The winds they are a changin’
Three of the tailwinds for ASX investors across the past decade — policy with respect to interest rates, trade, and regulation — have turned into headwinds. While profit may be hit, it is also likely that multiples will revert to something more like normal.
Policy has driven equity market returns for the past 30 years. The more leverage had to financial assets and falling rates, the better the equity performance, firstly as a consequence of policy designed to shed inflation, and latterly as a consequence of global QE. Our base case is that policy will drive the next decade’s equity market returns as well, just be a much broader policy set. The unwind of QE will be a big deal; the past month has seen nascent signs of this, however we are early in this process and the headwinds to date have unwound but a fraction of the tailwind enjoyed through the past decade. Apart from the increase in interest rates, however, government policy will be a massive deal for shareholders – in many cases, literally, the government is deciding what return is acceptable for certain industries, and this determination can change meaningfully through time.
The financial services Royal Commission has handed down its interim findings: three volumes, 1000 words, and a lot of cost to now come for the sector. As there has to be. As this extract from the report notes; "None of the submissions by the four largest banks (ANZ, CBA, NAB or Westpac) or by AMP suggested that the submission that it made in answer to the questions I had asked in my letter of 15 December 2017 set out a comprehensive and detailed list of all conduct of the kinds that the letter had asked them to provide. In several cases, the submission said expressly that it set out 'examples' of conduct that the entity had identified… Taken together, the course of events and the explanations proffered can lead only to the conclusion that neither CBA nor NAB could readily identify how, or to what extent, the entity as a whole was failing to comply with the law. And if that is right, neither the senior management nor the board of the entity could be given any single coherent picture of the nature or extent of failures of compliance; they could be given only a disjointed series of bits of information framed by reference to particular events.”
The “unquestionably strong” capital requirements brought down by the Financial System Inquiry of late 2014 has seen return on equity for the Australian banking system drop by almost 30%. The Royal Commission findings have the potential to have a similar impact, because while the FSI impact was almost wholly felt in increasing capital levels, the Royal Commission impact will be felt in decreasing revenues and increasing costs, at a time when structural forces were already seeing revenues reduced to flat outlooks at best. Policy is determining returns, and in a heavily regulated industry such as financial services, this may be appropriate.
Energy is, of course, another sector where returns for equity owners have been volatile in recent years, and where the spectre of policy change has prompted much of those gyrations. Having been allowed to purchase coal fired power stations, AGL has in turn made super profits from them, leading to an increase in profits and market value. Until the prospect of regulating the returns accompanied by the forced acquisition by the Commonwealth of assets enriching AGL shareholders at the expense of the industrial economy as a whole emerged, at which time both profits and market value retreated back to where they started. The dissolution of a government over contention about the National Energy Guarantee (among other matters) highlights how this issue will remain politicised no matter the government of the day.
Healthcare is obviously a sector beset by policy issues, but not always as generously as is the case in Australia. Many Australian equity investors think of Healthcare as a guaranteed growth sector, because of demographics. Maybe a better way to think of it is that it is a growth sector so long as policy is accommodative. That has certainly been the case for shareholders in Japara, Estia and Regis, who have had their equity value double and then halve in the few years since listing, as a consequence of policy change. The demographic driver of ‘growth’ should be similar across many developed countries, including Australia, the UK and France — and if anything, stronger outside the antipodes. Alas, that is not what has happened or is forecast to happen. As Ramsay notes in its 2018 annual report “The majority of Ramsay’s revenue in the UK and France is derived from government sources. Accordingly, Ramsay has prima facie significant risk exposure to adverse pricing changes as set by the respective governments.”
In practice, this has a big impact on valuation: in the growth rates applied by Ramsay in valuing these segments, beyond year 5 growth is assumed to be 2.9% in Australia, 2.3% in the UK and 1% in France (per note 12(1) of the 2018 Annual Report). Australian policy, it would seem, is expected to be more accommodative of higher returns into perpetuity; equally, whether it be 3% or 1% as a terminal growth rate, all of these numbers are well below market forecasts. The arbitrary changes which have beset the aged care operators and reduced returns for equity holders are implicitly anticipated by Ramsay as being applied to private hospital operations with these forecasts. The healthcare stocks that have done best on the ASX in the past decade have shared one characteristic; selling devices or products into the US market. To the extent that policy changes there, both all time high multiples and all time high margins may abruptly adjust.
We have spoken of policy along sectoral lines. Foreign investment is another fertile area where change is likely and consequences large. It is not just the case that Chinese investment may be restricted in western countries; the emergence of trade wars, to the extent that it acts to impede what has been imported deflation in the prices of goods for a couple of decades, may also act as a further driver for inflationary forces. Geopolitical policy in energy markets with the US sanctions on Iran taking effect through the next several weeks have already impacted on the oil price and again, in doing so, added further inflationary pressure.
In short, policy has been accommodative for equity returns in many ways through the past decade. Low interest rates globally through monetary policy, deflationary pressure upon the prices of traded goods through free trade, and light touch regulation of the prices of regulated services in areas such as finance and utilities have seen equity returns soar. It is not just digital forces now threatening that status quo; each of the three policy areas we have spoken to look on the cusp of reverting from tailwinds to headwinds.
Several of the monochromatic tailwinds for ASX investors through the past decade – policy with respect to interest rates, trade and regulation – have become headwinds. This may see profits for companies across almost all sectors revert to more sustainable levels, but in turn see multiples for industrial stocks, which had hit all time highs through the past quarter, revert materially. Stocks where the major source of return for investors has been rerating more bear close scrutiny, as the momentum trade matures.
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