Welcome to the August edition of the Burrell Blog for 2017.
Some good news on risk reduction in July
July 2017 saw two key risks reduced. Firstly, the Australian banking regulator APRA announced that the core capital ratio known as CET1 would be increased from 10% to 10.5% for the four major banks. This announcement was well received by the markets with research headings “Capital risks materially reduced; new capital rules pose no problems for the major banks; fair values unchanged”. The banks have until January 1, 2020 to implement the new capital settings. With the four major banks able to achieve this increase without major capital raisings, share prices recovered from their June lows, appreciating $1-2.
The reason the markets see these new capital requirements as being achievable is that the banks may underwrite their dividend reinvestment plans (CBA subsequently announced a discount to encourage CBA shareholders to do so) and some reduction in the rate of housing loan and growth will see capital released, as Australian households continue to pay mortgages well in advance of minimum monthly payments. This contrasts sharply with the position in April 2015 when that round of capital requirements saw the banks fall by 25% in the ensuing six months to September 2015. CBA fell from $96 to $72 and the other banks from high $30s to $30 and then ANZ and NAB fell below $25. So broadly the removal of capital risk allows the banks to again be valued as a key dividend yield driver and underpinning retirement incomes. CBA then spoilt the party with the AUSTRAC compliance breaches, but to date this appears predominantly a CBA issue caused by the increase to $20,000 in cash amounts which could be banked into their intelligent teller machines (ITM’s). While the AUSTRAC compliance breach is a serious issue for CBA, the noise creates a buying opportunity for those underweight the banking sector.
The second factor which reduced risk during July was the move by China and Russia to pursue a calming policy on North Korea, so much so that the USA did not seek to pass a resolution at the G20 meeting. Subsequently increased sanctions were approved unanimously by the Security Council of the United Nations. These sanctions appear to be working, as they have prompted sabre rattling by North Korea. While at the end of July matters had calmed and the risk of confrontation may have reduced to 15-20% from the 20-25% in your diarist previous blog, the August joint military exercises between the US and South Korea were always going to heighten tension and this was in evidence in recent days.
The July blog considered portfolio settings to commence the 2017/18 financial year. The July information flow was confirmatory of portfolio settings for the commencement of 2017/18 financial year as follows:
With 10 year rates well below long term averages, the risk of capital losses on long dated bonds is a risk Burrells would prefer to avoid. Fixed interested investors should look at short dated securities less than three years on a fixed basis or floating rate notes if longer term is preferred. This may be a replay of 1993-4 when bond rates rose resulting in capital losses on bonds.
The Suncorp result was solid with net profit after tax of $1075M and full year dividends of 73cents, up 7.4%. However Suncorp holds a large portfolio of fixed interest securities to match insurance liabilities. A$120M mark-to-market loss was included in the results from an increase in the risk free rates, partly offset by $52M gain from the outperformance of inflation linked bonds. Given the small movement in risk free rates during the period, this is an example of the possible downside if longer term bond rates increase. The probability of this occurring in the USA is much higher than Australia with the US Federal Reserve withdrawing from the longer term bond market, with the probability that the market will move longer term rates up in the USA faster than anticipated by the regulators.
There have also been a rash of Australian institutions seeking to issue fixed interest securities to take advantage of the current low rates.
Listed property trusts (LPT) have an intrinsic value equal to the net assets of the underlying properties. Where the LPT is stapled to a funds management or development business, some additional value should be added for these complementary businesses. Analyses indicates that several of the large LPTs are trading materially above intrinsic value and ipso facto the index is trading above intrinsic value.
The price of the LPTs was pushed up as long term bond rates fell, resulting in three strong years for property trust performance. However the June 2017 year saw the property trust sector perform about line ball. Burrells have been lightening selected LPTs and reducing index exposure. However research has identified several mid-size LPTs and those with exposure to the baby boomers, where purchases on market are helping to rebalance the LPT asset allocation weightings. Asset allocation is more likely towards the bottom end of the 10-20% range applicable to the majority of clients with a balanced or moderate growth asset allocation.
The previous blog commented that while commentators refer to ‘international markets’, in fact we are dealing with a set of overseas markets for individual countries and their correlation (r-squared) is not as high as might be thought. The starting point is to say the US stockmarket has as a main driver the US economy, the European stock market, the European economy and the Australian market, the Australian economy. One study recently shows the r-squared at .44 ie. the correlation across international markets is only 44%. Thus it is a simplification to say that the Australian market goes up and down with the US market. There is an overlay to the country factors for international trade, but the starting point is the domestic economies. Commentary continues that the strong majority view is that the US stockmarket is “expensive”, but economic growth and sentiment are more neutral factors.
During the past five to six weeks, this commentary has continued. However the quarterly reporting season in the US was generally favourable with a number of companies reporting satisfactory growth in revenue and profits. The US reporting season provided no real catalyst for any correction in the US stockmarket, which has moved up from the 20,000 level to around 22,000. Burrells continue to be cautious on the US market and to carefully consider independent research reports on global companies of interest.
Like the story of the frog being slowly heated in a pot, there has been a continuing realisation of the difficulties of the UK achieving Brexit without pain. Europe appears more attractive currently from the investment viewpoint.
The July blog noted that during the technology bubble in 2000, the US market moved well above the Australian market which continued at a modest trajectory. The result is that the Australian market did not move adversely during the technology bubble during the years from 1998/2001, but incurred a modest fall during the 2002 year as some Australians stocks including Melbourne IT failed to deliver.
The Australian market has performed in a similar manner to that period. The US market has some elements of technology bubble with your diarist highlighting the FANTS stocks ie. Facebook, Amazon, Netflix, Tesla and Snapchat as examples of companies being valued on revenue rather than profits. The debate remains whether the US market might correct on a sector basis, which has tended to happen in Australia, or whether there might be a more broad based sell off later in 2017 or early 2018.
Whatever happens in the USA, the dividend yield driver is alive and well in Australia with strong dividend yields likely to continue to underpin the Australian market such that no dramatic correction is anticipated (Xfactors excepted).
In summary, longer term interest rates have most likely bottomed, suggesting fixed interest investment should be kept shorter or floating rates. The LPT sector in Australia has been a useful source of profits but selective holdings in this sector based on careful research are the likely strategy for 2017/18. US equity markets appear fully valued on average, so selective investing is recommended rather than US indices/exchange traded funds (ETFs).
The removal of increased capital regulatory risk for the Australian banks is a major positive for the Australian stockmarket, notwithstanding the negative political environment for Australian banks and the recent AUSTRAC compliance issue for the CBA.
Xfactors include the geopolitical risk of a military confrontation with North Korea reduced to 15-20% probability (your diarist probability). A sharp correction to US valuations similar to the tech bubble is possible, but this may be sector specific given the US listed corporations reported well during the recent quarterly reporting season.
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This document contains general securities advice only. In accordance with Section 949A of the Corporations Act, in preparing this document, Burrell Stockbroking did not take into account the investment objectives, financial situation and particular needs ('relevant personal circumstances') of any particular person. Accordingly, before acting on any advice contained in this document you should assess whether the advice is appropriate in the light of your own relevant personal circumstances or contact your Burrell Stockbroking advisor. If the advice relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a Product Disclosure Statement relating to the product and consider the Statement before making any decision about whether to acquire the product.
Burrell Stockbroking Pty Ltd (ABN 82 088 958 481), a Participant of the ASX Group and the NSX.