A letter to investors

Understanding the real dilemmas for investors

Over the last few years, consensus projections for world economic growth have steadily declined while in recent months the prices of stocks have held at elevated levels and have actually risen sharply in those major economies that are undertaking QE (i.e. Germany and Japan). Figure 1 shows just how large this gap has become and clearly portrays that it is a real dilemma for investors.

Given that economic growth will translate into company profit growth we can perceive that stock prices continue to be buoyed by factors other than earnings growth. The price earnings ratios (PERs) of stocks have generally lifted. Buyers of shares are now willing to pay a higher multiple of both earnings and of equity per share than has been the historic average norm.

Figure 1. MSCI World Stocks vs World GDP Growth Expectations
Source. Bloomberg
High PERs are normal at the trough of economic activity. The market anticipates recovery in profits. However, there are times in history when exuberance takes over and price bubbles are seen. So is that what we are seeing today or is something more significant occurring?

Today’s investment dilemma has three parts:

  1. Why are earnings and equity multiples rising?
  2. Are current multiples sustainable?
  3. Can multiples of earnings and equity per share continue to rise?

Dilemma 1: Why are earnings and equity multiples rising?
The obvious factor that continues to affect stock price multiples is the general level of interest rate settings across the developed world. These settings plus the sustained maintenance of low historic cash rates has moved low interest rates along the yield curve. This is now reflected in extraordinary low long term bond yields. A little later we will cover the “Law of 20” to explain the nexus between bond yields and PERs.
In Australia we recently saw ten year bond yields fall below 2.3%. This is historically extraordinary but no more so than the current ten year bond yields seen in Spain and Italy which have both now fallen to below 1.4%. So much for poor sovereign debt ratings and the benefit of maintaining Australia’s AAA credit rating! These observations of bond yields tell investors that something peculiar is occurring and in particular that default risk is not affecting the price of bonds.

Figure 2. 10 year Government Bond Yields
Source. Thomson Reuters
Low cash rate settings have been supported by the massive quantitative easing (QE) or asset purchasing programs in the US, Europe and Japan. The purchasing of assets by major Central Banks has extended from bonds to mortgages and now to investment securities by the Japanese Central Bank. This is unique in history and the ultimate consequences are unknown. However, its short term affect is to support equity multiple expansion.
The first chart presented above also illustrated that world equity markets have been extraordinarily volatile over the last six months. A review of major equity markets shows the direct price response of equities to QE activity and pronouncements. As noted earlier we have seen a surge in Japanese and German equity markets as QE has been rolled out; whilst in the US we have seen a volatile stalling of the equity market after QE was tapered.
The second chart above shows that the bond yields of major economies rallied hard in response to QE. However, it remains truly concerning that with so much monetary stimulation occurring then why are world economic growth forecasts declining? There should be a strong co-ordinated economic recovery but none is apparent.
A little later we will conclude that the developed world has moved into a sustained low growth era but that monetary policy is causing buoyancy in asset values. Current monetary policy settings in advanced economies (ex: Australia) are designed to keep the servicing of debt by governments down because government debt is too high.
Dilemma 2: Are current valuations sustainable?
It is a confusing investment picture because short term market moves are stimulated by financial support rather than strong investment fundamentals. Whilst it is true that equity prices should move higher with bond prices, it is not true that the current long term bond prices (driven by QE) can be considered as sustainable. The biggest risk for investment capital is that investors en masse become intoxicated by sustained low interest rates, chase price momentum and allocate too much capital to shares whose prices are lifting independent of earnings. This market price movement represents type of bubble that ends when participants least expect it. However, whilst it develops it can be most rewarding to investors who perceive and can understand its risk profile.
Dilemma 3: Can earnings or equity multiples rise further? 
The above leads to a view that equity markets could struggle to lift much further this year unless there is a genuine economic recovery or they are buoyed by even more monetary or financial support of Central Banks. Importantly both recent history and the continued statements of policy by Central Banks suggest that support will be aggressively maintained until inflation lifts or unemployment levels decline. Today, neither is present and so support will continue.
However, in our view it is certainly arguable that markets have already priced recovery into equity prices. The following table shows that forward PERs for both the world indices and the Australian market sit at 18 times earnings.

Figure 3. Forward P/E Ratios
Sources. MSCI; Thomson Reuters
The above chart shows that Australian market PERs currently present at historic highs. Apart from the madness seen in the internet bubble, a forward PER of 18 times is high for Australia. However, every period is different and the economic environment needs to be considered in truly assessing the excesses of market price.
A useful but simple technique for looking at market PERs is the “rule of 20”. This rule suggests that the PER of the stock market plus the ten year bond yield should add to 20. This simple rule has some merit: it suggests that as bond yields decline, required returns for equity investment will also fall and earnings multiples will increase. Thus today an Australian bond yield of circa 2.3% will justify a market PER of 17.7 times. The PER is the inverse of the earnings yield. The current PER suggests an after tax earnings yield about 5.65%. On a payout ratio of 70% (driven by large banks and Telstra), the market dividend yield is around 4.0% fully franked. Based on comparisons with overseas markets and given current bond yields, the Australian equity market dividend yield is attractive.

Figure 4. Dividend Yields
Source. MSCI; Thomson Reuters
The rule of 20 suggests markets are at full value – but with bond yields in Germany and Japan of less than 1%, it suggests that PERs in those markets could expand further. Unfortunately the rule of 20 is a static measure as it focuses on the present and it does not assess the sustainability of interest rates and bond yields. Nor does it examine the logic of interest rate settings.
The key to investing is forecasting and assessing the likely changes in bond yields, economic and earnings growth. Today it is critical to understand and correctly forecast the policy settings of Central Banks. They rule the roost and are controlling asset market prices.

What will Central Banks do?

Based on the statements of major Central Banks there seems little doubt that they will continue with current policies. In highly indebted Europe and Japan this will involve more currency printing and the manipulation of bond yields. It is surely obvious that European and Japanese governments currently do not collect enough tax revenue to service their massive debt loads. So the Central Banks will continue to purchase more government debt at higher and higher prices. Yields will continue to fall, thereby forcing investors to seek out riskier assets with low projected returns. Importantly the interest costs of governments will remain manageable.
Economic theory suggests that QE would increase the supply of money and therefore credit growth. This in turn would drive economic activity and inflation. Consumption would be brought forward and economies would expand. However, whatever the theory, this has not happened in reality. QE across the US, Europe and Japan has not fed consumption or credit growth. Rather it has supported asset prices and it is now feeding asset speculation.
Remarkably, there is general consumer price deflation caused by excess supply of commodities and the emergence of cheap Chinese manufactured exports. If there is any sign of consumer price inflation it is mainly caused by higher government charges and taxes.
In our view, the advanced parts of the world have entered a period of sustained low growth. This is a function of the ageing population trend, high government debt levels and low interest rates. Each is feeding upon the other and creating a cycle of inactivity. Meanwhile the prices of financial assets are driven by the maintenance of negative real interest rates.

What does this mean for Australia?

Like our advanced world cousins, in this calendar year we have seen a solid lift in the equity market in response to a cash rate cut by the RBA (in February) and the devaluation of the $A. Thus from a currency and yield perspective, the market price moves can be explained. However the market moves are seemingly ignoring the substantial decline in Australia’s terms of trade. The fall in the iron ore price, if sustained at around $50 per ton, will seriously dent Australia’s trade account such that our annual trade deficit will lift above 1% of GDP (towards $20 billion). The weakness in the $A will not translate into improved export income because we have not developed other export industries of any substance. Corporate earnings outside financials and international companies will be tested by slowing growth.
Overlaying the above concerns and observations is that the Australian equity market is overweight with financials and resource companies. The lift in equity prices of financial stocks in Australia is magnifying the risk of a correction should the declining terms of trade translate into lower national income and economic activity. Higher unemployment would seriously affect the Australian market unless interest rates remain low and the $A falls further.
Figure 5. Composition of ASX 200 – 9 Feb 2015
Sources. ASX: Datastream
These emerging issues for the Australian economy are being hidden by the surge in residential property prices on the east coast of Australia, which in turn is buoying household credit growth and asset growth for banks.
It is important to understand that residential property prices are not indicative of economic success but rather of economic and financial excess. Sydney’s residential property market is behaving just like the German and Japanese stock markets and responding to low historic interest rates.

Figure 6. Housing Prices
Sources. CoreLogic RP Data; RBA
Australia has too much of its national and household wealth tied up in non-productive assets. In our view rising household debt into a surging housing market is not the basis of sustainable economic activity. It merely drives attention away from weakening underlying economic fundamentals such as low returns on capital, low profit growth, higher unemployment, low wages growth and poor consumer confidence.

Caution Required

In our view central banks have and will continue to miscalculate the ultimate risks of QE and ultra-low cash rate settings. QE has driven down the cost of debt but not lifted the demand for consumer or business investment credit. The asset bubbles of today have brought forward investment gains, but they have surely lowered the return from most assets going forward. If asset prices continue to surge and remain unchecked by central banks, then severe volatility will become a feature of markets. Thus portfolios need to be positioned for a range of possibilities.
The missing link is sustained economic growth in the developed economies. Whilst it is easy to see that growth of above 5% will be observable in the developing world (dominated by China), it is hard to see growth of the developed world reaching 2%. Indeed given the high earnings multiples that equity markets now trade at, the biggest risk to share values is not continued low economic growth but rather the emergence of faster economic growth that requires an adjustment to interest rates.
If the above conclusion sounds crazy, take a moment to reflect upon the recent gyrations of the US stock market as traders contemplate the likely timing of an adjustment to US cash rates.
The true dilemma is that central banks have caused bad news to become good news for markets and recently markets have been buoyed by much bad news.  

Key forecasts for the remainder of 2015

  1. The $A will continue to depreciate against the $US. A target of 65 cents to 70 cents is appropriate given the substantial decline in the iron ore price;
  2. The Australian equity market will remain buoyant supported by the weakening $A and lower interest rate settings;
  3. The May Australian budget will disclose a further sharp deterioration in the fiscal outlook. This will become the backdrop for a much needed restructuring of the taxation system in Australia;
  4. Cash rates will be lowered again by the RBA in direct response to overseas monetary policy settings. At some point the Government and RBA will realise that asset speculation is occurring and respond. The provision by banks of speculative credit facilities will become a matter of concern;
  5. Equity markets across Europe and Japan will push higher and possibly enter true bubble territory. The maintenance of zero cash rates and QE ensures that investors have little alternative but to speculate with their capital;
  6. China will continue to support growth in its economy through both fiscal and monetary policy settings. At some point the developed world will realise that China is solely focused on itself and it has declining interest in the fortunes of the developed world; and
  7. The US equity market will initially be challenged by slowing earnings caused by the rising $US. However, the Federal Reserve will be coerced into continued inactivity and the US equity will likely re-join in the equity market bubble.

Clime’s approach to managing capital in this environment

“The headwinds constraining the global economy are many and varied; similar but distinct issues are present in our domestic environment. In many instances, high asset prices and the lack of investment alternatives have added to investor unease. However, it is clear that Central Banks continue to offer support for asset prices.
At Clime, we are monitoring the markets very closely. We believe that today, shares are not cheap as an asset class; but we do not invest in the asset class. We invest in individual companies. We have a disciplined process designed to identify intrinsic value based on a company’s earnings and sustainable return on equity. Thus, we are still able to identify companies that are attractive long term investment opportunities trading at discounts to their value. This is what we spend our time looking for, and waiting for.
We continue to uncover stocks that are trading with reasonable dividend yields, low multiples of equity and low price earnings ratios. We are able to tick the boxes in our “must have” list – capable management, moderate gearing, easily understood business models, and good prospects for growing profitability.
As we have always maintained, no one can predict what the stock market will do this month or in coming months with any real accuracy. But for prudent investors with a reasonable timeframe, there are sound reasons for optimism that in the long run we will see higher, not lower, market valuations for the stocks in your portfolio. Our focus is on profit growth for that is the basis for sustained improvement in shareholder returns.
With our disciplined process, we expect to and are confident that we will achieve our absolute return objective over medium time frames”
Download Download: Letter to Investors – March 2015 (PDF, 745KB)

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