Category: Geld Zug

Most Australian investors have watched the recent gyrations in US and European bond markets with a feeling of relief that all this excitement doesn’t affect them, because they don’t own any US or European bonds. They have been watching the Grexit turmoil with similar emotions, because they don’t own any Greek bonds or shares. It is true that the immediate effects on Australian investors are modest, but we believe that these types of wild market moves are symptomatic of major underlying problems which will lead to further trouble in future.

US Treasuries and German government bonds are among the world’s safest assets. We can say this with confidence because their credit default swaps (which offer insurance against default) have long been priced more cheaply than almost all other forms of debt, even during the GFC. The safety of US government debt is what motivated finance theory’s concept of the “risk free rate” – i.e. the asset where you are sure what your return will be. When bonds like these suffer falls of up to 20% in their market value as a result of their yields rising 90 basis points, it signals that market perceptions of risk are changing for the worse.

What does the turmoil in global bond markets mean for Australian equities? The upcoming problems are the result of the ultra-low interest rates available to borrowers since the GFC. Companies and countries have been able to expand their borrowings because debt servicing costs are so low. At the same time, investors’ “reach for yield” has allowed many low-quality borrowers to access debt markets, because they are offering relatively high interest rates. The net effect is that there are a lot of bonds out there which should never have been issued, because the issuers are likely to default when global interest rates rise or if their own cash flows deteriorate.

The problem areas are not the “investment grade” bonds, where default rates are typically very low. Since 1920, according to Moody’s, the default rate on investment grade bonds has averaged only 2%. Speculative grade (“junk”) bonds are much riskier: their default rate often passes 10% in a recession, and it touched 14% in the GFC.

Greek sovereign debt has been in unofficial default since 2010, in the sense that that was when the supranational bodies the European Commission, the European Central Bank and the IMF started to lend Greece money to pay out its urgent private creditors so that it could reform its finances. Greece’s official default will be painful for the few banks which are directly affected, but it has long been anticipated by the bond markets, along with other basket cases like Ukraine and Venezuela.

The pain for investors in sovereign debt will come from unexpected defaults – that is, where a country’s finances have deteriorated so quickly that bond markets have not fully priced in the likelihood of default. Most of the problem areas here will be in emerging markets, where events such as domestic recessions or the Chinese economic slowdown have reduced a country’s ability to service its debt which is denominated in a foreign currency (usually USD). Another negative influence will be the eventual rise in US interest rates, which will not only raise loan servicing costs directly but will also support the ongoing rise in the US dollar against most currencies. Countries considered to be highest risk include Brazil, Colombia, Indonesia, Peru, Turkey and South Africa.

For corporate junk bonds, 2015 has already seen an upturn in defaults in some important sectors. The collapse of the oil price last year has put pressure on high cost producers worldwide, especially  the US shale oil sector which relied heavily on debt financing. In China, the slowdown in GDP growth and the fall in house prices has triggered defaults from some property companies. We expect that corporate defaults will accelerate, for much the same reason as sovereign defaults – the negative effects of rising interest rates, falling Chinese demand and domestic recessions on foreign currency borrowings. As a general rule, corporate bond defaults tend to track sovereign bond defaults, because they spring from the same underlying economic causes.

Bond defaults, whether sovereign or corporate, impact investors’ risk tolerance very quickly. A single default causes bond portfolio managers to analyze their portfolios for any similar exposures, and the equity portfolio managers at the next desk will start checking their portfolios to see if they have any exposures like this. The impact is twofold: the re-assessment of risk means not only that previously ignored risks take centre stage, but also that all risks are re-priced upward.

In these circumstances, equity investors become more cautious too. They want to sell out of some holdings where they used to think that the risks were acceptable, and they want to be compensated for taking on new risks, i.e. they want lower prices.

The past history of the “reach for yield” in Australia means that, in the next downturn, many high-yield stocks will be vulnerable rather than defensive. The coming rise in US interest rates, coupled with the re-assessment of risk, will force investors to focus on the downside risks of stocks which have above-average yields but poor growth prospects. The sector most at risk in Australia is the banks, where organic growth has been hard to find outside residential loans and where further capital raisings are a certainty. Next come the utilities and infrastructure sector: in the periods between the standard five-yearly regulatory re-sets, the utilities stocks are very bond-like. The property trusts will also be negatively affected, but the impact will also depend on the growth prospects of their underlying markets. The sector as a whole is over-priced relative to book values, but there are big differentials in future growth rates between subsectors, as well as wide variations in trust gearing and the quality of their asset portfolios.

Neill Colledge

July 2015

We were reminded of Mark Twain’s assertion when we read that the Chinese insurance group Anbang (安邦) had bought the Waldorf-Astoria hotel in New York city (Financial Times 06 Oct 2014), making it the most expensive single hotel transaction ever. Anbang has paid USD 1.95 billion to buy the historic 1,413-room hotel, which was built in 1931 and covers an entire city block. The sale price is equivalent to USD 1.4 million per room or 33x the hotel’s historic EBITDA. The seller was the Hilton hotel group (HLT:NYQ), which will retain management rights for the next hundred years.

Why did we think of Mark Twain’s words? Because twenty-five years ago, in October 1989, the Japanese group Mitsubishi paid USD 846 million to acquire 51% of the Rockefeller Group, which owned the Rockefeller Center, Radio City Music Hall and other Manhattan landmarks. Subsequent events showed that this was not a smart buy for Mitsubishi. This outcome was not surprising in view of the fact that the Rockefeller family had been dealing in Manhattan real estate since the 1880s.

Mitsubishi’s purchase was only one among many follies committed by Japanese corporations in the 1980s when, fuelled by low interest rates and high self-esteem, they bought “landmark” assets around the world and paid landmark prices for them. Readers may remember Sony’s completely incomprehensible purchase of Columbia Pictures for USD 3.4 billion in September 1989, which signalled the start of Sony’s downfall from admired tech leader to troubled conglomerate.

For those of us who have watched the sad fates of Chinese companies who bought or developed mines in Australia, the Waldorf-Astoria sale has a familiar ring to it. The Hilton group (majority owned by Blackstone) has managed the hotel since 1949 and owned it since 1972, so it is a fair bet that Hilton knows more about the asset than Anbang does. It is possible, however, that we have completely underestimated Anbang – after all, Anbang’s founder and chairman, Wu Xiaohui, is married to the granddaughter of former Chinese leader Deng Xiaoping.

They say that no one rings a bell at the top of the market, but the Waldorf-Astoria transaction may mark the high water mark for this round of Chinese companies’ global expansion.

Disclaimer: This report is general advice only and is issued by Millinium Capital Managers Limited, ABN 32 111 283 357, AFSL No. 284336 (“Millinium”). Investors should always consider obtaining professional advice that suits their objectives, financial situation or needs. This report may be amended, withdrawn or replaced without notice. To the extent of the law, Millinium, its officers, personnel and agents do not accept any responsibility for any loss or damage arising from reliance on this report.

Recent official statements indicate China’s GDP growth rate in CY14 will be about 7.5%. This figure is way above growth rates in the rest of the world, but nonetheless it marks another step down from China’s peak rate of 14.2% in 2007. The long term factors behind slower growth include:

• Ageing population: more retirees, less workers.
• Rising real wages, as regional and sectoral labour shortages enhance employees’ bargaining power.
• Over-capacity in many industries, as a long term consequence of policies that have favoured investment ahead of consumption.
• Visible pollution of air, water, soil, food: resistance from consumers and residents increases, and pollution control will mean higher costs for many companies.
• Too much debt: China’s debt now exceeds 200% of GDP – higher than countries like Greece, Cyprus, Portugal and Spain which suffered debt crises.

Why is slower growth in China important for Australia? Because China now buys 36% of Australia’s exports, and coal and iron ore account for three-quarters of the value of these exports. Taking a wider view, shared supply chains link China’s economy closely to Japan, South Korea, Vietnam, and neighbouring countries: East Asia in total buys 55% of Australia’s exports. China’s slowdown in the last two years has already caused 30%-plus falls in coal and iron ore prices, leading to the collapse of capital expenditure spending in Australia’s mining sector, with consequent job losses. It is clear that, even if China avoids the “crash” which some commentators have predicted, any further slowdown will be painful for Australia.

We must emphasize that, although a crash is possible in China in the next few years, it can still be avoided by prudent economic policies such as the reforms which the Chinese government is currently implementing. After all, China has a lot of room to manoeuvre thanks to its low government debt and high forex reserves: the latest official figure for China’s external financial assets is USD 6.13 trillion.

Although there are a number of problems in China’s financial system, we do not expect a re-run of the US housing crisis. Where the marginal US homebuyer in 2006 had loan-to-valuation ratios above 90%, the average Chinese residential borrower has a 30% LVR, and many have no debt at all. Where the ordinary US consumer in 2006 had maxed out his credit cards and drawn down his home equity loan, the average Chinese consumer has very little debt. Systemic risk is contained because the lending banks keep the housing loans on their balance sheets rather than packaging them up into CDOs and selling them off to investors. Most importantly, although apartment prices in China have been rising rapidly for a decade, rapid economic growth has meant that household incomes have been rising faster, with the result that affordability (apartment price divided by income) has been improving in most cities.

Nor do we expect China to repeat the US banking crisis, because its banking system is completely different from the US. There will be no “Lehman moment”, because the Chinese government never succumbed to Alan Greenspan’s fantasy that light regulation, bankers’ self-interest and the magic of the free market would prevent bubbles and frauds and insolvencies. In addition to the tight Chinese regulatory framework, the major Chinese banks are not managed by ex-traders in pursuit of multi-million dollar bonuses: they are run by senior members of the Chinese Communist Party (on modest salaries) for the benefit of the Chinese state. Banks will certainly suffer loan losses on commercial and local government debt, but the central government has recapitalized them before and will do so again.

For Australians, it is important to understand that Chinese banks are not just highly regulated, they also have much less exposure to property. The typical Australian bank has more than half its loan book in property: by comparison, in 2013 only 14% of the loans in the Chinese banking sector went to mortgages, with another 12% going to developers and construction companies.

This limited exposure means that China’s current property downturn will be painful rather than fatal. Since mid-2013 China’s property markets have been in cyclical downswing, after over-building led to an inventory overhang in residential and non-residential sectors. Non-residential markets throughout much of China enjoyed a building boom thanks to cheap money and government initiatives, but demand has slackened and vacancy rates are rising. In most residential markets, prices and new starts have been falling as developers tried to clear excess stock. The effect of the downswing will bring supply and demand back into equilibrium, but at lower prices – perhaps as much as 20% lower. A 20% price fall will bankrupt some smaller developers, but the larger developers will survive.

The current downswing may last two years, but long-term prospects for residential property remain strong, driven by improving affordability, ongoing urbanization (albeit at slower rates), and the need to replace low-quality housing stock built before 1990. But in the next two years, construction volumes must fall. As a consequence, demand for steel will fall, both for direct use in construction and in ancillary areas such as construction machinery. GDP growth in CY2015 may drop below 7%.

The impact on the Australian mining sector is obvious. Lower commodity prices mean lower export earnings (only slightly offset by some volume increases), hence lower company profits and cash flow. BHP and Rio will survive with lower profits and tightly controlled costs, but high-cost mines will be shut down, and there will be job losses in mining and in mining services. The resource states of Queensland and Western Australia will go into recession first. For Australia as a whole, higher unemployment and lower exports means falling growth and a drop in real living standards. The rising balance of payments deficit will push the AUD below USD 80c, although it will continue to be buoyed by Australia’s AAA rating and the yield differential against major currencies. Because the unemployed find it hard to keep making mortgage payments, the banks will suffer loan losses on residential property, but their commercial lending books are in good condition thanks to the tighter lending standards adopted in the wake of the GFC.

A recession starting in 2015 or 2016 is not factored into most forecasts, but we note that every Australian mining boom has been followed by a recession. Because people forecast the future on the basis of their experiences in the recent past, they never expect things to get as bad as they do. Looking at business cycles in the long term, it is easy to see that the last decade favoured resource-producing economies such as Australia, Brazil and Canada. With commodity prices continuing to fall, we expect that the next decade will favour resource-consuming economies, especially the US and Europe.

What should the Australian investor do in order to minimize the effect of the coming recession and the fall in the AUD? Domestic defensive stocks are part of the answer, but the key is to reduce exposure to AUD-denominated assets and increase exposure to the US and European economies because they will benefit from lower commodity prices. Preferred methods include US and European index ETFs or ASX listed companies with US operations. Qualified investors may wish to consider Millinium’s newly launched S&P500 Fund.

The investment strategies of Millinium’s Dividend Income Fund (soon to be re-named the Australian Equity Fund) take our macro view into account. The Fund is still weighted toward Australian companies with US exposure. We have reduced exposure to domestic cyclicals and consumer discretionary sectors, and are still watching for the early warning signals of a correction. Just lately, we have begun to consider when to sell out of the banks, on the grounds that the sector is not priced for any downturn in the economy.

Neill Colledge

Disclaimer: This report is general advice only and is issued by Millinium Capital Managers Limited, ABN 32 111 283 357, AFSL No. 284336 (“Millinium”). Investors should always consider obtaining professional advice that suits their objectives, financial situation or needs. This report may be amended, withdrawn or replaced without notice. To the extent of the law, Millinium, its officers, personnel and agents do not accept any responsibility for any loss or damage arising from reliance on this report.

In the Dreamworks movie “Madagascar 2”, there are many parent-intended lines uttered by the Lemur King Julien. One of his best is when they are leaving the African island of Madagascar on a plane, flown by the Penguins, bound for New York City. King Julien of Madagascar (self proclaimed) wants to know why people from the other end of the plane keep coming into the first class section;   “Maurice, whatever happened to the separation of the classes?”. The new Chief Economist of the IMF, Maurice Obsfeltd, answers this question in a recent report and the findings all lead back to New York City indeed; the Federal Reserve. A pending US interest rate rise is going to separate the developed and emerging economies in a way that may lead to unforeseen circumstances… [Continue Reading]

UNDERWEIGHTING THE POOR WHITE TRASH

The death of Lee Kuan Yew brought to mind his warning in 1980 that Australians were in danger of becoming the “poor white trash of Asia”. As things turned out, we didn’t: in terms of the World Bank’s inflation adjusted data, Australia’s GDP per head rose from USD 10,187 in 1980 to USD 67,458 in 2013, a six-fold increase. That’s pretty good compared to the US, which only managed a four-fold increase in the same period, to USD 53,042 in 2013. But let’s not get too cocky – over this period, Singapore’s GDP rose eleven-fold from USD 5,003 to USD 55,182. In short, Singapore has overtaken the US and is hard on our heels.

Source: World Bank GDP per capita in current USD

The point of these figures is to show that, although Australia has been a pretty good place to invest, there are other places which have been a lot better. In particular, we think that for the next five years Australian investors will do better outside Australia.

Many commentators have pointed out that the Australian share market has underperformed the US share market since the GFC. This has nothing to do with the innate genius of Americans or the laziness of Australians. It is the inevitable consequence of the end of the resources boom. From 2002 to 2012 rapid economic growth in many countries (especially China) pushed up commodity prices to record levels; but these high prices eventually encouraged producers to build new mines, and now the over-supply is pushing commodity prices down. The last decade favored resource-producing countries like Australia, Brazil and Canada, but the next decade is going to favor resource-consuming countries, particularly the US, Europe and Singapore.

Australia has enjoyed the benefits of rapid Chinese growth since 1990, and now its export dependence on China is causing the Australian economy to slow as the Chinese economy slows. China’s 2014 GDP growth rate of 7.4% was the lowest since 1990, and 2015 is forecast to reduce to around 7.0%. The long term factors behind slower growth include:

• An ageing population and a shrinking workforce.
• Rising real wages, as regional and sectoral labour shortages enhance employees’ bargaining power.
• Over-capacity in many industries, as a long term consequence of policies that have favoured investment ahead of consumption.
• Visible pollution of air, water, soil, food: resistance from consumers and residents increases, and pollution control will mean higher costs for many companies.

What should the Australian investor do? In order to minimize the effect of the fall in the AUD and the coming recession in Australia, investors should look at ways to reduce exposure to AUD-denominated assets and increase exposure to resource-consuming economies which will benefit from lower commodity prices. The cheapest methods are ETFs based on a US, European or Singaporean index, or ASX listed companies with substantial US or European operations.

Neill Colledge

Q.E.D.

INVESTMENT ARITHMETIC FOR 2015: 2 + 2 = 4

In 2014 my Australian Equities mandate returned 15.1%, but the S&P/ASX200 Index managed only 5.6%. Share prices in the mining sector dropped as iron ore and coal prices fell to levels not seen since 2009. Repeated downgrades to Chinese GDP growth forecasts added to the negative sentiment. In the second half of the year oil prices halved, causing share prices in the energy sector to join the miners in their slide. Things were worse in Australia than overseas: the US S&P 500 index returned 13.6% in CY14, and although European share markets had a mid-year attack of nerves, they have risen by 20% since mid-October.

In the wake of such experiences, many investors are now gun-shy, if not shell-shocked, and fearing more of the same in 2015. We believe that outlook can be summarized very simply:

• the two big trends of last year – low oil prices and a high US dollar – will continue to operate in 2015.
• the two long-term macro events which we write about almost every month – slowing GDP growth in China, and the eventual normalization of US interest rates – are still in place, and they will drive bond and equity returns over the next three years.
• these two sets of two factors just mentioned will trigger four sources of risk in 2015 – junk bond defaults in the US energy sector, defaults in US dollar bonds issued by non-US corporations, defaults in low-quality sovereign debt, and “covert defaults” by second-rank Chinese companies.

So that’s how we get 2 +2 = 4. The four sources of risk originate in the credit markets, but their effects will spill over to the equity markets. There’s nothing like a default in the portfolio next door to incentivize a fund manager to re-evaluate the risk in his own portfolio. Before we jump to investment conclusions, let’s look at all eight items in detail.

The halving of oil prices is a spectacular positive for oil importing countries, not only because it improves their balance of payments, but also because it reduces petrol costs for the average consumer, increasing their ability to spend on other things. (The impact of low oil prices was discussed in detail in our 19 December 2014 Commentary.) The US is a good illustration of the point. As its high-cost oil producers will go out of business over the next two years, states like Texas and North Dakota will suffer economic damage, but the effect on the US as a whole is positive because of the widespread benefits of lower petrol prices for consumers and lower input costs for downstream users of petroleum products. Petrol is a big expenditure in the budgets of US consumers because 86% of US commuters travel to and from work by car every day (according to Commuting in America 2013, from the American Association of State Highway and Transportation Officials). Because of the lags in oil supply, we expect oil prices to remain low for the next five years.

The rise of the US dollar against most other currencies reflects the resurgent economic strength of the US and in particular the fact that its growth rates are speeding up while other countries are decelerating (e.g. China) or stalled (e.g. much of Europe). The primary cause of this divergence is the end of the resources boom. From 2003 to 2012 resource producing countries such as Australia, Brazil and Canada prospered because resource consuming countries like the US had to pay higher prices for resources. Over the next decade, however, as commodity prices decline or stagnate, the resource consuming countries will prosper. Hence we do not expect that the rise of the US dollar will reverse in the near term, although it will undoubtedly have fluctuations and retracements. Students of history will recall the relentless rise of the US dollar in the early 1980s, which was halted only by the combined efforts of five central banks (the Plaza Accord of 22 September 1985). The rise of the US dollar is similar to the rise of the Chinese renminbi, which is now 51% above its real effective value in mid-2005 when it was unpegged from the US dollar: its appreciation against the rest of the world reflects the faster growth rate of its economy in the long term, despite the persistence of capital flight as Chinese elites smuggled their money off to safer jurisdictions. (That said, the Chinese renminbi is expected to depreciate in CY15.)

The big macro trend of China’s slowing growth is now part of the conventional wisdom. CY14 GDP growth was 7.4%, the lowest level since 1990. The slowdown is partly driven by tighter monetary policy and partly by structural change in the economy, so we expect that CY15 and CY16 will be slower again. The emerging economies which have profited from supplying resources to China are already suffering the pain of lower prices and lower volumes. For Australia, the China slowdown is an ongoing negative influence because a third of our exports go to China.

The eventual normalization of US interest rates seems likely to begin this year, if recent comments from the US Federal Reserve are any guide. The process of restoring cash rates from zero to their historic averages of 3% to 4% will take a year or two, and its speed will depend on how healthy the US economy is over this period. Higher cash rates will tend to push up term spreads and credit spreads in US bond markets, with flow-on effects to business financing and mortgage affordability. The key point here is the Fed is only concerned with the health of the US economy. The impact on the rest of the world economies doesn’t matter, because the rest of the world doesn’t vote in US elections. Because the Fed has been talking up the rate rise for some months now, it is likely that the first 0.50% of the rise is already priced into US credit markets.

The two big trends of 2014 interact with the two long-term macro events to produce our four sources of negative events for 2015.

The first source of risk – a rash of junk bond defaults in the US energy sector – is the inevitable outcome of lower oil prices. For high-cost producers, lower prices mean that operating costs can’t be covered and interest obligations can’t be met, i.e. they default. The financial consequences of these defaults will fall on bond portfolios and bank loan books. It is likely that many banks in the energy states will fail without Federal assistance. (Connoisseurs of banking crises may like to read Mark Singer’s Funny Money, which chronicles how oil-exposed banks collapsed in the 1980s.) The real-world consequences include insolvencies, unemployment and a slump in oil sector capex. Although these events will attract media attention (just as they did in the 1980s), the damage will be localized to the energy states.

The second source of risk – defaults in US dollar bonds issued by non-US corporations – is the result of the appreciation of the US dollar, reinforced by slowing Chinese growth and the normalization of US interest rates. Companies which do not have the natural hedges of USD assets and revenues will find themselves exposed to higher interest and principal obligations in their home currencies, and some of them will be pushed into default by high gearing or other misfortunes. This source of negative events will be more widespread than energy sector defaults and harder to predict.

The third source of risk – defaults in low-quality sovereign debt – is what happens when countries get into the sort of difficulties which force companies into insolvency. A country can’t go bankrupt, but it can certainly stop paying its creditors, and there are many examples over the last three decades. The usual solution is some form of “restructuring”, which means extension of maturity, partial forgiveness of principal, reduction of interest rate, etc. The main effect of sovereign defaults is on the bond portfolios which were foolish enough to own these securities, but they also provoke a re-evaluation of risks and a lot of media noise.

The fourth source of risk – “covert defaults” by second-rank Chinese companies – is a subset of the second source, but it needs to be considered separately because it has different consequences. Chinese companies are by no means immune from over-borrowing, but important Chinese companies enjoy the benefit of an implicit government guarantee. In the handful of near-defaults by Chinese companies over recent months, some arm of government has usually managed to arrange a last-minute rescue so that actual default does not occur. It is conceivable that these heroic interventions spring from the Chinese Communist Party’s deep concern for the welfare of investors. It is more likely that some level of government has a more direct motivation for averting an outright insolvency, such as the potentially disastrous impact on the local economy. In short, the only Chinese companies which will be allowed to go bust are the unimportant ones.

What do the four sources of risk mean for Australian investors? The sovereign and corporate defaults will have little direct impact on Australian bond or equity markets, but their impact overseas will increase the volatility of global capital markets. In this context, it is important to remember that, because Australia is small compared to the US, our capital markets function like a derivative of US capital markets. Or, to put it more bluntly, when the US sneezes, we catch cold.

The collapse of US energy companies will not be paralleled in Australia, because 160 years of resource booms have taught most Australian banks and investors not to lend money to mining and oil companies. Over the next two years, the listed mining and oil sector will shrink sharply.

The “covert defaults” by Chinese companies will reinforce the negative impact of slowing Chinese growth. A company which has just been rescued goes into work-out mode, not expansion mode, so it will not be importing more raw materials from Australia. This phase will be how the Chinese central government deals with the over-capacity which has been built up in many industries as a result of low interest rates and other investment incentives. Factories and plants will quietly shut down, and modest pensions will be paid to the laid-off workers, following the precedents set when the government shrank superfluous state-owned enterprises in the 1990s.

The net effect of our 2+2=4 is to bring the Australian and US share markets closer to their next correction. Because we expect higher volatility in 2015, we suggest that, from March onward, investors should either take out derivative protection against downside risk, or reduce their exposure to equities.

Neill Colledge

Q.E.D.