional lockdowns and border restrictions. It is reflective of an expectation that the negative economic effects of the pandemic are not yet behind us, and moreover a belief that any tightening in policy by the Reserve Bank has been pushed back even further.

In their most recent policy statement the Reserve Bank indicated a preparedness to consider an easing of their stimulatory bond-buying program in the final quarter of this year. This was to take the form of a deceleration or tapering of their net purchases. We now expect the RBA to defer any policy changes till 2022, and announce this intent following their August monetary policy meeting.

In corporate credit the spreads of both investment grade and higher risk securities continue to tighten, reflecting an investor appetite for yield of any type, and an expectation that defaults and loan delinquencies will remain low, assisted by ultra-low commercial rates and an inclination by public authorities to backstop the private sector. Higher risk fixed income securities are now priced at extremely skinny margins - so there’s not much room for error. Investors need to be very careful when investing in this sector.

There has been scant activity in the bank hybrid market except a new issue by ANZ and a generally stable to strong secondary market. Bank hybrid cash yields are in the 2% to 3% range though most enhance this with franking credits. Capital prices are reflective of the very low-rate environment and are in some instances overpriced.

The outlook for interest rates remains beholden to the duration of the current Covid restrictions and the actions of the Reserve Bank. The RBA’s stated position of no increases to the cash rate till 2024 remains bold but prolonged Covid restrictions would support their prognosis. For now, we expect rates to be steady and low, inflation to perk up but be largely transitory, and 2022 to arrive without any material interest rate change.