The Australian sharemarket (All Ordinaries) hit a post GFC high of over 5,900 points in early March 2015. On the surface things appear to be going pretty well. So right at the moment investing in shares (although not in cash and term deposits) appears easy. Just hold them baby and don’t worry about whether they are overvalued or not. Nevertheless the underlying risks are increasing. The current bull market is now 72 months old which is well past the 55 month average for a bull market since 1937. The current shorter term drivers of the market could be with us for quite some time yet. The dilemma as always is when will things change? When things do change it can happen very quickly with little warning. As the time honoured expression goes no one rings a bell at the top. For long term investors the only satisfactory solution is to maintain a highly disciplined investment strategy and be prepared to hold funds in cash if suitable share opportunities cannot be found. By opportunities I mean shares that appear to have the potential for a return that justifies the risk of the investment (see the September 2014 blog “Is Cash Trash” at “www.lifestylefstas.com.au/cash-trash/”.
The following is an article by David Walker, Senior Equities Analyst at Clime Asset Management Pty Ltd. It is an excellent summary of what is happening in the investment world at the moment.
Strategy & Stocks: Distortions growing as the Fed signals lower rates for longer
Well, reporting season is now over for another six months. About half of the major companies surprised on the upside though the quality of the beats was low and management and board attention largely remains focused on cost cutting, higher dividends and capital management, not expansion and growth. Companies have not yet fully faced the higher input costs from A$ depreciation, so that will be a negative margin shock for some this year before it is eventually passed on to consumers with the rate of pass-through determined by pricing power.
By the time you view this, ABS statistics on capital expenditure intentions will have been published and we expect little improvement in corporate bullishness. That will require a change in the political leadership in Canberra, which I now expect in coming weeks or months, and for the benefits of interest rate, currency and oil price stimulus to spread through the economy, which should happen gradually over the course of this year. For both reasons, the Reserve Bank’s cash rate should bottom at 2% and non-mining investment intentions should improve for financial year 2016. The recovery in business confidence will precede a recovery in consumer confidence, as unemployment is drifting higher and wages growth is at historic lows, as we saw this week. There was a pickup in like-for-like sales at several retail names in January and February but the performance of consumer-facing companies will remain inconsistent for a while and the Budget is a wildcard. You’ll recall how the 2014 Budget was a powerful hit to consumer confidence last year.
The great game remains to predict the trajectory and endgame of the forces driving the global economy: disinflation, feeble growth, central bank currency wars, cheap money and quantitative easing. Let me give you our emerging base case scenario for what will happen.
The central task is to understand the US Federal Reserve’s actions and intentions. The gravity of the eventual start of normalisation of the Fed’s main policy tool, the Fed Funds Rate, can’t be overstated as this cash rate anchors the US yield curve and also exerts a powerful influence over bond yields and inflation expectations globally. Therefore it affects equity valuations via the risk-free rates in required returns, and therefore it matters to your portfolio.
Fed Chair Janet Yellen’s statement this week that the Fed is preparing to consider interest rate hikes “on a meeting-by-meeting basis” is part of a very subtle campaign to temper a sustained US dollar bull market at risk of getting out of control. The Fed is trying to slow the rate of US dollar appreciation to reduce its drag on the US economic recovery and to make the transition to a higher Funds Rate more gradual. In doing so the Fed has joined the global currency wars! The stronger US$ is a de facto tightening because it is doing much of the work for the Fed by dragging on net exports. Markets interpreted Yellen as signalling a later date for liftoff so there was a relief trade that she wasn’t hawkish and stocks and bonds rallied on the apparently more dovish outlook. This accounted for much of our market’s rally on Wednesday.
What’s happening here is the Fed has been moving away from the sort of guidance it relied on through the financial crisis to influence markets, without simultaneously triggering a market overreaction with each tweak to its policy statement. Yellen’s comments on Tuesday marked another step in that process.
Now, Yellen did little to nail down the likely date of the first rate hike, with her testimony and answers to questions veering between confidence in a “solid” recovery and continuing concerns about weak wages and other signs the labour market is not fully healthy. This confirms the first rate hike will be later rather than sooner, so market consensus has shifted from June to September or October and in our view a further delay can’t be ruled out with the US$ likely to remain strong.
For us in Australia this means the current forces driving our market will continue for longer. This means more months yet of depressed bond yields, meagre retail fixed interest rates, and retail buying of overvalued yield stocks like Commonwealth Bank and Wesfarmers. When we compare bond yields with equity yields it is difficult to see this changing, particularly if there are further rate cuts and we expect one. Increasingly there will be yield-driven buying of our equities by hot foreign money from offshore hedge funds playing the global yield carry trade. So, hang on to your yield stocks for the moment. Our market has become more expensive, with the multiple on one-year forward earnings rising to 15.5 times from its long-term average of 14 times, but this is not yet in bubble territory so it can become more expensive yet. We’re going to stay overvalued for as long as interest rates continue to decline.
The Fed’s cheap money, combined with the same and quantitative easing in Europe and Japan, will compound the buildup of risks which are becoming evident. Let’s look first to history to remind ourselves what happened last time. The global financial crisis was caused, in the first instance, by desperation for yield after the Fed held interest rates too low for too long after the September 11 terrorist attacks, the tech wreck and the recession of the early 2000s. Desperation for yield always ends in tears eventually because it pushes investors to ignore downside capital risk and overemphasise yield differentials. Last decade, this led to the innovation of complex, risky, leveraged products like subprime securities and collateralised debt obligations which paid financially engineered higher yields. This time, risk premiums in traditional asset classes are compressing and some asset price bubbles have formed. This is why non-mining assets seem expensive across the developed world and it’s why our major banks are able to sell you overpriced hybrids with inadequate fixed interest returns for the equity risks you are assuming.
Now, let’s run through these distortions and how the risks in the system will build now bond yields are going to stay lower for longer. In Australia, the first distortion from ultra-low bond yields was inadequate traditional sources of retirement income like term deposits. This pushed retirees up the risk curve into equities and led them to buy equities for relative yield, not value. The market’s rally is now introducing a new risk in this cycle but one seen in all previous bull markets: having seen the market rally to 5,900 in a short time, growth investors are dusting off dormant margin lending accounts and opening new accounts. If the rally gets really hot we’ll see more aggressive, dangerous behaviour here and the marketing of leveraged products which will burn people when the bull market ends.
A further feature of the compression of risk premiums is my market strategist counterparts on the sell side upgrading their 31 December targets for the All Ordinaries because it’s only February and already the market has hit their 5900 targets. To get you to keep buying and paying them brokerage they need to stay bullish ahead of the market.
The next distortion caused by depressed yields will be M&A funded by printed money and cheap debt. Cashed-up global businesses able to issue very long-term debt will take advantage of the declining Australian dollar and make bids for our large industry leaders. Last week’s Japan Post bid for Toll Holdings was extravagant but it won’t be the last. There will be a significant acceleration in M&A in Australia this year as the lower Australian dollar offsets the valuation premium global companies have to pay to acquire their targets. Toll will not be the last large company takeover in 2015. We’re going to see more yield, currency and earnings arbitrage via M&A, private equity and cheap debt funding. The point is we all know how asset recycling and financial engineering ends eventually. For example it was the standard playbook in the REIT sector of the early 2000s and remember how that ended!
Another distortion caused by depressed bond yields is the froth in property prices in the large investor markets of Sydney and Melbourne. This is starting to feed on itself in a perverse way: would you believe in Sydney, new listings are down 8% on last year because vendors are worried about selling then not being able to get back into the market because prices are rising so quickly.
The longer the overvaluation of yield continues the worse the consequences when it eventually ends. The chief threat from the currency wars is it leads central banks to take monetary stances so extreme they damage the smooth functioning of financial markets. It is remarkable they are undermining the basic motive to save and entrenching expectations of risk-free investing.
The point about overvalued Australian equities being bought for yield is they can correct in the sharemarket even as the economy improves, the companies continue to be well-managed and grow, and well before term deposit rates rise. The yield trade can end suddenly once the Fed starts to hike later in the year or next, as the hot foreign money now buying our yield stocks flees to get set early in the next opportunity. The amount of volatility and the pace of adjustment will partly depend on how well the Fed telegraphs its moves and so far I would comment that Janet Yellen is proving to be quite artful in how she guides the market, but the start of Fed normalisation will still be a major turning point that will affect your portfolio and probably adversely.
Now, unless there is a left-field accident in the bond market, I don’t expect these risks to eventuate tomorrow. I’m monitoring the world for inflationary impulses but the most likely one, wage pressures in the US labour market, remains benign as evidenced by Yellen’s dovish testimony. After my old mate Yanis Varoufakis and the Greek government went eye to eye with their funding troika, blinked first then capitulated, the downside risk of a Euro breakup has largely evaporated for the time being. Attention will now turn towards negotiating a longer term program for Greece, which will stay in the Eurozone.
Finally there is one x-factor which could extend the era of ultra-low bond yields and all its perversities and distortions we just discussed, for even longer. The Chinese currency the yuan is broadly pegged to the US dollar but the dollar is rising relentlessly against other Asian currencies as the prospect of monetary tightening by the Federal Reserve lures a flood of capital into the US. This is compounding China’s problems at a delicate time when the economy is already facing a property crunch and bank bad debt writeoffs. Factory gate deflation has deepened to minus 4.3%.
China’s yuan has jumped 50% against the yen since early 2012, deepening the deflationary pressures and hitting exporters, so China could be forced to arbitrarily devalue its yuan to protect its export base and avoid a possible hard-landing. This would transmit a huge deflationary shock worldwide, given the sheer scale of China’s excess capacity, at a time when the world is desperate for inflation. The world is revisiting the ghosts of the 1930s as one country after another tries to steal a march on others by depreciating first but the lesson from the 1930s is those who do so early benefit at the expense of those who wait too long. The problem for the world is China’s huge size, so watch this space.
Finally, we’re very pleased to have picked QBE at the right time and we discussed that company’s turnaround in Stocks We Like this week. Our next call is Better Value Elsewhere on Medibank Private. This is a mature, slow-growth business with some problems. It is not worth $2.50 and my colleague Jonathan Wilson explains why in this week’s research note. I recommend it to you.
It’s been a long presentation. Thankyou for watching, please leave us a comment on the format and analysis, and I’ll see you next time.