Written by Jonathon Wilson, Equities Analyst
Excessive debt, negative bond yields, and deflationary pressures present unprecedented challenges for investors. How does one make money in this environment? Look for quality, secular growth and focus on the micro drivers.
If you lent someone money and expected less back, you’d be mad. But, increasingly, these are the terms traders in the global bond market are agreeing to. According to Barclays Plc, over a quarter of the $47 trillion of the investment grade bonds it tracks globally are offering negative yields. This is a rapid development since June 2014, when the European Central Bank (ECB) first introduced negative rates.
Participants in this market know they’ll lose money if they hold to maturity. Part of the reason they’re buying negative yielding bonds is driven by the potential for capital gains on the expectation yields will move to be even more negative. Essentially they are subscribing to ‘greater fool theory’, which assumes profits can be made regardless of value because there’s always a greater fool willing to pay a higher price.
Perversely, investors are turning to equities for income due to the low or negative bond yields on offer. A fundamental risk/reward relationship has turned upside down.
Figure 1. ASX dividend yield vs Australian Government 10 year bond yield
Source: Thomson Reuters
The state of the bond market is the culmination of a multi-decade credit cycle which has seen global debt climb to 2.4 times global GDP, higher than the 2.3 times level during the GFC. Most of the increase occurred over the last 15 years, thanks to central banks pushing credit into markets in pursuit of the 2% inflation rate ‘sweet spot’, where broad and stable price increase supposedly lead to optimal economic outcomes. Ironically, due to the astonishing amount of debt forced into global financial system, arguably the global economy has never been more fragile. Developed economies are contending with deflationary pressures resulting from not only the excessive debt, but also aging populations and disruptive technologies.
In broad terms investors should acknowledge that, notwithstanding a number of market crises along the way, investment returns over the last half century were supported by a combination of long term trends that will not be repeated. In addition to the exhaustion of the interest rate cycle, McKinsey Global Institute estimates that as populations age over the next 50 years, employment growth will fall to 0.3 percent a year, down from 1.7 percent a year in the last 50 years. These factors, as well as increasing competition from emerging markets potentially squeezing profitably, could see total equity returns in the US and Europe below 5% pa over the next 20 years, down from 8% pa between 1984 and 2014. McKinsey’s message is clear: best be lowering your (broader market index) return expectations.
Figure 2. Change in CPI for Developed and Emerging economies, %
Source: Thomson Reuters
On the home front Australia’s debt level has followed a similar trajectory to the developed economies and now stands at 2.4 times GDP. Debt markedly accelerated from around the year 2000. Despite the RBA’s May rate cut to a record low 1.75%, data released last Wednesday revealed inflation has drifted below its 2% target. This prompted speculation of a further rate cut in coming months, which was subsequently confirmed on Tuesday with rates hitting their new low at 1.5%.
Figure 3. Australia debt and GDP 1988 – 2016, $trillion
The RBA was in a quandary with a number of perverse and interacting effects. Australia’s record low 2% 10 year Government bonds offer relatively attractive returns to global investors and the associated financial flows puts unwanted upward pressure on the Aussie dollar, which hinders the transition from mining to non-mining activity. Viewed from this perspective a further rate cut seems logical.
However, lower deposit rates have increasingly pushed local investors into large cap equities for yield, and shareholder demand for dividends and franking credits has pressured company boards into higher payout ratios, thus constraining a potential boost to inflation from business investment.
Moreover, a divided parliament and a tight budget reduces potential for direct fiscal stimulus, which we believe would be much more effective than RBA actions.
Figure 4. ASX50 (constituents as of June 2016) average payout ratio 2007 – 2016
Source: Thomson Reuters
So Australia seems to have an up-hill battle to avert stalling growth, and investors ought to lower return expectations for the market index as a whole.
As active investors we believe opportunities will continue to present themselves. Volatility (which is likely to remain elevated due to the instability from excessive debt) creates opportunity, and innovation and changing demographics will provide new avenues for secular growth. In this environment investors who emphasise a bottom-up approach and focus on areas insulated from macro trends should do well.
Broadly, the banks, resources, and insurers face headwinds in the low-growth world. These business dominate the large caps. As a result, traditional approaches may be forced further into mid-caps where competition across a small supply of quality businesses is likely to strengthen.
Some of the growth areas we’re interested in include inbound tourism, heath care, aged care, retirement living, education, and IT development. As always, we’re looking for:
- Net cash balance (ideally) or at least highly manageable amounts of debt
- Pricing power
- Above-average management that are aligned with shareholders
- Industry capacity
- A reasonable share price