Occasionally, economic and market valuation conditions are supportive for bonds, shares
and property simultaneously. This has been the case in 2019; circumstances being somewhat goldilocks like, neither
too hot nor too cold.
Rather benign, though weakening, global economic conditions, and a spate of geopolitical
concerns and trade tensions have caused Central Banks to be particularly aggressive with their policy settings,
pushing and holding interest rates as low as they possibly can, in many cases causing rates to be negative. This has
provided a fillip to bond prices, allowed real estate to stabilise and recover, and boosted stock market valuations.
These conditions have triggered good performance from most investment assets classes,
except for cash, which languishes at less than a percent. But it is cash deposits that represent the risk-free
investment – all other asset classes carry varying degrees of risk. Indeed, the market price of a 10-year government
bond, whilst risk-free if held to maturity, will fall by about 7% if prevailing market interest rates rise from the
current miniscule 1% to the historically still miniscule 2%. So, if bonds are expensive, shares susceptible to
volatility risks, property high, and cash close to zero, what’s an investor to do? It is this question that is
exercising the collective minds of investors worldwide – some are upping their risks to chase higher returns, whilst
others are suffering but accepting the low but safe returns from deposits.
In August the German government issued over €800 of 30-year bonds, a common enough event except that this
particular bond had a zero-interest coupon, that is, it will never pay any interest for the full 30 years.
Further, it was issued at a premium to its face value, thereby guaranteeing a loss to the buyers who hold to
maturity, as well as receiving no interest! Approximately 30% of the world’s government bonds now trade at a
negative interest rate, equating to the staggering sum of $US17trillion! Even some large European
corporations such as Nestlé and Siemens have negative interest rate corporate bonds. The status of the
financial markets and global monetary system is truly bizarre, and inexplicable.
In our long experience, we have learnt to take particular notice of the more extraordinary global economic
and market events, and to err towards a more cautionary investment positioning when such events and pricing
tends towards the inexplicable.
Australian Shares
The Australian stock market, as measured by the S&P ASX200 Index, rose by a further 1% in the September quarter,
extending its fabulous performance for 2019, being up by more than 18%. This represented a strong bounce back
from the miserable final quarter of 2018. However, October started poorly, so hopefully the final few months of
2019 don’t parallel the large falls of this time last year. With dividends included, the returns in 2019 are
even higher, and the pattern of solid dividend payouts or share buybacks have remained a feature of the year.
Some stocks and sectors with significant overseas earnings have benefited from the falling Australian dollar –
down a further 3.8% in the last quarter. The lower dollar was partly caused by the Reserve Bank interest rate
reductions and partly by some softening economic data. Further, the dramatic declines in interest rates – to
never seen before levels – has created a significant relative valuation boost to risk assets such as shares and
real estate.
Annual profits were reported for most companies in August, and were generally underwhelming, with the usual
handful of significant negative shockers, and a few, but not many, large positive surprises.
Some, or perhaps all, of the more recent market rises can be attributed to external but temporary valuation
forces, namely the lower dollar and interest rates, rather than the core fundamentals of profit or economic
improvements. This does not augur well for the coming year, as much of the positive valuation effect is now
priced in.
Stock price trends are currently caught in a tug-of-war. On one hand the yield differential is strongly
supportive of higher prices. This is because when interest rates are very low the profit and dividend yield of
stocks is increasingly appealing, on a relative basis. Take for example the approximately $5 per share profit
that Commonwealth Bank makes each year, which, when divided into their $78 share price provides the owner with a
profit yield of 6.4%. This is a terrific relative return when the risk-free interest rate is only 1%. On the
other hand, there is clear evidence globally that economic activity is waning, in some areas dramatically so,
which will potentially drag consumption demand and corporate profits lower, leading to material downside risks
in share prices. It is this tug-of-war between the positive effect of low interest rates and the risks of
economic weakness that has garnered much of our analytical attention of late and is the primary reason for our
cautious investment stance, along with the multitude of global geo-political risks.
In our managed portfolio the shares of Link Administration, Wesfarmers, NAB and Santos performed well for the
quarter, whilst Woodside, Brambles, Amcor and InvoCare were the laggards. Generally, our defensive position,
with the maintenance of large amount of cash, provided capital preservation in a more volatile market
environment.
Global Shares
Global share prices were choppy in the September quarter, with volatility returning
after a period of relative stability. The Australian dollar remained weak, down about 4% against the US dollar which
assisted investment outcomes and smoothed some of volatility. The RBA helped by lowering the cash rate, thereby
causing some financial assets to exit the Australian dollar, seeking higher rates elsewhere.
The primary investment thesis is whether (or not) global economic activity wanes further, and if so, the
likely effect on share prices. The drawn-out trade imbroglio between the United States and China is the most
pressing issue, but unfortunately this is unlikely to be resolved any time soon. Investor psychology is
becoming increasingly short-term focused, waiting for trade-war news from the US or China, often delivered
via social media, then reacting in a Pavlov like manner. The looming 31st October Brexit deadline is also
causing some market anxiety.
Our valuation analysis of the various global stock exchanges indicates the German, Japanese and Chinese stock
markets to currently represent better prospective value than the US market, so we are directing our research
more in these areas. It shouldn’t be overlooked however that the US dollar has long been and remains the
strongest currency, so US$ denominated assets should form a component of a well-diversified global portfolio.
The global fixed income markets have been flashing economic warnings for much of this year, which would be folly
to ignore. Consequently, our global share portfolios have a diverse range of quality international stocks, and a
higher than usual cash balance, which is to mitigate some risks, and provide tactical capacity for future
investment.
Property Securities
The present value of future cash flows can be calculated mathematically by the
application of an appropriate discount rate. When interest rates are very low, the discount rate tends to decline,
causing todays’ valuations to increase. Real estate assets that have quality tenants with long term leases benefit
from this situation, as a low discount rate becomes increasingly justifiable based on the degree of surety of future
rental income. This has caused many commercial real estate current values to rise, and concurrently the prices of
listed real estate securities (REITS). Investors in REITS have benefited tremendously, but this positivity is driven
primarily by falling interest rates, rather than more fundamental factors such as increases in cash rent or
extension of leases. It concerns us that valuations are becoming stretched, and more particularly the market
reaction should rental flows suffer a downturn, or increasing debt become a burden, or interest rates rise.
Within the REIT sector the managers and owners of quality industrial and commercial
property have generally outperformed, particularly Goodman Group, which owns and manages a large portfolio of
industrial and logistics properties. The larger commercial and diversified REITS such as GPT, Dexus and Stockland
have been solid performers, delivering reliable income, whilst those that are shopping centre focused such as
Scentre (Westfield) and Vicinity have underperformed due to some uncertainties about the strength of retail sales,
and consequently rental growth.
The outlook for the REIT sector remains satisfactory, almost entirely due to their distribution yields, which
still compare favourably with prevailing interest rates. However, real estate is particularly susceptible to
economic trends, so any protracted slowdown could be a catalyst for investor disappointment.
Interest Rates
There is no topic currently more perplexing and difficult than interest rates. There are
few precedents for Australia’s low rates, nor the mass negative yield on global bonds, nor the hyper-stimulatory
unconventional policies adopted by Central Banks globally, nor the infinitesimal yield on investment grade corporate
bonds, nor the negative real rates almost everywhere, nor the extraordinary rate of increase of global debt.
It appears that the global economic and monetary system has cornered itself, such that
it no longer has any option but to persevere with wildly accommodating policies, doing, as European Central Bank
chief Mario Draghi said in July 2012, 'whatever it takes'. More than seven years later the leading global Central
Banks are still having to do 'whatever it takes' namely massively bloated balance sheets, aggressively operating in
the fixed income markets to hold rates close to zero, and never-before-seen monetary policy settings.
….and still there is almost no inflation.
….and now the Australian Reserve Bank is contemplating unconventional measures.
As we look ahead the direction of interest rates is unclear. Policy rhetoric suggest a
maintenance of the RBA cash rate at 0.75%, or perhaps a further cut to 0.5%. Banks will further reduce deposit rates
such that three to six-month term deposits will only pay 1.4% to 1.7%. However, the first sniff of inflation could
negatively affect bond prices, and any suggestion of market turmoil or heightened default risk would blow credit
spreads, which could lead to large losses in riskier interest-bearing securities.
The popular bank hybrid market has benefited from the extraordinarily low rates, such that hybrid prices have
regularly exceeded their $100 face values, and trading margins have retracted to historically low levels.
CBA has taken advantage of this by issuing a new 7.5-year security at a skinny cash interest rate of just
2.7%, (based on the current bank bill rate). This is the lowest cash yield ever offered on a tier-1 bank
hybrid, but unsurprising due to the attached franking credits and the low-rate alternatives.
Outlook
For some time now we have been encouraging clients to be somewhat cautious with their
investments - to not over-invest against their usual risk tolerance due to market, geopolitical and economic
concerns, nor under-invest due to very low interest rates. We have maintained a tactically high defensive component
in our managed portfolio, favouring a higher-than-usual proportion of capital preservation over speculation.
Generally, our preferred allocation to risk assets has been pared back by 20% to 30%,
for example a mostly high-growth biased portfolio should have this amount in defensive assets, for their tactical
reinvestment in due course. More conservative investment profiles should maintain even greater liquidity.
We expect some well-priced investment opportunities to arise in the coming months.
To conclude, this thirty-year chart produced by our colleagues at Morningstar shows the stellar performance
of Australian shares and REITS over that period, but most interestingly the extraordinary performance of
fixed interest (bonds) both domestically and globally. All these asset classes, including Government bonds,
which are risk free if held to maturity, have benefited enormously from the continuous ratcheting down of
interest rates. With interest rates now close to zero this valuation tailwind must now end. The respective
asset class performance in the next thirty years will look very different to this, particularly if the
interest rate trend reverses course, and begin to rise.
Yours sincerely,
Malcolm Palmer
Joseph Palmer & Sons
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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