The yield trade and the RBA's easing bias: More than meets the eye

The RBA confounded market expectations and left the overnight cash rate (OCR) unchanged at 2.25% at the March meeting, but adopted an explicit easing bias which would have appeased the market somewhat.  Its reluctance to cut rates in consecutive meetings stems from its desire to have more time to assess the impact of its decision to ease policy in February. 

Clearly, it wasn't persuaded to cut again by the unambiguously weak data flow since the February meeting, including the labour force survey and capital spending intentions.

In previous posts (notably, 17th December 2014, Money's Too Tight Too Mention) I suggested that February and May represented the most likely months for policy easing because in an interview in mid-December to the Fairfax press, Glenn Stevens laid the groundwork for lower rates based on a positive narrative.  He was keen to ensure that the markets would not interpret a shift to ease policy as reflecting weak demand, at a time when business and consumer sentiment were still fragile.  A reading of the interview suggested that the slide in oil prices and low inflation would form an integral part of the RBA's positive narrative.

The case for further policy easing has been compelling for some time.  The RBA's patience with the non-mining business sector has been wearing thin for a while.  Through 2014, the RBA implored businesses to invest for growth rather than remain fixated on their costs and internals.  The new normal of capital and cost discipline embraced across the corporate sector has dampened capital spending, to the point where now that the ratio of capex to assets has declined to 1.75%, well below the historical median of 2.2% (see chart).  

The RBA had clearly under-estimated the pervasiveness of this newly entrenched discipline.  Persistent revenue headwinds, a loss of trust in ability of CEOs  to undertake value accretive investments and acquisitions, and investors' insatiable appetite for income has meant that companies increasingly are focussing on trimming operating costs, deferring capex and restructuring to boost profitability.  CEOs with a track record of acquisition led growth no longer command a premium in the market for managerial talent. 

The Agency Costs of Free Cash Flow Have Fallen Considerably

It is a welcome development for shareholders that CEOs are now focussing on what they can control  rather than chasing the pipedream of double digit revenue growth.  Shareholders are exerting a tremendous discipline on companies to return surplus cash flow and in so doing, the agency costs of free cash flow have fallen considerably.  The interim reporting season confirmed that companies continue to lift payout ratios where feasible and more are undertaking buybacks.

But the flipside of the new normal of capital and cost discipline has been sluggish growth.  The economy has effectively been stuck in a nominal recession for three years now, coinciding with the negative terms of trade shock.  The December quarter National Accounts due for release today should confirm that the terms of trade has declined by over 30% from its 2011 peak and that the nominal economy has expanded by less than 4%pa over this time, representing the weakest period of growth since the deep recession of the early 1990s. 

Inflation does not represent an obstacle to lower interest rates.  Growth in unit labour costs - productivity adjusted wages growth - remains weak, private sector nominal wages are growing at their slowest rate on record, there is little sign that the depreciation of the Australian dollar has flowed through to higher prices of tradeable goods, inflation expectations are well anchored, the slide in oil prices pose a downside risk to headline inflation, and there is still considerable slack in the labour market .

Contrary to the RBA's view, it is the role of monetary policy to revive animal spirits, which have been dormant for three years now.  Also contrary to recent statements from Mr Stevens, policy easing at lower interest rates can be just as effective at boosting expectations of growth as policy easing at higher rates.   To the best of my knowledge, there is no theoretical support for the assertion that monetary policy is less potent at lower interest rates.  Further, the large scale asset purchases and forward guidance adopted by the US Federal Reserve, Bank of Japan and other central banks since the financial crisis offers ample evidence that the zero lower bound does not render monetary policy impotent.  Mr Stevens continues to under-estimate the power of monetary policy to revive growth and reduce unemployment.

The Yield Trade: More Than Meets the Eye

Many will interpret the RBA's adoption of an explicit easing bias as a harbinger for further out-performance of high yielding stocks.  At a time when term deposit rates continue to fall, the lure of high yielding stocks - particularly those accompanied by high levels of franking - is compelling.  But on closer inspection, high yielders have endured a period of under-performance in recent years.  Since the end of 2013, the low yielders have delivered an average portfolio return of 24%, well above the ASX200 (16%) and the highest yielding stocks (6%) - see chart.

Valuation theory sheds some light on the poor performance of high yielders at a time when interest rates have declined.  A stock's dividend yield equals the expected discount rate (k) minus expected dividend growth  into perpetuity (g).  Holding g constant, valuation theory says that high yielders ought to be associated with higher risk and higher betas than low yielders.  It so happens that risk assets have fared worse than safe assets in recent years, at a time when investors have eschewed risk from their portfolios; emerging market equities for instance have underperformed and sovereign bond yields around the world have declined to record lows.  Thus, the shift towards safe assets has undermined the performance of high yielders.

Aside from what valuation theory says about the riskiness of high yielders, the pattern of price performance also suggests that investors perceive these stocks as riskier.  The average price performance over the past six months among the high yielders is -11%, well below the low yielders (+1%).  For investors seeking to invest in high yielding stocks with strong price momentum outside of the banks, utilities and REITs, only three candidates meet these criteria: CCL, IFL and JBH.  In a forthcoming report, Evidente will showcase a systematic approach for investors to measure and identify stocks with sustainably high yields.