A scary number looming over Australian stocks
Blame central bankers for the yield-related vulnerability
Sydney Airport surged 89% over the past three calendar years. Toll-road operator Transurban rallied 71% over that time. Banks climbed 45%, REITs charged ahead 55% while utilities soared 51% compared with a gain of 26% for the ASX/S&P 200 Accumulation Index from 2012 to 2015. These companies didn’t become more efficient or announce anything masterfully strategic to deserve higher share prices. They mostly just benefitted from the way central banks have warped share markets with their promiscuous monetary policies.
The disfigurements on share markets swelled when central-bank asset buying on top of negative policy rates bludgeoned bond yields into unheard-of negative territory. Over the past 12 months, for example, yields on government bonds in Germany, Switzerland and Japan out to 10-years in maturity turned negative. Australian 10-year government bond yields dropped to a record low 1.82% on August 2 this year, swept along by this trend, low inflation and 12 rate cuts over the past five years by the Reserve Bank of Australia.
Investors, perhaps unwillingly but rationally, turned away from term deposits and low-yielding bonds and sought bond-like equities, those that offer stable long-term income streams just like fixed-income securities. Stocks with sound fundamentals, but which lacked the tag of “yield play”, were often overlooked as this macro-driven momentum distorted global share markets. Citi Research estimates that macro factors explain between 70% and 80% of equity-market variance over the past three calendar years, up from an average of about 55% over the previous five years.
But this rally in interest-rate-sensitive stocks could never last. The bubble would always expire when central banks refrained from more meddling and we may have reached this point. Bond yields are rising as policymakers, acknowledging that monetary policy has reached its limits, are turning to fiscal policy to prod economies. Amid a rise in global bond yields, a 50-basis-point jump in Australian 10-year government bond yields since August 31 has savaged many yield-sensitive stocks.
The concern for stock investors, especially passive ones, is that bond-sensitive stocks form a record 60% of the S&P/ASX 200 Index due to the financialisation of Australia’s economy of recent decades, which has seen bank lending balloon from 85% of GDP in 1991 to about 160% of output now. The unwinding of the distortions on stock markets magnified by central banks thus threatens a record part of the ASX.
Yield-plays, to be sure, assumed a greater proportion of the ASX before the global financial crisis so their pre-eminence is not all due to crazy monetary policies. Bond yields could drop again if deflation re-emerges as a threat. That would postpone any reckoning for bond-sensitive stocks. Cyclical stocks, in theory, also come under pressure from higher interest rates. However, having not participated in the gains from lower interest rates, it seems somewhat logical that they should be more insulated from increases. The worry for yield plays is that the rise in global bond yields looks entrenched. Be prepared for turbulence if yields rise faster and by more than expected.
The rise of bond sensitives
One way to analyse the ASX is to split stocks into the three categories; bond sensitives, diversifiers and cyclicals. Bond-sensitive stocks include financials, REITs, utilities, telcos thanks to their regulated and (often inflation-sheltered) income streams, infrastructure owners for the same reason and even healthcare companies due to investor belief they face endless revenue growth. The cyclicals are material, energy and consumer discretionary stocks. Diversifiers include consumer staples and industrials, sectors that fall outside the other two categories.
Such a breakdown would show that in 1973, when Australia was a relatively closed and rigid economy, bond-sensitive stocks only comprised about 15% of the benchmark (using the S&P/ASX 300 Index equivalent then as the proxy). This percentage dropped to about 10% during the recession of the early 1980s when credit growth slowed. It was only in the mid-1980s (when lending surged after the financial sector was deregulated and foreign banks were welcomed) that bond-sensitives reached 30% of the index.
The victory over inflation in the early 1990s and the borrowing binge that followed boosted bond sensitives to more than 50% of the S&P/ASX 300 by 1998, a level they hovered around until 2012, even allowing for gyrations around 2008.
Then came the emergency actions of central banks of recent years. Low interest rates have encouraged credit creation of 10% to 20% a year in recent times, lending sprees that have driven up prices on all assets including stocks but especially housing. This policy-driven resources allocation (there is little wealth creation) propelled bond sensitives to that record 60% of the ASX over the past year. (See chart below.)
This ratio has dipped now that bond yields are rebounding. The peak of central bank meddling seems to have been reached earlier this year when superstar economists such as Larry Summers questioned the effectiveness of extreme monetary policy and instead advocated steps tied to fiscal policy.
Whatever the catalyst, the appetite for bond-like equities is waning now that interest rates are rising. The rebound in the Australian 10-year yields past 2.3% pummelled Sydney Airport by 14% and lopped 9.3% off Transurban over the past two months. During that time, REITs were slammed 12% and utilities 6.2%. The S&P/ASX 200 Accumulation shed only 1.7% over September and October.
The unwinding of the bond-sensitive bubble is made even more precarious by the fact that management teams at many yield plays have made their company fundamentals more susceptible to a jump in interest rates.
Utilities, infrastructure stocks and REITs are more vulnerable because management used low interest rates to borrow heavily, sometimes to pay dividends. REITs’ average gearing, for instance, is about 33% now, which, while below the peak of about 40% that proved dangerous in 2007, is up from 28% three years ago. REITs have also massaged accounts by adjusting depreciation ratios to boost earnings, a ploy that investors can overlook when momentum favours such stocks, but not now. Healthcare stocks are being punished because their growth profiles are exaggerated.
Higher interest rates shouldn’t, in theory, hurt bank margins. The risk for banks is that higher interest rates might boost bad debt ratios. This is already happening to some extent – last fiscal year, the Commonwealth Bank of Australia reported a 27% jump in bad debts to a five-year high of $1.27 billion. But bad debts are still low, as major bank impaired assets only stood at 0.4% of total loans in fiscal 2016. To put any rise in that ratio in perspective, every 25-basis-point jump would shave about $6 billion off banks’ pre-tax and provision profits of about $46 billion for fiscal 2016.
Cyclicals are likely to remain relatively insulated from any shakedown triggered by higher bond yields. Not only are material and energy companies enjoying higher prices for their output, they reduced debt to cope with the decline in commodity prices from their record highs in 2011.
If recent slides on stock markets are part of a large downward repricing of all assets then watch out. Housing is especially exposed and a correction to home prices would have widespread effects on many industries, not just banking. For starters, there will be fewer people passing through Sydney Airport on holiday.
Bond sensitives versus cyclicals as share of ASX since 1973
Source: Macquarie, IRESS. S&P/ASX 300 Index to 30 September 2016. Bond sensitives include utilities, telcos, IT, property, financials and healthcare. Cyclicals include energy, materials and consumer discretionaries. Diversifiers include consumer staples and industrials.
 See Larry Summers, “The age of secular stagnation. What it is and what to do about it.” Foreign Affairs. March/April 2016. https://www.foreignaffairs.com/articles/united-states/2016-02-15/age-secular-stagnation
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