I'm from the Government and I'm here to help
I'm from the Government and I'm here to help
In the 1984 US Presidential debates, the Democratic nominee Walter Mondale consistently, albeit subtly, probed whether President Reagan, was too old to be effective as President. Reagan was 73 at the time and Mondale was 56. When questioned in the televised debate by a journalist on the issue, Reagan responded: “I will not make age an issue in this campaign. I am not going to exploit, for political purposes, my opponent’s youth and inexperience”. Even Mondale laughed at this turn of events.
Sometimes, strategies pursued with the best of intentions can take an unexpected turn. The Australian equity market saw an outworking of that in May as the Banks outperformed aggressively on the back of housing lending responding to booming house prices, which in turn has been driven by RBA policy. Indeed, the banks are now the best performing sector through the past year, outperforming the market by 20%. Apart from housing, however, credit growth in Australia is, well, not growing at all; Personal lending has been going backwards for the better part of a decade and is currently 8% down on a year ago, and Business lending is down 3% year on year in the face of the highest levels of business confidence on record. Recent feedback from senior office property executives is that demand is settling at a lower level than they anticipated; office property development will not be a source for loan growth for major banks in coming years. The only lending category with growth is Housing, and even then at 4% growth it is but a fraction of house price growth (let alone monetary stimulus growth). Loan growth is hard to come by, and will only be harder in coming years.
As CBA is the largest home lender in the country and the only major bank growing its home loan market share through recent years (and along with NAB one of the two banks to grow Corporate lending share), it is not surprising that it has been the largest (local) beneficiary of the performance of the Banks on the ASX in recent months. Matt Comyn’s relative youth and inexperience has not harmed CBA as it has seen its market cap surge $60b through the past year to $180b.
The massive market cap attributed now to the banking sector has been driven by two factors. The multiple has never been higher for the sector, and for CBA in particular its premium to ANZ and NAB has also never been larger and is now 50%. The other important factor for the sector has been earnings growth, which has purely been driven by the unwinding of the feared bad debt tsunami, which saw large provisions booked at the height of Covid concerns last Easter. Fearless predictions of material house price falls and rising unemployment have not eventuated; in fact, thanks to world leading levels of fiscal stimulus per capita and low levels of Covid infections, and strong monetary stimulus, house prices and employment markets have trended strongly in exactly the opposite direction to those misplaced fears. Government policy has hence directly led to bank earnings upgrades through the past year.
Rerating and earnings revisions have helped Bank outperformance, but what hasn’t helped is core (ie pre bad debt) profits growth. For the sector as a whole, this is still going backwards, with ANZ (-4%), NAB (-8%) and WBC (flat) all struggling with their recent results for the March half. We fully expect core profitability to continue to be sluggish at best; and unless we see further material releases from bad debt provisions, further earnings growth prospects are hence muted. At circa 10% returns on equity and 2.5 times book for CBA and 1.5 times book for the rest of the sector, the sector is not priced for much growth, but nor should it be, and as was the case a year ago, equity valuations are subject to the prospect of an economic shock.
Policy of course is also playing out in other areas. Monetary policy globally is intended to push risk appetite in investment, and it is; to the point that US ipo’s have not just hit record levels this year, but activity is almost ten times the levels seen through most of the past 15 years. Australian capital markets activity is similarly elevated. The lurch for growth has encouraged speculative extremes and seeded the inevitable disappointment when the hoped for gains prove ephemeral, at best. A2 Milk is a case in point; the downgrade it produced during the month saw the Asian region executive leave the group, however it is unclear what strategy that person could have followed which could have yielded a more durable outcome. Simply put, earnings were (materially) boosted by an unforeseen and unforecastable burst in demand a couple of years ago, which has now been pricked by Government policy; the subsequent evaporation of profits and consequent derating has seen the equity fall 75%, and we still do not yet see value given the high multiple on current earnings. Government trade policy has clearly also hurt TWE relative to what would have been expected a year ago, whereas other commodities – for example, coal exports to China are down 95% year on year whilst barley exports are down 98% - have proved more resilient to the whims of one trading partner. Whilst Ampol shareholders benefited through the month as the Government announced the Fuel Security Package, underwriting the economics for local fuel refining, just as CBA shareholders have benefited from policy as well, the experience for shareholders as a whole from Government actively joining as a participant in their industry is at best mixed, and our preference remains to be more confident in the durability of returns generated in deregulated markets.
Whilst policy has helped some sectors, it has oppressed others, and is apparent in the other end of the performance spectrum through the past year just as much. AGL and Origin have been standout poor performers as Energy generation and retailing has been pressured by declines in demand and changes in policy as renewables increase their share of the generation mix. Simply put, AEMO (the Australian Energy Market Operator) estimates the need to decarbonise the grid to require $68b of investment through coming years. Assuming that investment requires a return of at least 5%, $4b of ebit is required to be taken from current industry profits to pay for this renewal. Given AGL, the largest energy generator and distributor in Australia is likely to make $700m in ebit and has only once made more than $1.5b in ebit in recent years when prices were much higher, it can be seen that existing industry profits are unlikely to be sufficient to fund the required infrastructure investment (let alone provide a return for the existing asset base). Consequently, the Government investment in the gas peaking plant announced during the month, representing but a modest addition to supply, is highly unlikely to be the last direct or indirect Government investment in energy generation and distribution in Australia. As with Ampol, this may prove an initial windfall gain for shareholders in AGL and Origin and the resulting immediate market reaction may be positive; in all cases, however, the passage of time will prove whether greater Government involvement leads to better or worse outcomes for shareholders.
This issue is not just confined to the best (Banks) and worst (Energy) sectors of the ASX through the past year. Obviously, through fiscal and monetary policy, Government influence in profits and returns this year is at its highest level in decades, and withdrawal is slower than had been anticipated. Ever higher equity market prices across sectors suggests the market currently believes that the initial balm of subsidies may not be offset by a later sting in the tail; this may prove to be an overly optimistic view as Telstra shareholders ultimately found with the initiation of the NBN, Bank shareholders found with the initiation of the banking Royal Commission, and low tax paying entities are likely to find with minimum tax rates, etc...
The experience and outlook for inflation dominates current market thinking. The evidence is clear; steel and lumber prices up more than 200%, corn, soybean oil, iron ore, tin, brent crude and thermal coal all up more than 100%, and almost all commodities soft and hard up at least 30%; whilst locally house prices are up 10% year on year. The only argument is whether or not this shall prove transitory; if it does, then it is likely the reversion will take many equity prices with it as share prices move in sympatico with earnings (just as has been seen with CBA on the up, and A2 Milk on the down, amidst myriad examples). A bigger issue for long term value in our mind is the ongoing incursion of Government policy into industry, and the resulting impact upon sustainable returns across sectors. President Reagan didn’t just mock Walter Mondale. He also helped put Government influence in industries into context when he said: “The nine most terrifying words in the English language are: I'm from the Government, and I'm here to help”. Of course, orthodoxy has moved a long way from those times but the sentiment remains valid; extrapolating current returns where Government involvement has boosted them is fraught with danger, and our preference for returns generated away from public policy privilege is greater than ever.
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