Volatility is the value investor’s friend, so we started to use some of our sizeable cash pile last week, when the All Ordinaries Index fell 2.2% to dramatic headlines like “ASX loses $35b in worst day since Brexit” (noticed how when the market falls the media measures the loss by value, an emotive metric because people can relate to it, but when the market rises the gain is measured by drier metrics like points and percentages?). We picked up 111 ANZ at $26.19 and 74 CBA at $69.79, buying ANZ up to our 5.0% target weight and CBA up to a new 3.5% model weight. The purchases improved both cost bases. After several weeks of selling equities our cash peaked last week at 28.9% and is down to 27.6% this week. This is still elevated and we have the 2% BBOZ holding, so if the correction deepens we have abundant liquidity for buying more shares.
Though we actually doubt markets are about to enter a severe pullback due to fears of monetary tightening by the US Federal Reserve or no further largesse by the European Central Bank and Bank of Japan. The last thing Fed Chair Janet Yellen needs right now is a major episode of financial market volatility caused by the Fed, which could delay the cash rate increases she knows the US economy needs. In our view Yellen aims to deliver a series of ‘dovish hikes’, which means rate rises delivered after the US money market has already priced them in but before inflationary pressures in the US economy surprise on the upside. If the Fed is caught tightening too late – after the latter surprise has already happened – there could well be a bond and equity market crash. The speeches, conferences, media interviews and market guidance are all part of a coordinated attempt to deliver normalisation of the Fed Funds Rate without causing such undesirable financial volatility along the way. The Fed needs to normalise – at Jackson Hole Yellen said a 3% cash rate (currently 0.5%!) would be a reasonable new normal – to prevent labour market strength kickstarting wage inflation and to create room to cut if there is another recession (at some point, not yet, Australia will need to do the same).
As for the ECB and BOJ, they are not even talking about tightening and face nothing like the economic strength of the US (or Australia). All that’s happened here is the two central banks have indirectly, awkwardly and publicly admitted their extreme monetary policies are not working to return inflation to targets, so further monetary experimentation is possibly not worth the effort or risk and fiscal policy (government spending) should provide the next round of stimulus. This, not tightening talk by the Fed, started the bout of volatility mid-last week and is being fairly priced in. While the new guidance disappointed the expectations of some speculators for ever more central bank largesse, it is a long-overdue small first step back towards monetary rationality given the distortions caused by negative yield curves and negative interest rates. These distortions are worst in the banking system, where commercial banks would rather place cash on deposit with central banks than earn an inadequate return from borrowing short (deposits) and lending long (loans), and for insurers and pension funds, which can’t earn an adequate income return on their investment portfolios.
In any case the deflationary pressures and lack of growth in the Eurozone and Japanese economies will reassert themselves soon enough, which should renew expectations of deeply accommodative monetary policy for longer. This is not an environment where bonds are dumped. Their pricing may well be relatively rich and we are experiencing a correction but we don’t see the start of a huge bond bear market. The selloff of recent days is a risk adjustment, not a reflection of better economic data – especially inflation. We don’t expect a sustained selloff like late 2013 or early 2015.
One of the worst cases for stocks and equity indexes priced off Eurozone and Japanese GDP is something different: a choke by market participants who collectively realise the monetary largesse isn’t working and there is little to no growth. This happened in January, when we confidently bought equities.
$70, a 10% discount to our $77.50 CBA valuation, interested us because it seemed a reasonable entry point when CBA was recently derated relative to ANZ by one major broking firm. For many years CBA was the most expensive major bank, as measured by the share price’s multiple of book value, but this premium will narrow as ANZ’s and NAB’s profitability improve due to their turnarounds and divestments of non-core assets. At some point CBA will re-rate as other broking firms, which must for their survival sustain steady flows of brokerage commissions from client trading in banks, elevate CBA up their order of major bank preference by calling it oversold. So now is a reasonable time to add to CBA positions for an eventual exit around $80. We could lift the 3.5% model weight further if the stock weakens enough. The dividend yield at current prices is an attractive 6% – a good start for an investment which ideally would deliver a total annual return of, say, 8%, being the yield with some growth.
We now hope for more volatility which creates opportunities to deploy our cash. Until then the advantage of the permanent capital, value-investing approach demonstrated by the model portfolio is the ability to go to cash while we wait.
And it might be a wait given the strength (up 6.3% in August, beating consensus expectations for 6.1% and the fastest pace since March) in last weeks July Chinese industrial output data, which reflects stimulus to state-owned enterprises by central authorities concerned to minimise unemployment and related social unrest ahead of leadership changes later next year. Retail sales also surprised on the upside by surging 10.6% in a demonstration of China’s gradual transition to a more balanced economy with a greater role for the services sector.
So a serious correction on equity markets this year probably won’t come from the Fed or Chinese growth data. Instead there will be more moderate volatility like yesterday and investors need to be on alert to use it.
David Walker is a senior analyst at Clime Asset Management.
Clime Asset Management owns shares in AAA, AAD, ANZ, APD, CBA, CCP, CPU, CSL, CTX, CWN, FLT, HGG, IPH, NAB, QBE, QUB, RHC, SEK, TCL and USD for and on behalf of various mandates for which it acts as investment manager. David Walker owns shares in ANZ, CBA, CCP, CPU, CSL, CTX, FLT, HGG, NAB, QBE, QUB, SEK, TCL, USD and WOW.