Weekly Impressions: What the capex cliff reveals about Australia's 'big short'

In the past week, two bottom up developments dominated the financial market news flow in Australia: the belated announcement of CEO succession at Woolworths and renewed concerns that Australian banks represent a 'big short' thanks to rumours of the imminent collapse of residential house prices.  These two developments have more in common than meets the eye because they are revealing of the causes and consequences of corporate Australia's dormant animal spirits. 

The elevation of Mr Brad Banducci as Woolworths' new CEO comes not long after the Chair, Mr Gordon Cairn, announced that the company would be exiting its home improvement business.  Together with its joint venture partner, Lowe's, Woolworths has invested more than $3 billion in the Masters business and generated losses of around $1 billion in less than five years. 

At the time of establishing the business in 2011, then newly appointed CEO, Mr Grant O'Brien, had made a compelling case for entering into the fragmented home improvement space, whose size then was estimated to be over $30 billion in revenue, which has since been revised up to over $40 billion.  Surely the pie would be big enough to accommodate two big box hardware retailers?

Corporate Diversification: RIP

Woolworths effectively bucked the trend towards corporate clarity that has been a recurring theme in Australia and globally since the financial crisis, reflected in a wave of demergers and divestments.  Diversified and globally dispersed business models have given way to more geographically and product focussed models, including BHP, Amcor, Brambles, Fosters, Orica, and more recently NAB and ANZ.  By eschewing long held growth options that have failed to meet their cost of capital, Australian firms have effectively unlocked free cash flow which has been used to lift dividends, and  recognised that investors can engage in DIY diversification at low cost, via passive open ended funds and closed end exchange traded funds.

The decline in Australia's terms of trade by one-third from its peak five years ago has accelerated the trend towards corporate focus, as firms have sought to restructure, defer or abandon capital investment projects, and trim costs aggressively to combat strong revenue headwinds.  The outcome has been impressive; profitability has declined by less than 10% over this period (see chart).

Australia's Imminent Capex Cliff

The thematic of dormant animal spirits in the corporate sector remains strong.  During the week, the December quarter CAPEX data released by the ABS confirmed that firms continue to downsize their future capex plans. Each quarter, the ABS surveys a representative sample of firms across all industries who provide estimates for their capex spend in the current and next financial year. 

For the December quarter data just released, firms provided their fifth quarterly estimate for FY16 and first quarterly estimate for FY17.  The profile of capex intentions for FY16 most resembles those for FY11 (see chart).  The first estimate for each of those two years both started at a little above $100 billion, with the fifth estimates (the most recent one for FY16), pointing to $125 - $130 billion.  If the actual outcome for FY11 is any guide, total capex spend for FY16 will come in at around $120 billion (in nominal terms), which represents a shortfall of $30 billion or 20% from the previous year. 

To put this is context, this would amount to the largest nominal percentage decline in business investment in over 25 years.  During this time, the next largest decline occurred in Australia's last recession, where capex posted a 17% decline in 1992.

The preliminary estimate for FY17 of $83 billion points to further downside risk to the capex outlook beyond the current financial year.  The chart below provides the first of seven quarterly estimates (blue columns) for each financial year as well as the final actual outcome (yellow columns).  Typically, firms under-estimate their capex spend up to two financial years out, which is reflected in the fact that most of the yellow columns lie above their respective blue column.  The initial estimate for FY17 is marginally below that of the initial estimate for FY10.  If the actual outcome for that year is any guide, capex will come in at around $105 billion in FY17, around 12% lower than the implied outcome for FY16. 

Where is Mr Stevens' Growth Plan?

A drop in mining sector capex was to be expected after the end of the commodities boom.  But contrary to the RBA's expectations, the non-mining sector has not stepped up to the plate, which has frustrated the central bank's efforts to re-balance economic growth.  In the past, Mr Glenn Stevens, the RBA Governor, has asked rhetorically where corporate Australia's growth plan is, has bemoaned the lack of entrepreneurial risk taking and implored analysts and investors to encourage the companies they cover to invest for growth rather than focus on trimming costs. 

Woolworths' failed experiment in home improvement should offer the RBA a valuable data point why most of corporate Australia is reluctant to invest for growth, particularly at a time when the ABS release during the week showed that private sector wages grew by only 2% yoy in the December quarter, a new record low (see chart).

What the capex cliff means for Australia's big short

The reluctant rate cutter has had little choice but to deliver more monetary stimulus in recent years while the terms of trade have fallen by one-third and animal spirits in the corporate sector have remained dormant.  The re-balancing of growth hasn't exactly gone to the RBA's script but there has been a re-balancing of growth away from mining investment towards dwelling investment, household consumption and net exports. 

The RBA has felt that it is between a rock and a hard place; providing accommodative monetary settings given the shortfall in aggregate demand, but careful to ensure that multi-decade low interest rates do not stoke speculative activity in housing.  The strong lift in house prices in Melbourne and particularly Sydney from 2012-15 caused the RBA and APRA enough concern to encourage banks to reduce growth in lending to housing investors and adopt more prudent lending standards. 

It is against this backdrop that the talk about Australian housing and the major banks representing the 'big short' has polarised opinion if the news flow is any guide.  The quality of lending standards is a good starting point to gauge how widespread speculative activity is.  But any talk of a bubble discounts the important role that dwelling investment still has to play to support the economy until a revival in the corporate sector's animal spirits emerges.  The updated losses announced by Woolworths home improvement this week and decision to exit the sector altogether served as a timely and powerful signal to other corporates about the dangers associated with investing for growth in the current environment of deficient demand.  If there is a bubble in Australian housing, it therefore might well persist for quite a bit longer. 

Weekly Impressions: Global bankers should be more grateful for Basel

The past six months has been a challenging period for global bank shareholders.  The global bank stock index has declined by 20% since August, well below the 5% decline in the broader global market index (see chart). 

Emerging market banks have been the worst performers over this period, but some developed market banks haven't been spared either.  European banks, particularly those in the periphery countries, have delivered dismal returns.  Despite the reduction of European banks' non-performing loans in the past two years, they still account for 7% of total loans, well above other developed markets (see chart).  Non-performing loans as a percentage of total loans in North America and Australia are below 2%. 

Among the emerging markets, the credit bubble in China continues to pose a key risk to the global outlook.  Total debt of the private non-financial sector in China has lifted to 200% of GDP, double most other emerging markets (see chart).  The debt build-up has been associated with over-investment, particularly amongst property developers. 

Evidente has developed profitability adjusted book multiples as a framework for identifying pricing anomalies amongst stocks.  I have extended this model to the largest 60 developed market banks (see chart).  Valuation theory predicts a linear and positive relationship between an asset's expected ROE and price to book ratio.  The trend line is associated with a strong R squared of 80%.  A stock can lie above the regression line (ie. It has a higher profitability adjusted book multiple than the average of its peers) for a number of reasons: it is over-priced, it is cum an upgrade to its book value, it has stronger future growth prospects than its peers, investors are assigning a lower discount rate than its peers, or the consensus' ROE expectations are too conservative. 

The chart shows that a number of UK and Australian banks lie above the regression line, but at different ends of the profitability spectrum.  Some of the German banks, including Deutsche Bank, lie well below the regression line.

Global bankers should be more grateful for Basel and conservative prudential regulators

To dissect the under-performance from global banks in the past six months, I have sorted the 60 largest DM banks into quartiles, based on their respective deviations from the regression line.  The premium stocks (those that lie above the line) have been far more resilient, declining by 15% while the discount stocks have fallen by over 30% (see chart).  Many of the stocks that have high profitability adjusted book multiples probably have lower perceived risk or lower betas which has been associated with defensive attributes.

The volatility of returns for the premium banks (20%) is significantly lower than for the discount banks (26%) confirming the defensive characteristics of the former group.  Moreover, the premium banks have 50% more loss absorbing capital in their liability mix.  The ratio of shareholders equity to assets is 8.3% for this group, well above 5.2% for the discounted banks.  Despite global bankers' predictable chorus since the financial crisis that regulatory requirements to lift the amount of equity finance in their liability mix are impeding their ability to lend, the analysis here demonstrates that banks with more loss absorbing capital have been resilient to the market turbulence of the past six months.  Although more capital reduces expected ROEs (other things being equal) it also reduces a bank's risk profile.  Bankers should therefore be more grateful to Basel and conservative prudential regulators.

The chart below shows the stocks with the largest positive and negative deviations from the regression line.  I am not suggesting that the premium stocks are over-valued or that the discount stocks are under-valued.  As cited above, premium stocks with defensive characteristics can continue to trade at higher profitability adjusted multiples than their peers for extended periods.  But the model allows us to identify pricing anomalies.  For the premium stocks, RBS and Standard Chartered stand out because they have low capital ratios and high return volatilities.  Of course, its possible (but probably unlikely) that the stocks are cum-earnings upgrades.  After all, analysts have downgraded their 12 month forward EPS forecasts for RBS and Standard Chartered by 15% and 50% respectively in the past six months.

There do not appear to be any anomalies amongst the ten stocks trading on the largest discounts.  They all have low capital ratios and high return volatilise, suggesting that their defensive attributes are poor.  As long as global risk appetite remains low, I recommend investors stay underweight this group of stocks as well as RBS and Standard Chartered.  The key risk to this view is if global market sentiment swings quickly from risk aversion to risk appetite. 

RBA Governor waves white flag on Australia's growth prospects

The RBA Governor today delivered his twice year testimony to the Australian Parliament.  The central bank appears to have waved the white flag on Australia's growth prospects, with the Governor hinting that it had revised down the economy's potential growth rate.  Mr Glenn Stevens cited that the economy had expanded by around 2.5% in the past year and that 'real GDP is expanding at pace a bit lower than what we used to think of as normal'.  This might explain why the RBA has been a reluctant rate cutter at a time when animal spirits in the corporate sector have been dormant.

A good deal of the testimony was devoted to the puzzle of reconciling strong labour market conditions in the past year and the associated reduction in the unemployment rate to below 6% with record low wages growth and weak growth in GDP.  Mr Stevens suggested that benign wages growth is encouraging firms to lift hiring.  This may well be the case, but I suspect that an expansion in the supply of labour has probably played an important role. 

Mr Stevens is right to highlight the persistent weakness in unit labour costs is contributing to stronger growth in employment.  Productivity adjusted wages or wages per unit of aggregate output have not risen for four years (see chart).  In the past three decades, there have only been two other episodes where unit labour costs have been stable: the recession of the early 1990s and the latter part of the same decade.  It is noteworthy that these periods were associated with tight money.

A salute to corporate Australia's resilience

The Governor has previously bemoaned what he considers to be the absence of entrepreneurial risk taking, but corporate Australia's belt tightening, restructuring and trend towards corporate clarity have helped to boost efficiency, restrain growth in unit labour costs and ultimately facilitated a strong employment recovery in the past year.  This behaviour represents a rational response to what has been one of the largest negative terms of trade shock in Australia's history; the ratio of the prices the country receives for its exports relative to the prices it pays for its imports has declined by one third in less five years. Yet, corporate profitability has been remarkably resilient, falling by less than 10% over this period (see chart).

RBA Governor leaves the door further ajar for more monetary stimulus

The Governor re-iterated the central bank's easing bias, drawing attention to the fact path the inflation outlook does not pose an obstacle to further monetary stimulus if deemed necessary to support demand.  In contrast to the Governor's last testimony in September, Mr Stevens did not cite concerns that very low interest rates could foster a worrying debt build-up, nor did he refer to the macro-prudential measures implemented by APRA to maintain sound lending standards.  This suggest that central bank has left the door further ajar for more monetary stimulus.

Offshore earners struggle despite A$ weakness

Since September, the Australian dollar has remained broadly steady at a little above 70 US cents.  In the past five years, the local currency has been resilient, depreciating by 35% against the US dollar at the same time as global commodity prices have declined by 60%.  But the longer sweep shows that the A$ and commodity prices do not necessarily move lock in step; the lift in commodity prices during China's boom of the mid-2000s far outstripped the A$ appreciation at the time (see chart).  At its current level of 71 US cents, the A$ is 8% below its level that prevailed the last time the RBA commodity price index was at these levels in mid-2005.

Evidente's econometric model of the currency shows that at current levels, the A$ is broadly in line with fair value (see chart). 

After what had been strong out-performance for a little over three years, ASX listed US dollar earners have struggled in the past year, despite renewed A$ depreciation (see chart).  During this time, the overweight bet in offshore earners has remained a crowded trade.

The large cap US dollar earners have been de-rated in recent months, in line with the broader market.  The basket is trading on a median prospective earnings multiple of 18x, but continues to trade at a premium to the market (16.5x).  The premium reflects stronger long-term growth prospects and a lower beta (see chart).  Despite this, the percentage of buy recommendations from analysts is comparable across US$ earners and the top 100.  Despite the lofty multiple for Cochlear, the stock has continued its strong performance, jumping by 15% on its interim result.

From a longer term perspective, the Big Mac index suggests that the A$ is under-valued against the US$ by 25%, which represents the biggest under-valuation since 2003 (see chart).  Deviations from purchasing power parity can extend for long periods.  But short-sellers of the local currency should be cognisant that the US$ at present, is over-valued against all but three currencies based on the Big Mac index, notably the Swiss franc, Swedish krona and Norwegian krone.

Australian growth to remain stuck in the slow lane

At its first meeting for 2016, the RBA Board left the Overnight Cash Rate unchanged at a multi-decade low of 2%, as widely expected (see chart).  There was little change in the communication from the last meeting's statement two months ago.  It cited that global growth is lower than earlier expected, particularly in China and other emerging economies.  Risk appetite has diminished somewhat and credit conditions for low quality corporates has tightened, although funding costs remain low for high quality corporates. 

GDP growth came in below average in the second half of 2016, but business sentiment lifted to above average levels and labour market conditions continued to firm, reflected in a pick up in employment growth and a lower unemployment rate.  Underlying inflation is expected to remain at 2% thanks to the prospect of still low growth in productivity adjusted wages (ie. Unit labour costs) and spare capacity in the global economy. 

Against this backdrop, the RBA re-iterated that monetary policy needs to be accommodative.  Macro-prudential policies are helping to contain risks in the housing market, reflected in a moderation of house price increases in Sydney and Melbourne, and a changing composition in lending towards owner-occupiers and away from investors.  

The RBA identified two key developments it would monitor closely; whether the firming of labour market conditions would continue and whether the recent financial market turbulence points to prospects of weaker global and domestic demand.  It maintained its easing bias, stating that the inflation outlook provides scope for further policy easing if deemed necessary.

The RBA appears to be content for the Australian economy to operate with a degree of spare capacity.  It is clearly drawing some comfort from the improvement in labour market conditions, which is a welcome development.  While increased labour demand has played a role here, I suspect that an expansion in the labour supply can help to reconcile strong growth in employment with the absence of wage pressures.  

On face value, the renewed depreciation of the Australian dollar appears to be contributing to an easing of financial conditions.  But on closer inspection, it seems to reflect the weaker global growth environment and US dollar strength.  In the past five years, the Australian dollar has declined by 35% against the US dollar but by only 20% on a TWI basis (see chart).  Moreover, based on the Economist magazine's updated Big Mac index, the US dollar is under-valued against only three other currencies.

Australian growth to remain stuck in the slow lane

The RBA is content for growth in the Australian economy to remain in the slow lane over the course of 2016 and is hoping that the non-mining sectors grow enough to ameliorate the effects of the slump in mining business investment.  Evidente remains of the view that at least one more rate cut (and most likely two) is necessary to revive animal spirits in the corporate sector and boost household consumption.  International developments might well force the hand of the reluctant rate cutter, notably more monetary stimulus from central banks in response to further deterioration in the global growth environment.   

Weekly Impressions - Reminder to investors: Do not under-estimate Haruhiko Kuroda

In last week's post (Super Mario to the Rescue?) Evidente recommended that investors take a tactical overweight position in global equities on the expectation that the Bank of Japan and European Central Bank would have little choice but to deliver more monetary stimulus given the persistent weakness in their economies and the continued shortfall of underlying inflation measures relative to target. 

The announcement from the Bank of Japan of more stimulus was therefore not surprising to Evidente, but the introduction of a negative interest rate was.  Gauging by the deprecation of the yen and lift in global stock markets, the announcement was a shock to investors more broadly.   An interest rate of -0.1% will effectively apply to incremental or new reserves that commercial banks hold at the BOJ.

As Evidente read through the BOJ's press release on Friday, I was struck by the complex nature of the framework.  It has adopted a multi-tiered system in which the outstanding balance of each commercial bank's current account at the BOJ will be divided into three tiers in which a positive rate of +0.1% will apply to the basic balance, a zero rate will apply to a macro add-on balance and a negative rate of -0.1% will apply to the policy rate balance (see chart).

This might account for why the volatile reaction of the Topix following the announcement, as investors clearly sought to digest the news.  The index ended up strongly, suggesting that investors gradually understood that the negative interest rate on incremental commercial bank reserves would be unambiguously stimulatory for the economy by encouraging financial institutions to lend out funds to households and businesses.

The scale of the market reaction was probably disproportionate to the quantum of the negative interest rate.  But I suspect that the reaction reflects two developments.  First, the BOJ effectively drew  investors' attention to another unconventional policy tool it has at its disposal at the zero lower bound to complement its asset purchase program, including 80 trillion yen a year in government bond purchases.  The market would have more easily processed an expansion of the BOJ's asset purchase program.  But the already large scale of the program meant than any such announcement might have had a muted market reaction due to concerns about diminishing returns.  Second, the recent experience of the Swiss National Bank, which has a target range of its policy rate of -0.25% to -1.25%, suggests that the BOJ has ample scope to lower its negative interest rate further if deemed necessary.

Despite the narrow 5-4 majority vote in favour of the negative interest rate, the BOJ's announcement should provide investors a timely reminder of Mr Haruhiko Kuroda's determination to rid Japan of its fifteen year long deflationary mindset.  The next two central bank developments to watch for are the prospect that the FOMC members have little choice but to downgrade their internal projections for a further three hikes to the federal funds rate this year, and the next monetary policy meeting of the ECB's Governing Council on March 10th, in which Evidente expects the ECB to deliver more monetary stimulus.  With the prospect of more central bank stimulus globally, Evidente continues to recommend that investors take an overweight tactical bet in global equities and risk assets more broadly. 

Tame inflation data and market turbulence unlikely to sway the RBA

Australia's December quarter CPI confirms that inflation remains benign and that the inflation outlook does not pose an obstacle to further monetary stimulus.  The RBA's preferred measures of underlying inflation increased by 0.5%-0.6% during the quarter and are now around 2% higher than a year ago, which is at the bottom end of the RBA's target range of 2%-3%.  The disinflation in the underlying measures has persisted now for around two years (see chart).

The 10% plus depreciation of the Australian dollar in the past year is gradually passing through to higher consumer prices, with inflation of tradeables lifting to a year-on-year rate of almost 1%.  Considering the scale of A$ deprecation in recent years, the pass through to higher retail prices remains modest probably thanks to intensive competitive pressures amongst retailers and supply chain efficiencies.  At the same time, disinflation in non-tradeables remains strong, with the year-on-year rate moderating to sub-2.5%, well below the he peak in 2013 of over 4% (see chart).

The provision of non-tradeables has a high labour content.  The disinflation of non-tradeables in recent years is therefore consistent with the moderation in private sector wages growth to a record low since the inception of the series in the late 1990s (see chart).  The slowdown in wages growth is at odds with the pick-up in employment growth in the past year.  I suspect that an expansion of the supply of labour can reconcile low wages growth and firming labour market conditions.

The Australian economy set to remain in the slow lane in 2016

Mr Glenn Stevens has proven to be a reluctant rate cutter during this prolonged easing cycle.  The tame December quarter inflation data are unlikely to sway the RBA board at February 2nd meeting.  In the central bank's latest communication about the inflation outlook in November, it expected underlying inflation to remain around 2% over the course of 2016.  Today's release would have come in broadly in line with the bank's own forecasts and thus will do little to change that view. 

Nor is the renewed turbulence in financial markets of recent months influence the RBA's deliberations.  Mr Stevens' has communicated from time to time that he believes that risk premia in financial markets are compressed and that investors are too complacent about risk.  He would therefore see the renewed volatility of recent months as a welcome development.

I have long held the view is that more monetary stimulus is necessary to revive the animal spirits in the corporate sector, particularly given that the economy is on the precipice of a capex cliff.  The inflation outlook does not represent a hurdle to further rate cuts as is reflected by the RBA's own easing bias.  The tame inflation data combined with the slide in global oil prices provides a great opportunity for the central bank to deliver more stimulus at next week's board meeting, and frame a rate cut with a positive narrative. 

But the reluctant rate seems to be content with the Australian economy growing at a sub-trend rate for a while longer, and probably wants to see more tangible evidence of a cooling property market before cutting rates again.    Although the economy needs more monetary stimulus, my view is that another rate cut won't be forthcoming next week. 

Weekly Impressions: Super Mario to the rescue? Not just yet

The relationship between market participants and the President of the European Central Bank has been a turbulent one in recent times.  Financial markets were clearly disappointed at the outcome of the meeting of the ECB’s Governing Council in early December, with the euro strengthening and global stock markets falling sharply despite the announcement that the ECB would extend its asset purchase program by six months, which is now intended to run to March 2017 or beyond if necessary.

Mr Mario Draghi has long struggled to convince the inflation averse Bundesbank for the need for more aggressive monetary stimulus.  The unnecessarily wordy and absurdly low inflation target of a 2% ceiling adopted by the ECB reflects the influence of the Bundesbank.  The widely documented upward bias of consumer price indexes globally, thanks to the rapid improvement in the quality of e-services suggests that a 2% measured inflation rate equates to a modest deflation.

The poor market response to the ECB’s decision in early December and an assist from the recent slide in oil prices appears to have given Mr Draghi the upper hand against the inflation hawks internally.  At the latest ECB press conference on January 21st, Mr Draghi flagged that the ECB would need to re-assess its monetary policy stance at the next meeting in early March because euro area inflation dynamics continue to be weaker than expected.  The ECB now expects the path of annual HICP inflation in 2016 to be significantly lower compared with the outlook in early December.

To boost the ECB’s credibility in terms of its ability and willingness to achieve its inflation target, the central bank will likely need to announce an expansion and extension of its asset purchase programme at its next meeting.

Decisive action necessary to rid Japan of its deflationary mindset

The Bank of Japan is similarly facing a battle to combat persistent disinflationary headwinds.  At the time of writing this post, Reuters has reported comments from the BOJ Governor at the World Economic Forum that indicators of inflation expectations have been somewhat weak and that the central bank would not hesitate to adjust policy settings again to achieve its 2% inflation target.  At present, consumer prices in Japan excluding fresh food and energy are only 1.2% higher than a year ago.

These comments echo those made in a speech by the BOJ Governor on January 12th, in which Mr Kuroda acknowledged that the central bank’s efforts to achieve its price stability target of 2% are only halfway there, and that decisive action is necessary to eradicate Japan’s fifteen year long deflationary mindset.

Since the launch of Abenomics in 2012, analysts have lifted their expectations of profitability for the Topix companies by 75%.  In contrast, forecasts of profitability for the Euro Stoxx 600 companies have remained stagnant for the past five years (see chart).  Along with the disinflationary headwinds buffeting the euro area, this represents another clear signal that Mr Draghi has more work to do.

Tactical overweight in global equities

In the past month, investors have clearly been unnerved by renewed concerns around persistent disinflationary headwinds in the euro area and Japan, China's growth prospects, and the FOMC members' projections pointing to at least another three hikes to the federal funds rate over the course of 2016.  It is difficult to reconcile these projections with communications from various Fed officials that the process of monetary policy normalisation will be gradual.  The Fed Governors are likely drawing some comfort from the continued firming of labour market conditions, but at the same time various indicators of US manufacturing activity are contracting.

Despite the weakness in global stock-markets in the past month, earnings multiples for the S&P500, Euro Stoxx and ASX200 remain above their ten year medians.  Nonetheless, with Messrs Draghi and Kuroda signalling that more stimulus is on the way, and increased likelihood that the FOMC participants will have little choice but to downgrade their projections for the federal funds rate as the IP cycle in the United States tips over, Evidente recommends investors have a tactical overweight bet in global equities. 

Weekly Impressions - Light at the end of a still long tunnel for commodities

Since the devaluation of the Chinese Yuan in August, the US dollar has appreciated by over 6% against the currency, with the PBOC undertaking a further devaluation most recently on January 6th (see chart).

The adverse impact the devaluation has had on global financial markets reflects the signalling effect; in much the same way that a cut to dividends signals to investors that the insiders are concerned about a company’s future growth prospects, market participants have inferred from the devaluation that Chinese authorities have a pessimistic view about the economy’s growth trajectory.

These concerns are well founded: manufacturing and industrial production remain in a funk (see chart), renewed volatility in the Shanghai Composite Exchange has rattled confidence, and many residential and commercial property markets are suffering from an inventory glut.  The authorities' efforts to stabilise the stock market also probably contributed to a crisis of confidence.

What seems to have gone under the radar in much of the press and commentary is that the Chinese Yuan (CNY) has undergone a significant appreciation in recent years.  In real or inflation adjusted terms, the CNY has appreciated by 60% against a basket of its major trading partners over the past decade. In contrast, the US dollar effective exchange rate is only now back at the level that prevailed a decade ago (see chart). The real appreciation of the CNY amounts to a significant tightening of monetary conditions in China.

The classic symptoms of a domestic cyclical downturn besetting China are tied up with the strong appreciation of the currency over the past decade.  This is not to deny China's many structural challenges, including much needed reform of the financial system and re-balancing of growth towards consumption.  Such structural reforms are necessary to help China achieve sustainable growth over the medium term.  But China is also currently suffering from deficient demand and an ongoing re-alignment of its currency and the associated monetary stimulus represents an appropriate policy response.

Indeed, the CNY would likely have long depreciated if it had been a floating currency.  The PBOC has not put up the white flag; it is right to seek to re-align the currency with the economy's fundamentals. The scale of the real appreciation on the CNY over the past decade and weakness in manufacturing sectors suggests that further and significant devaluation is a likely prospect.  Any such re-alignment will help to stimulate the economy and unwind some of the decade long appreciation.

If the PBOC can see through the market turbulence and keep its resolve to stay the course with further devaluation, this should help to stabilise the manufacturing sector and property markets.  Against this backdrop, there promises to be significant upside to commodities from current levels.  But not just yet.

Weekly Impressions: Investor appetite for infrastructure assets to remain strong

In December, Evidente published a post which cited a speech from Governor Lael Brainard, in which she discussed the likely path for monetary policy normalisation, based on the framework of the neutral rate of interest.  This is the federal funds rate that is consistent with output growing close to its potential rate with full employment and stable inflation.  Tepid growth in the US economy and quiescent inflation suggests that the neutral rate is not far above the federal funds rate.  Ms Brainard indicated that the neutral rate would remain low (possibly close to zero) for some time to come and concluded that the normalization of the federal funds rate is likely to follow a more gradual and shallower path than in previous tightening cycles; what Evidente depicts as the new normal of low and slow.

A recent speech from Vice Chairman Stanley Fischer suggests that the secular decline in the neutral rate of interest is guiding the Fed’s view and internal debate around policy normalization.  Vice Chairman Fischer speculates that the world is moving toward a permanently lower long-run equilibrium real interest rate, consistent with the fall in the level of longer-term real rates observed in the United States and other countries (see chart).

A world with a permanently lower neutral interest rate thanks to structural shifts

The balance between desired saving and investment intentions governs the neutral rate; a lift in intended saving over investment has led to a lower neutral rate in equilibrium.  Vice Chairman Fischer cites a number of developments that have contributed to the shortfall in investment relative to saving: deficient aggregate demand since the financial crisis, the low capital intensity of the IT sector, a slowdown in productivity growth, the demographics of ageing, and high savings rates in emerging markets combined with a shortage of profitable investment opportunities in those countries.

In a supply-demand framework, the supply curve for saving is upward sloping because a higher interest rate is associated with greater supply of saving, while the downward sloping demand curve corresponds to investment demand.  The developments cited by Fischer correspond to an outward shift of the supply curve and left shift in the demand curve, which produce a lower neutral rate in equilibrium (see chart).

To the extent that these structural shifts are long lasting, Fischer suggests this supports the case for the neutral rate remaining low for the policy relevant future.  Consequently, it is likely that the zero lower bound will continue to constrain monetary policy at times.  In other words, lift-off in December does not imply that the federal funds rate won’t return to zero in the foreseeable future.  This represents a subtle hint from Fischer that growth in the US economy might remain tepid for some time and that inflation will remain low thanks to the long lasting powerful impact of excess desired saving over investment intentions.

Fischer offers an innovative means of lifting the neutral rate and thus easing the constraints imposed by the zero lower bound; an expansionary fiscal policy designed to improve the stock of public infrastructure.  Presumably he is implying that the social rates of return of such public investments would exceed the required rates of return.

Environment conducive to continued strong returns from listed infrastructure assets

Infrastructure assets have been amongst the best performing sectors on the ASX over the past decade.  Sydney Airport has yielded an accumulated return of 19% over this period, while gas line operator APA has produced a return of 17.5%, and toll-road operator has delivered a return of 11.5%, well above the ASX200 return of 5.5% (see chart). 

Large depreciation charges for these stocks depress reported earnings, thus rendering standard earnings multiples meaningless as valuation yardsticks.  But the strong performance of the sector has lifted free cash flow multiples to record highs. Nonetheless, if Fischer is right that the saving-investment imbalance is expected to persist and hold down the neutral rate of interest for the policy relevant future, then the new policy normal of low and slow should provide an environment conducive to continued strong returns from listed infrastructure stocks. 

Concluding remarks

In summary, I expect that investors will continue to pay a premium for the earnings certainty and long duration that infrastructure assets offer, a desirable attribute for sovereign wealth funds and pension funds with a long investment horizon seeking assets that match the long duration profile of their liabilities. 

Of course, the strong appetite from this clientele for low risk assets offering some growth comes with a sting in the tail.  The higher prices for these assets point to lower expected future returns.  Based on Fischer and Brainard's assessment of the slow process of policy normalisation, this dynamic has some way to play out.  Against the backdrop of the new policy normal of low and slow, investors should treat any price pull-back in the sector as a buying opportunity. 

Weekly Impressions: Behavioural traps to avoid - Overconfidence

It has been a good year of performance for many Australian fund managers, with the average active stock fund delivering returns well above the benchmark thanks in part to underweight bets in resources and the major banks.  Despite the out-performance, various structural headwinds continue to retard growth of inflows into active funds, including: the shifting locus of power towards asset owners, limited diversification benefits offered by a highly concentrated benchmark, and strong appetite for lower cost ‘smart beta’ products.

With the day to day portfolio responsibilities less pressing at this time of year, it represents a good time to reflect on some of the pitfalls associated with active management.  Drawing on the burgeoning field of behavioural finance, this post investigates the behavioural trap of over-confidence and addresses how portfolio managers can reduce the prevalence and costs associated with over-confidence. 

Skill or Good Luck?

Behavioural finance is the intersection of applied psychology and the behaviour of financial market participants.  Researchers have done a tremendous job in elucidating the heuristics or mental rules of thumb that investors (and broking analysts) rely on, which contribute to systematic errors in judgement and decision-making.  One of these heuristics is self attribution or over-confidence, where people attribute their good performance to skill or judgement, and poor performance to bad luck or factors beyond their control.

Although these errors are not unique to financial market participants, such errors can be costly, particularly when portfolio managers are managing billions of dollars.  If enough investors suffer from such biases they also lead to significant limits to arbitrage, which imposes costs and risks on other investors.

A number of widely cited studies in the field of applied psychology document the above average driver effect, in which the overwhelming majority of respondents believe that their driving abilities are above average.  Over-confidence or illusory superiority is not confined to self-perceptions of driving ability.  Many people over-estimate their abilities, knowledge and future prospects compared to other people.

Over-confidence and excessive trading hurts your portfolio performance 

Terrance Odean and Brad Barber have explored the effects of over-confidence in financial market settings. Over-confident investors over-estimate the precision and accuracy of their information, which lifts the likelihood that such investors trade too frequently based on their perceived superior information. The empirical evidence is not kind to over-confident investors; the more individual investors trade, the more they lose.

Odean and Barber use over-confidence to link gender with trading performance. Female portfolio managers have superior track records than their male counterparts thanks to lower churning of their portfolios because they are less prone to suffering from over-confidence. Individual investors are found to trade more after they experience high stock returns, which might explain why aggregate turnover increases after periods of high market returns. 

Shhh...Listen First, Speak Last

Portfolio managers that work in a group setting might draw some comfort from the fact that group decision making helps to address or neutralise the behavioural biases that individuals exhibit, including over-confidence. But group decision making can also be beset by psychological biases, notably groupthink. A head of equities with a strong personality who expresses his view forcefully can effectively discourage junior members of the team from freely expressing their own views that challenge his. In his auto-biography, Courage to Act, Ben Bernanke explains that he sought to reduce the prevalence of groupthink by speaking last at the FOMC meetings. 

Ironically, the evolution in the structure of the funds management industry might actually reward over-confidence. Fund of funds and asset consultants are increasingly shifting towards a core –satellite approach to portfolio construction, where index and smart beta products are combined with high conviction/high tracking error funds. These funds typically require PMs to have a high degree of confidence in their stock calls, and be willing and able to take large active bets.

In a recent paper, David Hirshleifer and Kent Daniel suggest that overconfidence contributes to the profitability of the betting against beta trade, which represents the poor returns from high beta stocks.  Overconfident PMs – particularly those working in high conviction funds whose clients expect high returns - are more likely to buy high beta or cyclical stocks to generate outperformance.  The strong appetite for such stocks lifts their price and drives down their expected future returns.

In praise of humbleness

The literature on over-confidence in financial markets suggests that PMs ought to be more humble and trade less. Even when investors believe that they have access to superior information, they should be cognisant of the limits and costs to arbitrage, which can cause mispricing to persist for an extended time. To reduce the likelihood of becoming over-confident in their own sectors, PMs should be encouraged and incentivised to seek out opportunities and challenge the views of PMs responsible for other sectors.

Heads of equities should encourage a collaborative and collegiate team environment, where members are not afraid to debate and express views that challenge the consensus view internally.  And PMs should document their views rigorously in real time, to ensure that over-confidence does not also morph into hindsight bias.

Weekly Impressions - The new normal: Low and slow

Mr Draghi undershoots on expectations and inflation

Financial markets were clearly disappointed at the outcome of the meeting of the ECB’s Governing Council overnight, with the euro strengthening and global stock markets falling sharply despite the announcement that the ECB would extend its asset purchase program by six months, which is now intended to run to March 2017 or beyond if necessary.

At the September meeting, ECB President, Mr Mario Draghi, had clearly raised expectations of more monetary stimulus at the December meeting than was announced.  The market’s disappointment stems from the poor run of monthly inflation data since then; readings for the months of October (+0.2%) and November (-0.2%) were particularly disappointing.  As a result, the core Harmonised Index of Consumer Prices (which strips out food, energy & tobacco) is only 0.9% higher than a year earlier, a long way from the ECB’s inflation target. 

The ECB’s own staff projections indicated slightly weaker inflation dynamics than previously expected.  If the run of poor inflation data continue and if core inflation continues to undershoot its target by such a long way, Evidente expects more aggressive monetary stimulus – specifically a lift in the run rate of monthly asset purchases of 60 billion euro - at the next meeting of the Governing Council.

The global stock market response to the ECB’s announcement represents another nail in the coffin for the military analogy of currency wars.  The euro rose by 2½% against the US dollar.  But contrary to a key prediction of the currency wars thesis – that the lower US dollar would boost the competitiveness of exporters - US stock markets fell by over 1% following the announcement.

Lift-off this month would be premature...

At her testimony to Congress, Federal Reserve Chair, Ms Janet Yellen, laid the intellectual framework for lift off at the FOMC meeting later this month, citing three key factors.

• Ongoing gains in the labour market suggest that inflation will return to its 2% target as the transitory effects of lower commodity prices and a stronger US dollar will wane.

• Were the Fed to delay the normalisation of monetary policy for too long, it would risk having to hike interest rates quickly due to the lags in the operation of policy, thus lifting the likelihood of turmoil in financial markets.

• Holding the federal funds rate at its current level for too long could encourage excessive risk-taking and thus undermine financial stability.

Evidente’s econometric modelling of US inflation suggests that if commodity prices and the US dollar remain unchanged from current levels, core inflation will rise over the course of next year but remain well below 2% by the end of 2016.

The proximity of the financial crisis suggests that the Fed is justified in being concerned about financial stability.  But more targeted macro-prudential policies designed to reduce the size and influence of the shadow banking sector, and lift the loss absorbing capital on the balance sheets of financial institutions would do far more to reduce systemic risk of the financial system.

Evidente remains of the view that the Federal Reserve will be committing a policy error by undertaking lift-off at a time when core inflation is undershooting its 2% target by over 50 basis points.  But of some comfort is an evolution of communication from Fed officials that the new normal of monetary policy normalisation will be low and slow.

...But the new normal will be low and slow

Governor Lael Brainard has invoked the Wicksellian concept that the appropriate pace and target for normalizing monetary policy depends centrally on understanding the neutral rate of interest; the level of the federal funds rate that is consistent with output growing close to its potential rate with full employment and stable inflation.  When the federal funds rate is below the nominal neutral rate, monetary policy is accommodative, and, when it is above the neutral rate, policy is contractionary.

Ms Brainard argues persuasively that the fact that the U.S. economy is growing at a pace only modestly above potential while core inflation remains restrained suggests that the nominal neutral rate may not be far above the nominal federal funds rate, even now.  Drawing on market measures of forward rates and surveys of economists, Ms Brainard suggests that the neutral rate will remain low (possibly close to zero) for some time to come.

Ms Brainard speculates that a higher expected equity risk premium (associated with risky investments) has contributed to the reduction in the neutral rate of interest.  A higher risk premium necessitates a lower risk-free rate to encourage the same amount of riskier investments as previously.  A higher risk premium is consistent with the earnings yield on stocks remaining broadly unchanged at a time when the risk free rate has trended down for years and can explain the sluggishness in growth of global capital investment during this recovery (see chart).

Ms Brainard concludes that the lower neutral rate means the normalization of the federal funds rate is likely to follow a more gradual and shallower path than in previous cycles.  Evidente expects the new normal of low and slow to be reflected in the language of the statement accompanying the decision to engage in lift-off, which should reduce the likelihood of a broad based sell-off in risk assets.

Dissecting Australian Retailers' CSR Credentials | Unlocking Embedded Value in Myer's Iconic Brand

The Rise of the Asset Owner

The fulcrum of power and influence in Australia’s sophisticated retirement income system has been gradually shifting towards asset owners – particularly industry super funds – from asset management firms that utilise active strategies.  The shifting sands reflects four developments.

• The poor performance of active equity funds in Australia during the financial crisis has led to scepticism about the ability of these funds to deliver sustainably strong returns to outperform the ASX200, net of fees. 

• The growing scepticism about the value add offered by high cost active equity funds has come at a time when there has been renewed focus on costs and management expense ratios, which has led to strong investor flows into low cost index, enhanced index and exchange traded funds. 

• The introduction of My Super has put pressure on pension funds to shift their allocation to these lower cost funds and asset classes, and also bring investment capabilities in-house.

• The Superannuation Guarantee – the 9.5% compulsory superannuation contributions made by employers on behalf of employees – has underpinned strong growth of inflows into industry super funds at a time when many firms operating in financial markets have downsized due to lower growth in revenues and profitability.

Against this backdrop, a cottage industry has emerged around Environmental, Social and Governance (ESG) considerations, which has been given an assist by the fact that many institutional investors in Australia have signed up to the United Nations Principles of Responsible Investing.  Not-for-profit campaign communities such as Getup! have been successful in raising awareness public and investor awareness around issues relating to economic fairness and environmental sustainability, social justice, including the plight of refugees being held in Australia’s detention centres.

A key implication of the shifting locus of influence towards the asset owners has been renewed interest in ‘activist’ investing.  Industry super fund led Divest campaigns have attracted tremendous media attention in Australia over the past year, including decisions of various pension funds to divest fossil fuel companies, coal miners, tobacco manufactures and the old Transfield Services (the new Broadspectrum).  Asset owners and institutional investors are more proactive during AGMs and use the proxy process to affect corporate governance policies.

Sharper focus on corporate social responsibility

Australia’s changing investment landscape is having an impact on corporate policies around factors as disclosure, climate footprint, remuneration, board independence, treatment of employees and other key stakeholders, and license to operate.  As asset owners and institutional investors continue to flex their muscle, listed companies will increasingly need to balance the goals of maximising profits and shareholder value with reputational risks around managing ESG considerations.

Retailers are particularly exposed to these developments because of the frequent contact that the community have with their stores and the high level of investor recognition they have.  This clearly has benefits in terms of promoting their respective brands but it can also be costly for retailers to manage reputational concerns if something goes wrong.

Earlier this year, Evidente noted the Four Corners program (Slaving Away) which went to air on May 5th, which showed damning evidence of exploitation of migrant workers in Australia's fresh food supply chain.  The allegations were levelled at stores that sell fresh produce to the public, including Woolworths, Coles, Aldi, IGA and others.  Four Corners posted to its website the written responses from each of these businesses, including Woolworths.

Although each of the supermarket chains deals with hundreds, possibly thousands of suppliers, the big supermarket chains need to be careful about managing their reputational risk, particularly as the community and governments have effectively conferred a license to operate to Woolworth, Coles and other supermarkets.  The sheer size of Woolworths and Coles suggest that they have more to gain from leading the charge and ensuring that their suppliers do not engage in worker exploitation.

As retailers continue to extract synergies and efficiencies from their supply chain management, they will need to carefully manage ESG considerations that might adversely impact on their suppliers.

More recently, the 730 Report has drawn attention to the practice of ‘sham contracting’ used by Myer.  A whistle blower – who was a cleaner at the flagship Myer Melbourne store - who raised his concerns to the media recently about being paid below award rates without superannuation or other benefits, has been fired.  Myer contracts out its cleaning services to Spotless which sub-contracts to another firm.  According to the 730 Report, this firm then hired cleaners as ‘contractors’ to avoid paying various entitlements under the award system.  The sub-contractor has been ordered to reimburse cleaners who were paid below the award rate and denied penalties by the Fair Work Ombudsman.

Retailers – particularly those who invest so much in their brands – will increasingly need to be careful about managing these relationships, particularly in a climate where asset owners and institutional investors are increasingly focussed on corporate social responsibility.

Myer: Unlocking the embedded value in an iconic brand

Myer’s poor market performance since re-listing around five years ago has been underpinned by negative earnings surprises, with the current 12 month forward PE of around 11x comparable to the level that prevailed in 2010 (see chart).

Growth in revenues and profitability has suffered due to structural challenges facing the department store business model including greater competition from e-tailers, a household sector keen on undertaking balance sheet repair in the wake of the financial crisis and up until recently, a strong Australian dollar, which has encouraged foreign entrants into the space.  As a result of these developments, department store sales have flat-lined in the past three years while household goods retailing and clothing & soft goods retailing have lifted substantially (see chart).

Evidente has suggested previously that some of these headwinds facing discretionary retailers are gradually transforming into tailwinds.  The household saving rate remains high by historical standards (at levels prevailing in the late 1980s) so there is scope for it to fall, particularly in an environment where the change of government leadership in September has given consumer sentiment a fillip.  Evidente believes that more monetary stimulus is necessary to support consumption and non-mining business investment.  The Australian dollar has depreciated in recent years, which is likely to discourage further foreign entrants into department stores.

Ultimately, new management at Myer will need to address the structural challenges facing the business model.  The recent equity raising of over $200 million has helped to shore up the balance sheet.

Against the industrial universe, Myer remains cheap on an ROE adjusted price to book basis, with the stock lying 30% below the trend line, suggesting the much of the pessimism is already priced in (see chart).  However, reported earnings (and therefore forecast earnings) are probably overstated to some extent because ongoing expenses associated with restructuring the business in recent years have been treated as non-recurring items.  Myer however is not the only company undergoing restructuring to have used their discretion to bring such items below the line.  Nonetheless, this practice probably overstates the stock’s valuation support.  Much also depends on the transformation of the David Jones business model under the new ownership of Woolworths Holdings. 

If the new CEO, Mr Richard Umbers is able to unlock the embedded value in the iconic brand that Myer represents, Evidente expects that patient investors will be rewarded.

Weekly Impressions: Australia's export revolution to China's Rising Middle Class

The key macro announcement in Australia in the past week was the stronger than expected employment print for the month of October.  Total employment lifted by almost 60k and the unemployment rate dropped to 5.9% from 6.2%.  Expectations of a December rate cut have consequently diminished.  Evidente has been of the view for a while that given the spare capacity in the economy and labour market, the RBA should deliver more monetary stimulus.  One strong monthly employment outcome is not sufficient to alter my view that labour market conditions are slack and that another rate cut is necessary, for three reasons.

• The labour force survey is widely understood to be plagued by sampling problems which have meant that the monthly estimates have become more volatile and a less reliable barometer of the cyclical weakness or strength of the labour market.
• As long as these sampling issues remain, the Wage Price Index becomes an increasingly important indicator to assess the state of the labour market.  On this front, there is little to concern the inflation hawks; private sector wages in the past year have grown at their lowest rate since the inception of the series in the late 1990s. 
• Employment growth and core inflation have moved in opposite directions this year.  The lift in employment growth in the past three quarters – the strongest gains since the back end of the credit boom (see chart) – has been associated with a drop in core inflation.  Evidente has written on the phenomenon of a flatter Phillips Curve more extensively for the United States; in recent years, disinflation has intensified at a time when the unemployment rate has dropped 300 basis points to 5%.  Why various measures of economic slack are becoming increasingly unreliable gauges for inflation in countries like Australia and the United States remains puzzling.

China's Rising Middle Class and the Upheaval in Australia's Exports

A number of developments in the past week confirmed that Australia's exports to China are undergoing a revolution thanks to inexorable rise of China's middle class.  At a time when BHP dropped briefly to below $20 – its lowest level since 2005 due to the Samarco dam disaster and renewed weakness in crude oil prices – the news-flow in Australia focussed on the growing shortage on supermarket shelves of Bellamy’s baby formula, while overseas arrivals from China continue to surge.    

Chinese demand for Australia's agri-food products, vitamins, wine, tourism, higher education and other non-commodity goods and services will continue to grow strongly and help diversify our export basket.  In an environment where the aggregate supply of growth in Australia is anaemic, the rise of China's middle class is a powerful and seductive investment theme that offers strong growth prospects to Australia's non-commodity exporters.  

Australia's White Gold Rush

Tasmanian based company, Bellamy’s (BAL AU Equity) – which produces organic certified baby formula - has captured the imagination of investors and the media due to the lift in the share price this year from less than $2 to close to $10.  In recent weeks, the shortage of baby formula in supermarkets has become a barbeque stopper in Australia, made more severe by Singles Day in China on November 11th.  Evidente can vouch for the shortage on supermarket shelves; recent visits to the local Coles and Woolworths supermarkets revealed that neither had Bellamy’s baby formula in stock (see photos). 

The issue has even become politicised, with politicians at the federal level voicing concerns that mothers in Australia are missing out.  However this dynamic plays out, the one sure thing is that the stellar returns from companies like Bellamy’s and New Zealand’s dairy company, A2 will attract an influx of new capital and entrants into this space.

Chinese overseas arrivals continue to surge

ata released by the ABS during the week showed that short term overseas arrivals grew by 2.5% in the September quarter to 1.87 million, outstripping growth in short term overseas departures of 1% (see chart). 

This continues a trend evident over the past four years, in which growth in arrivals has exceeded growth in departures, in large part thanks to the renewed weakness in the Australian dollar.  Stocks such as Sydney Airport (SYD AU Equity) and hotel operator, Mantra Group (MTR AU Equity) have been beneficiaries from the lift in growth of tourists visiting Australia, while stocks such as Flight Centrehave been affected adversely by the slowdown in growth of Australians holidaying overseas.

Amongst overseas arrivals, the number of Chinese tourists visiting Australia has grown rapidly and now account for over 16% of all overseas arrivals (see chart).  The growth in Chinese overseas arrivals should also benefit from a recent announcement from the Australian government of the introduction from 2016 of a new 10 year multiple entry visa available to Chinese citizens travelling to Australia.  Australia is the fourth country to offer Chinese nationals decade long visas, following Singapore, the US and Canada.

Weekly Impressions

RBA communications dominated financial markets in Australia over the past week.  Aside from its decision to leave policy unchanged at the November Board meeting, the central bank released its quarterly Statement of Monetary Policy (SoMP) and Governor Stevens and Deputy Governor Lowe delivered speeches. 

Mr Glenn Stevens gave the clearest indication that the RBA has adopted an easing bias, flagging that 'were a change to monetary policy to be required in the near term, it would almost certainly be an easing, not a tightening.'

And for good reason.  In the SoMP, the RBA re-iterated that the inflation outlook poses no obstacle to further stimulus, following the lower than expected 3Q CPI print, and that the +6% unemployment rate and record low growth in private sector wages confirms that there remains spare capacity in the labour market.  Further, the RBA lowered its outlook for GDP growth and inflation (again) and continues to acknowledge that the economy is expected to operate with a degree of spare capacity for a while. 

Against this backdrop, Evidente remains puzzled why the RBA chose not to deliver more stimulus in November to address the shortfall in aggregate demand.  Particularly at a time when the RBA has revised down its real GDP growth forecast for CY2016 to 2.5% from 3.25% in the past year.  Over the coming months, I believe that there will be a growing chorus for the central bank to cut official interest rates again, irrespective of whether the US Federal Reserve engages in lift off.

Macro-prudential policies and a steep learning curve

Mr Philip Lowe drew attention to problems associated with implementing APRA's macro-prudential measures, designed to curb growth in mortgage lending to investors below 10% pa.  The RBA has identified large upward revisions to investor loans over the past six months, and yet in recent months, a sharp fall in investor lending has been offset by a sharp rise in lending to owner-occupiers.

Mr Lowe suggested that lenders' internal systems have not been up to the task of reporting accurate data on the split between investor and owner-occupier loans.  It is reasonable to think that investors are also gaming the system and reporting to banks that they are owner-occupiers to benefit from lower mortgage rates.  The RBA and APRA clearly remain on a steep learning curve in using macro-prudential policies.

More equity does not equate to a higher cost structure

Mr Stevens echoed recent comments by head of APRA, in suggesting that the effect of recent supervisory measures (notably the lift in capital requirements) would have the effect of lowering expected future bank stock returns.  Evidente has previously suggested that a lift in the share of loss absorbing capital in banks' liability mix would have the effect of lowering their expected cost of equity, consistent with the Miller-Modigliani proposition that capital structure is irrelevant for firm value.  A lower expected cost of equity commensurate with a lower risk profile should be viewed as a welcome development, not a lift in a bank's cost structure.

Who is afraid of the robots?

A number of widely cited journal papers in recent years have predicted that the emergence of robots and ongoing automation will render obsolete a large number of occupations, leading to concerns of mass unemployment.

But these concerns are overblown.  Mr Stevens suggested that few can predict where future jobs will come from, and cited the unanticipated growth in employment in computer system design in recent decades, as well as the more recent growth in employment associated with cloud computing services, social media and environmental sustainability services.

How we spend our leisure time is also likely to give rise to occupations that are unimaginable today.  At the turn of 20th century, few could have predicted the rise of tourism related employment, vets or gardeners, simply because the little leisure time we enjoyed at the time, was not devoted to doting on our pets or travelling on holiday.  Futurists who have an eye on history, should therefore have little to be afraid of in terms of the employment consequences of the rise of the robots. 

Domino's Pizza - The risk of strong growth in a low growth environment

DMP finished up 1.3% on the week against a 0.5% decline in the broader ASX200 index.  At its AGM, the company lifted guidance for same store sales to 10% for Australia & New Zealand and 7% for Europe, while new store openings were upgraded to around 270.

The company has defied market expectations for a while now, with sell-side analysts upgrading their forecast EPS for the stock by a compound annual rate of 25% over the past seven years.  This has occurred at a time when the broader universe of ASX200 companies have experienced a growth stall (see chart).  In a forthcoming report, Evidente will provide more detailed analysis around the stock's growth prospects and draw attention to a growing risk that the few stocks offering strong growth are becoming over-priced in low growth environment. 

Weekly Impressions - Competition intensifies amongst banks and supermarket retailers

The banks and supermarket retailers dominated financial market developments in Australia over the past week.  Investors were disappointed by full year results from ANZ and NAB, with the stocks falling by 6-7% over the week, well below the 2% weekly decline in the ASX200.  Woolworths was down 13% following another profit warning, while Wesfarmers was part of the collateral damage of what appears to be a renewed supermarket price war, with owner of Coles supermarkets falling 5% for the week.

Banks – Rebasing dividend expectations

Good news from NAB that it had sold an 80% stake in its life insurance business to Nippon Life was offset by further deterioration in the business banking net interest margin, an acknowledgement that competition in business lending remains intense and a flat dividend for the full year.  ANZ’s dividend was up only 2% for the full year.

Despite marginal improvements in bad & doubtful debts for the sector as a whole, bank earnings are no longer benefiting from such a big free kick as in recent years.  Combined with dormant animal spirits in the corporate sector and anaemic growth in business lending, analysts have scaled back expectations of dividends this year after rapid growth for five years (see chart).

Lift in capital requirements leads to higher equity, not higher costs

The major banks’ desire to halt their deteriorating net interest margins does a better job of explaining the recent lift to mortgage lending rates, than APRA’s recommended lift in capital requirements (see chart).  It remains disappointing that there is a widely held view in the investment community that the lift in mortgage lending rates was a rational response to higher costs of capital.  An increase in the amount of loss absorbing capital or equity finance used to fund its assets represents a shift in capital structure, not an increase in costs.  The lift in capital requirements affects the balance sheet– specifically a change in a bank’s liability mix – not the income statement.

Mr Wayne Byers, the head of APRA, was right to testify to Parliament recently that the increased capital requirements should be associated with lower expected returns from the sector.  By making banks safer and less risky, the Miller-Modigliani Irrelevance Theorem says that more equity capital should reduce banks’ expected cost of equity.

Woolworths – Rebasing expectations

New Woolworths Chairman, Mr Gordon Cairn, swept the slate clean by delivering NPAT guidance for the first half of 2016 that was up to 35% lower than the 1H15 result.  Since Evidente suggested in early June that the risk-reward proposition had become more compelling, analysts have continued to downgrade the stock’s growth prospects, as the company’s supermarket margins come under pressure from Coles and Aldi, and BIG W and Masters continue to perform poorly.

Investors are likely to reward WOW if it divests these businesses in due course, which will leave management to focus on boosting sales and profitability of its supermarket division.  Unlike Tesco in previous years which suffered a series of severe downgrades, Woolworths is not priced for perfection, and remains cheap across earnings and book multiples.  This should help to limit the downside from current levels and probably explains why the price fall in the past week was significantly smaller than the downgrade in guidance.

Supermarket price war augers well for low inflation and lower interest rates

The profit warning was also associated with a sharp fall in Wesfarmers shares, presumably as investors lift the likelihood of a renewed price war amongst the supermarket retailers.  It is another clear signal that growth in consumer demand is struggling to keep pace with the ability for the supermarket chains to grow supply.  Evidente remains of the view that the RBA should respond to the broader shortfall in aggregate demand in the economy by delivering more monetary stimulus at the Board meeting on Melbourne Cup Day.  At present, interbank futures are assigning a probability of a rate cut in November at 50%.

So Mr Stevens...What are you waiting for?

Earlier this month, I discussed five reasons why the RBA ought to deliver more stimulus at the next Board meeting in November: Australia remains stuck in a wage recession, animal spirits in the corporate sector show little sign of revival, macro-prudential measures are curbing rapid growth in mortgage lending to investors, a low September quarter CPI print should offer the RBA the positive narrative that it seeks to cut rates, and the absence of an explicit easing bias has not stopped the central bank from easing in the past.

At the time, interbank futures were implying a 25% chance of a rate cut in November.  Following the release of a benign 3Q CPI, those expectations have ramped up to almost 70% from 30% immediately prior to the CPI print (see chart).

Prior to the CPI release, three developments this month would have influenced the RBA’s thinking. 

• The latest employment report recorded a small contraction in the month of September. 
• The major banks’ decision to lift mortgage rates (dubiously citing APRA’s lift in mortgage risk weights) would have allayed the central bank’s concerns around deteriorating lending practices. 
• The worsening global growth environment has led to expectations of more central bank stimulus globally.  Market participants have pushed back expectations of lift off in the Federal Funds rate to next year, the ECB has flagged that it will consider more monetary accommodation at its December policy meeting and the PBOC has cut the benchmark lending rate to bring the cumulative decline to 165 basis points in the past 12 months.

The 3Q CPI release showed that core inflation recorded a quarterly increase of 0.3%, the lowest outcome since 2011.  The year-on-year increase of 2.2% is remains entrenched at the bottom end of the RBA’s target range (see chart). 

My expectation that food deflation would intensify was not realised.  But the food & non-alcoholic beverage component recorded a rise of only 0.1% and has been broadly stagnant for the past 12 months.  This is unlikely to change while competitive pressures amongst supermarket retailers remain intense.  Electricity retail prices declined by 3.5%, consistent with the recent determinations by the Australian Energy Regulator for lower network charges in NSW and South Australia.

The low core CPI print surprised even Evidente's benign expectations and reinforces the view that the Australian economy continues to suffer from a shortfall in aggregate demand.  The CPI has also clearly given the RBA some comfort that importers are absorbing the effects of the A$ depreciation through lower profit margins, thus limiting the flow through of the lower currency into higher consumer prices.  Importantly, the central bank now has the smoking gun to deliver another rate cut on Melbourne Cup day; a positive narrative of benign inflation. 

So Mr Stevens, what are you waiting for?

Weekly Impressions - Deleveraging dynamic blunts China's Monetary easings

Central bank communications and actions dominated financial market developments over the past week.  The European Central Bank’s President re-iterated the bank’s willingness and ability to use all instruments within its mandate if warranted.

What specifically sparked the rally in global equity markets was Mr Draghi’s acknowledgement that the degree of monetary policy accommodation would need to be re-assessed at the December monetary policy meeting, thanks to downside risks to the outlook stemming from concerns over growth prospects in Emerging Markets and related developments in financial and commodity markets.  Although Mr Draghi cited these concerns at the September press conference, at that time, he suggested that it was too early to assess whether these developments would be transitory.

The shift in Mr Draghi’s rhetoric at last week’s press conference confirms that that the ECB assesses that the risk has increased that these developments – if left unaddressed - could have a long lasting impact on the outlook for prices.

Core inflation has undershot the ECB’s target for the past decade

On that measure, the ECB’s more aggressive rhetoric and stimulus this year reflects a belated acknowledgment that it should receive a fail for its continued inability to meet its inflation target, which is to achieve an inflation rate below but close to 2% over the medium term.  Over the past decade, the core Harmonised Index of Consumer Prices has consistently failed to get anywhere near 2%, with the exception of 2007 and 2008 (see chart).  Although inflation has picked up this year, the year-on-year rate still doesn’t have a 1 in front of it.

The strength and persistence of global disinflationary forces since the financial crisis suggests that the ECB will need to extend (and probably expand) the asset purchase programme to beyond September 2016.  Expect global equity markets to rally on this announcement.

As an aside, the ECB’s inflation target is too high.  Once the upside bias in the measurement of consumer price indices is taken into account – particularly the rapid innovation in the provision of IT and related services – a 2% inflation target translates into modest deflation.  Evidente will explore this in more detail in a forthcoming research report.

Someone forgot to tell global stock markets about ‘currency wars’

The euro depreciated against the US dollar by 3% on the announcement to its lowest level in two months (see chart).  The zero sum game embedded in ‘currency wars’ predicts that outside of Europe, stock markets should have fallen on the ECB’s announcement due to adverse effect of euro depreciation on the competitiveness of non-European exporters.  But not only did European stock markets rally strongly but so did global stocks, including stock markets in the United States.  The overwhelming weight of evidence supports the view that monetary stimulus works by boosting consumption and investment, not net exports.

Deleveraging dynamic blunts China's policy easings

China’s central bank cut its 1 year benchmark bank lending rate by another 25 basis points to 4.35%.  This represents the sixth cut in twelve months, bringing the cumulative decline to 165 bps since November 2014 (see chart).  The benchmark deposit rate was also cut by 25 bps to 1.5% and the reserve requirement ratio (the amount of reserves held be banks) was reduced by 50 bps for all banks. 

The additional policy stimulus is designed to moderate the continued slowdown in various activity indicators, including fixed asset investment and industrial production (see chart).

Growth in industrial production has been particularly weak for construction related products.  Steel industry conditions remain weak, with domestic production having moderated.  Against this backdrop, domestic iron ore production and iron ore imports (including those from Australia) have trended lower (see chart).

The policy easing thus far has done little to mitigate the ongoing deleveraging dynamic in China.  Growth of total social financing continues to moderate due primarily to a sharp slowdown in off-balance sheet financing activity, reflecting both cyclical and regulatory developments (see chart). 

A number of other key developments are weighing on activity and working to blunt the efficacy of monetary policy in China: low efficiency of investment, the decline in corporate profitability, lower interest coverage ratios for SOEs and other excess capacity sectors even as interest rates decline, and the high debt burden of the non-financial corporate sector (see chart).

Dear Mr Hartzer, Please Explain

Dear Mr Hartzer,

In the press release accompanying the announcement on October 14th, that Westpac would be undertaking a $3.5 billion rights issue, you state that “capital raised responds to changes in mortgage risk weights that will increase the amount of capital required to be held against mortgages by more than 50%...to be applied from 1 July 2016.  As a result, Westpac has also announced an increase in its variable home loan (owner occupied) and residential investment property loan rates by 20 basis points.”

Demystifying the myth that capital sits idle in bank vaults

There are two parts of this statement that I do not understand.  The first is a myth that is commonly propagated by bankers; the notion that a bank must ‘hold’ capital, the implication being that it sets capital aside that burns a hole in a bank’s balance sheet while it sits idly in a vault.

This is far from reality.  Let’s start by quantifying the incremental capital requirement.  You’re correct in stating that the capital requirement for mortgages will be 50% higher from 1 July 2016.  At present, the Internal Ratings Based (IRB) risk weights assigned to residential mortgages is around 17% on average for the major banks.  In July 2015, APRA announced that for banks accredited to use the IRB approach, the average risk weight on Australian residential mortgage exposures would increase to at least 25% by mid-2016.  This is designed to narrow the competitive advantage that the IRB accredited institutions (notably the major banks and Macquarie Bank) have over authorised deposit-taking institutions (ADIs) that must use standardised weights.

For ADIs using the standardised approach, risk weights are prescribed by APRA.  The average risk weight for residential mortgage exposures under the standardised approach is around 40 per cent (see chart).

The current IRB accredited risk weight of 17% on a $600,000 home loan equates to a risk-adjusted exposure of $102,000, so a bank would need to allocate $10,200 in additional equity finance to achieve a capital ratio of 10% of risk-weighted assets.  Under APRA’s new guidelines from mid-2016, the new capital requirement increases to $15,000 for the same size mortgage, but remains well below the $24,000 that applies to non-IRB ADIs (see chart).

The nonsense that banks need to ‘hold’ or set aside capital stems from the misconception that bank capital is an asset like reserve requirements.  Bank capital is a liability, which together with customer deposits and wholesale debt, is used to finance a bank's loans.

As you would well be aware Mr Hartzer, the key function that a bank performs is maturity transformation.  It carefully manages its liabilities which are liquid with a short duration, and its loans which are illiquid and typically have long duration.  If a bank uses more shareholders equity in its liability mix, in no way is it forced to cut back on loans or dividends.  On the contrary, it can use those additional funds to lend.  Unfortunately, the terminology is confusing; capital regulation is a regulation of a bank's liabilities, not its loans or assets.

The folly of linking lending rates to capital structure

Which brings me to the second part of your statement that puzzles me; that Westpac has lifted its variable home loan rates in response to the new capital requirements.  This might not be unprecedented but it is highly unusual for a company to link price hikes to the need to use more loss absorbing capital in its liability mix. 

In recent months, a number of ASX listed companies have undertaken rights issues to shore up their balance sheets, including Myer and Origin Energy.  Yet despite the rights issues, Myer did not announce its intention to lift profit margins to fund the incremental capital raised and Grant King has not flagged that he will lift electricity prices that Origin Energy charges customers. 

The technology giant Google uses very little debt in its funding mix and certainly cannot draw on funding from government guaranteed customer deposits.  Despite this, it doesn’t charge users for an array of incredibly useful and valuable services.  Sure, the company benefits from a network effect of attracting a critical mass of users to its services and to that end, offer such services for free or well below marginal cost.  Nonetheless, to my knowledge, outside of the banking sector, CEOs do not propagate a narrative linking their capital structure to prices they charge customers for their products and services.

So Mr Hartzer, why are you seeking to confuse politicians, policymakers and the public by linking the composition of Westpac’s liabilities with the assets or loans that the company writes?  Of course, citing the lift in mortgage risk weights for higher variable home loan rates helps to deflect blame to the prudential regulator.  It might even encourage other major banks to lift their home loan rates and adopt a similar approach in managing their own reputational risk by shifting the onus to APRA.

Nonetheless, I believe that Westpac will need to carefully manage the longer term brand damage if it continues to link further movements in lending rates to the amount of loss absorbing capital in its capital structure.

What’s capital structure got to do with it?

Finally, a number of media reports have suggested that despite APRA's additional capital requirements, Westpac has maintained its target ROE of 15%.  To the extent that these media reports are accurate, their thrust is inconsistent with Miller and Modigliani’s Irrelevance Theorem; that a firm’s capital structure doesn’t matter for firm value.  Increases in leverage leave the weighted average cost of capital unchanged because the expected cost of equity rises, commensurate with the company’s higher risk profile.  Conversely, lower leverage is associated with a lower expected cost of equity, other things being equal.

So the additional loss absorbing capital in Westpac’s capital structure should lower its expected ROE by making the bank safer and more resilient.  The chart below confirms that the largest global banks which are heavily dependent on equity finance in their capital structure tend to have lower volatility of stock returns.

Weekly Impressions: org | anz | WOW

The two key company announcements in Australia in the past week were Origin Energy’s launch of a $2.5 billion entitlement offer designed to strengthen its balance sheet and CEO succession at ANZ, with Mr Mike Smith stepping down after eight years in the role.

Origin Energy (ORG) shores up its balance sheet

In addition to the $2.5 billion entitlement offer, ORG announced that it would adopt a number of other measures to shore up its balance sheet, including cutting dividend guidance, selling non-core assets, and reducing capital expenditure and working capital requirements.

This has occurred against the backdrop of a lift in the company’s ratio of total debt to equity to over 90%, its highest level in a decade (see chart).  If the proceeds from the 4 for 7 rights issue are used to pay down debt –as the company has announced – the gearing ratio will decline to below 70%.  ORG announced on Friday that there had been 92% take up by eligible institutional investors at the $4.00 offer price.

The weight of the academic literature shows that firms undertaking seasoned equity raisings tend to under-perform because company insiders are more likely to issue equity – to finance acquisitions and investment projects - when they believe that their scrip is overpriced.  But the international evidence is more supportive of capital raisings that are designed to strengthen a company’s balance sheet.  In fact, many of the capital raisings in Australia through 2008 and 2009 in the wake of the financial crisis, were associated with subsequent out-performance as investors assigned lower default risk to many of these firms.

The balance sheet impact of lower capex and working capital requirements – up to $1 billion across FY16 and F17 should not be under-estimated.  ORG’s capex spend in FY15 was $1.7 billion, so the planned cut would amount to a 30% reduction in each of the next two years (see chart).  Much will hinge on the outlook for oil prices, but the measures to streamline the asset side of the balance sheet and lift the equity component of the company's liabilities should re-position the company in the event that oil prices remain at current levels.  But it also gives shareholders greater participation in the upside if the outlook for oil prices improves.

Sizing up Mr Smith's footprint

Mr Mike Smith announced that he would be stepping down as ANZ's CEO after eight years in the role.  Much of the media commentary has focussed on the bank's Asian footprint as his legacy.  Has the strategy to expand into banking markets more competitive than Australia to get exposure to the region's rising middle classes been a sound one? 

The company's growth prospects relative to other banks represents a good starting point.  Analysts' forecasts for ANZ's EPS are 20% higher now than when Mr Smith commenced in his role in 2007.  Although this is well above the NAB's performance, it is substantially lower than CBA and slightly lower than WBC (see chart).

 Analysts downgraded the bank's growth prospects more aggressively than WBC and CBA during the financial crisis, and never fully recovered.  In fairness to Mr Smith, ANZ's business exposure - already a feature of the bank's loan book prior to his tenure - largely contributed to the significant downgrade to the company's growth prospects during this time.  The chart below shows that the spike in the sector's non-performing assets during the financial crisis was larger for business loans than for either personal or housing loans.

The fact that the company's price to book ratio remains comparable to NAB's - as it was at the start of the Mr Smith's tenure as ANZ CEO - but worsened relative to WBC and CBA's book multiple confirms that Mr Smith's strategy has not improved the bank's growth prospects relative to its key peers (see chart). 

The difficulty with sizing up Mr Smith's footprint is not knowing the counterfactual; that is, what strategy would Mr Smith have pursued if he had not sought to expand ANZ's Asian footprint?  With the benefit of hindsight, the rapid growth of housing credit - particularly for investors - suggests that ANZ might have benefited from gaining market share from WBC and CBA  in this space and reducing its reliance on business lending, which has remained anaemic.  But this approach could have led to a price war, which would have been detrimental to sector wide profitability and attracted the attention of APRA and the RBA. 

Woolworths: The quest to combat poor value for money perception

The senior management ranks at Woolworths remain in a state of flux, while its CEO succession 'planning'  drags on; it has been over three months since Mr Grant O'Brien announced he would be stepping down.

WOW has been much criticised across a number of fronts, including its willingness to maintain and expand already fat profit margins at the expense of delivering value to the customer, at a time when Coles and Aldi have been competing aggressively on price.

WOW has started to embark on its quest to neutralise its perceived poor value for money. On a recent visit to the local Woolies supermarket, Evidente noticed that staff had put a trolley at the store entrance, with a price comparison that showed that the items in the trolley were 20% cheaper now than at the start of the year. The trolley also drew attention to the fact that prices had dropped on over a thousand products, presumably over the same period (see photo).  Evidente will shortly be releasing a research report, reviewing the investment case made for WOW earlier this year.