Commentary: The tectonic shifts of interest rates and wealth distribution have commenced
As inflationary fears increasingly morph to a stubborn, lived experience, investment markets reacted through the September quarter. If bond yields remain near current levels, equity markets will continue to struggle and higher multiple areas of the market remain especially vulnerable.
Tectonic shifts in market prices are sometimes sudden, and become folklore. The 1987 crash; TMT bubble; and GFC are all well known phenomena and often referred to in market commentary, largely because of the sudden and large movement in asset prices they represent. But it’s those inexorable shifts with a moderate short term impact but with extended duration – which morph into very large shifts in value – that can often be far more meaningful for investors. Sometimes, they present opportunity but equally sometimes a large dollop of risk. History suggests that long run, large shifts in value are lying in plain sight every year. Where are we currently seeing the emergence of cracks which presage these tectonic shifts in value on the ASX?
The selloff in bonds which has progressively occurred through the past two years and featured increasingly through the past quarter (impacting equity prices especially for those equities that are interest rate sensitive and/or bear undue levels of gearing) is one live example of a tectonic shift. Just as it was in reverse through the past decade; the prolonged compression of interest rates took multiples for stocks offering future prosperity to multiples that hitherto had never been experienced on the ASX. In the face of this, only those that believed that monetary conditions could be loosened infinitely, without inflationary consequence, could have imagined that to be a durable macro environment. While we are obviously now much closer to equilibrium, decarbonisation and the nascent energy transition (especially in Australia) will see inflationary pressures continue to a greater extent, and for longer, than may currently be anticipated.
Star goes black hole
At a sectoral and stock level, the gaming sector, and Star Entertainment Group in particular, are a classic example of a prolonged tectonic shift in value. A share price of A$0.60 is a far cry from the A$5.00 seen in early 2018. Operating risk and financial leverage have clearly hurt the business, but the kryptonite has been delivered in the royal commissions initiated by the Hon PA Bergin SC in 2019. The consequent and recent $750m equity raising by Star was notable on several fronts. Firstly, the sheer quantum of the raising, especially given it followed a $800m raising in February this year; the amount raised in those two issues is greater than today’s market capitalisation for Star, and contrasts markedly to the then market capitalisation of greater than $5b six years ago. Secondly, as part of the recent recapitalisation, Star also secured $450m in new debt facilities, at a margin which saw the debt offering a greater return than that implied by the new equity, absent significantly greater growth in free cashflow than currently anticipated. This is a stark reminder of how far equity investors still need to adjust their mindsets to a world with risk free rates of 4% rather than close to zero.
Source: Refinitiv Workspace, Schroders
Clean energy costs not so shiny
If casinos represent a past large shift in value, a looming tectonic shift may be the energy transition. While the cost in Australia is impossible to dimension with precision, a few guideposts exist which suggests that the quantum involved will be far greater than currently anticipated. For reference, the Mining Supercycle almost 15 years ago saw investment of A$200b, for which significant productive capacity was added (including in iron ore, which today continues to produce enormous excess return for producers). As much of the investment attaching to decarbonisation will be substituting renewable energy for an existing, albeit socially toxic, energy source, it cannot be expected to produce anything like the same returns, and yet we expect the quantum required to be far larger.
The guideposts to the investment required for Australia to decarbonise are several. At a crude level, an industry rule of thumb is that 1 watt of renewable energy costs US$1. The world’s biggest lithium-ion battery, built in South Australia in 2017 by Tesla, is reported to have cost in that vicinity, with 70MW of capacity contracted to the South Australian government, and a further 30MW of capacity and 90MWH of storage uncontracted, at a capital cost of A$90m. Another example rests in New Zealand, where with 1/5 of the population of Australia and a much lower land mass per capita, 82% of electricity generation is renewable today. “The Future is Electric – A Decarbonisation Roadmap for New Zealand’s Electricity Sector” was produced by BCG in 2021 and commissioned by the major gentailers in that market. That extensive report detailed why New Zealand’s decarbonisation by 2030 to a system with 98% renewable energy will cost an estimated NZD$42b. The Clean Energy Council estimated last year that renewable energy in Australia is currently accounting for 36% of electricity generation, and it has a 2030 target of 82% renewable energy. Of course, in Australia the cost escalation from AU$2b to AU$20b attaching to Snowy 2.0 for 2,200 megawatts of generating capacity and approximately 350,000 megawatt hours of large scale storage is well known. Perhaps less well known in Australia is that this is not an isolated occurrence. In New Zealand, the proposed Lake Onslow pumped hydro scheme has seen its estimated cost quadruple to NZ$16b. Because of the cost inflation, the ultimate cost of decarbonisation in Australia is highly elastic, with a risk it could be materially higher than the A$300b which can currently be inferred from the industry rules of thumb and comparable projects.
The above matters for several reasons to an ASX investor. Firstly, the sheer quantum of this spend is such that it will be a tectonic shift in the economy, played out over many years. In itself, it will be inflationary. The energy transition will also be prone to missed deadlines and deferrals; already in the past two months, two planned, large withdrawals of fossil fuel energy capacity in the Australian market have been deferred (Loy Yang A in Victoria owned by AGL, where the Victorian government also agreed to provide capacity payments while AGL kept the plant operating in order to underwrite security of supply and Eraring in NSW, owned by Origin).
Indeed, at a stock level, one of the major issues facing the Australian equity market through the coming quarter will be the shareholder vote on the A$19b takeover offer for Origin Energy from Brookfield and EIG. Since the time the bid was announced in March, local wholesale electricity prices and futures have moved higher, the two major state governments have announced plans to defer plant closures and the 20% stake in Octopus Energy that Origin acquired three years ago (which has cost it A$700m) has also grown in value materially. Octopus has benefited from stellar growth in its global customer service platform, Kraken, which now has 30m customer accounts globally. It has equally created a large energy retailing business, with the imminent acquisition of Shell’s UK and German home retail energy business following last year’s acquisitions of Bulb Energy (1.5m customers) and Avro Energy (0.6m customers). This has seen Octopus become Britain’s second largest energy retailer with 6.5m customers. Given Octopus only commenced operations in 2016, and continues to have global growth aspirations in energy retailing, its valuation is obviously elastic and yet could easily decide the fate of the entire Origin bid.
Source: AEMO NEM Generation Information Nov 2022, forecast capacity based on committed energy projects, capacity factors estimated by using midpoint of CSIRO 2022 Gencost assumptions.
Public sector balance sheets get the wobbles
Another tectonic shift which is emerging and will continue to feature as a factor in investment returns, in our opinion, will be the ongoing rise of sovereign risk. The COVID response has left a residue of exaggerated public sector balance sheets, and rising bond yields have put pressure upon servicing capacity, just as the call to decarbonise – quickly – becomes louder. There are a few obvious sectors globally that are feeling the hands of government reach for their profits as a consequence. Owners of fixed assets is one – a former Victorian premier described a 7.5% tax upon short stay accommodation revenues as a ‘modest charge’, and Atlas Arteria’s performance struggled through the month after the French government proposed a 4.6% tax upon the revenues of transport infrastructure such as airports and motorways (with the proceeds of the tax earmarked for decarbonisation initiatives). For Atlas Arteria, its 31% stake in Autoroutes Paris-Rhin-Rhone generates 80% of its group toll road income, and hence this is a material consequence.
An intersection of the prior two themes – the energy transition investment bonanza precipitating higher for longer energy prices; and sovereign risk where excess profits exist – can be seen as an example in the UK electricity generator levy. This levy, imposed upon larger generators, effectively taxes returns generated from prices in excess of the equivalent of A$150 per Mwh, at 70%. If new generation is prone to material cost blow out, and yet if all goes well the State lays claim to excess return, little wonder there is currently extreme hesitancy in committing the massive amounts of capital required to undertake the energy transition in Australia.
Banking on new taxes
One of the largest impacts by sector of fiscal rebalancing through the past year has been the banking sector, which globally has been subjected to increased levels of tax. In fact, the economic equivalent of approximately A$6b has been recently earmarked from the sector in each of the Czech Republic, France and Spain, joining the UK which has had a similar impost in place now for a decade. Nuances exist in every case; some countries apply the taxes to increases in net interest margin (NIM) as rates have increased from zero, some allow offsets to the extent that government bonds are purchased, and almost all refer to the explicit and implicit aid provided to the sector through state payments in response to COVID in recent years. Jobkeeper equalled mortgage payments; record dividends flowing from that source of funding has not unreasonably attracted the subsequent attention of government.
It would be wrong to think that the banks here are ignorant of this risk. In fact, a record profit reported by CBA in August was accompanied by an intriguing slide toward the very front of a 146 page slide deck. As can be seen below, the slide prudently reflected more humility than hubris; more caution than exuberance. Social licence concerns for the banking sector in Australia are real, and while competitive pressures are seeing realised revenues remain less than market expectations, and costs continue to be greater than expected, the likelihood of any material excess returns being generated and returned to shareholders is low.
Source: CBA, Schroders
As we have noted previously, the dilemma for investors remains that those fair returns are priced by equity markets at a much higher multiple than is the case in other countries, especially for CBA. There is little scope for downwards pressure on returns, whether that arises from regulatory changes or from competitive pressures or bad debts increasing. ANZ, NAB and Westpac are some of the very worst performers among major companies on the ASX through the past five years now, and yet we continue to have a large underweight position for the sector.
While pressure upon consumers continues to mount, with rents, mortgage rates and general living expenses all continuing to increase materially year on year, it is only starting to impact upon consumption, and the impact is aggressively demographically skewed, with the lower income and wealth cohort (notably the young) being impacted to a greater extent than others (notably, the not so young). While earnimgs per share (EPS) revisions for FY22-23 have been negative, they have not been as aggressive as we anticipated they may be as commodity prices have remained high, and employment has remained strong, supporting industrial and bank earnings. While market FY23-24 earnings growth is expected to be relatively strong at 11% despite commodity prices reverting, to date it is only the healthcare sector that has shown any notable weakness. Beyond 2024, large shifts in value are likely to globally arise as a consequence of several structural themes; fiscal pressures, redistribution of wealth and decarbonisation. We suspect Australia will be affected by each of these factors at least as much as most countries, and that those forces are all still nascent.
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