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Bubble, bubble, toil and no trouble!

Montgomery Investment Management

February 2021

There are a number of arguments being advanced to suggest the stock market is in a gigantic bubble that is at risk of bursting imminently. Some of the arguments relate to broad overvaluation, the tidal wave of overpriced IPOs that double on listing, and the observation that interest rates remaining low forever is tantamount to the unrealistic, and previously unrealised, expectation of high rates of earnings growth being sustained forever.

For this article however I want to look at the market's valuation compared to bond yields to help understand the extent of any euphoria in markets that may cause them to be at risk of imminent collapse.

Australian ten-year bonds have traded almost in lockstep with their global peers over recent decades, and since the early to mid 1980's bond yields have been in inexorable decline.

Source: Tradingeconomics

According to Bloomberg, the ten-year Australian bond yield is 1.17 per cent. The bond yield will move independently of short-term cash rates set by the Reserve Bank of Australia, so while the RBA Governor Philip Lowe has made it clear that the overnight cash rate of 0.1 per cent will not be moving for some years or until inflation is "sustainably" in the target band of 2-3 per cent, that does not mean the yield curve cannot steepen with ten-year bond yields rising.

Nevertheless, the starting point for one method of assessing equity market valuation is the ten-year bond yield. To that yield we add an equity market risk premium. On this number there is much conjecture. The equity market risk premium is the average return that investors require over the risk-free rate (ten-year treasury bonds for example) for accepting the higher variability in returns that are typical of equity investments. In other words, the Equity Market Risk Premium reflects a minimum threshold that motivates investors to invest.

Investors and academics have long debated this number, which of course changes over time. Turning to the RBA again, and its June 2019 Finance Bulletin - The Australian Equity Market over the Past Century[1], reveals the following:

"Using the updated dividends data, the new historical series (extended with available data for more recent time periods) imply that the total nominal return on equities (i.e. the sum of capital gains and dividends) has been around 10 per cent, per year over the past 100 years (based on a geometric average which allows for compounding over time). In real terms - i.e. after accounting for inflation - the average annual return was about 6 per cent. There have not been material differences in returns across sectors over this time, although of course there have been periods in which sectors have performed differently. Over the same period, the total nominal return on long-term government bonds has been around 6 per cent, implying an average equity risk premium (excess return of equities over safe assets) of around 4 per cent."

So, to the bond yield of 1.17 per cent, we should add four per cent for the equity market risk premium. The product of the two is of course 5.17 per cent. This is the theoretical fair value Earnings Yield for the market.

The Earnings Yield is of course merely the inverse of the Price Earnings ratio so, by dividing 100 by the earnings yield we can arrive at a theoretical fair PE for the market of 19.34 times earnings.

If the 1-year forward PE of the market is much higher than this, investors are willing to accept a narrower than reasonable future return above bonds, given the risk of investing in equities.

According to Bloomberg at 12.17 pm on 3 February 2021, the 1-year forward PE for the ASX200 (excluding loss making companies) is 19.26.  By including loss making companies the 1-year forward PE is 20.55 times suggesting there is only marginal enthusiasm for equities overall.

This picture of course changes throughout each day. As bond yields rise, the fair value of the market falls, and the reverse occurs when bond yields decline. If bonds yields do begin marching materially higher the risk for the market rises, even if the market itself does not rise. This is because the fair value PE would decline moving further below current levels.

Today, as it stands however, on this measure at least, it doesn't appear that the Australian stock market is in a bubble.

[1] https://www.rba.gov.au/publications/bulletin/2019/jun/the-australian-equity-market-over-the-past-century.html

Damen Purcell, COO of Australian Fund Monitors, speaks with Chris Wheldon, Portfolio Manager at Magellan Asset Management

The Magellan High Conviction Fund follows an unconstrained, highly concentrated long only strategy investing in global large cap stocks...with the fund investing in just 8-12 of Magellans best ideas. The fund also has the ability to take a cash exposure of up to 50%.

Cash rates locked, but dividends unshackled

Dr Don Hamson, Managing Director, Plato Investment Management

9 February 2021

We didn't get another "historic" rate cut from the RBA on February 2, but we did get some absolute confirmation of what we've been saying for quite some time - rates are staying lower for longer.

In his rate decision statement, Philip Lowe said, "The Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. The Board does not expect these conditions to be met until 2024 at the earliest."

In short, Lowe's probably not going to even think about lifting the cash rate until at least 2024. The ramification of this statement for those investors still trying to make ends meet  from yield on term deposits and other cash-backed products is obvious.

But that's where the retirement income pessimism should stop - after a tough year for dividend income there's a break in the clouds.

We've entered 2021 with some positive news, which lays a strong foundation for what should result in a strong dividend recovery in the coming 12 months.

Bank dividends

The first piece of positive news, a capital management update from APRA in December. The regulatory authority repealed restrictions imposed on banks earlier in the year regarding dividend payout ratios. In April 2020, APRA initially warned against paying any level of dividend. In July, an update putting dividends back on the table, but the authority said they must not exceed more than 50% of earnings.

The December update put an end to the regulatory uncertainty with APRA noting further improvement in the economy and removing all hard restrictions on bank and insurance dividends.

Bank dividends cut an average of 60% in FY2020 so there is significant upside. While we don't expect them to go back to pre-COVID-19 levels for at least another two years, we do expect to see bank dividends begin to move toward more normal payout ratios of between 70 and 80 per cent over the next 12 months. Still a big improvement from what many were anticipating only a few months ago.

Franking is here to stay.

The second announcement was from Federal Labor Leader Anthony Albanese. Many readers of this article will remember myself and the Plato team campaigning against Labor's policy to scrap franking credits at the last federal election. This would have had a serious impact on retirement income. In fact, the policy was labelled the 'retiree tax' by many.

On January 2, 2020, Mr Albanese said in an online address to Labor party members, "I can confirm that Labor has heard that message clearly and that we will not be taking any changes to franking credits to the next election." 

Uncertainty surrounding franking credits has been an ongoing concern for retirees seeking to move into equities to generate income. It's been a common theme during my firm's regular investor Q&A's.

If you take Fortescue Metals (FMG) for example you can see why. For tax-exempt investors, the Iron Ore miner paid a gross yield including franking of 14.5% in 2020 - that's more than 4% from franking alone.

Dividend cut probability reduced

For more than a decade, the Plato Investment Management team has been using proprietary quantitative analysis to predict the likelihood of dividend cuts. Our latest modelling now shows a significant improvement in the outlook, with the probability of dividend cuts from Australian stocks now back to around the long-term average.  To us this signals that the big Covid-19 related dividend cuts are now behind us.

The income landscape

Buoyed by some of the aforementioned factors, we maintain an actively managed and well  diversified portfolio of dividend paying stocks is the most compelling income generating strategy, particular for Australian retirees.

Our latest 12-month income forecast shows equity income remains well above other major asset classes.

Whilst the big traditional Australian income stocks such as the banks have cut dividends and underperformed, on the upside we've been generating strong income for investors from miners such as Fortescue Metals, BHP and Rio Tinto in recent years and we expect this to remain consistent throughout the year.

We also expect strong yield from select retail businesses in the year ahead - the likes of Wesfarmers, Coles, Super Retail and JB Hi-Fi.

When it comes to the banks, the Commonwealth Bank maintains a strong balance sheet with excess capital. This raises the likelihood of a buyback in the coming years, which would benefit retirees particularly.

On the flip side, avoiding dividend traps is still important, although it would appear there are now less dividend traps in the market than there was in 2020. We would caution inflated historical yield figures in sectors such as Tourism and Leisure, Energy and Infrastructure and Retail REITs.

Finally, the only free lunch remains diversification. And for retirees, that lunch can get a little better if your portfolio is being managed to take advantage of franking credits and other tax-effective opportunities such as buybacks.

Australian Fund Monitors' CEO, Chris Gosselin, speaks with Michael Frazis from Frazis Capital Partners about the Frazis Fund what drove the Fund's significant outperformance over the past 12 months. Michael also shares his thoughts on the current state of markets around the world.

The Frazis Fund has risen +109.74% over the past 12 months vs AFM's Global Equity Index's +2.59%. Since inception in July 2018, the Fund has returned +35.74% p.a. vs the Index's +10.54%.

Charlie Jamieson, Chief Investment Officer at Jamieson Coote Bonds, discusses the market and performance of high grade bonds in January 2021.

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Chief Investment Officer, Steve Johnson, is joined by Alex Shevelev, Senior Analyst on the Australian Shares Fund, as they discuss the factors contributing to a strong start to the year for Australian retailers including JB Hi-Fi and Super Retail.

Forager Australian Shares Fund

Forager International Shares Fund

Transcript:

Steve

Hi everyone and welcome. It's Steve Johnson here, Chief Investment Officer at Forager Funds, bringing you our first video for 2021. I'm joined by Alex Shevelev, Senior Analyst on the Forager Australian Shares Fund. Hi Alex, how are you?

Alex

Hi Steve, hello everybody.

Steve

It's been a bumper start to the year for Australian retailers, lots of them out early in 2021 talking about some very buoyant Christmas trading. We saw JB Hi-Fi, Super Retail, a couple of stocks that we own small positions in our portfolios such as Shaver Shop and Michael Hill pretty consistent across the retail industry, making lots of money.

Alex

It's been a great time to be a retailer. All that money that we saw that's not going towards international travel and a lot of the money that's coming from government stimulus is ending up in the coffers of some of these businesses and the revenue growth has been absolutely staggering for what are already some pretty large businesses. Supercheap and JB Hi-Fi group grew 23% and 24% in total revenue and that's including the fact that some of these stores were shut down for a period during that half.

Steve

I remember doing an analysis of JB Hi-Fi probably 10 years ago, questioning whether it could ever get to $10 billion of sales given the amount they Australians spend on electronics. But we've seen through this past period, they just keep taking market share and also the market keeps growing. The big thing though, has been profit. You talk about sales up 20%, but profit numbers are up a lot more than that.

Alex

In some cases they're up 80% plus and the reason here is twofold. Firstly, we've got increasing gross margins. So the retailers have managed to tick up the sales prices of their products ever so slightly relative to their costs. That might only be a couple of percentage points and you may not see it necessarily in your purchases but for a retailer that makes maybe a high single digit margin that is a really big change.

Secondary to that, you've then got all those extra sales, all that extra gross margin coming through and the operating costs of these businesses have stayed largely similar. So you're getting a double benefit there.

Steve

I think as a well-run retailer, you might be talking sort of 6% to 8% margins at the bottom line. So as you can add 2% at the gross margin level, that's having a fairly dramatic impact on your profit. Maybe a bit counter-intuitively retailers are talking about it being difficult to get goods into the country, from China in particular, with lots of capacity constraints in shipping. It's probably been a good thing net for them because there's less competition and lots of demand and it's enabled them to put those gross margins up a little bit. Now the share price reactions have been muted using profit here up 80% and 90% on stocks that were not trading on crazy multiples to start with.

Yet we've seen share prices, maybe up 5% or a bit more on the day and retracting a bit over the days after that. What's going on with the bumper results coming out way above everyone's expectations and share prices not really moving?

Alex

These retailers had run up to some extent already. There was already an expectation that there was going to be more revenue flowing in. However, it is higher than people expected, but that increase is limited, or appears to be limited in investor's minds, to this first half of the year and potentially subsequent couple of months. These businesses are not necessarily getting credit for this level of profitability continuing.

We're going to really get to see that in the first half of next financial year, how these businesses end up relative to the half they've just had.

Steve

I'd probably say we agree with that. That's a sensible reaction from the market to say this is clearly unsustainable, both at a sales level, people are going to start spending money on travel and other things again, towards the back end of next year. Probably most importantly, you would assume these to come back to something more normal eventually.

Alex

That's right. There are some things that have changed though for some of these retailers and Shaver Shop is a good example of this. There has been a transition to online and the businesses that have really been able to seize the opportunity in online and transition some of their offline sales to online should be better positioned for that come next year.

Shaver Shop for example, has seen its online sales percentage tick up from 10%, two years ago, closer to 30%. Now that's a big change for a business like that.

Steve

Yeah and I think you've seen some of these businesses manage that transition well. Shaver Shop is up to more than a third of its sales through its own website online. They're delivering those through the store network. But it says to me that all of that brand awareness they have, when you think I want to buy a shaver, where do you go? The money that's been spent on that over all these years is worth something. As long as you can get your offering right online, you're not actually seeing the likes of Amazon kill these businesses. In fact, they're doing quite well online.

Alex

That's not the only thing that's happening though. There's a secondary aspect of it and that is that this period has really been a shake up for a lot of these industries.

So you've got, for example in the jewellery space, some competitors that might struggle more than the listed player Michael Hill. In that situation you might be taking sales off competitors. Eventually, like we had seen with someone like Baby Bunting, over a long period of time those competitors might fold and you might capture more of those sales.

In other situations that shake up has really been a COVID affected shakeup, but with implication over a long period. So personal travel on motorcycles for example, is likely to be a bigger feature going forward as people remain a little bit hesitant of public transport, and that's really feeding into a Motorcycle Holdings result, which probably is not going to be quite as good as our bumper first half of 2021, but has a good chance of being better than the prior years as that industry is really shaken up.

Steve

I think people are actually underestimating how difficult the environment was for the three years leading into this COVID meltdown. Retail in Australia has been really hard. You've had costs marching up slowly while revenue has not been growing at all across the whole sector and this leakage to online going on at the same time. I think you've seen some of those businesses do a great job of consolidating in their industries and I don't think we're going back to 2019 levels of profitability.

There's no doubt that this year is going to be an anomaly on the high side. But I think people are looking back and saying, well I'm going to apply a multiple of 2019 earnings. In my view, that might be a bit too conservative given where share prices are at the moment. So still some really interesting opportunities out there in the space and still a meaningful part of our portfolio.

We're looking forward to hearing those and other companies give us further updates through February as our Australian portfolio reports results. Thanks for tuning in, and we'll be back with some regular updates over the next month as we get all of those results.

ARE RISK MARKETS ENTERING A CORRECTION ZONE?

Chris Manuell, CMT, Jamieson Coote Bonds

5 February 2021

The market adage of January being the barometer for equity market performance for the year will always get tossed around as investors outline their roadmap for the year ahead particularly coming off the historic events of 2020. The RBA may also be paying particularly close attention to the performance of the US equity market given the strong marriage of the pair since the nadir in risk markets last March. The RBA governor could become a fan of seasonals, with strong statistical evidence that the S&P 500 Index performance for the start of the year drives returns for the remainder of the year. With this in mind, the S&P 500 Index fell -1.11% (for the first month of 2021) in price terms and Deutsche Bank has studied data going back to 1872 that shows negative first months of the year have a strong impact on the performance for the remainder of the year, with 58% resulting in down years.

The RBA will be very disappointed that after embarking on an aggressive QE campaign it has failed to generate the transmission mechanism into the exchange rate that it would of anticipated - an 8% rally since November 2020 would have figured deeply in the surprise move to extend QE by another 100 billion of bonds or 5 billion a week for a further six months. The currency has managed to continue on its ascent with the global liquidity pump switched on full power mode driving a strong performance in commodities markets - with iron ore 22% of our exports - and domestic data surprising to the upside as the fiscal cheque book keeps printing alongside a successful Covid-19 suppression strategy.

The weakness of the USD has also played its part in providing a tailwind for the AUD which will stymie any attempts for the RBA to achieve its overly optimistic target of getting inflation consistently in the 2-3% target band. The RBA is not alone in lamenting the weakness in the USD with the ECB continuing to talk down its currency as USD strength will continue to undermine global economies' attempts to escape a post-Covid world.

We monitor price action, sentiment and investor positioning as part of our rigorous investment framework and within that there are some subtle signs that indicate that risk markets may be entering a zone where they could pause or correct from their recent moves.

The record short positioning in the USD is a dangerous development with the market all on one side of the boat leaving it very unstable and vulnerable to any unexpected shocks which can generate aggressive unwinding. 

The below chart highlights the historically stretched positioning of USD bears which will make it difficult for another secular leg lower in the USD currency as sellers become exhausted.

Source: Bloomberg

The robust correlation between the AUD and risk markets is well documented and is interesting to note that the price action of late has showed some signs of that marriage starting to sour which provides investors with a salient reminder of the old risk-on/risk-off nature of financial markets and of the possibility that the text-book philosophy of interest-rate differentials may become in vogue again in 2021. The intention of the RBA to weaken the currency with its outsized bond buying program might finally gain some traction if the US/Australian yield differential reasserts its downward trend. Careful what you wish for, as a weaker Australian currency could also suggest trouble lies ahead for risk markets in general.  

Performance of Australian Dollar (RHS) and US Equities (LHS)

Source: Bloomberg. Past performance is not indicative of future performance.

CHINA IS NOT GOING TO SAVE THE WORLD THIS TIME

Marcel von Pfyffer, Arminius Capital

4 February 2021

In November 2008 a panicked Chinese government launched a stimulus package equivalent to 12% of then GDP. The package propelled China out of the GFC, but it created more problems than it solved, e.g.:

• A tenfold increase in corruption.
• Useless or non-economic projects: "bridges to nowhere".
• A surge in banks' bad loans.
• A sharp increase in the ratio of debt to GDP.
• Unsafe buildings, and highways that collapsed.

The current Chinese government is not about to repeat this mistake. Its response to the GFC has been modest, focusing on maintaining public sector investment and propping up the banking sector. Households have been left to fend for themselves, with no support payments like Jobkeeper or Jobsaver. Many small businesses have closed permanently, and many low-skilled workers and new graduates have been unable to find jobs. Households' need to draw down their savings means that, even for those who still have incomes, spending remains subdued and consumer sentiment remains cautious.

The IMF forecasts GDP growth of 1.9% in 2020 and 7.9% in 2021. Although this level of growth is better than most of the world, the Chinese economy is still operating well below potential, with more downside risk than upside:

• The central government may cut back spending too soon, before private sector capex has strengthened enough.
• Many small rural and regional banks still have weak balance sheets and rising bad debts (especially related to local governments), so that further runs and collapses are likely.
• Corporate bond defaults spiked in 2020, and 2021 will see even more defaults, particularly in the property sector.
• Decreasing credit quality may cause solvent banks to tighten loan criteria, reducing the availability of finance to the private sector.
• China's strong export performance was strong in 2020, but in order to continue it relies on sustained economic recovery in the rest of the world.
• The US trade war and "technological decoupling" may worsen profitability and employment in several Chinese sectors. So far, the Biden Administration seems to be continuing Trump's hard line on China.
• In the immediate future, Chinese authorities are hoping that the annual Spring Festival migration will not trigger more coronavirus outbreaks.

For Australia, a slowdown in the Chinese economy would be very negative. More than a third of our exports go to China, and another quarter go to China's Asian neighbours, whose economies are also linked to China.

South Korea is the country that China imports most from, at US$203 billion, with Japan second at $180 billion and Taiwan third at $177 billion (although China may not agree that these are cross border flows). Just off the podium stands the US in fourth place at $156 billion, with Australia coming in sixth place at $105 billion - remembering that America started a trade war based on these figures (a mere $51 billion difference between US and Australian numbers).

When viewing the trade balances (below) between China and the rest of the world we understand far better the precarious position Australia is in. Although, commodities are in finite supply around the world with only a few other countries physically able to step into the breach should China make the political decision that they would no long wish to purchase Australian commodities.

In light of current political tensions between China and Australia, and Australia's over-reliance upon China as its primary export market, policy makers and diplomats both need to ensure that their current strategies are robust enough to ensure that Australia does not also sneeze should China catch a cold.