Most investment markets performed admirably in the last twelve months, particularly as economic
trends have generally been uninspiring. Stock and real estate prices have certainly benefitted from
the unprecedented stimulus provided by central banks and governments, in the form of
extraordinarily low interest rates, and even more extraordinary money printing programs.
This central bank largesse had the intent (hope) of reflating economic activity and hence jobs, but in
reality, has been more beneficial for investment asset prices rather than broad economic growth.
There is no better illustration than this chart,
which shows a collapse in business investment
in Australia despite the extraordinary interest
rate settings. This is not a good look.
The primary global economic conundrum ahead
is how and when this post-GFC stimulus process
ends. The importance of this can’t be
understated as the quantum of assets acquired
by the central banks is truly enormous – more
than US$12 trillion, at last count, by the troika
of the US Federal Reserve, European Central
Bank, and the Bank of Japan. Each of these
institutions is now contemplating the process of
unwinding, either by maturing or reducing bond
purchases or raising interest rates. The pace and consequences of their actions will be watched very
carefully in the coming year.
Two rather disparate points of view contest investment asset price deliberations. Firstly, the more
optimistic case, argues that deflationary risks are dissipating, and global economic activity is on the
mend. This view is supported by some improving data, including global PMI (manufacturing
expectations) and modest gains in some labour markets, and concludes that profit growth will justify
relatively high share prices, even if interest rates rise. The second point of view is that there is a wide
Source: RBA
disconnect between investment asset (shares and real estate) prices, and economic activity, and
sooner-or-later weak GDP, retail sales and business investment will drag asset prices lower.
There is some truth in both these perspectives. It is our view that economic activity will generally
remain below trend, interest rates remain very low, and asset prices find it difficult to rise very much
further for a while. Stock market volatility, which has been subdued this year, will likely increase, such
that there will probably be a couple of sharp sell-off periods ahead, during which assets can be
acquired at more prospective prices.
There are always geopolitical events to worry the naysayer. This coming year these include the
outcome of the German election in September, the momentum of the populist Five Star Movement
ahead of Italy’s 2018 election, the diplomatic tensions on the Korean peninsula and South China Sea,
and presumably a recognition at some stage by Americans that their commander-in-chief is entirely
unsuitable for that role.
Domestically, the primary issue ahead is the potentially calamitous consequences of too much
household debt, in the face of waning employment growth and stalling house prices. At best, this
issue is likely to lead to slack consumption and retail sales growth, but could turn very ugly indeed.
Australian Shares
The Australian stock market lost its positive momentum in May and June such that the return for the
June quarter was negative 2.5%, or negative 1.6% when dividends are included. However, the market
returned a positive 9.3% in the 2016/17 financial year, and an impressive 14% when dividends are
included.
Australian shares have benefitted from the concept of yield compression, that is prices are generally
higher when interest rates are low, and vice versa. This is because the yield on both profit and
dividends is more attractive when interest rates are very low, causing prices to rise. The analytical
concept called the Price/Earnings ratio
is a good reflection of this.
To illustrate the low interest rate
effect, this chart shows that Australian
shares were (on average) priced at 10
times their annual profit between 1960
and 1990, a period during which
interest rates were notoriously high.
Yet since 1990, a period notable for
steadily declining interest rates, the
ratio has averaged 16 times. This
means that the same types of shares
(BHP, Westpac etc.) are priced these
days, relative to their annual profit,
60% higher than they used to be – just
because interest rates are lower!
In our managed portfolios we have adopted a more cautious investment approach, and gradually
divested during the last six months. Shares such as Lend Lease, QBE, Spotless and Goodman Group
were sold and some other stock weightings reduced. Consequently, the managed share portfolios
now have, quite deliberately, a large cash component, which will be held and reinvested as and when
market conditions and opportunities arise.
The banking sector has regularly been in the news recently, due to regulatory changes, government
reviews and enquiries, and new tax levies. We continue to hold bank shares, including ANZ, CBA,
Macquarie and Westpac, but have tended to lighten the exposure. The banks’ challenge is their
requirement to increase regulated capital, at a time that loan book quality might deteriorate,
particularly if real estate prices were to fall.
Global Shares
Stock markets in the United States, Germany and Britain have surged to successive all time high levels
in 2017. The Australian index (inclusive of dividends) was similarly strong, reaching a record high on
1st May, but has declined a little since then. Technology stocks have been particularly strong as
witnessed by the tech-heavy US NASDAQ index, which has risen by a staggering 25% in twelve months.
Whilst returns have been very good, some sectors are now overpriced, and we have reduced the
investment exposure in our managed portfolios accordingly.
The US stock market has also been a beneficiary of the long decline in interest rates and the substantial
liquidity provided by central bank
actions. One commonly referenced
valuation tool is the Shiller cyclically
adjusted P/E ratio, developed by
Professor Robert Shiller, a Nobel
Laureate from Yale University. The Shiller
P/E is clearly indicating a fully priced
market, particularly if interest rates were
to rise.
Recently, our analytical attention has
been directed more towards European
and Asian stock markets, where some
sectors and stocks have appealing
valuations.
Property Securities
The Real Estate Investment Trust (REIT) sector of the stock market fell in 2016/17, and indeed was one
of the few poor performing investment sectors. The decline followed the rush up in REIT prices last
year, which were deemed to be too high relative to a weakening forward view of real estate prices.
The market is often cannily predictive, and the security price declines could well be a harbinger of
weakness in underlying real estate values in the coming year or two.
Within the REIT index, the larger
securities such as Westfield,
Scentre, GPT and Stockland all
delivered poor performance,
whilst industrial property
Goodman Group was the star
performer last year, benefiting
from a well-managed and
executed financing and
development model of global
industrial properties.
Some pockets of retail, commercial and residential real estate are overpriced. In recent years demand
has generally outstripped supply, though significant new development is now causing this to change.
Property valuations with a capitalisation rate of sub 5% for premium commercial property have
become commonplace, with some lower than 4%. This has caused asset price inflation, even in
circumstances lacking strong fundamentals such as tenancy tenure, and rental growth. Low interest
rates are the reason. However, REIT market security prices have already adjusted lower, so the
likelihood is that this sector will stabilise and enjoy a modestly better performance in the coming year
Interest Rates
The Reserve Bank of Australia (RBA) released their quarterly monetary policy statement in mid-June
and reaffirmed the cash rate at 1.5%, a rate that has not changed for nearly a year, and is likely to prevail
for some time. The RBA justified retaining their policy by observing that ‘low growth in incomes, along
with high levels of household debt, appeared to have been restraining growth in household
consumption’. Further, they noted a considerable additional supply of apartments in the eastern capital
cities in the next couple of years, and worryingly, that growth in housing debt had outpaced the slow
growth in household incomes. In such
conditions interest rates are unlikely to
rise much for some time, though the
RBA might start hinting at future rate
hikes, as part of their longer term
program of normalizing rates.
Australian longer term interest rates
have remained in the 2% to 2.5% range
for five year securities, and just a bit
higher for longer dated maturities. The
yield curve, the difference between
short and long term rates, is fairly flat. This pattern is normally indicative of weak economic activity
ahead, a prognosis that concurs with much of the anecdotal statistics.
The components of our fixed interest portfolios are mostly shorter duration securities and deposits, as
longer dated instruments have more price volatility risk. Term deposit rates have stabilised at 2.5% to
2.75%, and continue to offer a very safe investment. Major bank and corporate income securities offer
a yield enhancing alternative, but have market price and capital structure risks that need to be carefully
considered.
The Australian dollar seems to have found more stability, trading between US70 and US77 cents all
year. It has been similarly stable on a trade-weighted basis. Against the Euro, the dollar has fallen a
bit, reflecting expectations that Eurozone economies are beginning to shake off their long period of
economic malaise. Looking forward, the Australian dollar lacks much upside momentum, due to
lingering weakness in the market prices of our major export commodities such as iron ore and coal.
Outlook
We remain concerned that share and real estate prices are somewhat disconnected from underlying
economic activity, and for much of this year we have been expecting markets to encounter some
bumps. To date, stock market setbacks have been relatively minor and real estate prices have proved
resilient. Nevertheless, the outlook is beset with uncertainties, so we are retaining our cautious
investment stance.
Economically, we expect the weak trend in retail sales, consumption and the labour market to continue,
offset by strong tourism and services sectors and robust construction activity. Interest rates will remain
low and share prices will suffer some short-term pitfalls. This would be a generally satisfactory outlook
if it were not for the frightening level of household and government debt. We don’t have a lot of room
for error.
Disclaimer & General Advice Warning
This publication has been prepared by Joseph Palmer & Sons (ABN 29 548 490 818) an Australian Financial Services Licensee (AFSL 247067). Whilst the information contained in this publication has been prepared with all reasonable care from sources, which Joseph Palmer & Sons believes are reliable, no responsibility or liability is accepted by Joseph Palmer & Sons for any errors or omissions or misstatements however caused. Any opinions, forecasts or recommendations reflects the judgment and assumptions of Joseph Palmer & Sons as at the date of publication and may change without notice. Joseph Palmer & Sons, their officers, agents and employees exclude all liability whatsoever, in negligence or otherwise, for any loss or damage relating to this document to the full extent permitted by law. This publication is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Any securities recommendation contained in this publication is unsolicited general information only. Joseph Palmer & Sons are not aware that any recipient intends to rely on this publication and are not aware of the manner in which a recipient intends to use it. In preparing our information, it is not possible to take into consideration the investment objectives, financial situation or particular needs of any individual recipient. Investors must obtain individual financial advice from their investment advisor to determine whether recommendations contained in this publication are appropriate to their personal investment objectives, financial situation or particular needs before acting on any such recommendations.
| Author | Malcolm Palmer |
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