There are multiple explanations. Firstly, lower risk-free rates infer a better (lesser) inflation outlook, which is generally positive for businesses. Secondly, the central banks (in this instance the US Federal Reserve) pronounced an intention to commence a reduction in the short-term official rate, which stimulated investment activity and potentially arrested the rising interest burden on corporate profits. Thirdly, share prices are partially a reflection of the present value of future cashflow and profits, so when interest rates fall so too does the degree by which future earnings are discounted, thereby increasing the present value.
The improved investment conditions have extended to the credit markets in the form of very tight credit spreads. Credit spreads are the margin above a reference interest rate that corporations need to pay for their debt. It is rather surprising that spreads are currently so low – the inference being low default risk and benign to strong economic conditions. Reality suggests this to be a delusion, as households are burdened by higher costs, consumption spending is softening and unemployment rising (albeit slowly, thankfully). We have concluded that credit market conditions are too optimistic, and caution investors in higher risk, low quality debt instruments to be extra vigilant – the obvious strategy being divestment of such, in favour of lower risk deposits and bonds.
The Australian economy proved rather resilient in 2023, propped up by robust exports (primarily minerals, gas, and agriculture), higher than usual government spending and the benefits of significant population growth, mostly via immigration.
But consumer spending has been weak, reflecting elevated household costs stemming from persistent goods and services inflation and higher mortgage rates. Retail sales data suggests a trend towards discounting and a slackening of discretionary spend, particularly higher ticket price items.
There is no obvious reason that the phase of economic activity ahead is much different from the recent experience, as the governments continue to spend (perhaps a little rashly), and commodity volumes and prices are mostly satisfactory. The International Monetary Fund has projected real GDP in Australia to be just 1.4% in 2024, which is unsatisfactorily low by our historic expectation, but nonetheless, not a recession. Key risks include commodity prices and volumes, particularly Chinese demand for iron ore, and the possibility of escalation of geopolitical crises and tensions in Europe and the Middle East.
Australian Shares
The Australian stock market, as measured by the S&P ASX200 Index, rose by 4% in the March quarter, extending the upwards trajectory that commenced last November. Dividend payments added a further 1.3% for the quarter. The better performance of the market was driven by a sharp rise in US share prices, which in turn were boosted by improved investor sentiment, economic upgrades and reducing inflationary expectations and bond yields.
A good deal of the recent market improvement is a relief bounce-back from a very poor July to October period last year. Australian shares now reflect an earnings yield of about 5.9% (or a P/E ratio of about 17x). On a cyclically adjusted basis (and excluding inflation) this earnings yield is about 5%, which is modestly lower than our long-term average, suggesting a slight but tolerably overpriced market. Our long bond yield, after a period of volatility, has settled in the 3.8% to 4.3% range, which is broadly reflective of a ‘normal’ rate given the economic and inflation outlook, whilst average dividends have reverted to our historically consistent 4%.
A fully priced market will inevitably suffer a retracement, probably within the usual correction range of 5% to 10% and perhaps driven by a slack earnings outlook, and possibly less dovish mutterings from the central banks. Longer term investors shouldn’t fret as any pullback will be temporary, but those needing to raise funds this year should do so whilst prices remain elevated.
Within the market subsectors, property, consumer discretionary and bank shares performed strongly, all being economically cyclical sectors, suggesting a broad satisfaction amongst investors about the economic and profit outlook. Wesfarmers, a conglomerate is a good case in point. Their discretionary retail chains exceeded profit and sales growth expectations, particularly Kmart, which benefitted from value conscious consumers. The shares of Woolworths and Coles and many of the healthcare stocks struggled, due to higher wage and operating costs crimping profit margins.
Looking forward, our analysis of the major stocks and our assessment of the returns an investor needs to compensate for risk (the equity risk premium), suggest limited upside for a while. Extraneous events, such as a continuation or escalation of the Ukrainian or Middle East crises, or a credit event such as an increase in defaults amongst the commercial real estate sector could derail the sanguine position and cause a sharp market sell-off. Also, the Reserve Bank might take a not so market-friendly approach by deferring interest rate reduction decisions.
Global Shares
In the March quarter the MSCI world stock market rose by 8.5%, adding to the strong recovery phase that commenced in November last year.
Central bank policy has pivoted. In the US, the Federal Reserve has projected multiple interest rate cuts, reversing their prior policy. In contrast, the Bank of Japan ended its negative interest rate policy in March and softened their ‘yield curve control’ mechanism, hinting that the entrenched deflation of the past decades might be ending. The European Central Bank and the Bank of England both dropped expressive hints that rate cuts are coming, whilst the Swiss National Bank did cut its benchmark rate by 25bps to 1.5%. Global shares liked this collective central bank pivot and surged higher.
Higher global share prices were achieved despite there being some factors and events that otherwise might have caused markets to fall. These include higher (though abating) inflation, raised geopolitical tensions and weak consumer confidence. It’s great that markets are performing so strongly, but a tad surprising, nevertheless.
Momentum can play a key short-term role in markets. The surge in artificial intelligence and advanced technology stocks last year was a catalyst for more speculative profit-seeking investors to pile in, thereby increasing buy side volumes and pushing prices higher, partly via market algorithm products and funds, where transactions are sometimes made with scant regard to intrinsic value. Optimism in markets inevitably leads to greed, as does pessimism lead to fear. A key and important adage for long-term successful investing is to accelerate purchases when markets are fearful, and back off when the optimists have caused market froth.
In the United States the stock market profit yield on a cyclically adjusted basis is a paltry 3.2%. This, at face value, is insufficient to adequately compensate investors for market risk. The market seems to be pricing in a significant further surge in profits, which would increase the profit yield, or a large drop in interest rates, which would improve the relative value of shares. Should neither of these occur US share investors might have a disappointing period ahead. Whichever way fundamental data is analysed, the US market is due a pullback.
Elsewhere, shares in Japan have rebounded tremendously due to better economic growth, improved corporate governance structures and a bit of inflation, following a sluggish period. Mainland Chinese shares have also rallied from a low level whilst Hong Kong share market valuations remain considerably cheaper than any other major market, in our assessment.
The Australian dollar has been range bound between US64c and US66c for a while and similarly stable at about €0.61 but has been noticeably higher against a weakening Japanese Yen. Our dollar is sensitive to commodity prices, our terms-of-trade, our relative purchasing power, and our relative interest rate. Our RBA cash rate of 4.35% is lower than the corresponding US rate of 5.25%, so our currency may rise a fraction should the US Federal Reserve proceed with their interest rate cut program whilst our RBA sits pat.
The outlook for positive investment in overseas shares is presently stymied by relatively high prices and the poor purchasing power of the Australian dollar. Nevertheless investors benefit from global diversification by accessing a multitude of economic sectors and currencies, so we continue to make and recommend modest and selective investments offshore.
Property Securities
The prices of listed Real Estate Investment Trusts (REITs) rose by a further 16.1% in the March quarter, representing an acceleration of the gains achieved late last year. Most of the significant security price recovery was a rebound from an undervalued status rather than meaningful increases in property valuations or funds from operations.
REITs that develop or manage industrial property have performed best as the tenancy demand for such property remains strong. Goodman has been the standout, benefitting from well managed industrial exposures, and an increasing investment in data centres.
The shopping mall REITs have also performed well, though this was (unsurprisingly) the sector initially hardest hit by the pandemic onset. Scentre Group (Westfield) and Vicinity Centres have proved to hold resilient assets with consistently high occupancy, which has led to a quick recovery in their funds from operations, and an increase in securityholder distributions. BWP (principally a Bunnings landlord) hasn’t fared so well having less flexibility with leasing renewals and suffering a bit from higher interest rates.
By contrast, the office sector has performed relatively poorly, still struggling to recover from the CBD exodus of 2020/21. Premium-grade office vacancy in Australia’s major CBDs exceeds 12% and B-grade office vacancy rates even higher. Lease incentives have risen above 30%, in some instances approaching 40%, levels that haven’t been seen for decades. This situation will be exacerbated for a while due to more supply, principally new and renovated buildings including redevelopment of state government transport infrastructure sites.
Hence, there isn’t much good news in the commercial office space, except that stock market investors can still buy securities at a sharp discount to the underlying property values. Dexus for example disclosed net tangible assets per security of $10.04 as at end-2023, but their unit price has been consistently sub $8. Good value, in our assessment.
Residential property prices (and rents) have remained strong, benefitting from weak supply and strong demand (including from immigration). A perfect storm perhaps, because it is so out of sync with the core fundamentals of the consumer economy. Supply has been curtailed by stifling regulation and a shortage of labour, whilst demand has been driven by investors competing with first homebuyers and migrants. Meanwhile significant government funded public infrastructure projects have dragged workers away from housebuilding, exacerbating the cost pressures. It’s a problem that won’t be solved easily nor quickly.
The near-term outlook for investors in the REIT sector is satisfactory, but no longer as appealing as it was last year. A fall in interest rates would help, but we think any such fall to likely be relatively modest.
Interest Rates
There’s been a lot (far too much) media and market chatter about when/will/how much the central banks might lower interest rates later this year. What’s often overlooked is that interest rates have merely normalised from an artificial low and are not actually particularly high. Those expecting rates to fall significantly in the next year or so are likely to be disappointed.
A ‘normal’ interest may reflect a country’s core undelaying inflation rate plus a relevant risk premium. If we consider our inflation rate to settle at close to 3% (accepting this to be higher than the RBA’s 2% to 3% target) and add a 1% risk premium, we get approximately todays rate – and it would take some meaningful event or trend change for the Reserve Bank or the markets to materially alter this. The RBA also considers a concept called the non-accelerating inflation rate of unemployment, this being the unemployment rate at which inflation is stymied. They are too conscious of appropriate rhetoric to illustrate that this is about 4.5% unemployment – in other words unemployment needs to rise a lot before the RBA thinks inflation will be tamed by reduced demand.
So, the RBA is sitting pat on its 4.35% cash rate contemplating all the domestic and global factors of influence for a while. They don’t meet every month anymore, just 8 times per year now, so it could well be that the present pause in rates persists well into the second half of the year.
The US Federal Reserve has been more vocal about projected rate cuts, but so they should because they had raised rates by more than here. It is widely expected that US rates will begin to fall soon, perhaps two or three small reductions this year. When the Fed or the ECB do start cutting rates, they will probably concede that their policy settings had been sufficiently ‘restrictive’, so they can justify adjusting rates a tad lower even if inflation hasn’t abated to their target. Our view is that central banks will proceed with caution, not wanting to make a policy error by cutting too quickly then having to reverse course should inflation persist into 2025.
Such a scenario is likely to cause a moderate flattening of the yield curve, i.e. shorter-term rates fall only modestly, which might then cause mid- term (2-5 year) rates (which have been priced expecting larger rate cuts) to rise a bit. Bond investing has high security of coupon and principal, but market pricing volatility risk that increases with duration. Our position at present is to hold a majority of our defensive assets in short dated variable rate securities, retain (but not increase) mid-duration bonds, and watch for an opportunity to add duration as 2024 proceeds.
Higher risk fixed interest has remained popular as investors chase fattened yield. Private credit pools have proliferated, and so have a variety of asset and mortgage-backed securities. Credit spreads are very tight, meaning investors are keen for high returns and more lackadaisical about risk. In our assessment spreads are now too tight relative to the sanguine (but a bit soft) economic outlook. There’ll be some pain ahead in higher risk fixed income investors as incidences of arrears and default increase.
The bank tier 1 hybrid sector is being reviewed by the Australian Prudential Regulatory Authority (APRA). APRA has expressed some concern that retail investors lack sufficient information and knowledge about the risks associate with this type of investment security, a concern that we share given the unexpected wipeout of investors’ capital in Credit Suisse hybrids last year. APRA may tighten the distribution rules, or the structure or preferred market domicile of these securities but haven’t yet released their report.
Having considered the multitude of interest-bearing investment types and the various associated risks there is a lot to be said for a cautious and defensive approach. Term and cash deposits, bonds and high-grade credit offer decent low risk returns.
Outlook
The global economy in 2024 is doing better than expected, so there is some justification to support elevated asset prices. It’s difficult though to find good investment growth prospects on a near-term forward-looking basis as asset prices generally are a full reflection of the sanguine conditions.
Consequently, investment portfolios should be tilted a bit more defensively, happy to collect some interest whilst rates are up, and providing portfolio ballast to be applied to further stock purchases when better-priced market opportunities arise in the coming months.