Welcome to the first edition of the Burrell Blog for 2017.
Taking some gains from the Trump Rally
Lighten Banks going into 2017?
Several clients have asked the question in recent weeks concerning building up cash balances going into 2017, perhaps by lightening some banks and financials.
With the strong performance of the Australian stock market and the risk factors surrounding 2017, the question deserves serious consideration. The S&P ASX 200 index has improved 8.9% from the BREXIT lows around 30 June 2016 of 5233 and 10.5% from the Trump electoral day low on the 9th of November of 5156 to close the year around 5700 points.
The dominant factor driving up bank stock prices over the past 3 years has been the dividend yield driver ie. Dividend yields on bank stocks at over 5% fully franked are attractive compared to current low interest rates, particularly TD’s where rates have more than halved since the GFC. However every time the bank prices have moved up, some external event has brought them back. The most dramatic correction was in April 2015 when the global banking regulators meeting in Basel, Switzerland promulgated increased capital requirements for global banks. These new rules saw the Australian banks peak in April 2015 and fall in the ensuing 5 months to 30 September by 25%. CBA fell from over $90 to $72 and the other banks fell from high $30s to around $30. In fact ANZ and NAB continued to fall, due to particular issues surrounding those banks and have only recovered in recent months.
Renny Ellis who is a key manager of the DDH Preferred Income Fund visited our offices in the week before Christmas. His weekly update of 18 December 2016 makes a number of observations which are useful in understanding the current market and some pointers for 2017.
“The elephant in the room for the Government, the Ratings Agencies and now all Australians is the level of household debt”. Australian household debt as a percentage of annual household disposable income has moved from 70% in the early 1990 to 185% currently. Renny explained that this is the key single factor that the Ratings Agencies are concerned about, combining as it does with a heavy dependency on residential properties. “Faced with such a high level of Household Debt, it is important the Financial System can withstand a fall in property prices.
Next month the Bank of International Settlements is due to announce the “Basel IV” reforms. These may include a 75 per cent capital floor for large banks using internal modelling systems. If this occurs APRA is likely to move quickly (by June) and require some additional capital for the Australian major bank mortgage portfolios. Increased equity (CET1) backing would further diminish the Banks returns.” If this view is correct, then the 25% fall in bank share prices in 2015 would suggest there is some risk of history repeating, although probably not to the same extent, and the answer to the question is that some lightening of selected banks and financials at the commencement of 2017 maybe useful, if only to reduce risk of further volatility.
It should be said that the view in the above paragraph has not been the consensus view of most analysts. The current consensus is that the banks have raised sufficient capital both from shareholders, divestitures (eg Esanda by ANZ) and dividend reinvestment so that they can gradually continue to increase capital levels going forward. The banks themselves have the view that their capital is sufficient and that APRA, the regulator is being overly cautious, given that the Australian banking system sailed through the GFC relatively unscathed, as compared to other countries. This was not overly surprising, given the GFC was caused by the USA mortgage market collapse from engineered products by the merchant banks.
Other Australian drivers
- In terms of the Australian government budget, Renny notes that the key issue for the Australian Government is “the need to show a material cut in government outlays that reduces spending from the 25.2% GDP forecast in 2019/20 to something closer to 23%” “The Governments’ recent success in passing difficult legislation through the Senate should provide the Ratings Agencies with some confidence that the current Senate is a lot more pragmatic and fiscally responsible than the preceding one (Hinch won’t be fooled a second time).”
- “The Australian dollar last week fell to a new low in the current pattern. Our target remains 68cents in the short term”. This is as much due to strength of the US economy as to weakness in Australia.
- The weak economy in Australia results in “Declining inflation and declining growth in wages”.
- The weak Australian economy means that while the 10 year government bond yield has moved up from 1.8% to 2.85%, Renny forecasts the curve “to flatten at the long end and bring the 10year yield back towards 2.2%”.
In summary, Renny’s comments highlight the fallacy of looking to the stronger US economy and assuming Australia is in the same position. The Australian economy was able to rely on a concerted pick up in housing to replace the decline in business investment from the mining boom. As both those drivers continue to weaken, a recent recovery in commodities prices has provided some breathing space for the Australian economy. However there is little sense of urgency in Canberra and the September negative GDP growth number was passed off with a “She’ll be right mate” approach. “We are not in recession because commodities prices have picked up and the December quarter will be positive” was the common repartee. And none of this faces the reality that the Australian economy and in particular the Queensland economy are not growing strongly enough to provide jobs for the 2017 new job seekers entering the market.
The Trump rally since the US Presidential election (still ongoing) parallels that when Reagan was elected. The republican policies have some commonality. In the ensuring first year of the Reagan presidency, the US stock market fell by 20%. Part of this was the reality that the President is one cog in a complex wheel and there are many checks and balances in the US political process. In fact it was not until the second Reagan term that material tax cuts were delivered. There is a strong argument for Deja vu in that while the President-elect may wish to increase infrastructure, increase defence spending and reduce taxes, there will be long term republican members of the Congress and the Senate who will insist such measures be revenue neutral. It should be remembered that the republicans refused Obama spending which was not revenue neutral in a number of instances.
One of the difficulties for share market investors in Australia is the lack of consensus on a whole range of global issues. The USA has always been considerably more myopic then say Australia. The US stockmarket has rallied since the election and seems to have factored in tax cuts and to assume that the new Trump in office will behave quite differently from Trump during the election campaign. An opposite view was contained in a video by Peter Hall, long term ethical fund manager who visited Australia in November. The Australian newspaper quotes as follows; “The issue is that Trump is a crook. He has always been a bad person to deal with; he has no experience of government; he is an isolationist, so he doesn’t believe in global trade, and the global security situation is now thrown into uncertainty. “He is a profligate spender in his own activities, doesn’t believe in paying his debts so basically all of the pieces have been thrown up into the air and we have got a very inexperienced person running the ship and that is a recipe for disaster in my view.”
Your diarist is inclined to take a middle ground, based partly on the checks and balances in the US political system. A first move was to ask Japan to make a meaningful contribution to the US defence budget to reflect the cost of Japan’s defence. This is likely part of a broader strategy to pull back from the role of the USA as global policeman and it is likely there will be some pull back also from NATO, or at least the extended NATO which allowed a series of fringe countries to in theory be subject to NATO protection. It may result in the US recognising Russian areas of influence in some of the fringe countries such as the Ukraine etc. Such a strategy would be positive for US defence manufactures as countries realise a need to be more self-sufficient.
In respect of taxes, it has been widely publicised that US corporations have significant sums in Ireland and other offshore countries, because it is subject to full corporate tax if remitted to the USA. A free kick for the President-elect is to allow the remittance of this money, provided some of it is allocated to infrastructure bonds to fund the infrastructure spending that is foreshadowed. Such a policy has not been announced and is speculation on the part of your diarist, but it would be well received domestically in the USA.
Unlike the Australian economy, the US economy is quite strong with unemployment halving from 10% after the GFC to around 5%. This is in contrast to a weak US economy at the time that Reagan was elected so that it was easier to use fiscal stimulus to achieve good outcomes. The US bond market has factored in considerable stimulus with the US ten year treasury yield increasing from 1.45% in July to 2.6% currently. This is one of the factors that has led to the stronger US currency. Stronger US currency makes it harder for the President-elect to achieve a resurgence of manufacturing, as it makes it more attractive to produce in offshore US countries.
The Chinese Yuan is pegged to the US dollar and China has employed considerable means to try to stem the reduction in its foreign capital reserves. Some commentators see the Yuan devaluing by up to 20% if a free float was implemented. Now there is no proposal for this to occur, but there is considerable risk around the value of the Chinese currency and it is more likely there is downward pressure against a surging US dollar. While the Chinese economy has been stronger than many forecast in 2016, two key issues in 2017 for the Chinese economy, which in turn add to risk are: firstly, that the banks are being required to bring onto their capital ratios their former off balance sheet activities and secondly that the five year re-election of the Chinese President occurs in late 2017 and there is a major change in the leadership team with many senior retirements. Five years ago, when this occurred little happened in China for the six months up until the central party meeting.
In conclusion you diarist has no quibble with carrying a level of cash into 2017 and 10% may be a useful guideline. Should there be market or stock corrections as a result of various global events, the question as always will be to focus on the value of the underlying businesses that we are able to buy or sell both in Australia and overseas. Ultimately it is the research and views on the values of these individual businesses which should drive portfolios. It is always a danger to get lost in market sentiment, although sentiment should not be ignored. Value of the business, the economy (ies) in which the businesses operate (GDP Australia, China, USA etc) and sentiment are three key factors in understanding markets.
We take this opportunity to wish readers a Happy New Year for 2017.
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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.
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