Is this the global macro landmine no one is talking about?

Scott Williams, FiftyOne Capital

1 March 2021

While all eyes are on the recent rise in yields, the debate has largely been centered around inflation expectations and how far the Fed will actually let inflation run before raising rates. While all this is all very interesting and sounds smart and logical, there is a much more concerning issue, deep within the technical plumbing of money markets, that equity traders are mostly unaware of.

On February 23rd 2021, testifying before congress, Jay Powell was asked the following question, and his answer, although somewhat vague, should have warranted a much more intense interrogation.

Question: Senator Rounds: It would appear Congress is going to create even more bottlenecks in our financial plumbing by flooding the economy with about $1.9 trillion in new money, that banks will have to hold capital against as soon as the treasury starts writing the checks. My question is would you agree that it makes sense to seriously consider extending the SLR exclusion, given the other measures the Fed and Congress are taking to facilitate our economy's recovery?

Answer: Jerome Powell: So I do think that the SLR exclusion, I know it expires at the end of March, and we actually haven't made a decision on what to do. It's something we're in the middle of thinking about right now. And so I'm just going to have to say that we'll be making a decision in announcing pretty soon here.

So what is the SLR? 

The supplementary leverage ratio, or SLR, requires banks with more than $250 billion of assets to maintain an extra cushion of high-quality capital against their total assets. Banks must maintain a minimum 3% ratio against their total leverage exposure. The ratio is 5% for the largest bank holding companies. In April 2020, the Fed allowed U.S. Treasury securities and deposits held by commercial banks at Federal Reserve Banks to be excluded from the calculation of total leverage exposure for purposes of the supplementary leverage ratio. This exclusion however, expires on March 31st 2021.

And, why does this matter?

Its all related to the Treasury's General Account, the TGA, which is essentially the governments bank account that holds the proceeds of selling T-bills. The proceeds are a liability on the government balance sheet and the funds are supposed to be spent on government bills, stimulus payments and anything they need to fund. Former Treasury Secretary Steve Mnuchin allowed the account to skyrocket to $1.6 trillion. To put this into perspective, the account generally held ~$5bn prior to 2008, and more recently between ~$150bn on average.

Current Treasury Secretary, Janet Yellen recently outlined plans to reduce the TGA account (remember it is a liability) from $1.6trillion to $800 billion by the end of March, and then further to $500 billion by the end of June. That's a whopping $1.1trillion of liquidity that is being unleashed into the system within a very short time frame. So big, it has been dubbed a "tsunami of liquidity" into the economy.

Yellen needs the account to be at a more manageable size for several reasons, the first being she needs it to meet 2019's debt ceiling requirements for holding no more than $120 billion in the TGA by August this year. But whatever the reason, the cash needs to be deployed somewhere, and the first stop is usually the banking system. Banks have previously been able to absorb this liquidity and allow their reserve accounts at the Fed to grow dramatically. But commercial banks currently hold $3.4 trillion in reserves and they probably don't want to hold anymore earnings almost 0% interest while inflating their leverage ratios to uncomfortable levels which will only limit lending and risk another repo rate market explosion.

This comes at a time where there is a shortage of collateral that the banks can find in the market to hold against a wave of cash. The Treasury has been reducing its T-bill issuance in order to extend the duration of its debt portfolio and take advantage of the lower longer term interest rates. Banks simply cant comply with the SLR requirement.

So Fed Powell has one clear option, extend the temporary exemption of bank reserves and treasury securities from the supplementary leverage ratio (SLR) calculation and/or increase the leverage ratio. But, as explained above, there is no incentive for the banks to participate. In fact, releasing so much liquidity into the system lies another problem, money market rates are already trading close to 0%. This sort of influx can take short-term rates into negative territory.

BAML bond strategists like Mark Cabana thinks the Fed will have to raise IOER (interest on excess reserves) to keep rates from slipping below zero. This would be a "technical" rate rise and not one associated with any kind of change in its policy stance, but how would it be viewed by the Market? The real net effect will be a steeper yield curve, as the long end continues to rally, the short end will be fighting to hold above zero. At the end of the day, its the rate of change that determines how the market views rising rates. And all this is taking place at a time when markets are already nervous about inflation and financial market bubbles.

While we all like to sit back and debate on inflation and the rising 10yr yield, we should be more concerned about what is happening at the short end and how steep the curve can go. How will the market react to a IOER rate rise, despite it being strictly technical in nature? How much of this excess liquidity finds its way to the equity market? And what does this mean for the US Dollar?

10yr vs 3mth yields: While 10yr rates are rising, short term rates have been trading lower, the risk is a test of 0%, and potentially negative rates:

Funds operated by this manager:

FiftyOne Capital Progressive Global Fund

Six Key Reasons to Invest in a Managed Fund

APSEC Funds Management

March 2021

The share market is a popular investment choice for many Australians looking to grow or protect their wealth over time.

According to the ASX Australian Investor Study 2020 (1), of 19.4 million adult Australians, 46% (9 million) Australian adults currently hold investments other than their primary residence, with another 900,000 planning to begin investing in the next 12 months.

Of these investors, more than half are direct, or DIY shareholders. The growth of available investment research and the decreasing cost of executing trades has made this an accessible and potentially lucrative pathway for investors of all experience levels.

The other major share market investment pathway, for both individuals and institutions, is the managed funds industry, which held $3,828.1b billion total funds under management in September 2020, as per the latest ABS industry data. (2)

Managed funds allow you as an individual to pool your money together with the money of multiple investors, to purchase units in the fund, and a professional Investment Manager then buys and sells shares or other assets (property, cash, bonds etc) on your behalf.

The value of units you own in a managed fund start with the amount of money you invest at the value of each individual unit at the time of purchase, along with any additional investments or redemptions you make. The unit price then fluctuates along with the underlying investments, and the value of your holdings become a function of the success of the fund's investment performance.

All of the decisions on what, when and how much to buy or sell are made by the Investment Manager, so you should conduct careful research up front to choose a Fund with an investment strategy that suits your needs, which will be documented in their Product Disclosure Statement (PDS).

So why choose a managed fund rather than doing it yourself?

1) Expertise of the managed fund team

As with any profession, experience matters. A prime reason many investors choose managed funds rather than DIY to is have a dedicated investment professional managing their future prosperity, as they would have an accountant manage their taxes, or a lawyer managing their legal affairs.

Fund managers are strictly regulated by ASIC and other oversight bodies, especially in the wake of the 2019 Royal Commission (3) which led to increased oversight and accountability for the financial services industry, and extra protections for investors.

Reputable Funds should make it easy for investors to access details on the team that will be managing their investments, and objectively measure their short and long-term results.

2) Access and use of investment grade research

While there are a plethora of research reports, tools, websites and other services that can provide share market information, sifting through available data and knowing how to apply what's relevant to your investment objectives is challenging for many investors.

Fund managers usually have access to relevant research and maintain professional networks inside and outside their firms that support their investment objectives.

APSEC's portfolio leads helped create the powerful share market research and trading platform HALO, which provides a competitive information edge for the fund.

The platform is used by thousands of individual and institutional investors for up to date research on over 20,000 global equities, advanced portfolio management tools, and signals to help guide buying and selling decisions.

Examples of HALO technical trading indicators used by the Atlantic Pacific Australian Equity Fund, October 2020.

3) Diversification and risk management

Diversification is a fundamental principle of prudent investing - spreading your cash across a range of assets, asset classes, geographies etc to reduce the impact of any one investment moving against you.

Australian investors would typically select from a mix of local shares, international shares, property, bonds, and cash in a balanced portfolio.

There are also more complex products like equity derivatives (such as options or futures), Initial Product Offering (IPO's) share buy-backs or placements, etc, that may not be offered to, or cost-effective for individual investors.

Managed funds usually have the resources to hold a larger number of stocks than individuals, and/or a range of other complementary products to help advance the Fund's investment strategies.

Investors should take care to research the Fund's investment mandate and asset allocation, to ensure they align with your own investment goals, whether that's higher risks for higher returns, or more stable investments designed to preserve capital or pay a reliable income stream.

The APAEF's long/short investment mandate allows us to invest in all of the products mentioned above, however in practice our short positions (i.e. Positions whereby we seek to profit from downward price movements) are mostly S&P/ASX 200 SPI futures contracts, designed to reduce risk and shelter the Fund from large capital drawdowns that the market can experience. This core focus on risk management has helped the APAEF smooth out the impacts of market volatility over the long run, while still generating above-market returns.

As you can see in the risk statistics chart below, the largest drawdown the fund has experienced in more than 7 years since inception was -7.1% while the largest drawdown for the S&P/ASX 200 in the same time period was -26.7%. The Alpha value shows the outperformance of the Fund vs the benchmark S&P/ASX 200, annualised at 1.1% per annum since inception (net of all fees). Annualised returns since inception in June 2013 of the Fund are 9.3% p.a.* vs the S&P/ASX200 Accumulation Index returning 8.2% p.a. as at December 31, 2020.

*Source: ASPEC Investor Monthly Report, December 2020

4) The ability to start small and build holdings incrementally and consistently

Managed funds allow you to start at a relatively lower threshold than some comparable investment options, like property or bonds, and then build the value of your holdings over time through ad-hoc or structured top-ups.

The APAEF, for example has a current minimum investment amount of just $10,000, and a minimum additional investment amount of $1,000, making it accessible for most investors.

In contrast, investing in property can require a minimum deposit of up to 20% of the property's value, as well as substantial on-costs like stamp duty, inspection, conveyancing and other legal fees, creating a substantial barrier to entry for new buyers.

5) Focussed investment

Emotions and attitude play a large part in successfully navigating the share market, and can be a significant challenge for individuals in developing and sticking to a long-term investment plan.

Aside from maintaining the discipline for continually researching the market and maintaining portfolio hygiene, high levels of media noise and information saturation can lead to emotive short term behaviours, such as the well-studied syndrome of performance chasing:

- Fear of missing out on a stock that's climbing fast can cause you to buy in at a high point of the valuation, with limited upside potential.

- Panic at a sudden drop in one of your shares can cause you to sell down at a low point, crystalising your losses with no possibility of a recovery in value.

- Excitement caused by a stock you hold that's doing well can cause you buy more at a high point, rather than prudently taking some of the profits and rebalancing your holdings in line with your larger portfolio and investment objectives.

Fund managers are paid to professionally manage your money in line with their stated investment mandate, replacing the emotions that can lead to irrational behaviours with systematic and disciplined decisions deigned to optimise long-term returns, rather than short-term reactions.

6) Time saving and ease of reporting

Finally, a significant reason for choosing managed funds rather than DIY is the time involved in market research, portfolio management and administration tasks like tax reporting

Researching stocks to trade can be both intellectually satisfying and potentially lucrative. However, maintaining this research across a balanced portfolio of 10-15 or more stocks, and potentially multiple portfolios can become a significant impost.

Consider your own situation - if you like to be hands on and are happy to commit the time needed to do justice to your investments, DIY may suit.

If, however, your work, family or other commitments don't leave enough scope for adequate research and portfolio management, a managed fund may be an attractive option.

References:

1) ASX Australian Investor Study 2020: https://www2.asx.com.au/blog/australian-investor-study

2) ABS, Managed Funds, Australia: https://www.abs.gov.au/statistics/economy/finance/managed-funds-australia/latest-release

3) Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry: https://www.royalcommission.gov.au/royal-commission-misconduct-banking-superannuation-and-financial-services-industry

Disclaimer:

*Fund Returns are prepared on a redemption unit price basis after management and performance fees inclusive of GST. Distributions are assumed to be re-invested at the mid unit price. Individual tax is not taken into account in deriving Fund Returns. In calculating the NTA, the Atlantic Pacific Australian Equity Fund ("Fund") asset values have been calculated using unaudited price and income estimates for the month being reported. Past performance is not indicative of future performance.

APSEC Funds Management Pty Ltd ACN 152 440 723 (APSECFM) is a corporate authorised representative (CAR: 411859) of APSEC Compliance and Administration Pty Limited (AFSL 345 443 ACN 142 148 409). APSECFM is the investment manager of the Atlantic Pacific Australian Equity Fund (ARSN 158 861 155) (Fund). This document has been prepared and issued by APSECFM. Equity Trustees Limited ("Equity Trustees") (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity of the Fund. Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX:EQT). A Product Disclosure Statement (PDS) for the Fund is available at www.eqt.com.au/insto and can be obtained by calling APSEC on +612 8356 9356. The PDS should be considered in deciding whether to acquire, or to continue to hold, an investment in the Fund. This material is for general information purposes only. It is not an offer or a recommendation to purchase or sell any security and is not intended to substitute for the Fund's PDS which will outline the risks involved and other relevant information. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Please note that past investment performance is not a reliable indicator of future investment performance. Equity Trustees do not express any view about the accuracy or completeness of information that is not prepared by Equity Trustees and no liability is accepted for any errors it may contain. The performance of the Fund or the repayment of any investor's capital is not guaranteed. This information has not been prepared taking into account your objectives, financial situation or particular needs. This document may contain information provided directly by third parties. To the maximum extent permitted by law, APSECFM excludes liability for material provided by third parties. APSECFM does not warrant that such information is accurate, reliable, complete or up-to-date, and to the fullest extent permitted by law, disclaims all liability of APSECFM and its associates. APSECFM believes that the information contained in this document is accurate when issued. To the maximum extent permitted by law, APSECFM excludes liability for any loss or damage arising as a result of reliance placed on the contents of this document. HALO is an analytical tool developed and owned by HALO Technologies Pty Ltd (ABN: 54 623 830 866) (HALO Tech) a Corporate Authorised Representative (CAR: 1261916) of Amalgamated Australian Investment Solutions Pty Ltd (ABN: 61 123 680 106. AFSL: 314 614) (AAIS) and a related party to ASPEC FM. HALO only contains factual and forecast information. Information presented or extracted from HALO should not be considered advice or a recommendation. Any forecast information relates to the intent, belief and current expectations of various analysts via Factset with respect to the performance of the respective stocks based on historical and projected performance data. You should not place undue reliance on these forward-looking statements. While all due care has been used in the preparation of the forecast information, actual results may vary in a materially positive or negative manner. Forecasts and hypothetical examples are subject to uncertainty and contingencies outside of HALO Tech's or AAIS's control. If you would like more detail in relation to HALO please contact APSEC FM / or your Adviser. A copy of the privacy policy and FSG can be found here www.apsec.com.au.

Funds operated by this manager:

Atlantic Pacific Australian Equity Fund

Reporting Season Wrap: Equities

Michelle Lopez, Aberdeen Standard Investments

March 2021

This was a remarkably strong reporting season. Remarkable in that operating conditions for most companies were still very challenging given the stop-start economic activity we saw over the period 1 July 2020 to 31 December 2020. Yet it was one of the strongest in the last decade, with beats significantly exceeding misses by approximately 3x and EPS growth for FY21 now sitting at close to 15%. Better than expected margins, rather than higher revenue, drove the beats. We also saw good cost control across the board - which talks to the uncertainty management faced over the past 6 months. The return of Outlook statements and re-instatement of dividends points to greater confidence in the period ahead.

There were three stand-out categories: Commodities, Banks and COVID Winners: the latter two which delivered ahead on earnings, dividends and sales. However, we acknowledge that the COVID winners face tougher comps in coming months as they begin to cycle the very strong COVID numbers. The other interesting trend was greater upgrades in Large caps. Driving this was the concentration of Banks and Commodities in large cap, but it also suggests the earnings trends in large companies are stronger, which contrasts with recent years where small caps had stronger earnings.

We remain positive on the earnings cycle, with the recent pull back in equity prices and valuations, driven more by bond yield rises than reporting season, was needed given the very strong rally we had year-to-date. From here, we expect returns to be driven by earnings growth. However, we need to start seeing businesses invest for the future (through capex) and focus less on short term cash burn/profitability. Australia cannot rely on a consumption-led economic recovery for the long term. In fact, a sustained economic recovery in Australia will only be achieved through business investment, job creation and productivity improvement which we hope to see come through over future reporting seasons.

SECTOR Round-Up:

Financials

Banks were the highlight of reporting season, reporting significant beats. Main driver was lower impairments (WBC and ANZ wrote back part of their General Provision, NAB held constant and CBA topped up by a small amount), but underlying results were generally better than expected too with a couple of the banks (ANZ and WBC) reporting an increase in margins. This led to material upgrades to bank earnings growth: FY21 earnings growth is now expected to be up close to 25% (from <1% in January), materially outpacing the broader market. Banks outperformed on the back of rising bond yields as it is one of the few sectors that benefit from this, given the ability to re-price their loan book, lifting margins. Another positive was the improved Asset quality. COVID deferrals now only represent <3% of the portfolio across the majors in both housing and SME, although we continue to closely monitor for renewed signs of stress as stimulus policies roll off. From a portfolio positioning perspective, we have been closing our underweight over the past 6 months, with increased exposure mainly to CBA, NAB and Macquarie Bank.

Exchanges while holdings like the ASX reported resilient results where increased trading volumes offset lower activity in interest rate derivatives, sentiment was weighed down by the likely ongoing cost reinvestment required to deliver major IT projects such as the CHESS replacement, which extends into 2023. Furthermore, given ASX's strong infrastructure-like cash flows, valuation have also been impacted by rising forward yield curves. Across the ditch, NZX enjoyed similar themes of stronger than expected trading activity and their growth vectors in ETFs and wealth platform also performed well, albeit requiring further cost investment before these will contribute more meaningfully to earnings.

Turning to the insurance sector, the greatest impact has been COVID business interruption claims after unfavourable test cases imply that insurance policies do indeed provide some pandemic coverage. This has forced large provisions across the sector. While the rear view mirror does not provide much confidence, strong rate cycle momentum has been maintained and we expect the current hardening cycle to be elongated to account for the barrage of recent catastrophes, COVID-19 losses and a structurally lower interest rate environment. Given this backdrop, we have increased our conviction in our IAG holding and see this as a high quality cyclical opportunity to capture outsized risk adjusted returns. Our investment in insurance broker, AUB, delivered a strong set of results, capitalising on both the hardening rate cycle as well as driving margin improvement through IT and cost out initiatives. Outlook for the insurance brokers remains buoyant and AUB remains our preferred exposure.  

Wealth platforms demonstrated a return to strong rates of organic FUA growth after some slowdown in client activity amidst the COVID-19 disruptions, and this was also aided by a strong equity market recovery. While the outlook for continued secular growth remains, recent results saw some concern emerging on further margin compression through the repricing of the back book by Netwealth. While we continue to see a strong likelihood of further margin compression, we see the pace of decline moderating and are encouraged by the stable competitive environment and the accelerating inflow momentum.

Property

Dispersion in performance across property sub-sectors continued this reporting season, with investors focusing on different key metrics depending on the impact that COVID has had on the respective businesses. Benefitting from government stimulus and a supportive interest rate environment, residential players such as Cedar Woods was able to deliver as the focus was on the solid uplift in their pre-sales pipeline. Other performers were those within the Industrial and fund managers space such as Goodman Group and Charter Hall, whereby structural demand for improved supply chains continue unabated whilst investors continue to deploy capital benefiting FUM growth.

Performance in the office sector were generally muted as investors grapple between what looks to be a strong macro recovery versus post pandemic demand trajectory given the WFH phenomenon, although companies like Mirvac managed to demonstrate resilience owing to long term leases whilst able to deliver a slight positive leasing spread. Finally some retail names did indeed outperform despite the longer term structural headwind as domestic restrictions continues to lift, arguably a transitory effect in our view as the market was overly negative around the amount of COVID rental provisions that was required. Overall sector performance in the near term will likely remain weak, as rising bond yields acts as a macro headwind.

Mining

For the miners, dividends were in focus with bumper returns to shareholders and commentary that these levels would be sustained in the future driven by continued strength in commodity prices with capex set for the medium term. BHP, RIO and FMG all delivered payout ratios over 70% with BHP and FMG recording their largest dividends. Looking forward, earnings are supported by recovery in global growth and supply side constraints despite some headwinds from currency and cost inflation. Valuations are full for base and bulk miners but there is support from macro tailwinds and leverage to global reflation.

Gold stocks delivered record free cash flows on higher realised prices but stocks have under-performed with gold price weakness attributed to improving real yields. Whilst gold is likely to have peaked this cycle and is a headwind to earnings, there are stocks in the sector that will be able to generate attractive cash flow through the cycle and have production growth optionality.

Industrials

Industrial stocks had a mixed February reporting season with those exposed to domestic cyclical activity seeing a strong bounce in earnings over the past 6 months as the health crisis receded, which is a contrast to companies that are more reliant on offshore markets or a restart of travel, still reporting weak results. For example both Sydney Airport and Auckland International Airport reported sharp declines in earnings due to low volumes of international travel and a disruptive stop-start approach to domestic travel restrictions. The silver lining for the airports were the commencement of COVID-19 vaccinations and strong operating cost control, which should see permanent cost savings even when travel restrictions ease.

Outside of travel, we have seen the mining services sector report a strong uptick in activity levels over the past 6 months, with Perth based mining service contractor Monadelphous reporting a strong recovery in workforce numbers to pre-COVID levels, as major Iron Ore replacement projects ramp up in the Pilbara. However, this sharp lift in activity levels combined with ongoing movement restrictions in WA has reduced the typical pool of workers available to fill this rising labour demand, driving wage inflation and margin pressure for mining service companies. Finally, offshore earners such as patent firm IPH was impacted by the strengthening Australian dollar, despite managing to grow like-for-like earnings and having successfully navigated through the risks of COVID-19 disruptions to patent filling volumes.

Healthcare

Generally speaking, the Healthcare sector has been classified as "COVID Winners". However, within our Holdings, we have seen a broad range of outcomes. The key beneficiary of COVID (Fisher and Paykel) did not report in February, however they did upgrade guidance (the 7th upgrade in 18 months) on the back of stronger demand for their respiratory devices demanded by the second wave washing through the US and Europe. Cochlear and Nanosonics saw a solid recovery quarter-on-quarter with new candidate pipeline rebuilding  quickly across all age groups, rather than deferrals for Cochlear leading to upgraded guidance. CSL, although beating market expectations in the 1H (main driver the Seqirus vaccine business) provided a sobering outlook for the 2H as the impact of the lower plasma collection flows through to their core Behring business. The other main factor causing a headwind for all our Healthcare holdings was the higher AUD, given they are mostly offshore earners.

Information Technology

High valuations and a rise in bond yields is a headwind to sector performance that we expect can persist in the short term but ultimately given the secular tailwinds over a multi-year period, the sector's growth appeal will be restored and we expect can out-perform. COVID has been a headwind for the sector broadly with commentary from management teams that decision making had slowed down through this period and weighed on revenue growth across a number of stocks including Altium and Nuix. But this is now expected to lead to pent up demand for the sectors services as customers return their focus to improving efficiencies and opening up their capex wallet and will underpin earnings as operating conditions normalise.

Both Audinate and Megaport management teams talked to industry conditions improving. Altium's result showed resilience for geographies that were less impacted by COVID and is a positive sign for operating environment when conditions normalise more broadly. 

Consumer

COVID-19 pandemic restrictions and fiscal stimulus measures meant that most Retailers enjoyed very strong sales growth. Earnings grew even faster due to robust operating leverage. Online sales growth accelerated and there has been a considerable increase in the proportion of consumers who are purchasing online - a trend that we expect to persist, even as vaccines are rolled out. Looking forward, there are mounting concerns that sales growth is now decelerating and may turn negative as Retailers start to cycle last year's strong pandemic sales periods. Woolworths and Coles expect their supermarkets sales to decline over March to June as they cycle last year's COVID surge.

Meanwhile, online furniture and homewares retailer, Temple & Webster, gave a sales update for the first 7 weeks of 2021 which continued to show growth above 100%, supported by the ongoing adoption of online shopping. Consumer companies also reported supply chain disruption such as Wesfarmers and ARB. While most inventory shortages have been resolved, there are still cases where this is persisting, such as auto components. There was evidence of cost pressures in freight, input components and wages. Some companies also complained that it was difficult to hire labour domestically (particularly ARB and Bapcor) but this is expected to be resolved as stimulus measures are wound back. IDP Education's English language testing and University/College student placement businesses had been heavily impacted by COVID-19 restrictions, but are rebounding faster than expected with English testing levels now back at pre-pandemic levels.

Energy

Earnings and cash flows for the sector were severely impacted by lower oil and gas prices, however this has now turned into a strong tailwind given where commodity prices are trading so we expect a sharp recovery in earnings. With a more constructive outlook, companies have returned their focus to their growth projects which are now back on the agenda and expected to deliver an attractive growth profile for certain stocks in the sector. The outlook is also more favourable given the macro backdrop and reflation trade which are supportive drivers of the energy sector.

Woodside, Santos and Beach Energy all have robust growth projects to execute on which is not reflected in the current stock prices on an un-risked basis.

Telecommunications

Telstra and Spark reported a solid set of results. While both were impacted by lower international mobile roaming revenues, the outlook was slightly improved and both telcos were able to keep their dividends steady. For Telstra, earnings have reached an inflection point as the worst of the NBN disruption has been absorbed and Mobile segment earnings are starting to improve. Two key positive catalysts for the industry are 5G and the opportunity to monetise infrastructure assets, such as mobile towers, through selling down strategic stakes.

Utilities

Not all names under coverage reported however those that did generally delivered to expectations, noting the sector in general has been sold off as viewed generally as proxy to bond prices amidst rising bond yields. Gas pipeline player APA Group delivered a solid result and a slight increase in dividend guidance, with management expressing greater confidence in future growth as they broaden their mandate to invest in a variety of energy related infrastructure including pipelines, firming and storage assets as well as renewables. Over in NZ, electricity gentailer Mercury Energy also outperformed as higher wholesale electricity prices was an offset to low hydro volume, though a delay in their wind farm growth project mired their result. From an outlook perspective, regulatory stance remains either benign, as companies that are beginning to embrace the global push towards net zero emissions are less likely to be impacted longer term from future regulatory imposts.

Important Information

Issued by Aberdeen Standard Investments Australia Limited ABN 59 002 123 364 AFSL No. 240263. This document has been prepared with care, is based on sources believed to be reliable and all opinions expressed are honestly held as at the applicable date. However it is of a general nature only and we accept no liability for any errors or omissions. It has been prepared without taking into account the particular objectives, financial situation or needs of any investor. It is important that before acting investors should consider their own circumstances, objectives and financial situation, the information's appropriateness to them and consult financial and tax advisers. You must not copy, modify, sell, distribute, adapt, publish, frame, reproduce or otherwise use any of this material without our prior written consent.

Australian equities funds operated by this manager:

Aberdeen Standard Australian Equities Fund, Aberdeen Standard Australian Small Companies Fund, Aberdeen Standard Ex-20 Australian Equities Fund

Own the bank not a bank deposit

Roger Montgomery, Montgomery Investment Management

22 February 2021

After 37 years of declining interest rates that have fuelled asset price increases but laid waste to lower-risk income streams, it is perhaps surprising that now should be the time to be discussing dividends. But dividends are back in the spotlight, in no small part due to pronouncements by central bankers including the US Federal Reserve's Jerome Powell and the Reserve Bank of Australia's Phillip Lowe that low short-term rates are here to stay, perhaps for years.

The search for higher income and yields

The desire to deliver income in a low yield and low growth world is, we believe, driving a surge in corporate merger and acquisition activity. And the buyers aren't just trade operators but also large pension and superannuation funds looking to enhance income returns to their clients, investors and members.

Evidence of this demand is reflected in mutterings by the NSW Government that they are considering selling the revenue stream from gambling taxes (to also plug the hole left by changes to stamp duty), and in Telstra's idea to spin off its cell towers.

We recently wrote about this thesis, translating the search for income and higher yields by pension and super funds into the purchase of securities in companies with boring but stable annuity-style income streams. Included in the list of small cap candidates are REITS such as National Storage REIT and retirement and caravan park owner Ingenia Communities Group, as well as companies where we believe reliable annuity income streams are being developed such as Macquarie Telecom and Uniti Group.

Will the banks return higher dividends?

The banks are also back in the spotlight with a meaningful rebound possibly underway in the prospects of higher dividends. Prior to the global pandemic, bank dividends amounted to A$24 billion in 2019, representing almost a third of all of the dividends and franking credits paid by companies listed on the Australian share market.

While vaccination programs are still underway and COVID mutations may yet keep company boards on edge, stronger balance sheets, a recovery in the economy and particularly real estate prices should give the banks leeway to increase their payout ratios.

Any upside from the 0.1 per cent cash rate?

One upside from the decline in cash rates by the RBA to 0.1 per cent at the same time consumers cannot travel overseas, is that they are reassessing the suitability of their homes and borrowing to renovate or upgrade.

The pile of non-performing home loans is defrosting, repayments have recommenced, and home loan credit growth is being fuelled by refinancing and house upgraders and sea and tree changers thanks to technology and the work from home trend COVID spurred. ANZ CEO Shayne Elliott recently noted 92 per cent of customers who had deferred mortgage repayments had returned to repayments.

Changes to lending and borrowing

At the same time, the government's management of the economy has meant job losses have been less acute than expected and consequently the number of frozen home loans is thawing. Fewer underperforming loans will also help bank confidence in the future.

Also favouring a more generous dividend payment policy for the banks, are changes in posture by legislators and regulators. Late last year, the Australian Prudential Regulation Authority (APRA) cancelled its previous ruling that prevented banks from paying dividends in excess of fifty per cent of profits. Bank boards now have control of the payout ratio.

And around the same time the Federal Government indicated it would relax the rules surrounding responsible lending.

These changes are occurring at the same time consumers, having been banned from travelling overseas, and therefore from spending A$42 billion per year there, now have more firepower to spend locally or accumulate savings. Indeed according to the banks, bank customers have been building cash deposits at a record rate despite returns falling to close to zero.

With more of the onus around the risk of borrowing being born by the consumer/borrower, and with consumers flush with cash, the endemic fear of lending hitherto held by the banks is lifting and that means a return to credit growth along with confidence in paying higher dividends.

The shift in confidence should not be underestimated. It was only six or nine months ago that some of the major banks' economists were predicting economic Armageddon and property price falls of up to a third.

Commonwealth Bank results

Earlier this week the Commonwealth Bank of Australia  announced its half year results. After delivering a cash net profit which fell 10.8 per cent to $3.9 billion in the six months ended December 31, the bank announced a fully franked $1.50 dividend to be paid on March 30. The dividend exceeded expectations $1.45 a share and while it was 25 per cent down on the first-half dividend last year of $2 per share, this interim dividend was 53 per cent higher than the second half's 98¢ a share.

As an aside, the bank pointed to the economy returning to good health. It recorded strong growth in residential housing and business lending, along with deposits.

For years bank dividends were sacrosanct and surveys of retiree self-managed superannuation portfolios revealed heavy weightings to the banks. In an environment of plunging yields elsewhere bank dividends became indispensable. With the threat of the COVID-19 pandemic now dissipating, with bank forecasts for a property calamity turning 180 degrees and with business confidence returning tentatively, bank credit growth should cease slowing at the same time Net Interest margins could cease narrowing. Consequently, we believe bank dividends may once again be the lure that sees bank share prices improve.

And sturdier bank share prices are both directly and indirectly good for shareholders. Keep in mind, they make more attractive, and less dilutive, future capital raisings improving bank capital management flexibility.

At Montgomery, we don't expect the banks will immediately return to the payout ratios of old, but the main obstacles to increasing payout ratios have been removed and that makes banks prospects and shares a vastly more attractive proposition compared to term deposits than they were before.

Macquarie Bank's result

Elsewhere Macquarie Bank, this week, delivered a surprise profit upgrade at its operational briefing, highlighting very strong trading conditions in 3Q21.

While the trading businesses benefitted from market volatility, the bank also highlighted ongoing growth opportunities (infrastructure, commodities, renewables and retail banking) and a focus on Asset Management and Macquarie Capital.

Importantly, management flagged the FY21 result is expected to be only slightly down on FY20's NPAT of A$2,731 million. If "slightly down" means circa 2.5 per cent below FY20, it implies A$2,660 million for FY21), which is 22 per cent above the previous consensus estimates of circa A$2,180 million.  This resulting in big upgrades by analysts for FY21 and FY22 and possibly puts the stock on a PE of less than 18x FY22 estimated NPAT.

Funds operated by this manager:

Montgomery Small Companies Fund, The Montgomery Fund, Montgomery (Private) Fund

The Australian February 2021 Reporting Season

Arminius Capital

28 February 2021

Twice a year we summarise the half-year and full-year results of the companies in the ALCE portfolio. Most of the companies in the portfolio reported strong earnings recoveries in the December half-year, and dividend payouts were higher than our forecasts. This suggests that company boards - who by definition are in possession of inside information - believe not only that the worst is past us, but also that earnings will continue on a strong upwards trajectory.

Ampol's result for the year to 31 December 2020 was slightly better than expected. Net profit was down 38% to $212m before inventory losses. The final dividend was cut from 51c to 23c, making 48c fully franked for the year. Australian petrol volumes were down 17% year-on-year, but in the December half sales were recovering along with the economy. Shop sales were up 7% on a like-for-like basis. Nonetheless, strong cash flow enabled Ampol to halve its net debt to $434m, equivalent to 18% of equity. The retail network will be completely re-branded from Caltex to Ampol by end-2022. At present, it is likely that Ampol will close the loss-making Lytton refinery unless the Federal Government improves its proposed support package.

At end-January Bluescope had pre-released its unaudited figures for the half-year, and the official result was in line with the pre-release. Recovering housing demand in Australia and automotive and housing demand in the US lifted demand for BlueScope's flat steel products, propelling underlying earnings before interest and tax (EBIT) to $531m from $302m in the December 2019 half. The final dividend was unchanged at 6% unfranked. Management indicated that, for the key Australian and US steel businesses, the June half was likely to be better than the December half, putting underlying group EBIT in the range $750m to $830m.

BlueScope is actively improving the sustainability of its operations and reducing carbon emissions, but the commercial viability of "green steel" is probably a decade away. A further complication is that BlueScope's Port Kembla steel mill faces an uncertain future after 2025. The only blast furnace operating there (No. 5) will reach the end of its economic life between 2026 and 2030. BlueScope may have to spend up to $800m re-lining the No. 6 blast furnace, which has been mothballed since 2011. In addition, the Illawarra coal mines may not be viable in the long run, because falling Chinese, Japanese and Korean demand will lower coal prices, while new mines and expansions are constrained by their impact on Sydney's water catchment areas. Shutdown of the Illawarra mines would force BlueScope to spend an extra $100m per year to import coal. On the positive side, BlueScope can afford the necessary capex because it has strong cash flow and zero net debt.

BWP Trust, which is the landlord of most Bunnings stores, reported a solid result for the December half year. Like-for-like rents rose 2.0% year-on-year, and 99.0% of rent due was collected. The weighted average cap rate for the portfolio improved from 6.08% to 5.84%, which is still well above the yields on recent transactions for Bunnings stores. The portfolio value rose by $87m and NTA increased from 304c to 320c. Gearing declined slightly to 17.8%. The December half distribution was unchanged at 9.02c, and management re-affirmed that the level of the FY21 distribution was expected to be similar to FY20. Disappointed investors marked the share price down.

Property group Charter Hall reported a 43% fall in operating earnings after tax to $129m (27.8c per share), but raised distributions 6% to 18.6c per share. (For property stocks, operating earnings are a better measure of underlying profitability than statutory profit, which includes changes in property values.) Operating cash flow was only 70% of operating earnings, because of changes in working capital and differences between tax expensed and tax paid. Charter Hall increased its funds under management by $3.6bn net to $46bn. The group has zero net debt and $5.3bn in undrawn facilities, so it is likely to make more acquisitions this year. Management upgraded its guidance for FY21 operating earnings from 53c to 55c per share.

As expected, Coles reported a strong result, with sales up 8% and earnings before interest and tax (EBIT) up 12%. The interim dividend was lifted 10% to 33c, in line with the group's policy of paying out 80% to 90% of earnings. Operating cash flow was extremely strong at $1.7bn, equivalent to 120% of reported profit, and the group's cash holdings exceeded its borrowings.

Management indicated that supermarket sales could "moderate significantly or even decline" in the current half and in FY22 as pandemic-driven demand returned to normal levels, i.e., as the pig moved through the python. The end of government support schemes could trigger a decline in consumer demand. They also warned that reduced immigration would create a headwind for longer-term sales growth. These remarks frightened investors, who marked the share price down 10%, even though other retail CEOs made similar comments.

But Coles is not going back to the way business used to be. The group has taken advantage of the pandemic to improve its quality, convenience and fulfilment of its online offer, e.g. the Ocado automation program and the Coles Plus subscription membership. Management noted that omni-channel customers spend twice as much as store-only customers,

Real estate website Domain reported 3.6% higher EBITDA despite a 5.5% fall in revenues. (We have used the company's "like-for-like" figures.) Management attributed the improvement to the cost reduction program, but noted that costs would rise by 5% to 10% in the current half. Volumes and revenues improved in the key residential segment, especially in NSW. The commercial market remains very weak in all three East Coast capitals. Operating cash flow was unusually low in the December half, but management attributed the weakness to temporary factors and said that cash flow had subsequently returned to normal. Net debt of $112m was equivalent to only 12% of equity.

Industrial supplier GUD Holdings reported a 17.6% increase in net profit after tax to $31m (34.5cps). The dividend was maintained at 25c fully franked. A strong recovery in demand for cars lifted revenue by 10.7% to $251m, although exports were still hampered by COVID-19. Operating cash flow improved from $26m to $40m, even though, as management noted, the company was still bearing substantial costs related to COVID-19. Net debt is a modest $118m. Management suggested, with several provisos, that FY21 earnings before interest and tax would be $95-100m, implying a second half very similar to the first. The GUD share price has now returned to its pre-pandemic level.

Lend Lease beat market expectations with a 26% fall in core operating profit after tax to $205m. Development EBITDA fell 10%, investment EBITDA almost halved, but construction EBITDA rose 3%. The unfranked dividend of 15c was half of the December 2019 half-year, but much better than the 3.3c of the June half-year. Net debt rose from $0.8bn at June 2020 to $1.8bn at December 2020, but this is a positive sign because it reflects greater development activity hence more profits in future. CEO Steve McCann will hand over to Asia regional head Tony Lombardo in June.

Property group Mirvac reported a disappointing result, and the share price is now below NTA of 258c. Operating profit after tax of $276m was better than the June half number of $250m, but well below the $352m achieved in the December 2019 half. Earnings from office and industrial property held up well, but earnings from residential dropped to $76m, compared with $146m in the December 2019 half and $79m in the June 2020 half. The balance sheet remains strong, with gearing of 21.4% and $1.3bn in cash and undrawn lending facilities. The half year distribution was only 4.8c, compared to 6.1c in the December 2019 half. Management indicated that the FY21 distribution was expected to be 9.6c to 9.8c. The market had been hoping for a rapid return to the days of 12c distributions, so the share price has been marked down.

Media group Nine Entertainment saw first-half NPAT rise 79% to $182m, compared to the December 2019 half. Revenue slipped only 2% because large rises in digital revenue almost offset the declines in print and radio revenues. The interim dividend was unchanged at 5c fully franked, indicating the board's renewed confidence after the FY20 final had been cut to 2c. Strong operating cash flow allowed Nine to slash debt from $291m at June 2020 to $150m by December 2020.

The CEO stated that the pandemic lockdowns had accelerated Nine's transition to digital and allowed the group to bring forward its strategic plan. For the June 2021 half, free-to-air advertising markets have recovered to their pre-coronavirus levels, while digital audiences and subscriptions have re-based to higher levels and are continuing to grow.

Heath insurer NIB reported a 15.9% rise in net profit after tax to $66m, partly because of a $25m provision release related to COVID-19 claims liability. In the core business of Australian residents' health insurance, policyholder numbers increased, the lapse rate declined, and the net margin improved. The interim dividend was unchanged at 10c fully franked, and far above the 4c dividend for the June 2020 half-year. Gearing of 26.7% is below the policy target of 30%. Management warned that claims outlook remained uncertain, with no clear pattern in the catch-up of previously deferred treatment and ongoing COVID-19 implications.

Scrap metal dealer Sims (SGM) is enjoying a very good recovery. Even though sales revenue fell 9.5% and volumes fell 3.7% (compared to the Dec 2019 half), the company returned to profitability. Net profit after tax moved from a $91m loss to a $53m profit (26.3cps), and the dividend was doubled from 6c to 12c fully franked. Sims lifted operating cash flow from negative $34m to positive $149m, so that its cash holdings rose by $55m to $165m. Management attributed the improvement to a cost reduction program, better control of margins, and higher prices for ferrous and non-ferrous scrap. No guidance was offered for FY21 profits, but the market has concluded that recent strength in scrap prices justifies a higher share price for Sims.

Insurance broker Steadfast continued its record of steady growth, despite the pandemic. Underlying net profit after tax rose 19.3% to $60.4m. Insurance broking continued to benefit from premium increases by insurers, with no loss of volume, while insurance underwriting continued to benefit from market share gains as well as premium increases. The interim dividend was lifted from 3.6c to 4.4c fully franked. Steadfast completed $121m of earnings-accretive acquisitions in the December half, while keeping debt still within the target range. Management re-affirmed its guidance for FY21: underlying NPAT of $120m to $127m, and underlying diluted EPS growth of 10% to 15%.

Diversified property group Stockland is still a long way from full recovery. Funds from operations (FFO) rose only 0.4% to $350m or 16.2c per unit. Net rental collections from the property portfolio reached 90%, compared with only 61% for the June 2020 half. Higher foot traffic and better sales have improved the expected credit loss from 16% of billings at June 2020 to only 3% at December 2020. Stockland's residential development business is back to normal, with sales and enquiries picking up strongly in the current half. The interim distribution fell from 13.5c to 11.3c, which was at least better than the 10.6c paid for June 2020. Gearing of 24.2% is in the middle of the target range of 20% to 30%, and weighted average debt maturity is a comfortable 5.6 years. Management indicated that FY21 FFO would be 32.5c to 33.1c, with a payout ratio of 75% or better.

Retail conglomerate Wesfarmers announced a 23% rise in net profit to $1.39bn and a 17% lift in the interim dividend to 88c as its Bunnings, Officeworks and KMart businesses prospered during the pandemic. Bunnings was the strongest performer with a 28% increase in sales, and it provided 62% of group EBIT. Operating cash flow was strong at 102% of net profit before depreciation and amortization. In the wake of the Coles selldown, Wesfarmers has net cash of $817m. The company plans to spend more than $1.0bn on its lithium project, but management said that a capital return was possible once the COVID-19 risks had passed.

Engineering contractor Worley had already signalled at end-January that profits for the December half-year would be down because collapsing end-market demand had forced the deferral of many of its contracted projects, particularly in the Americas. For the December 2020 half-year, revenue dropped 25% from $6.0bn to $4.5bn, and underlying earnings before interest, tax and amortisation plunged from $365m to $207m. Management emphasized that long-term contracts remained in place and that project cancellations had been minimal. In addition, many contracts scheduled to be awarded in the December half had been delayed. Gearing of 22% is well below the target range of 25% to 35%. The interim dividend was unchanged at 25c unfranked, which suggests that the board is confident of a rapid rebound. Management expressed optimism for a better second half, but did not offer any firm numbers.

Funds operated by this manager:

Arminius Capital ALPS Fund, Arminius Capital GMMA Fund

Damen Purcell, COO of Australian Fund Monitors, speaks with Jonathan Wu, Executive Director at Premium China Funds Management.

Premium China was started their first fund in 2005 and have grown to offer 4 actively managed specialist Asian equity and fixed-income funds to both Australian and New Zealand investors. Their Premium Asia fund, which was started in 2009 has returned 12.97% per annum since inception outperforming the Asia Pacific Ex Japan benchmark by over 8% per annum.

Funds operated by manager: Premium Asia Fund, Premium Asia Income Fund, Premium Asia Property Fund, Premium China Fund

Australian Fund Monitors' CEO, Chris Gosselin, speaks with Charlie Aitken from AIM Investment Management about the AIM Global High Conviction Fund's recent and long-term performance.

The AIM Global High Conviction Fund is a long-only fund that invests in a high conviction portfolio of global stocks. The Fund has achieved a down-capture ratio since inception in July 2015 of 81.83%, highlighting its capacity to outperform when market's fall. The Fund has outperformed the Index in 7 out of 10 of the Index's worst months since the Fund's inception, further emphasising its strength in negative markets.

Damen Purcell, COO of Australian Fund Monitors, speaks with Richard Ivers from Prime Value Asset Management about the Prime Value Emerging Opportunities Fund.

Since inception in October 2015, the Fund has returned 14.86% p.a. against the Index's annualised return over the same period of +9.64%. The Fund's Sortino ratio (since inception) of 1.27 vs the Index's 0.74, in conjunction with the Fund's down-capture ratio (since inception) of 45.74%, highlights its capacity to significantly outperform in falling markets.

Funds operated by manager: Prime Value Emerging Opportunities Fund, Prime Value Equity Income (Imputation) Fund - Class A, Prime Value Growth Fund - Class A, Prime Value Opportunities Fund

The Bond Market: The Tail Wagging the Dog?

Aitken Investment Management

11 March 2021

US political strategist James Carville once remarked, "I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. Now I would like to come back as the bond market. You can intimidate everybody!" This witticism was vividly bought to life in February.

The ongoing progress made in administering vaccines more widely has raised the prospect of considerable levels of pent-up demand being unleashed as the global economy re-opens in the second half of 2021. Combined with ample amounts of monetary and fiscal stimulus - and assurances by governments and major central banks that policy will remain accommodative for several years - the outlook for an increasingly robust economic recovery over the next 18 months is taking shape. Alongside the prospect of this stronger economic recovery is the fear that permanently higher levels of inflation - benign for a long period of time - could be unleashed.

In our recent investor webinar, we specifically addressed the issue of inflationary risks in some detail (which you can watch by clicking here). We anticipated the potential for an inflation-led market wobble during the first half of 2021 as reported year-on-year inflation cycles the disinflationary period of March to July 2020. The volatility experienced in February may be the first sign markets are beginning to price in the implications of potentially higher levels of inflation.

Should inflation run hotter than the Federal Reserve is comfortable with - meaningfully above 3% year-over-year for a sustained period of time - the risk of interest rates needing to be increased to cool down the economy would be materially higher than markets assume today. 

To illustrate why higher bond yields could negatively impact valuation, imagine that you invest in an asset that will produce $1 in cash flow in year one, growing thereafter at 3% every year into perpetuity. How much should you pay for this asset? The answer depends to a significant degree on your discount rate, which is determined by the prevailing interest rate offered on long-dated government bonds.

In the chart below - adapted from our aforementioned webinar - we illustrate that as the discount rate rises, the fair value (or justified price) of a stock declines. Higher interest rates, all else equal, leads to lower valuations.

At present, our central case is that inflation will increase in 2021, but will then trend back down towards 2% over time. However, despite the fact that we believe there is a high likelihood of an inflation overshoot this year, it is an open question whether the current market positioning and structure is sufficiently robust to absorb rates moving sharply higher. On the evidence offered in February, there are potentially quite a few pockets of the market where higher discount rates will have a materially negative impact on valuations - in particular for highly leveraged investors. We remain cognizant of this risk and have taken appropriate steps to protect the capital in the Fund. In anticipation of a potential increase in discount rates, the Fund had already reduced its exposure to technology businesses with long duration cash flows, selling out of Apple, Netflix and Salesforce.com.

Funds operated by this manager:

AIM Global High Conviction Fund

Finding hidden value in volatile markets

Against a backdrop of heightened economic uncertainty and ever-falling interest rates, Australian investors have flocked to "quality": paying higher multiples across the board for the highest returning, fastest growing businesses. The challenge, in this environment, is to satisfy the desire to invest in quality businesses, without overpaying for them.

In this webinar with Airlie Australian Share Fund portfolio managers, Matt Williams and Emma Fisher, they explore their investment framework for finding underappreciated quality or hidden value in businesses, and how to invest sensibly when markets swing so quickly between fear and euphoria. They also dissect the latest interim results season and what it means for their portfolios.