Investing in Volatile Markets - A letter by John Abernethy

Letter to Investors: March 2016

In recent years, we have asked the question, “Are rising house prices the measure of a country’s success, or a measure of its excess?”
This vital question is flagged at the outset of this letter because we believe that residential property prices can no longer be ignored by Australian investors. Neither can negative international bond yields and cash rate settings. The unwinding or normalisation of each of these markets remains an omnipresent risk for valuations and therefore market prices.
However, in acknowledging the long term risks of price adjustment, we suggest that investment portfolios continue to adopt a proactive approach to managing those risks. This letter outlines our views and responses.

Australian residential property

It is important to understand that it has been the consistent lift in property prices that has historically resulted from economic growth and reflected wealth creation in the Australian economy. More recently, residential property prices have sustained private wealth as export prices plummeted, the equity market stagnated and growth in national income has been challenged.
The chart below plots the extraordinary rise in residential property prices in Sydney and Melbourne that followed the significant rise in prices in Perth during the resources boom. Overall, prices have risen across Australia so that national weighted prices are 75% higher than 10 years ago.
Figure 1. Housing Prices
Figure 1. Housing Prices
Source. CoreLogic RP Data; RBA
It is our view that if house price rises had been matched by growth in household income and/or average wages, then there would be no concern – however that is not the case. Today, average house prices in Sydney are a staggering twelve times the average salary of Sydney residents. Over past decades, the ratio has typically averaged between six and eight times.
Concurrent with the lift in residential property prices, there has been the lift in household debt. There can be no doubt about the connection between rising household debt and rising property prices. While economic growth supports moderately rising house prices, it is excessive leverage that pushes prices to unaffordable levels – the point that has now been reached in Sydney and Melbourne. It is this observation, coincident with a deteriorating Commonwealth fiscal position, which is leading to a reassessment of negative gearing. The chart below suggests that the “housing debt horse has bolted” and this in no small part is due to debt on investment properties.
Figure 2. Household Finances
Figure 2. Household Finances
Source. ABS; RBA
The above observations are made to put into context the challenge that is presented to Australian investors. The excessive lift in house prices creates a heightened risk for Australia’s financial system and for the Australian equity market. While we may avoid a significant house price correction, it may be because interest rates, driven by offshore events, remain at historic low levels. However, there will be other consequences of sustained low interest rates. While it may save the housing market, low rates will act to hold down term deposit rates and result in capital drawdowns by pension fund investors. That deterioration in investment returns will challenge economic growth as well.
While we cannot put an exact time to it, our view is that high residential property prices will eventually correct and highly leveraged households will come under pressure. Further, there is another emerging headwind: the emergence of slowing wages growth after a protracted period where growth either mildly exceeded or matched inflation. As noted above, the recent decade has seen house prices rise substantially above wages growth and this disconnection has accelerated in recent years. The result is declining affordability, mortgage stress and a feeling in our younger generation that property is beyond their reach.
Figure 3. Wage Price Index Growth
Figure 3. Wage Price Index Growth
Source. ABS

International bond markets

While the above analysis of excessive housing prices is Australian-centric, it is also symptomatic of developments in major offshore bond markets. It is these offshore developments that are pushing interest rates lower in Australia and thereby supporting both residential property speculation and the extraordinary rally in Australian Government bonds shown by the dramatic drop in yield (evident in the next chart).
Figure 4. 10-year Australian Government Bond Yield
Figure 4. 10-year Australian Government Bond Yield
Source. RBA
International bond pricing has gone to another level with an estimated $7 trillion dollars (about 10% of the world’s bonds) trading with a negative yield to maturity. The purchasers of these bonds at market prices today are guaranteed to lose capital if they hold them to maturity. In recent months, Japanese ten year bonds have gone to negative yields and German bonds are threatening to join them.
Figure 5. 10-year Government Bond Yields
Figure 5. 10-year Government Bond Yields
Source. Thomson Reuters
Similar to Australian house prices, we predict that at some future point the prices of bonds will fall substantially (and yields will rise). There can be no certainty as to the timing, but it will be the great unwinding of the bond market that is the most challenging aspect of long term investment.
Simply stated, a long term investment portfolio is almost certain to be confronted at some point by sharply weakening bond prices. In our view, this will constrict the ability of equity markets to sustain price recovery. Indeed, an equity price recovery that results from a lift in world economic activity may be short-lived as it confronts sharply rising bond yields and required returns. If inflation develops, then the valuation effects will be even more significant.

Increased volatility needs to be accessed rather than avoided

While this is confronting, now is not the time for investors to default to cash and condemn themselves to sub-optimal returns. Rather, it is a time to acknowledge an environment dominated by price volatility. Investors can then appreciate the risks and challenges of the markets to access the opportunities created.
While we believe that the risk of longer term asset price correction is relatively high, there is a chance that such an event may not occur for many years. This is because central banks (ex-Australia) remain dogmatic in their resolve to bail out governments and utilise quantitative easing (QE) to purchase bonds and other assets. Further, central banks are using QE and negative cash rates as a means to devalue their currencies with the hope of stimulating dormant growth. Central banks will not give up and it is doubtful that markets can overwhelm them in the next few years.
The adoption by major central banks of negative “real” (below inflation) and “absolute negative” cash rates should have stirred economic activity by now – but it hasn’t. Rather, it has stirred asset market prices and, as a secondary effect, the housing market in Australia.
Low sustained cash rates and bond yields are the result of both central bank manipulation and actual low economic growth. These factors suggest that most investment asset classes are set to generate sub-optimal returns well below historic norms.
One  feature of this environment is price volatility. The financial system, dominated by large banks and related institutions, has an insatiable appetite for revenue and trading profits. In this low growth era, financial participants will manufacture and manipulate market sentiment to create price volatility, thereby creating trading opportunities. They do this with research, opinions and forecasts which vary widely and are inconsistent. That is convenient because it focuses on the short term rather than the long term, setting the stage for excessive trading. Further, it is not only equities that are volatile – but also currencies, commodities and corporate debt spreads.
The medium term trend for asset markets is sideways and therefore a passive or inactive approach to investing is likely to generate low returns. Thus investors need to adjust and lower their overall investment return targets. Further, they need to increase their trading activity in equities by accessing volatility, and lift their allocation to yield as a portion of their portfolio.
The focus on trading and yield is exemplified in the next two charts.
The first chart shows that Australian dividend yields are superior to offshore markets. The high payout ratios are driven by franking credits and have resulted in dividend returns dominating the total return from the Australian market over periods from 3 to 10 years.
Figure 6. Dividend Yields
Figure 6. Dividend Yields
Source. Bloomberg; MSCI; Thomson Reuters
The next chart shows why capital gain has not been generated in the Australian market. Quite simply, earnings per share for the market have been flat to declining from 2007 to 2016. The lines below show the trend in consensus earnings forecasts – from where they begin as estimates, to where they end up in actual results. Australian companies have consistently underperformed expectations and this is why diversification into international investing is an essential part of a balanced portfolio. Put simply, Australian equities are yield focused and offshore equities (particularly US) are growth focused.
Figure 7. Forecast Earnings per Share
Figure 7. Forecast Earnings per Share
Source. Thomson Reuters

China remains the key for the next few years

This is a period where equity markets will produce anaemic returns. At a macro level, Australia’s economy will continue to be affected by the economic performance of China. In particular, China’s growth will affect commodity prices and the level of the $A. Economic growth that leads to Chinese household income growth will feed the growing levels of Chinese inbound tourists to Australia.
The next charts illustrate the difficult current account and international debt position of Australia. They highlight the deterioration that has occurred as China rebalances its growth from investment to consumption. This has contributed to the rapid decline in commodity prices and our declining trade account.
Australia’s current account deficit (made up of the income and trade accounts) has recently lurched towards 6% of GDP – a critical level. If it deteriorates further,  the $A will surely come under pressure once again.
Figure 8. Current Account Balance
Figure 8. Current Account Balance
Source. ABS
Figure 9. Net Foreign Liabilities
Figure 9. Net Foreign Liabilities
Source. ABS
While the current account is a lower percentage of GDP than 10 years ago, this improvement is a result of historic low international interest rates. Australia has record levels of actual net foreign debt (around $1 trillion), but this is masked by the low international cost of debt. However, the deterioration in the trade account is clear and will need to be monitored. It is difficult to see how this could improve without a strengthening in commodity and energy prices or a sharply lower $A.
The final chart covers China’s output and activity levels. These are crucial for they directly affect the demand for our bulk resources and energy. This chart shows that the astronomical Chinese growth of the past decade is in decline. While  Chinese households are maintaining their spending growth (10% retail sales growth per annum), investment and production growth is slowing. Therefore Australia’s exports of bulk commodities will slow but inbound tourism will  continue to grow. The crucial question is whether the negatives will outweigh the positives. Time will tell.
Figure 10. China - Activity Indicators
Figure 10. China – Activity Indicators
Source. CEIC Data; Markit Economics; RBA

Conclusions

  1. Portfolios must be actively managed and exploit price volatility where possible. Yield is important and should be garnered from the listed equity market and direct property investments (not residential). Highly volatile pricing around a “value” metric should be utilised through trading because fundamentally based valuation growth will be hard to find;
  2. The $A has recently rallied due to offshore cash rate adjustments in Europe and dovish statements by the US Federal Reserve. The recent bounce in bulk commodity prices has also had an influence. The $A will be lower by the end of 2016 as Australia’s Capital Account comes under scrutiny;
  3. Sydney and Melbourne residential property has reached unaffordable levels based on average wage multiples and excessive household debt. The RBA will continue to coerce the financial system to slow credit growth to this sector; if prices do not drift lower in the next year or two, a residential property price correction becomes a real risk;
  4. China’s growth will slow further and Australia’s bulk commodity trade position will continue to deteriorate. However, China’s economic focus to maintain household income growth and consumption ensures tourism to Australia will continue to grow. This is a tailwind for a slowing Australian economy.

As QE continues in Europe and Japan, our long held forecast of the forgiveness of excessive Government debt will become a reality (but perhaps only in about ten years’ time). Large amounts of European, Japanese and possibly even US Government debt will never be repaid. The solution can only be a compromise of the debt held by central banks, but at this point they seem oblivious to this prospect. In the meantime, central banks will battle on with no real view as to how this debt situation will be resolved and that simply adds to the volatility of world asset markets.
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