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F Palmer & ME Palmer
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Investment & Economic Review July 2017

Most investment markets performed admirably in the last twelve months, particularly as economic trends have generally been uninspiring. Stock and real estate prices have certainly benefitted from the unprecedented stimulus provided by central banks and governments, in the form of extraordinarily low interest rates, and even more extraordinary money printing programs.

This central bank largesse had the intent (hope) of reflating economic activity and hence jobs, but in reality, has been more beneficial for investment asset prices rather than broad economic growth.

There is no better illustration than this chart, which shows a collapse in business investment in Australia despite the extraordinary interest rate settings. This is not a good look.

The primary global economic conundrum ahead is how and when this post-GFC stimulus process ends. The importance of this can’t be understated as the quantum of assets acquired by the central banks is truly enormous – more than US$12 trillion, at last count, by the troika of the US Federal Reserve, European Central Bank, and the Bank of Japan. Each of these institutions is now contemplating the process of unwinding, either by maturing or reducing bond purchases or raising interest rates. The pace and consequences of their actions will be watched very carefully in the coming year.

Two rather disparate points of view contest investment asset price deliberations. Firstly, the more optimistic case, argues that deflationary risks are dissipating, and global economic activity is on the mend. This view is supported by some improving data, including global PMI (manufacturing expectations) and modest gains in some labour markets, and concludes that profit growth will justify relatively high share prices, even if interest rates rise. The second point of view is that there is a wide Source: RBA disconnect between investment asset (shares and real estate) prices, and economic activity, and sooner-or-later weak GDP, retail sales and business investment will drag asset prices lower.

There is some truth in both these perspectives. It is our view that economic activity will generally remain below trend, interest rates remain very low, and asset prices find it difficult to rise very much further for a while. Stock market volatility, which has been subdued this year, will likely increase, such that there will probably be a couple of sharp sell-off periods ahead, during which assets can be acquired at more prospective prices.

There are always geopolitical events to worry the naysayer. This coming year these include the outcome of the German election in September, the momentum of the populist Five Star Movement ahead of Italy’s 2018 election, the diplomatic tensions on the Korean peninsula and South China Sea, and presumably a recognition at some stage by Americans that their commander-in-chief is entirely unsuitable for that role.

Domestically, the primary issue ahead is the potentially calamitous consequences of too much household debt, in the face of waning employment growth and stalling house prices. At best, this issue is likely to lead to slack consumption and retail sales growth, but could turn very ugly indeed.

Australian Shares

The Australian stock market lost its positive momentum in May and June such that the return for the June quarter was negative 2.5%, or negative 1.6% when dividends are included. However, the market returned a positive 9.3% in the 2016/17 financial year, and an impressive 14% when dividends are included.

Australian shares have benefitted from the concept of yield compression, that is prices are generally higher when interest rates are low, and vice versa. This is because the yield on both profit and dividends is more attractive when interest rates are very low, causing prices to rise. The analytical concept called the Price/Earnings ratio is a good reflection of this.

To illustrate the low interest rate effect, this chart shows that Australian shares were (on average) priced at 10 times their annual profit between 1960 and 1990, a period during which interest rates were notoriously high. Yet since 1990, a period notable for steadily declining interest rates, the ratio has averaged 16 times. This means that the same types of shares (BHP, Westpac etc.) are priced these days, relative to their annual profit, 60% higher than they used to be – just because interest rates are lower!

In our managed portfolios we have adopted a more cautious investment approach, and gradually divested during the last six months. Shares such as Lend Lease, QBE, Spotless and Goodman Group were sold and some other stock weightings reduced. Consequently, the managed share portfolios now have, quite deliberately, a large cash component, which will be held and reinvested as and when market conditions and opportunities arise.

The banking sector has regularly been in the news recently, due to regulatory changes, government reviews and enquiries, and new tax levies. We continue to hold bank shares, including ANZ, CBA, Macquarie and Westpac, but have tended to lighten the exposure. The banks’ challenge is their requirement to increase regulated capital, at a time that loan book quality might deteriorate, particularly if real estate prices were to fall.

Global Shares

Stock markets in the United States, Germany and Britain have surged to successive all time high levels in 2017. The Australian index (inclusive of dividends) was similarly strong, reaching a record high on 1st May, but has declined a little since then. Technology stocks have been particularly strong as witnessed by the tech-heavy US NASDAQ index, which has risen by a staggering 25% in twelve months.

Whilst returns have been very good, some sectors are now overpriced, and we have reduced the investment exposure in our managed portfolios accordingly.

The US stock market has also been a beneficiary of the long decline in interest rates and the substantial liquidity provided by central bank actions. One commonly referenced valuation tool is the Shiller cyclically adjusted P/E ratio, developed by Professor Robert Shiller, a Nobel Laureate from Yale University. The Shiller P/E is clearly indicating a fully priced market, particularly if interest rates were to rise.

Recently, our analytical attention has been directed more towards European and Asian stock markets, where some sectors and stocks have appealing valuations.

Property Securities

The Real Estate Investment Trust (REIT) sector of the stock market fell in 2016/17, and indeed was one of the few poor performing investment sectors. The decline followed the rush up in REIT prices last year, which were deemed to be too high relative to a weakening forward view of real estate prices. The market is often cannily predictive, and the security price declines could well be a harbinger of weakness in underlying real estate values in the coming year or two.

Within the REIT index, the larger securities such as Westfield, Scentre, GPT and Stockland all delivered poor performance, whilst industrial property Goodman Group was the star performer last year, benefiting from a well-managed and executed financing and development model of global industrial properties.

Some pockets of retail, commercial and residential real estate are overpriced. In recent years demand has generally outstripped supply, though significant new development is now causing this to change. Property valuations with a capitalisation rate of sub 5% for premium commercial property have become commonplace, with some lower than 4%. This has caused asset price inflation, even in circumstances lacking strong fundamentals such as tenancy tenure, and rental growth. Low interest rates are the reason. However, REIT market security prices have already adjusted lower, so the likelihood is that this sector will stabilise and enjoy a modestly better performance in the coming year

Interest Rates

The Reserve Bank of Australia (RBA) released their quarterly monetary policy statement in mid-June and reaffirmed the cash rate at 1.5%, a rate that has not changed for nearly a year, and is likely to prevail for some time. The RBA justified retaining their policy by observing that ‘low growth in incomes, along with high levels of household debt, appeared to have been restraining growth in household consumption’. Further, they noted a considerable additional supply of apartments in the eastern capital cities in the next couple of years, and worryingly, that growth in housing debt had outpaced the slow growth in household incomes. In such conditions interest rates are unlikely to rise much for some time, though the RBA might start hinting at future rate hikes, as part of their longer term program of normalizing rates.

Australian longer term interest rates have remained in the 2% to 2.5% range for five year securities, and just a bit higher for longer dated maturities. The yield curve, the difference between short and long term rates, is fairly flat. This pattern is normally indicative of weak economic activity ahead, a prognosis that concurs with much of the anecdotal statistics.

The components of our fixed interest portfolios are mostly shorter duration securities and deposits, as longer dated instruments have more price volatility risk. Term deposit rates have stabilised at 2.5% to 2.75%, and continue to offer a very safe investment. Major bank and corporate income securities offer a yield enhancing alternative, but have market price and capital structure risks that need to be carefully considered.

The Australian dollar seems to have found more stability, trading between US70 and US77 cents all year. It has been similarly stable on a trade-weighted basis. Against the Euro, the dollar has fallen a bit, reflecting expectations that Eurozone economies are beginning to shake off their long period of economic malaise. Looking forward, the Australian dollar lacks much upside momentum, due to lingering weakness in the market prices of our major export commodities such as iron ore and coal.

Outlook

We remain concerned that share and real estate prices are somewhat disconnected from underlying economic activity, and for much of this year we have been expecting markets to encounter some bumps. To date, stock market setbacks have been relatively minor and real estate prices have proved resilient. Nevertheless, the outlook is beset with uncertainties, so we are retaining our cautious investment stance.

Economically, we expect the weak trend in retail sales, consumption and the labour market to continue, offset by strong tourism and services sectors and robust construction activity. Interest rates will remain low and share prices will suffer some short-term pitfalls. This would be a generally satisfactory outlook if it were not for the frightening level of household and government debt. We don’t have a lot of room for error.

Disclaimer & General Advice Warning

This publication has been prepared by Joseph Palmer & Sons (ABN 29 548 490 818) an Australian Financial Services Licensee (AFSL 247067). Whilst the information contained in this publication has been prepared with all reasonable care from sources, which Joseph Palmer & Sons believes are reliable, no responsibility or liability is accepted by Joseph Palmer & Sons for any errors or omissions or misstatements however caused. Any opinions, forecasts or recommendations reflects the judgment and assumptions of Joseph Palmer & Sons as at the date of publication and may change without notice. Joseph Palmer & Sons, their officers, agents and employees exclude all liability whatsoever, in negligence or otherwise, for any loss or damage relating to this document to the full extent permitted by law. This publication is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Any securities recommendation contained in this publication is unsolicited general information only. Joseph Palmer & Sons are not aware that any recipient intends to rely on this publication and are not aware of the manner in which a recipient intends to use it. In preparing our information, it is not possible to take into consideration the investment objectives, financial situation or particular needs of any individual recipient. Investors must obtain individual financial advice from their investment advisor to determine whether recommendations contained in this publication are appropriate to their personal investment objectives, financial situation or particular needs before acting on any such recommendations.

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