Investment & Economic Review October 2021

The Reserve Bank of Australia is facing a similar dilemma to their global peers, that being the timing and extent of the withdrawal of their pandemic stimulus measures in the face of burgeoning public sector indebtedness. If they leave it too late, money supply dilution and government debt may become unmanageable, and asset prices will bubble, causing some future dislocation to financial markets, but if they go too early, the green shoots of a consumption driven recovery might wither. The most likely scenario is a change of direction by the RBA well before their oft-stated 2024 date, but not just yet.

Global geopolitics has been a more prominent feature of recent months. The new security pact between Australia the United States and Britain, dubbed AUKUS, has heightened regional tensions and perhaps contributed to temporarily weaker trade relations with China. Certainly, the market price of iron ore, Australia’s largest export item to China, has fallen calamitously, coincident with these trade tensions, but also reflective of genuinely lesser demand.

Meanwhile, other commodity prices, notably the prices of energy commodities natural gas, LNG and coal have risen spectacularly, by more than 100% in a few short months in some markets. Gas and fuel shortages in parts of Europe, and coal shortages in India, are symptomatic of a changing order – ESG and climate change considerations have stymied new investment, supply chain blockages and constraints and costs of trade have been materially affected by COVID, and in the case of European gas, the Russians are seemingly taking advantage of the situation by crimping supply flows. One might surmise that Russia’s supply restricting tactics are an attempt to take some international sanction pressure off their Nord Stream 2 Baltic gas pipeline.

Higher commodity and freight prices are stoking fears of uncontrollable inflation. The Reserve Bank measure of underlying inflation remains stubbornly below their preferred 2% to 3% range, suggesting that sharp spikes in individual components are transitory, having been based off last years’ pandemic affected price collapses. A combination of relatively low wage growth, industrial and service industry automation, and globalisation have so far combined to stymie inflation risks. However, some specific price hikes, freight rates for example, are now so much higher that is seems improbable that they won’t lead to more widespread inflation, and potentially bring forward mitigating actions by central banks. We consider the bond market to be a good indicator of inflationary risks and economic trends, so we shall be keeping a wary eye on bond yields, particularly longer dated bonds where regulatory intervention is less pronounced.

The Australian stock market, as measured by the S&P ASX200 Index, had a quiet September quarter, up by just 0.3%. However, this small movement belies significant intra-quarter action – a strong rally enjoyed till mid-August, followed by an equally quick retreat. Dividend payouts were much improved, particularly in the resources, banking, and healthcare sectors, such that the market average dividend yield is back above 3%, having fallen considerably last year.

The bulk commodity resource companies were particularly profitable, with BHP’s profit from operations up a staggering 80% to US$25.9bn. This was largely driven by strong demand and prices for the steel making commodities iron ore and metallurgical coal. The market price for iron ore soared above US$200 per tonne, with tight supply driven by supply chain bottlenecks, but reversed direction recently, falling back towards US100 per tonne. BHP remains one of our preferred stocks, and Fortescue was added to most of our client portfolios recently due to their large cashflows from iron ore operations and their intriguing transformation towards renewable energy investments and projects.

One useful analytical mechanism to value shares is calculating the present value of future revenues. When assessing the appropriate discount rate, a business’ weighted average cost of capital (WACC) is often used. WACC is a percentage based on a company’s proportionate cost of debt and equity. In recent years interest rates have been extraordinarily low, and this trend is lasting through a full business cycle rather than being fleeting. Consequently, many companies have successfully refinanced their debts to interest rates considerably lower than prior and locked in these lower rates for years to come. The effect of this is a justifiable reduction in a company’s WACC, which in turn leads to higher present stock values, as future revenues are being discounted by a lesser rate. This provides some justification for higher shares prices now and ahead.

Low interest rates have also boosted merger and acquisition activity. Australia’s listed infrastructure sector has been the subject of a frenzy of takeover deals. Sydney Airport has now received three offers from the Sydney Aviation Alliance consortium, Spark Infrastructure has agreed to a binding scheme and AusNet is now the subject of a contested takeover offer. Furthermore, Woodside is seeking infrastructure style investor(s) to partner their Pluto 2 LNG development. More corporate takeover offers are likely due to the cashed-up nature of private equity and pension funds, low funding costs, and generally accommodative credit conditions.

Stock market volatility increased recently as investors contend with a mixture of positive and negative scenarios. Fundamental valuations are satisfactory due to improved earnings and dividends, plus the time value economic benefit of retained profits. However, the geopolitical lens has clouded, demonstrated by our deteriorating relationship with China, who happens to be our largest trading partner, and the COVID pandemic consequences have been partly glossed over by the ultra-supportive monetary and fiscal actions of central banks and governments respectively. We are now edging closer to the time when stimulatory actions unwind, hopefully in a phased and controlled manner, rather than via economic or market disorder.

Considering the various scenarios, the Australian stock market outlook remains satisfactory. On our assessment, corporate earnings growth will slow in 2022 but the effect of low interest rates will remain positive, at least for a while longer. A projected fair value for the ASX200 index of about 7700 points provides scope for modestly positive returns ahead.

International stock markets were mostly flat in the September quarter, with the MSCI world index falling by 0.35% in US dollar terms. There was a generally positive tone in July and August, but much weaker since, as investors ruminated over valuations in light of deteriorating global order, rampant inflation in the energy and freight sectors and the creeping certainty that monetary stimulus needs to end.

The United States is now dealing with budgetary funding issues, needing to surpass their government financing debt limits yet again, at the same time as congress seeks trillions in funding for generational infrastructure and social investments. US shares have been relatively strong in recent years and now carry fulsome valuations – there is apparent downside risk if their finances are not adequately solved, or if economic activity slips.

A notable outlier market recently is China, whose Hong Kong, Shanghai and Shenzen stock markets have been tumultuous due to regulatory intervention in various sectors. Their property sector has contributed to the uncertainty. A generation of rural to urban domestic migration and easy stimulatory conditions have combined to create a boom in residential construction, and a corresponding heightening of risks and indebtedness. One giant developer, Evergrande, has aggressively expanded and is now recklessly and precariously indebted. Their development empire is huge, comprising 1,300 housing projects (mostly apartment blocks) in 300 cities. Evergrande’s indebtedness is also massive – estimated to be about US$300bn, a staggering amount for an individual company. The contagion risks of an Evergrande collapse are significant, including mass defaults to its creditors and customers, the possibility of heightened civil distrust and the uncertainties of the rather opaque shadow banking industry in China. This stands as one of the market’s risk factors for the final quarter of 2021, though is not expected to have a material lasting impact on global credit markets and banking.

Of late, we have preferred the Singapore and Japanese markets for our Asian share exposures, though the relative value of some Chinese stocks has now become much more appealing.

European markets have been up and down, contending with rampant energy prices as they head towards the colder months, stubbornly persistent COVID infections, supply chain congestion but a generally brighter consumer outlook. In Germany’s election the centre-left Social Democrats came out on top following the retirement of the popular and successful chancellor Angela Merkel. However, neither the Social Democrats nor Merkel’s Christian Democrats won a clear majority which will cause an extended period of negotiation to form a government and create a period of policy uncertainty. Our investment focus in Europe has mostly been in global leading companies in the healthcare, consumer staple, automotive and industrial sectors. We consider the continental European markets and Britain to be prospective investment destinations in the coming years.

The Australian dollar followed the iron ore price down in August but has since stabilised at about US73c. Other cross rates are a bit better with our currency rising slightly against the Euro and the Japanese Yen in recent weeks.

The unit prices of Australian Real Estate Investment Trusts (REITS) had a moderately positive September quarter, up by 3.7%, outperforming the broader share market. Much of the improved performance reflected the bounce back from last year’s shock, and a realisation that commercial property conditions were not as fearfully bad as expected.

The Property Council of Australia reported that occupancy of Sydney’s CBD was just 4% of the pre-COVID level during that city’s recent lockdown period, a staggeringly low number that undoubtedly was one of the factors behind the NSW state government’s rapid reopening strategy. Yet valuations, transactions and lease deals have stayed relatively healthy, despite the low physical occupancy. Clearly, the pandemic is being seen as a temporary interruption to the commercial property market, which was otherwise performing well. The test will be 2022, when CBD restrictions are over, and occupancy theoretically reverts to normal. Any disappointment in 2022 occupancy and rental data will weigh on property business’ funds from operations, and perhaps hinder the performance of listed securities.

Commentary and results from Scentre Group, the operator of the Westfield shopping centres, provides good insight to the operational conditions of the retail property sector. In their review of the 2020/21 year, released in August, Scentre reported strong occupancy of 98.5% leased, and 1,515 lease deals during the prior six months including 619 new merchants. Scentre reaffirmed distribution guidance of 14c per security for the year, assuming city lockdowns end prior to 31st October. Undoubtedly, the operational conditions in large format retail are much improved, with visitations and foot traffic quickly returning to pre-pandemic levels. There has been a noticeable uptick in retail shopping centre transactions, particularly regional and rural, often on capitalisation yields tighter than expected.

Residential property remains strong nationwide. Regional property has benefitted from border closures and more adaptation of flexible work location practices. The banking and financial system regulator, APRA, recently raised the minimum interest rate buffer it expects banks to use when assessing the serviceability of home loan applications. The adjustment was small, now 3% (was 2.5%) above the relevant loan product rate but is the first regulatory step taken to cool a heated market, and potentially assist the housing affordability problems.

The Reserve Bank of Australia (RBA) meets on the first Tuesday of each month to deliberate economic settings and interest rate policy. The cash interest rate was emergency-reduced by the RBA in March 2020 to 0.25% then further to just 0.1% in November 2020. Their most recent pronouncement cited the COVID delta outbreak as interrupting the recovery of the Australian economy and consequently the RBA expect a material decline in national GDP for the September quarter. Inflation, apparently, is just 1.7%, providing justification for the RBA to stay its stimulatory course. Their measure of inflation is starting to lack credibility as everywhere you look in the real world – freight, commodities, real estate etc. – inflation is considerably higher than the RBA’s statistical reading.

Nevertheless, the RBA is still saying that the conditions required for an interest rate raise are unlikely to be met before 2024. We’ll see.

Meanwhile, long term interest rates are rising already. US 10-year treasuries are 1.6%, up from their low of just 0.6% last year. Australian 10-year government bonds are 1.7% up from last years’ low of 0.7%. Market forces are clearly pricing in some inflation and growth momentum, regardless of the RBA’s observations.

Elsewhere, official cash interest rates have begun to rise. The Reserve Bank of New Zealand raised their cash rate to 0.5% this month, following central bank interest rate rises in South Korea, Norway, Czech Republic, Brazil, Chile, Russia, and Mexico. These actions represent the winding back of emergency measures implemented last year and reflect the need to waylay inflationary pressures. Moreover, there is a growing understanding that there is a limit to government indebtedness and money printing programs. Other countries including Australia will surely follow, perhaps by tapering the quantum of their asset and bond buying programs, ahead of cautious increases in rates.

The credit markets remain well supported. Indeed, the trading margin of Australia’s big four bank hybrid AT1 (additional tier 1) securities is at about the lowest point in a decade. The only lower point was just preceding the financial crisis in 2007. Such low margins are good for issuers, who can raise capital at reduced rates, and are also attractive to investors as they hunt yield in an otherwise barren landscape, with perhaps too little consideration of the inherent risks.

Term deposit rates remain very low, typically between 0.3% and 0.5% as banks find that they have ample liquidity via customer deposits and RBA facilities. Eventually the banks will need to raise deposit rates as they seek to diversify their sources of funding, but probably not for a year or more.