Global bond yields continue to decline, as the outlook for global growth has become more uncertain since the Brexit decision. German Bonds are now trading at negative interest rates. Australian Government bonds are now trading at record low interest rates, with the yield on a 10 year bond under 2%. In spite of this low rate, Australian bonds are among the highest four yielding countries in the world. Iceland, NZ and Portugal are the only countries whose bonds pay more (and Australia and NZ are the only ones rated AAA).
The RBA is tipped by many in the market to cut can rates at the next meeting (2 August), and the money markets have begun to price this possibility in.
In recent weeks we have seen equity markets recover from the knee-jerk reaction to the Brexit vote, with many markets now trading at record highs. While not back in record territory, the ASX200 is trading at levels not seen since August last year.
It is important to highlight that in any discussion about the comparison of capital prices (as measured by price indices), Australian companies tend to have much higher dividend payouts than companies in other markets. When we look at the performance of the ASX200 Accumulation Index (which incorporates dividends), we are trading at record highs. In fact, we are over 20% higher than the previous highs set in 2007.
S&P/ASX200 Price Index v S&P/ASX200 Accumulation Index (July 1996 – July 2016):
The recent performance of equities and listed property can be related to the movement of interest rates. Without being able to generate sufficient returns in cash or bonds, investors around the world have moved 'up the risk curve' towards riskier assets. Interestingly, the main attraction of these asset classes appears to be the yield on offer, rather than an attraction to the capital growth prospects.
As Katrina King of QIC was quoted in the Australian Financial Review today as saying, "buy bonds for capital gains and equity for income - it should be the other way around." QIC have been buying some government bonds with negative yields, on the expectation that these yields will fall further, and the prices of the bonds will rise. We are in uncharted waters.
Lower risk free rate underpinning valuations
Our analysis of the current level of equity, infrastructure and property markets is that they are expensive. When traditional valuations are used, equities are trading at the top end of historic Price Earnings Ratio levels and listed REITs are trading at historically high premiums to Net Tangible Assets. In both cases, yields are getting low when compared to historic levels.
While these valuation measures do give us reason to pause, and exercise caution, we are also reluctant to recommend clients rationalise their portfolios and sell out of the markets at current levels. Rather, it is important to look at these valuations in the context of global interest rates and the reduction of the 'risk free rate'.
There are various ways to value assets, and while PEs and NTAs are widely used, these are simplistic and a quick way to compare (which is why they are widely used). Other methods such as Capital Asset Pricing Model (CAPM), Weighted Average Cost of Capital (WACC) and Discounted Cash Flows (DCF) incorporate other inputs when valuing assets. Key amongst these variables is the 'risk free rate', which is usually the 10 year bond rate. With a lower risk free rate, the relative valuation of the asset (which should generate a return higher than the risk free rate) increases.
Essentially, in periods with lower interest rates, investors are more willing to take on more risk to generate a return above that with low risk. Such valuation methodologies are able to provide some comfort that although equities and listed property may look expensive by some measures, others measures are providing support for current levels.
If interest rates remain at record low levels for some time (which is the current belief by most), the present level of markets may be sustained for some time . . . and could continue to move higher in the absence of major negatives.
Importantly, the risks of the markets are elevated at current levels, and the margin for safety has reduced. As we move into the August reporting season - potentially following another interest rate cut - the prices of individual securities can become highly sensitive to news. As we have witnessed for many reporting seasons now, share prices can react wildly (and quickly) to the tone of news releases as companies announce their annual results. Being positioned in a portfolio of diversified stocks with reasonable PEs and solid management are some of the ways that we assist clients to mitigate these risks.
News in Review
- Despite his “ironclad” guarantees that new superannuation rules will not change, Malcolm Turnbull conceded that he is prepared to “listen very keenly and carefully to concerns that have been raised by my colleagues", perhaps a sign of concern for a potential backbencher rebellion.
- The NAB Australian Business Survey revealed business confidence weakened in the second quarter, a sign the economy was losing some of its momentum after a solid start to 2016. The business conditions index however rose one point to +11 in the second quarter of 2016, well above the long-run average and the highest since the global financial crisis.
- The Australian share market reached an 11 month high and broke through the psychological 5500 point barrier as global risk sentiment continued to improve.
- The IMF revised down its forecast for global growth to 3.1% and 3.4% for this year and 2017 respectively (from 3.2% and 3.5%). This outlook followed the Brexit vote and is based on the assumption that the EU and UK negotiate a deal that does not lead to a large increase in economic barriers.
- The RBA minutes from the most recent June meeting reinforced the bank’s easing bias, with a rate cut likely in August if Australia’s economic outlook worsens and underlying inflation remains weak. A rate cut in August is expected by 24 out of 25 economists surveyed by Bloomberg, while markets are pricing in a 64% chance that the cash rate will fall to 1.5%.
- Britain's Purchasing Managers Index (PMI) fell sharply to 47.7 in July following a reading of 52.4 in June, the sharpest one-month drop on record and the first sign of economic weakness following the Brexit vote. A reading above 50 indicates expansion and a reading below indicates contraction. The Pound also fell a further 0.8% after the data was released.
- Woolworths is conducting a sale process for both Home Timber & Hardware (HTH) and Masters with final bids received last Monday. Industry sources suggest the bidders for HTH were 1) Metcash, 2) Anchorage Capital Partners, 3) A syndicate led by 2 former HTH executives and 4) Blackstone Group who is bidding for both Masters and HTH.
- It was announced earlier today that Metcash has received ACCC approval to participate in Woolworths sale process for Home Timber & Hardware with the condition of a court-enforceable undertaking that it doesn't restrict independent hardware stores from acquiring products from non-Metcash sources, nor favour its own hardware stores over nearby independent stores. With the ACCC decision concluded, WOW will now be looking to finalise a deal for HTH in the near term.
- Oil Search has backed down from a bidding war over New York-listed explorer InterOil, following a counter-bid by global energy giant ExxonMobil. "Given the decision by ExxonMobil to make an offer for InterOil on the terms it has announced, we do not believe it is in the best interests of our shareholders for Oil Search to submit a revised offer," Oil Search chief executive Peter Botten said on Thursday.
- Asciano: The ACCC has announced it will not oppose the acquisition of Asciano by Qube, Brookfield, and a group of global investment funds, citing that there will not be a substantial lessoning of competition in any market as a result of the takeover. The takeover is expected to proceed with Asciano shares ceasing to trade on the 29th of July. The special dividend will be paid to shareholders on the 11th of August.
- South32 has beaten production guidance at most of its major assets in the June quarter and confirmed its taste for copper and base metals by farming into prospective acreage in Canada. The Worsley Alumina refinery in WA did better marginally better than the 3 950 000 tonnes that was forecast, while the 7m tonnes of coking coal produced in the Illawarra region was 2% better than guidance.
- Telstra will undergo its first major brand shakeup in five years as it looks to pivot away from being viewed as a telecommunications business towards a technology company.
The Week Ahead
- US: Consumer Confidence (JUL), Durable Goods Orders (JUN P)
- Australia: Consumer Prices Index (YoY) (2Q)
- UK: Gross Domestic Product (YoY) (2Q A)
- Europe: Euro-Zone Gross Domestic Product (YoY) (2Q A)), German Unemployment Change (JUL)
- China: Industrial Profits (YoY) (JUN)