Alternatively, the US could seek to tighten the private/public sector nexus, by significantly raising taxes and transferring more of the vast wealth of America Inc. to public coffers.
In Australia such issues are thankfully less evident. We have a more robust federal fiscal position, (though some State government balance sheets are now stretched), strong financial, political, regulatory institutions and processes and a well-functioning civil service and liberal democracy. Andrew Hauser, the new deputy governor of the Reserve Bank, (he previously served on the Bank of England) made a compelling speech at a recent economic forum in which he, as a Brit, observed the extraordinary prosperity and endowment of Australia. Mr. Hauser noted our below ground prosperity (presently iron ore, oil and gas and other mining, and historically gold mining), our above ground prosperity of agricultural industries and the burgeoning services sector, principally inbound tourism and education. Moreover, he concluded that with our strong and diverse mix of attributes, Australia has come pretty close to identifying a golden source of national prosperity. The point is, we can sometimes get too caught up in the minutia of present day pessimism and overlook the more positive bigger picture.
I am reminded of the ‘Australia in the Asian Century’ whitepaper, published in 2012. This paper presented an optimistic assessment of our national future, given the staggering pace of Asia’s developing middle class and the fact that are in the geographic sphere and time zone of the world’s largest producer and consumer of goods and services.
The world is experiencing an exciting and compressed period of innovation and technological advancement, manifest in rapid advancements in machine learning and artificial intelligence. The stock market has caught the AI fervor, prices of associated companies rising significantly. The AI revolution is real and will likely cause unexpectedly large shifts in corporate competitiveness and labour trends.
The objective of raising interest rates is to soften consumer demand, thereby abating inflationary pressures and achieving a net social and economic benefit over time. But higher rates are a blunt pecuniary tool, often precipitating a sharper than expected slowdown. We shouldn’t forget that raising rates is supposed to slow the economy, so we shouldn’t be surprised when it does. Its inconceivable that consumers and the global economy more broadly will escape the punishing effect of higher rates, and the effect on economic consumption and corporate profit trends is a key area of consideration in the coming year. Australians are awake to the probability of an inflation/interest rate induced crunch, as reflected in the consumer survey of personal finances, which is disturbingly weak, worse than both the pandemic and GFC periods.
The Australian dollar has stabilised recently (and indeed risen a bit). There are four broad factors that tend to affect the movements in our dollar – commodity prices (particularly those that represent large components of our exports), our terms-of-trade, relative interest rates, and purchasing power parity (a measure of price of goods relativity). We have enjoyed a positive trade balance for an extended period thanks to continuing strong conditions for our agricultural, mineral and energy exports, which have benefitted from expansive Asian trading relationships. This has contributed to a much-improved current account, for which we have hitherto experienced decades of deficits. The current account represents our net import and exports plus international transfers of capital. The international transfer component has been bolstered by a large increase in home-based capital, specifically very large and rapidly growing pools of savings via the superannuation system. It’s a positive trend and a testament to the core stability and strength of our economy.
More people will vote in a general election in 2024 than any year in history. More than 4bn people vote this year, greater than half the world’s population. Surprising trends have already emerged, some leading to hung or alliance based parliamentary outcomes. The snap parliamentary elections in France saw a lurch to the right in the first round, but a lurch leftwards in round two. The Brits unceremoniously dumped their Tory conservatives, India reelected Narendra Modi’s BJP party short of the expected majority, Indonesia elected Prabowo Subianto a former General and son-in-law of General Suharto and Mexico elected Claudia Sheinbaum as their first female president. Russians, meanwhile, voted as they were told. The United States’ presidential election on 5th November is already capturing massive attention, not the least because of the character and pugilistic nature of one of the protagonists.
Financial markets tend not to react dramatically to elections as most expectations are priced in, and the policy variances between left and right are usually mild in most liberal democracies. The US election might be an exception, as some electioneering policy pronouncements by Mr. Trump are rather extreme, if they can be believed.
There is presently no clear signal for an imminent trend change in interest rates. For now, the Reserve Bank’s policy is neutral – weighing the stubbornness of services-based inflation on one hand, and the suffering consumer on the other. Further ahead, it’s possible that the US Federal Reserve may initiate a small preemptive rate cut prior to their November election, and this might be followed by similar action here. The catalyst might be a particularly low inflation number in the September or December quarter, not because inflation has disappeared, but because of the rolling off of last year’s inflation spike from the twelve-month data, and the budget’s political sleight of hand taking $75 off all household energy bills – this being a component of the inflation basket.
Australian Shares
The Australian stock market, as measured by the S&P ASX200 Index, fell 1.6% in the June quarter, ending the rally that commenced last November. The market rose by 7.8% in financial year 2023/24 and dividend payments added a further 4% for the year. The recent performance of the market was curtailed by a moderation in commodity prices, which affected the larger mining stocks, but was boosted by strong performance by the banks.
Corporate profits are under the spotlight due to slowing consumer demand for some discretionary goods, higher wage and operational costs, and softer commodity prices. The big four banks have suffered a diminution of their net interest margin, and higher costs, leading to an expectation of a moderate decline in earnings, though this has been partly offset by surging revenue from digital payment fees. Given this environment it is odd that bank share prices have been rising sharply, but is probably a testament to their dividend policies and their sheer size, which is attracting automated investment flows. CBA has been the standout, now trading at the highest multiple of their profit, the highest multiple of their book value and lowest dividend yield in memory. Its been a good share but is overpriced.
The price to earnings ratio of Australian shares is approaching 19x, which reflects some investor optimism, but is also a reflection that share prices have run ahead of earnings growth. This happens on occasion, followed by weaker period for share prices (as we experienced last quarter) or a resurgence in earnings.
It’s been a very poor period for shares in base metal and battery metal mining sectors. Extraordinarily, the price of lithium carbonate has crashed from CNY600,000 (Chinese Yuan) to just CNY86,500, completely reversing the corresponding boom of 2021/22. The price collapse reflects a temporary oversupply of this commonly found metal following ramped-up mine production globally. The share prices of local lithium exposed stocks have fallen considerably, including IGO, Pilbara Minerals, Liontown, Mineral Resources and Arcadium. Mining shares are notoriously volatile, but this sector (at these much lower prices) is now more worthy of investment consideration, as too are miners of other industrially important minerals such as copper, nickel, cobalt, mineral sands and rare earths.
Meanwhile the iron ore price has held at above US$100 per ton, pleasingly contrary to most expectations (including federal treasury). But the outlook is softening, as evidenced by a 12% decline in the price of steel rebar in China, the primary destination for our exports. China’s economic activity is waning; 4.7% in the June quarter, down from 5.3% previous. Their property construction sector is in precipitous decline, reflecting a period of excess building and suspect debt schemes.
Consequently, the share prices of the diversified bulk miners, BHP Rio Tinto and Fortescue, have all drifted lower in price recently, placing these too within the prospective buy zone.
Looking forward, recent softness in domestic share prices is likely to continue for a while, as the market considers the profit trend effects of higher interest rates and costs against the relatively strong balance sheets and improved dividend payments. Merger and acquisition activity has quietened but it remains likely that a handful of larger companies be subject to acquisition offers or demerger strategies this coming year.
Global Shares
In the June quarter the MSCI world stock market rose by a further 2.2%, extending the strong phase that commenced in November last year. For the 2023/24 financial year this index rose by 18.3%, approximately twice its long-term average.
US large company shares have been particularly strong, notably those in the artificial intelligence thematic such as Nvidia, Apple, Microsoft, Broadcom, Alphabet and the semiconductor sector. This has created a noteworthy (and concerning) narrowness to the market – significant overvaluation in pockets of the market, exaggerated by the money flow effect of passive and algorithmic investing. Many people now have shares bought for them via these automated processes, the acquired stocks being only because they are large companies, and with scant regard to whether they are a good value investment. This can’t end well.
By consequence of its performance the US stock market now represents lesser relative value. However, we think investors should maintain exposure to the US as it does represent +60% of the world market and contains many of the best globally exposed and innovative businesses.
Last years’ positive repricing of Japanese shares is now slowing. Japan benefitted from a bit more inflation and their exporters from a weak yen. The Bank of Japan however is now cautiously backing away from their ultra-accommodative yield curve control (meaning they were actively holding interest rates down), such that the relative attractiveness of the Japanese stock market has lessened a bit. Hong Kong shares remain underpriced due to the relative weakness of theirs and the mainland economy, and a heavy discount for governance risks.
Europe has been in the economic doldrums, particularly Britain, and to a lesser extent Germany. This has weighed on their stock market performance. However economic green shoots are emerging in Europe, and they have already commenced their interest rate reduction phase. Hence Europe now screens as a more appealing investment destination, and we are actively screening for opportunities accordingly. Much is reported on technological prowess in the United States, but Europe too has some great success stories, think Novo Nordisk (diabetes and obesity treatments) ASML (semiconductor equipment) and not to forget AstraZeneca, Glaxo and Sanofi, all world leaders in vaccines and other pharmaceuticals.
The Australian dollar has staged a moderate rally to ~US67c, improving the relative value of investing offshore. The higher dollar trend is supported by our improved current account balance, and a deferral of interest rate reduction expectations.
The outlook for overseas shares is favourable for the investment benefit of global diversification and for accessing broad economic sectors and currencies and high quality stocks.
Property Securities
The prices of listed Real Estate Investment Trusts (REITs) fell by 6.8% in the June quarter, reversing the upswing that had commenced late last year. Higher bond yields and persistent pressure on commercial property occupancy were the cause of the declines. Most REITs shed their distribution in late June, so its not surprising that investors are taking a wait and see approach, given the importance of yield as a component of returns in this sector.
Goodman remained the standout sector performer, bolstered by its active data centre and industrial development assets, and strong occupancy. Goodman, by virtue of its strong relative performance, now represents an astonishing 42% of the REIT index. This may cause significant concentration risk for index-based passive-styled investment products, so we caution investors who invest in this manner to seek a more equal weighted product instead.
Dexus is a bellwether of the commercial property sector, as it owns and manages 176 office and industrial properties. Their June 24 valuation report reflected a 9% decline on their previous book value, representing a decrease of $1.3bn to their gross asset base. Their office portfolio decreased by 11.3% and industrial by just 1.2%, reflecting the relative strength of the latter. The capitalization yield on their office properties widened to 6.01% and industrial to 5.45%, both reasonable given occupancy trends and the present risk-free rate. By comparison, Goodman’s weighted average valuation capitalization rate is 5.1%, which seems a bit light.
In the retail sector Scentre Group (Westfield) reported excellent occupancy (99.2%), an increase in customer visitations and moderately higher tenant revenue receipts. Vicinity Centres reported similarly strong occupancy (99.1%) but a moderation in tenant revenue receipts, emanating from weak discretionary goods sales, more so than staples. Both have elevated costs to contend with, and some operational margin pressure from the higher cost of their debt.
Residential property prices (and rents) have begun to taper, as the construction costs and elevated interest rates bite, despite continued constrained supply. Regulated decline in immigration and foreign student intakes might dampen demand a bit, but it will need time to improve both the supply and demand imbalances before residential and rental affordability normalizes.
Governments, both federal and state, are trying to incentivize residential construction supply but it’s a difficult problem that won’t be solved easily nor quickly. But the problem must be solved as a social and economic necessity, as housing approvals are far too weak (about 150,000 per annum – much the same as it was 20 years ago).
Incentives bode well for corporates in this space as they should have fewer regulatory impediments in future. Mirvac and Stockland stand out as investment prospects in this regard.
The outlook for investors in the REIT sector has improved, as some prices have slipped, occupancy is more stable and interest rates have peaked. There is value in this sector, particularly for yield seeking investors.
Interest Rates
The most notable feature in recent time is the expectation pivot backward and forth from ‘the RBA will cut rates’ to ‘the RBA might raise rates.’ Our view remains that 4.35% (or thereabouts) represents a reasonable reflection of a normal rate in an economy with a stable outlook and abating inflation (which we have). Hence, we are not expecting the RBA to act with any haste, and probably maintain their neutral stance for a while longer. When the US cuts rate, which may happen prior to their election, our RBA might make a preemptive small cut, particularly if a quarterly inflation print reads favourably. Such an action might be early 2025 as short-term futures market pricing is indicating little likelihood of a rate cut this calendar year.
Our long-term bond yield has been jinking either side of 4.2% for a while, reflecting a flattish yield curve (albeit with a small dip in the middle). There isn’t much risk in bonds at present – the running yield being comparable to cash rates and a bit higher than average dividend yields. Hence, we are a supportive investor in bonds and think their low-risk characteristics play an important role in fixed income portfolio construction and diversification.
Overseas, interest rates have begun to fall, notably in Europe, where the inflation battle looks to have been won and economies need a boost. Small rate cuts have been initiated by the European Central Bank, and the respective agencies in Switzerland, Sweden and Canada. The Bank of England is actively considering following suit. In the United States rate cuts have been put on hold due to persistent services inflation and their better-than-expected economic growth last year. But a federal funds rate of 5.25% is constrictive, so it’s likely that the US Federal Reserve will initiate at least one small cut before Christmas. The US bond yield curve is steeply inverted, so a short-end rate cut will probably just flatten the curve rather than stimulate a bond rally.
Private credit funds remain a popular strategy for higher yield seeking investors. These pools of secured corporate loans have thrived as a competitive source of funding often at the expense of more traditional bank loan syndicates. But there is a finite amount of higher interest demand from decent quality borrowers, and as many of these private credit pools are closed-end funds I wonder (and worry) how they can maintain decent investor returns without materially increasing the associated risk. Consequently, I consider this sub asset class to carry risks that are not disclosed with sufficient clarity and warn investors accordingly.
Low-risk interest-bearing investment types such as term deposits, bonds and high-ranking credit are preferred at present, as these offer decent income yield at low risk. Lower ranked credit should be avoided, particularly those that are exchange listed as these may be susceptible to capital price declines should credit conditions tighten.
Outlook
There are likely to be more market sensitive events and news in the second half of 2024 than the first. This includes corporate financial reporting, imminent in Australia, developments in the ongoing crises in the Middle East and Ukraine, concerns about inflation and central bank monetary decisions (of relevance the US Federal Reserve) and a cacophony of noise from the US election campaign.
Consequently, investment portfolios should remain tilted a bit defensively. But this is a temporary stance, so investors should be watchful for good-value investment opportunities which will inevitably arise.