April 2015 Review & Comments
Written by Tony Gray   
Thursday, 07 May 2015 09:37

As expected, the Reserve Bank of Australia cut the overnight cash rate in early May by a further 25 basis points to 2.00% - another all-time low.  It is telling that this failed to stimulate the local share market.  In fact, the market gave up the morning gains once the cut was announced and continued to drop the next day.

The real story as I see it is that bond yields are on the march higher.  The downward trend in US interest rates has been broken – with US 10 year bond yields moving to 2.18% on the 5th of May – from a low of 1.63% at the end of January.  The actual record low was back in July 2012 when a 10 year bond was yielding just 1.38% and Quantitative Easing was in full swing.

In Australia, 10 year government bond yields have also been rising and now sit at 3.19% and in fact the margin above US rates has begun to expand after a long period of compression.

Historically, it seems to me that investment markets are initially slow to adjust to changing interest markets, but when the change becomes accepted wisdom then a step change can occur.  Examples that I can reference include the 1987 crash and 1994 correction.

If rising interest rates do turn out to be the trigger that leads to a correction in growth asset values, where are the main areas of risk? 

International Shares

US stocks trade on high multiples of earnings and yet March quarterly results for S&P500 companies shows declining profitability.  Whilst the decline is attributed by many to the stronger $US – which is undoubtedly a factor, when I look at many individual stocks it appears that costs have been rising and profit margins contracting.  Smaller US stocks are very expensive.

Australian Shares

Bank Stocks
Holding Australian banks represents a bet on the Australian housing market, employment market and interest rate markets.  Until recently, this bet has paid of nicely – with rising earnings, dividends and share prices.  The half-yearly result for Westpac and third quarter result for Commonwealth Bank this week showed no earnings growth.  ANZ did generate some growth and at the time of writing National Bank is yet to report.  Westpac are now offering a 1.5% discount on a dividend reinvestment plan – which means flat earnings will be shared across more shares in future!

With record low interest rates (RBA rate), record low bad and doubtful debt levels, record levels of house prices to income, record level of consumer debt to GDP and an extended period of real wage growth, the tail wind for domestic banks has been strong and prolonged.

Despite this, the slow-down evident in results this week and the slowest wage growth in 17 years (to below inflation levels), coupled with rising bond yields suggest changes are underway.  My strong feeling is that many share and housing investors have little idea of the impact of the head-winds that could emerge from rising interest rates and reduced income.

The big four banks have extremely leveraged exposure to housing – counting only 16% to 18% of actual loan amounts when assessing capital adequacy.  The maths is frightening – relatively minor increases in bad debts can severely restrict the capacity of banks to lend.  Restriction of credit could then easily trigger a recession and further increase bad debts…

Consider the fact that for the entire existence of Commonwealth Bank as a listed entity that there has not been a recession in Australia!  While it’s all very well to be aware of the risks, I freely admit that this risk may not be triggered anytime soon or does not lead to an extreme outcome.  This noted, with the absence of profit growth means income yields plus franking are not sufficient to generate a double-digit return.  If the return is not sufficient, why accept the risk?

Commonwealth Bank and Westpac Bank are the two stocks trading at the highest premiums to book value and with the biggest emphasis on housing (and that have reported flat earnings).  I don’t expect to be popular with this call, but my feeling is that it is safer to sell (or at least lighten) – of course the capital gains tax implications are something to consider on a case by case basis.

Earlier this week I read an article in the Financial Times questioning the pricing of the UK government plan to sell their 24% stake in Lloyds Bank (which came about as part of their rescue of the banking system during the GFC).  The columnist was questioning the high valuation – with Lloyds trading at 1.3 times book value – making it the most expensive of the UK banks!  Put simply, this means if all liabilities of Lloyds Bank were settled, then the share price is £1.30 for each £1.00 of net bank assets. In the US JP Morgan trades at 1.0 times book value and in China the Peoples Bank of China trades at 1.1 times book value.

By comparison and even after the sharp falls this week, Commonwealth Bank trades at $3.42 per dollar of net assets and Westpac Bank trades at $2.90 per dollar of net assets!

Utilities/Infrastructure
These assets are typically highly geared and interest rate sensitive.  Further, regulatory decisions in recent times have cut the ‘allowed’ returns for these businesses. 

Property

Listed property trusts are trading at substantial premiums to asset backing.  Whereas a few years back we were happily buying these trusts for less than asset backing (in some cases we paid only 70 cents for each dollar of net asset), the average trust is now trading at a premium of more than 20% (i.e. >$1.20 for each $1.00 of asset backing).

While the level of gearing is not a concern, it is the risk of falls in unit prices that worries me.  When interest rates ticked up in 1994 listed property prices fell by ~ 20% in 10 months.

Yields are only a modest premium to deposit rates and insufficient reward for the valuation risk in my opinion.  Lightening trusts such as BWP (Bunnings) - which trade at a premium of more than 40% to asset backing, is recommended.

Summary

If we have not spoken recently or taken defensive action, please contact me to talk through your portfolio – but beware that there may be delays as it is a busy time both with investment markets and financial year planning checks.

While selling growth assets will add to lower returning cash, this is a prudent course of action at this time in my opinion. 

Best wishes


A.W. (Tony) Gray BCom, LLB, Dip FP, GDipAppFin, CFP, FFin
Principal, TG Financial

Please treat the above comments as General Advice or general information, with no action to occur until we have considered with reference to your financial position, needs and goals.


Last Updated on Wednesday, 13 May 2015 09:48
 

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