When does safety become risky?
Having been one of the few oases in the desert when it comes to offering investors some semblance of return on their capital, the decline in cash rates during October and a bond market pricing further cuts, suggests that the Australian oasis may soon become a mirage. Policies of financial repression by global behemoths are exerting gradually mounting pressure on those more reluctant to experiment with monetary policy, suggesting that most will eventually be dragged into the vortex. As we all forcibly board the TARDIS we shall have to wait and see what pleasures the destination holds!
As thrift becomes more punitive, it is readily apparent that the nexus between the equity market and bonds is strengthening. The reaction of aggrieved savers responding to policies which amount to a surreptitious form of tax is relatively rational. As traditionally low risk investments are made less attractive through intervention, investors in search of yield are pushed progressively along the risk spectrum. Corporate debt, high yield debt and property have all been subject to the same squeeze. As artificial buyers with artificially created money increasingly occupy the Olympic pool which is the government bond market, a few chagrined swimmers progressively opt for smaller and less congested pools, until they too become unpleasantly warm and crowded. For much of the past few years the equity market has been the kiddies’ pool. Shallow, warm and perceived as toxic, most of the big kids have opted to stay out, whilst the regulatory lifeguards have herded more swimmers into the Olympic pool due to previous misconduct in the smaller pools. This shallow pool is obviously more susceptible to a changing water level as a few extra kids get in, and that’s exactly what’s happening at present. As these incremental swimmers are almost all yield seeking investors, it is unsurprising that banks, REITs, Telstra and utilities have featured prominently on the list of strongest performers in the past year.
Although moves in the equity market are in no way extreme relative to bonds as yet, we believe it is important to understand the progression of risk. It is irrational to denounce the bond market as an unsustainable bubble and then purchase a basket of stocks on a simplistic dividend/income yield basis and expect them to offer material diversification benefit. As bond yields approach zero and yield based stocks follow, risk cannot be falling. We remain adamant in the view that the principal value of debt across a broad spectrum of instruments including significant amounts of sovereign debt cannot and will not be repaid, or if it is, it will be in sharply devalued currency. As such, the convergence of yield towards zero across the spectrum should cause investors to turn their attention almost solely to the sustainability of cashflow supporting the yield. The determinant of long run return is far more likely to be whether you lose a substantial portion of capital rather than a 0.5% differential in the running yield. The likelihood of future returns congregating around a mean of low single digit with a standard deviation of almost nothing is about as likely as Ben Bernanke becoming a staunch advocate of Austrian economic theory.
Assessing the extent to which risks are elevating is not straightforward. One of the more perplexing questions in this regard is that of exactly who central banks expect to be the incremental borrower. As households and governments are generally at a less than auspicious starting position, financial system stability seems unlikely to be enhanced by the addition of further leverage. While the corporate sector is more sensibly leveraged, plentiful capacity and indebted consumers create limited scope for organic growth. We appear to have a stalemate. We may be overly sceptical, but our concern is that a banking sector pressured and keen to open the purse strings aligned with a corporate sector without organic growth opportunities, may succumb to the temptation of growing inorganically by purchasing existing assets at increasing prices. This concern is based on observed history. Corporates are the equivalent of Lance Armstrong with far less discipline and banks are steroid salesmen with less integrity. If our suspicions are correct, this outcome will ensure nothing is added to future growth prospects (no new assets) whilst adding further to system leverage. This will not end well. If incremental borrowing is instead directed into sound organic and infrastructure investments which can redress the productivity declines of recent years, we would become far more optimistic. Very recent trends from BHP and Rio Tinto would fall into the more positive category in this regard.
Graincorp and Arrium were the canaries in the coalmine this month. Archer Daniels Midland offered a large premium for Graincorp (fresh on the heels of the company having made significant recent acquisitions itself), while a consortium involving Posco and Noble Group amongst others, offered a substantial premium for Arrium. Signs are also ominous in the REIT sector. Spurred by cheerleading analysts who’ve erased 2008 as a minor error in an otherwise spotless copybook, expectations of cap rate compression (rising prices) are already inciting additions of debt and equity capital to fund empire expansion. I can’t help recalling the lyrics of Peter Garrett in his far more coherent time with Midnight Oil, “short memory, must have short memory”.
The month ended with NAB reporting its annual result. In the race for supremacy amongst the big 4 banks, NAB retained its position, fourth. Our primary frustration remains the lack of acknowledgement and need for improvement. Rather than seeking to improve operational fitness in the bank, management seem more intent on using creative accounting, excuses and self-deception to convince themselves that the photo finish which showed them last by a large margin could be viewed differently if you closed one eye, tilted the photo slightly and wore 3D glasses. With remuneration in no way reflecting their actual race position, a concerted fitness campaign is long overdue.
As greater numbers seek safety in purchasing perceived stable cashflows at progressively higher prices, they will necessarily become less safe. Despite cyclicality, if the prices for cashflows from less stable businesses fall and financial leverage remains low, it is only from here that sensible diversification benefit and higher prospective returns will be found. Financial leverage will always amplify equity risk and rising prices will always depress future returns. Assuaging words from central bankers will not dissuade us into believing that these rules can be temporarily suspended. Although we will always seek to move in the right direction on these axes, we can guarantee that we will rarely move at exactly the right time.
These beliefs have resulted in progressively increased weightings towards low cost, high quality mining businesses that we feel sure can sustain reasonable levels of cashflow even in unsupportive economic conditions. At the other extreme, our weightings to the financial sector of the economy and stockmarket (banks, insurance and REITs) have continued to decrease as the leveraged nature of these businesses is overlooked in favour of yield focus. Whilst Dr Bernanke may prove more adept at piloting the TARDIS than Dr Who, the risk that the TARDIS may hit a power line will continue to cause us some consternation.
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