Australia’s Reserve Bank meanwhile has found itself caught in a dilemma, feeling inclined to raise rates further to waylay inflationary pressures but knowing that doing so may cause unreasonable pain to a cohort of society. You see, the Reserve Bank’s interest rate tool is a blunt one, as it can cause a small group of mostly younger borrowers’ financial hardship but do nothing to really arrest supply chain or commodity side inflation, not to mention undoing the money supply inflation that they contributed to.
The RBA is also mindful of the Australian dollar which has been trading sharply lower. One reason for this is the wide cash interest rate differential between Australia (4.1%) and the United States (5.5%). Money flows have been strongly towards US dollar deposits, exacerbating the cost of imports domestically, witness for example the bowser petrol price.
So, on balance it is likely that the RBA will raise rates again, perhaps more than once. This may happen imminently, or they may continue their pause into the new year. This will be a further adjustment towards a normalised interest rate and shouldn’t be considered as particularly negative for financial markets.
Borrowers will need to adjust to these higher for longer conditions, but thankfully most mortgagees in Australia have been acutely aware of the additional costs associated with higher rates, particularly those loan structures that are flipping from fixed rate to variable. In the main, borrowers have been making mortgage payments considerably more than the requisite principal and interest amounts. This was particularly evident during the recent years of ultra-low rates, leading to a much more comfortable loan to income and loan to value coverage than was expected. Hence the so called ‘mortgage cliff’ has thankfully not materialised.
There has been a noticeable slowdown in China’s pace of economic growth, this being important as it is the recipient nation of 30% of Australia’s exports. Pleasingly, the drop in exports to China recently, partly caused by their trade restrictions, has been largely offset by resurging trade with Japan, most notably LNG exports.
Nonetheless, a slowing China escalates the economic risks for Australia, so the parlous state of their commercial property market, and the extent to which authorities can and will provide stimulatory support is being watched very closely. Such stimulatory actions have been routine in recent years but the sheer size of the financial calamity in property development businesses such as Evergrande and Country Garden might test the resolve and capacity of the People’s Bank of China.
Australian Shares
The Australian stock market, as measured by the S&P ASX200 Index, fell by 2.1% in the September quarter and has fallen a bit further since. Dividend payments were generally satisfactory, highlighted by CBA which paid $2.40 for the half-year, their highest ever dividend payment.
The modest decline in share prices has caused Australian shares to now represent good value. An important analytical gauge we use for macro market forecasting is the relationship between the yield offered on shares with that provided by other asset classes. The primary reference yield is the risk-free rate, represented by the Australian Commonwealth 10-year bond, to which we add a risk premium to determine the appropriate price for shares. In essence we are looking to see whether an investor in shares is being adequately compensated, based on the price they are paying, for the risks they are taking.
Now, this reference rate (the 10-year bond) has been rising, creating a higher hurdle rate for shares and hence causing temporarily lower prices. In other words, the recent drop-off in share prices is a reset that now adequately reflects the effect of higher interest rates.
There has been an unusually wide dispersion of equity sector performance and volatility this year. Energy shares, for example Woodside, have performed satisfactorily, enjoying strong export-based cash flows from LNG. Banks too have been resilient, benefitting from slightly improved net interest margins due to the pass-through effect of higher rates, yet suffering from a surprisingly low level of arrears and loan impairments. Meanwhile, consumer staple shares such as supermarkets have noticeably underperformed as purchasers spending habits are crimped by the inflation impact on consumer goods. A good example is Kmart, a subsidiary of Wesfarmers, which reported robust sales growth due to its generally lower price point, whilst Coles and Woolworths are struggling to keep up.
The sector of most interest at present is healthcare, the constituent shares having taken a severe tumble recently. Healthcare businesses typically struggle to quickly pass through elevated costs such as labour and consumables and the revenue and pricing components of their services are often quasi regulated. Hence inflation has affected this sector more than some others and created an earnings growth obstacle that will take a bit of time to overcome. Moreover, the healthcare sector shares are usually valued by analysts as growth-styled businesses, meaning that that the present share prices are a function of applying a discount factor to future projected earnings, so the higher discount rate (bond yield) is weighing on their current share prices. But the healthcare sector has significant long-term potential, benefitting from demographic trends and the essential nature of their services. Hence healthcare shares have become excellent value, and portfolios should be overweight this sector, as we have done. Prospective shares of note include CSL, Sonic Healthcare, Ansell, ResMed and Ramsay.
Looking ahead, Australian shares are fairly good value, so should soon revert to their typical long-term return trajectory. Getting in the way for a while is heightened geopolitical events and risks around the world, which tend to temporarily elevate the required risk premium. Considering about 7,000 index points for the ASX200 as fair value, fluctuations of 300 to 400 points either side of this can be expected as a normal range of volatility.
Global Shares
In the September quarter the MSCI world stock market index fell by 3.8%, reversing the strong performance of the prior six months. The subdued market performance was widespread as the influences were globally based – a period of heightened inflation and bond yields causing a recalibration of profit projections and valuations, and an increase in global geopolitical risks.
Our macro modelling assesses eleven global markets (including Australia) and determines relative value from a wide range of analytical data points. This helps us with our portfolio geographic allocations.
In Europe, Germany stands out as the best value market, assisted by their cyclically adjusted P/E ratio now being lower than usual, an acceptable equity risk premium status, solid corporate profitability, a low sovereign risk and the strong Euro currency. French shares also offer some value, but British shares at present are less favorably priced. We also like the investment attributes of some of the Scandinavian and Swiss businesses.
In Asia, Japanese shares offer some value though this is premised on a continuation of their ultra-loose monetary settings, as the prime driver of valuation is the favorable relativity of shares versus their sub 1% long bond yield. The Bank of Japan is under some pressure to conform to global trends and tighten settings, perhaps even altering their yield curve control policy.
Elsewhere in Asia we consider the Hong Kong market undervalued, as a period of economic recovery is happening specifically in the SAR, but mainland China shares are not as compelling. Singapore is a standout investment destination driven by strong financial, governance and economic fundamentals. India remains a market of interest due to its continuing expansion and growth, but its shares are not cheap, having been one of the few regions to enjoy positive returns recently. We are likely to invest in Indian shares but would prefer more compelling entry prices.
Shares in the United States are generally fairly priced, in our assessment, and offer pockets of good value. The US represents an enormous 70% of all world markets so any well-diversified share portfolio should have some exposure, particularly via some of their ultra large global leading businesses. The US dollar stands as the world’s reserve currency, and indeed the currency destination of choice, and this adds to the appeal of the US as an investment destination.
Regarding the currency, the recent decline in the Australian dollar against most other global currencies degrades temporarily the relative value of investing overseas. In other words, the Australian dollar has relatively weak purchasing power, and hence may act as a handbrake on overseas share performance for a while, meaning that, on a relative basis, investing more domestically for a while is more appealing.
Looking ahead, it’s pleasing to see few signs of badly deteriorating corporate earnings and the much talked about forthcoming global recession has not eventuated. Hence the weaker markets of late should stabilise and recover, though not without the continuation of some fairly severe volatility, possibly brought on by spikes in bond yields and/or geopolitical conflicts. Longer term, arresting the significant rise in global sovereign indebtedness is a policy necessity, failing which there will be a financial reckoning.
Property Securities
The prices of listed Real Estate Investment Trusts (REITs) fell by 2.9% (including distributions) in the September quarter, and have fallen a further 4% since, reversing all the recovery that had commenced late last year. This recent period of underperformance is due to the combined effects of rising interest rates and general uneasiness about commercial property occupancy levels and rental growth potential.
Interest rates affect REITs in three key ways. Firstly, owners of real estate usually carry borrowings against these assets, so higher rates will cause extra interest costs and possibly crimp the owners receipted funds from operations. Secondly, real estate valuations usually use a capitalisation rate methodology, essentially capitalising expected rental income at a rate that is referenced to prevailing market interest rates. Higher interest rates may therefore lead to reduced carrying valuations. Thirdly, the stock market prices REITs as interest sensitive investments as the trust component is required to distribute all income. When interest rates rise the income yield of REITs needs to be commensurately higher, which can cause market prices to reset lower.
However it’s hard to fundamentally justify a continuation of low REIT market prices for too long as in many cases the projected distribution yields are above 6%, which is satisfactory on a relative basis, and share market capitalisation values are an enormous 30%+ discount to the value of the underlying real estate.
Within the real estate sectors industrial property has performed best, and now commands lower than expected valuation capitalisation rates. Goodman Group is the primary beneficiary due to their large high quality portfolio of logistics and data centre properties, but its not likely that valuation metrics in this sector retain such relative strength and may lead to a period of underperformance.
REITs with a diversified portfolio of commercial, retail and industrial property are more appealing. These include Stockland, Charter Hall, GPT and Dexus, all of which are trading at significantly depressed share prices, yet have reported relatively sanguine operating conditions. GPT for example, reported high sales productivity and 99.5% occupancy in their shopping centres, a 7% revenue increase in their logistic division but a challenging leasing market for offices. Their financial accounts revealed an increase in financing costs due to rising cost of debt, but their share price is just $3.60, well below their net tangible asset value of $5.85 per secuity. The stock market is being unreasonably pessimistic.
Interest Rates
After all these years of ultra-low rates and central bank interference interest rates are now rapidly normalising.
The Reserve Bank (RBA) has been assessing a range of economic data and trends, particularly trends in inflation and employment and watching for consumer stress points. Inflation is a bit stubborn, veering lower but not very quickly, whilst employment trends remain remarkably resilient. It’s likely therefore that the RBA will again raise the cash rate, perhaps more than once, as they continue their inflation-taming battle.
At the other end of the interest rate market long-term bonds have been ratcheting higher, driven by global trends, stubborn inflation, an inclination by central banks to tighten policy and a perception of supply risks, particularly those countries with excess sovereign indebtedness. Thankfully Australia is not one of those countries, as we have a (close to) balanced federal budget and a relatively low government debt to GDP ratio.
The average long-term bond yield in Australia over the last sixty years is 7.25%, but this included periods of 10%+ plus rates in the 1970’s and 1980’s. Since the turn of the century our long-term rate has averaged 4.1%, so the current 4.75% rate should be considered relatively standard. It is the artificially low rates that prevailed between 2016 and 2022 that should be considered abnormal, rather than the present rate.
Now that rates are trending up it is unlikely that this trend will stop for a while, so the unsettling effect on consumer confidence and asset valuations will persist. Periods of rapid reset in financial markets are implicitly linked to volatility, as we have seen recently. However, this volatility will ease as quickly as it arose.
The interest-bearing securities that pay interest at margins above prevailing bank bill rates have benefitted from the rise in benchmark rates, triggering considerable increases in income for investors. But with stronger demand for these instruments (including bank tier 1 and tier 2 hybrids and various credit securities), comes higher market prices such this there is not a lot of outstanding value in this sector, and there should be an unwillingness by investors to take unreasonable risks in the hunt for high returns.
Instead, investors should focus on low-risk interest bearing investments such as bonds, term deposits, cash and strong investment grade credit. These now pay decent rates of income without having to take unnecessary risks.
Outlook
Share, property security and bond prices have all recently fallen such that each of these asset classes now represents acceptable investment value.
Our key stock market modeling, which utilises equity risk premium methodology, suggests Australian shares are now modestly underpriced on a risk relative basis. Some international markets are also satisfactory value, but the weak buying power of the Australian dollar erodes this appeal, causing us to strongly prefer domestic shares at present. Property securities are underpriced and are likely to rebound when the interest rate cycle shows signs of peaking.
Bonds have become an important and rewarding component of an interest-bearing investment portfolio, now offering solid income with low risk.
But there are worrying geopolitical risks abroad, and the global economic environment is moderating, so investors should remain cautious and increase asset positions selectively rather than going all in.