22 Aug July Market Commentary
Relativities between asset classes have remained stable over the past month. We now see the outlook for the Financials sector as broadly in line with the overall Australian Equities, whereas previously it had been lower due to rising share prices. Any further weakness in Financials is likely to lead to a review of this stance which will be communicated in due course.
Let us revisit quickly the topics covered in last month’s commentary, before we move on to the promised discussion of the Australian banks, their regulatory capital requirements and the residential property market. In Europe, the subject of Greece and their debt is occupying a far less prominent place in the minds of investors and the financial media since our commentary just a month ago. Negotiations between finance ministers are expected to conclude shortly which will secure additional bailout funding for the Greeks to service their debt. Talk of an exit has now largely been discounted and for everyone other than the Greeks themselves, we can move on with our lives and our market analysis and portfolio management. Sadly for the Greeks they are likely to endure a moribund economy for years to come.
Elsewhere in Europe we continue to see signs that an inflection point has been reached and the trajectory is positive. As Bloomberg has recently reported: “For the first time since [Mario Draghi] took office as President of the European Central Bank, the region’s four biggest economies are posting growth, spurred by a weaker euro and lower oil prices that are boosting consumer spending. Fears about deflation have abated, and another year of extraordinary ECB stimulus means economic tailwinds are likely to persist.”1
We also spoke last month of China, and in particular the significant correction that had occurred in the mainland equity markets in Shanghai and Shenzhen. These market conditions presented authorities with one of the first real challenges to their intent to allow the market to play a decisive role in the allocation of resources within the Chinese economy. Rather than allowing this to occur, they have enacted a vast array of measures designed to put a floor under the sinking share indices, which has provided temporary relief but raises longer term questions.
Nobel laureate economist Paul Krugman provided a timely reality check in his observations of this activity: “So what have we just learned? China’s incredible growth wasn’t a mirage, and its economy remains a productive powerhouse. The problems of transition to lower growth are obviously major, but we’ve known that for a while. The big news here isn’t about the Chinese economy; it’s about China’s leaders. Forget everything you’ve heard about their brilliance and foresightedness. Judging by their current flailing, they have no clue what they’re doing.”2
We have mentioned in recent weekly commentaries our disappointment with the policy response. It is worth noting that we tend to make a more measured assessment than would be reflected in the language of a newspaper opinion article. The Chinese leadership is expected to meet shortly in the beachside town of Beidaihe, ahead of the formal plenary session of the party’s Central Committee to be held in Beijing in a couple of months’ time. Anecdotally it is understood that the first meeting is in fact where the policy consensus is agreed between the current leaders, the party elders and the new generation of leaders that will in time assume the mantle of reform from President Xi Jinping and Premier Li Keqiang.
In recent days we have observed the People’s Bank of China make adjustments to their exchange rate, and this has led to the predictable bouts of condemnation, notwithstanding the blatant double standards and hypocrisy from those commenting. My colleague Jonathan Pain wrote recently: “Furthermore, it has not gone unnoticed in Beijing that the Japanese Yen has depreciated an extraordinary 50%, against the RMB (Chinese currency), since Shinzo Abe was elected in December 2012. In brief, the free currency lunch, at China’s expense, is over for the rest of Asia and the world.”3 He went on to reiterate our long stated view that it was inevitable and welcome that growth in China would slow to 5% to 6% as the economy grows beyond US$10 trillion, noting that reform minded leaders were still in control.
In various forms we have been writing about the rebalancing required within the Australian economy for many years now, initially as we grappled with a two speed economy, and more recently on the transition in phases of the mining boom. Largely as a result of rapid growth in China and the urbanisation of their rural population, high demand for our resources attracted a lot of investment in future commodity production. During this period, and in particular when the Chinese enacted enormous stimulus programs to combat the financial crisis, mining came to represent an historically high proportion of our economy. Now as that sector is producing much more, the prices have lowered, and the economy needs to adjust and to replace the diminishing mining contribution from other sectors within the economy.
In general terms, central banks around the world seek to enact policy that will achieve steady economic growth, promote full employment and maintain price stability. To do so, they have one main tool at their disposal which is adjusting interest rates, a tool which has often been described as a blunt instrument. While our mining sector was booming through the first half of the last decade, the RBA gradually increased interest rates which slow down sectors like housing, retail spending and non-mining business investment. As we entered the financial crisis and the mining boom transitioned, they have since cut interest rates seeking to stimulate those same sectors and again balance overall economic growth.
Lower interest rates means cheaper money, and in Australia and elsewhere the first place we normally see that represented are in house prices. As our house prices start to increase we begin to see the familiar articles about a bubble in residential property. Indeed, upon returning from the lunchtime presentation from which these charts are drawn, the afternoon headline on the Sydney Morning Herald website was “Australian housing market facing ‘bloodbath’ collapse: economists” – reminding us again of the sensationalist language often found in our media. The charts below reflect that Sydney has led the way in house prices, and as we can see this price increase has been pronounced not least because of the demand from overseas buyers who benefit from our lower currency exchange rates. However, the right hand chart shows that the demand is also being reflected in strong building approvals.
It follows that the building activity is in time reflected in the labour market, and other economic data such as durable goods and retail sales. Whilst Sydney has led house prices we have also observed that New South Wales is leading the Australian economy and contributing to the required rebalance. Supporting this view, we have heard recently from the RBA that they expect the unemployment rate has likely peaked and the trend is now expected to revert to a stronger jobs market.
The debt in Australia is largely held by those most able to service it. This chart shows that the top two quintiles of the income distribution hold about 75% of the household debt. In this way we look very different than the environment in the United States that preceded their housing bubble bursting. Furthemore, we have observed banks increasing the rates on investor loans for housing, and we are also hearing of higher deposits being required and lower leverage ratios being accepted. In addition, as rates have been lowered many borrowers have maintained their previous repayments, the result being that the average mortgage in Australia is now a little more than two years ahead of its repayment schedule. Finally, the regulators both here and internationally are gradually increasing the amount of regulatory capital that banks are required to hold. Essentially this will make the banks more defensive in nature, which is important not only for equity exposures but of course also in any income securities on the market.
The result of raising capital has been recent price weakness in the ANZ and Commonwealth Bank share prices in particular. It is also true that there may be further capital raisings to come from these or the other banks. As the prices have fallen recently, so the rate of income has increased and we are now seeing the grossed up dividend yields from the major banks at between 8% and 9%. Our long term target valuations remain consistent and our forecast returns on the Financials sector has increased by around 1.5% in the last couple of weeks. That forecast is now just under 11% which is broadly in line with our overall Australian Equities forecast.
There are undoubtedly societal issues to be considered in the recent housing market developments. Our Quarterly Asset Allocation Update will be published in early September and will contain details of our latest forecasts and views on each asset class.
1. C Bosley, “Draghi Savors Synchronized Summer for Top Euro-Area Economies” 11-Aug-15. Bloomberg.
2. P Krugman, “China’s Naked Emperors” 31-Jul-15. New York Times.
3. J Pain, “China at a Crossroads” 17-Aug-15. The Pain Report.
4. All charts are from presentation of P Bloxham, “Australia’s Housing Boom – Is there irrational exuberance?” Jun-15. HSBC Global Research.
DISCLAIMER: The information in this commentary has been provided for publication by Implemented Portfolios (ABN 36 141 881 147. AFSL Number 345143). The information has not been verified by Implemented Portfolios or Adapt Wealth Management (ABN 33 711 661 027 Corporate Authorised Representative of Paragem Pty Ltd AFSL 297276) but is believed to have come from reliable sources as noted in the acknowledgements. No Liability is accepted by Implemented Portfolios, or Adapt Wealth Management Pty Ltd, its Directors, officers, employees or contractors for any inaccurate or incorrect information. The information is a broad commentary and there is no intention that a client should act on the information without seeking professional assistance from their own advisers (legal, tax, accounting, financial planning) for suitability in respect of their unique circumstances.
About Reuben Zelwer
Reuben Zelwer established Adapt Wealth Management in 2011 to help time poor clients achieve financial freedom. For over 15 years, Reuben has helped professionals, executives, business owner and those approaching retirement make the most of their circumstances by making good financial decisions. Reuben’s professional practice is complemented by substantial voluntary work, which has included setting up financial literacy and savings programs in the local community.