12 September 2014
By David Poppenbeek
There is currently no shortage of analysis suggesting that long term bond yields are too low and accordingly higher rates are inevitable. Further to that, consensus thought is that higher bond yields must equal asset price volatility and a subsequent equity market sell-off. However, recent experiences are to the contrary. When the average long term bond yield of the ten main developed regions has moved up by more than 75 basis points, equity markets have generally rallied.
Bond rates and equity market rallies . . .
US rates have an upward bias, particularly given that the economy is regaining momentum. Since the depths of the GFC in early 2009, the US unemployment rate has improved from 10% to near 6% today. Over the same time frame the US Manufacturing PMI has expanded nearly 70%. The Open Market Operations (OMO) of the Federal Reserve (FED) has clearly helped keep a lid on interest rates; $3.5 trillion of long term US securities have effectively been removed from circulation. Now that the program is near completion, market participants will ultimately determine the near term trajectory of US interest rates.
Offsetting an improving US economy however is a very mixed set of conditions in Europe. The unemployment rate for the Eurozone has actually risen from 8.6% in 2009 to 11.5% currently. As a result, much like the FED, the European Central Bank (ECB) has conducted open market operations. The most recent program will accumulate a broad portfolio of asset-backed securities so as to support the provision of credit to the broad economy. However, the ECB has not implemented any on-market purchases in the secondary sovereign bond market. Accordingly, solvency fears could still drive long term European bond yields sharply higher. That said, we feel that the ECB has learnt from its experiences in 2011 and would quickly step in to the market so as to smooth out any predatory actions. It is worth remembering what the ECB President said a few weeks ago;
“The risks of doing too little – i.e. that cyclical unemployment becomes structural – outweigh those of doing too much – that is, excessive upward wage and price pressures.”
“We have already seen exchange rate movements that should support both aggregate demand and inflation, which we expect to be sustained by the diverging expected paths of policy in the US and the euro area.”
Presumably the ECB must be pleased that the euro has lost 7% against the US dollar over the last few months. Hopefully the Reserve Bank of Australia (RBA) is taking note. The RBA at present seems to be more focussed on Australia's current performance relative to its own historic averages. However, it would appear to us that global capital is far more active today and is subsequently more motivated by the relative indicators of the main economic regions.
The most influential relative indicator must be Australia's inflation rate; the 60% premium to peers is clearly excessive. This high rate would appear to be impacting the short end of the Australian yield curve and therefore the demand for the Australian dollar. However, it would appear to us that the inflation premium will most likely contract over the coming year.
Firstly, the abolition of the carbon tax, along with lower demand, should ensure that retail electricity and gas prices decline substantially in FY2015. Secondly, domestic petrol prices are starting to reflect lower demand from the resources sector as well as from the average household; Woolworths said that they sold 3.2% less retail petrol during FY2014 alone. Finally it will be interesting to see whether the government starts to address the exponential price rises in that have been embedded within the education and health industries; both segments have trended annual CPI gains of 5.4% and 4.3% respectively for 25 years. The forthcoming privatisation of Medibank and the recent raft of listings of educational providers may result in more market share oriented pricing strategies.
The other interesting observation is that Australia’s 25 largest listed companies are trading on a lower earnings yield than the developed peer group. However, as a result of significant equity raisings during the GFC, Australian corporates do not need to retain profits to grow. Accordingly, Australian listed companies generally distribute nearly 30% more profits to shareholders than peer regions. As a result, Australian listed companies offer shareholders a significantly higher starting yield than just about any other country in the world. This is becoming increasingly relevant as a large share of the world’s population trends towards retirement.
The World Bank has published work suggesting that by 2025, on average, 23% of the population in the largest developed economies will be older than 65 years of age. Given that these economies today have male and female participation rates of 70% and 57% respectively, it would seem that, as retirement balances replenish in-line with higher asset prices, focus will move towards income generating investments. When coupled with banking and insurance regulatory changes that significantly tilt capital away from growth and towards income assets, then it is little wonder that there is a global “search for yield”. If we simply consider the example from Australia’s three largest general insurers we can get a sense for what is truly happening globally.
For the year ended June 2014, Insurance Australia Group (IAG), Suncorp (SUN) and QBE together generated gross written premiums in-excess of $36b. These premiums enable the insurers to carry a combined investment portfolio worth about $60b. However, global regulatory intervention during the GFC has meant that insurers are penalised for carrying growth assets; simply put regulators assume that long duration, high yield assets are risky and need to be supported by more capital. Interestingly, IAG, SUN and QBE have 93% of their investments ($28b) in low yield, highly rated fixed interest assets. Given that Australia generates around 2% of global gross written premiums, one can see that the global pool of general insurance investments seeking low risk, fixed interest assets could be well over $3 trillion. Life insurers broadly are in the same situation.
Finally it is probably worth looking at the performance of equities over longer horizons. We think that in a world of risk weighted capital, longer cycles should be applied to long duration assets. If banks are encouraged to prioritise lending to low loan-to-valuation borrowers, and insurers are corralled into investing in short duration, low yield assets, it would follow that the risks of high leverage will ultimately lie within the balance-sheets of a smaller number of participants. As a result, given its premium yield and long duration of capital, listed equity should be seen as more valuable to those investors who can hold assets for the long term. As a result, we believe it is worth considering the trough-to-peak performance of US share prices since the 1920’s.
Interestingly, since the 1920’s the average trough to peak performance of US share prices has been 311% (excluding dividends) and the average cycle has been 106 months in duration. Maybe the current uptrend in share prices has a structural component to it and could continue to surprise on the upside.
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