Investment & Economic Review January 2021

In Australia, the Federal Government, and their agency the Reserve Bank have come to the rescue. When the 2020 chapter is inserted in history books, as it indubitably will, some reference will be made to the gigantic increase in Australia indebtedness, and the abandonment of any pretense of balancing budgets, and this by a Liberal government, whose core philosophies have been scrapped.

A trillion dollars are being borrowed in Australia, but at least the financial conditions for doing so are perfect. Inflation has been kept at bay for decades, due partly to the disinflationary effects of globalisation and industrial automation. This has caused interest rates to be ultra-low, and with a bit more rate-tweaking by the Reserve Bank, has allowed this mountain of debt to carry miniscule interest rates – though one does wonder where the refinance or repayment funding will come from when the principal falls due.

Ultra-low interest rates have coincided with a disposition towards higher savings, and consumption expenditure has declined. The effect of this is that Australian households, and the private sector generally, are in extremely strong financial position, which will lead to a consumption led economic surge in 2021 and 2022. In fact, household balance sheets, largely consisting of assets such as real estate and superannuation less mortgage and credit liabilities, have never been stronger.

After a prolonged drought agricultural conditions have improved dramatically, and this fortuitously coincided with a surge in agricultural commodity prices. Wheat for example, is now above US$6 per bushel, up from an average of US$4 to US$5 in recent years. NSW enjoyed a particularly large 2020 grain crop, about four times the drought affected 2019 harvest. This rare combination of high volumes and high prices will significantly bolster incomes and economics in rural and regional Australia. With surging farm incomes, and generous government asset depreciation incentives, John Deere dealers in regional towns would be well advised to have plenty of stock.

Australia continues to weather the pandemic and global downturn better than most, and with robust conditions in our core export sectors and higher household savings and wealth, our recovery and longer-term growth outlook is excellent. It is little wonder that share and real estate prices have been rising. Now, if only the COVID pandemic would come to an end!

In 2020 the energy, industrial, utilities, financials and property stock market sectors fell, all materially affected by pandemic economics and sentiment. However, in the December quarter bank, energy and property shares resurged, as the market rotated towards these economically cyclical or ‘value’ sectors. For context, Commonwealth Bank shares are currently about $85, having plumbed a low point of less than $55, albeit briefly, last March.

One of the standout features of 2020 was the price resilience, then price surge, of mineral and agricultural commodities, Australia’s primary exports. The doubling of the iron ore price led to strong share performance from industry participants like BHP, Rio Tinto, Fortescue and Mineral Resources, and has also underpinned a recovery in the Western Australian economy, bolstered the nations terms of trade, and caused the Australian dollar to rise. The price of coal also rose considerably, and just recently port supply chain constraints and blizzardy conditions in North Asia caused a dramatic increase in the spot price for liquified natural gas (LNG), our third largest export item.

Individual stock performance remained unusually unpredictable this last quarter. Very significant recoveries occurred in energy production and supply stocks Woodside and Santos, yet AGL shares, in the energy utility sector, declined. Bank shares rebounded strongly as loan default risks eased, BHP rose by about 20% on the back of higher commodity prices and agricultural stocks such as Costa rose due to better growing conditions. Healthcare shares, which have been stellar for several years underperformed, partly due to their fairly full prices and also the higher dollar, given that CSL, Ramsay and Sonic all have considerable overseas operations.

A major market feature is the reference ASX200 P/E ratio which (believe it or not) is currently 22.3x. However, this is a trailing data point, reflecting the significant decline in reported earnings per share (EPS) in 2020. Looking forward, there is forecast to be a 28% increase in average EPS post pandemic, which if attained would quickly revert the market average P/E ratio to the usual 16-17x, assuming no change to current share prices.

Consequently, market index forecasts of about 7200 points for the ASX200 are reasonable, assuming a reversion downwards in the P/E multiplier (caused by EPS recovery), a corresponding gradual, but not dramatic, uptrend in bond yields and the maintenance of the long-term average Equity Risk Premium (ERP), which allows an undemandingly low required market return (due to ultra-low bond yields).

A more bullish case would arise if the post pandemic EPS bounce happens whilst ten-year bond yields remain low, say below 1.5%. In this scenario the ASX200 would breach its previous high and head even higher.

The bearish case involves a stalling of EPS recovery due to constrained economics and a corresponding dislocation in the bond market should Central Banks either lose control of their monetary processes or choose to lessen their involvement. In this scenario share prices would fall sharply, though it is difficult to analytically justify an index below 6000 points for any sustained period.

Like Australia, overseas economic cyclical styled stocks generally outperformed in the December quarter, at the expense of the health and technology sectors, which are having a lull period after a few stellar years. However, as usual there has been considerable volatility on an individual stock basis. In our model portfolio US industrial General Electric and energy company Schlumberger both rose sharpy, as did financial service stocks BlackRock and Wells Fargo, and Japanese industrial automation stocks Nidec and Fanuc. European health stocks such as Roche, Sanofi and Novo Nordisk were a little weaker, as was Salesforce following their dilutive acquisition announcement of technology business Slack.

Most international stock markets now exhibit less favourable valuations than Australia, as their relative economic performance is weaker, and the pandemic effect more severe. However, unsurprisingly, our dollar has risen, which makes overseas shares a bit cheaper for Australian domiciled investors. Consequently, some foreign stocks are appealingly priced and have been added to our global portfolio. These include the Singaporean real estate company CapitaLand, and the British health/hygiene company Reckitt Benckiser, which counts Dettol, Mortein and Nurofen amongst its many brands.

The near-term outlook for the Australian dollar is bolstered by the strong volume and price conditions of our key exports, iron ore, coal, LNG and grains and cattle. Global supply chain constraints have generally helped Australian exports, but post pandemic de-bottlenecking will likely erode this advantage and cause the Australian dollar to stop rising.

Meanwhile, suburban industrial and logistics real estate is booming, as a scramble for e-commerce distribution locations is forcing up rents and valuations. The favourable trend towards suburban and regional real estate, at the expense of CBD, will likely continue in 2021.

When inbound international tourism recommences and office demand outstrips supply again, the CBD will recover. However, in Sydney’s CBD new supply of more than 500,000sqm is looming in 2021-22 from developments currently under construction or refurbishment, to be followed by the completion of the Metro projects in 2023-24. A period of rising vacancy, a squeeze on rental income for landlords and juicy incentives for tenants is coming.

The specialist retail REIT’s have recovered considerably. Scentre Group, which owns the Westfield malls, has benefitted from a quick resurgence in suburban assets, despite some leasing difficulties with discretionary goods tenants, and low foot traffic in its CBD malls. The negativity of mid 2020 has proven to be overdone, however it is likely that pricing power has shifted markedly from the landlord to the tenant, meaning that growth in funds from operations, the key financial metric in REIT valuations, will be more difficult to achieve for some time.

The RBA’s economic assessment led to their cash rate reduction decision, and they also added further significant stimulus by reducing the yield target for 3-year bonds to just 0.1%, reducing the interest rate on new Term Funding Facility drawings to 0.1%, and reducing the interest rate on exchange settlement balances to zero. Furthermore, they allocated $100m towards the purchase of 5-year to 10-year federal and state bonds in the first half of 2021, the significance of which is important, as it indicates a preparedness to maintain aggressive interest policy for an extended period.

The RBA has made it clear that they are not contemplating further interest rate reductions and will not consider a policy of negative interest rates due its questionable benefit. They have made it abundantly clear that their policy of ultra-low rates will persist for a few years, which should maintain a stimulatory tailwind to economic activity recovery.

Low cash rates mean term deposit interest will be similarly miserly. Banks don’t need significant funding from customers when the RBA is providing it more cheaply, so interest-seeking investors will regrettably have to suffer an income hit for an extended period.

Credit spreads and yields generally on higher risk fixed income securities have been surprisingly stable, reflecting very little delinquency or default expectation. Indeed, credit markets are remarkably calm, perhaps too calm, as some lingering economic effects of last years’ turmoil are still to play out. Hybrid prices in Australia are relatively high, reflecting a stronger outlook for domestic bank financial stability, but remain one of the few areas where a 2% to 3% cash income yield is still available.