Harvest the yield field

PORTFOLIO POINT: Corporate earnings growth will remain subdued and lower interest rates are likely. Investors should focus on sustainable equity yields.

Last week I noted that the lift in the value of the growth portfolio was quite pronounced in the September quarter. Pleasingly the income portfolio has also done quite well.

The portfolio returned 8.4% in the quarter and 7.3% since inception. Readers will note that the income portfolio has not exhibited the volatility of the growth portfolio and nor should it. However, it is worth exploring the influences that are lifting the prices of listed debt, hybrid and high-yield securities.

To do this I am looking at a range of economic charts released this week by the Reserve Bank. But before looking at charts that could help determine the direction of interest rates, it is instructive to review this first chart that compares the dividend yield of Australian listed shares to those of the rest of the world.

Australian shares are clearly attractive on this measure, and this is the reason why the income portfolio includes ordinary shares.

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The outlook and trends for interest rates from RBA Charts

To start it is incredible to see that interest rate settings in the US, Japan and Europe resulting from the global financial crisis have barely moved over the last four years. Whilst the RBA had been actively adjusting (up) and now readjusting (down) settings, the overseas Central Banks have been resolute in holding down overnight rates. If interest rate settings in the US and Japan were economic heart beats, then the patients look dead.

Australian interest rate settings should now continue to be reduced by the RBA given the unrelenting policies overseas. Such a policy would also put downward pressure on the A$, and this is becoming an urgent need given the deterioration in our balance of trade in recent months (see below).

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These overseas policies and the associated quantitative easing programmes have had the desired effect of driving down bond yields in highly indebted countries. Countries such as Japan and the US can borrow at lower rates than ever before. Is it a “flight to safety” or an admission by capital managers that they just have no idea of how to price risk?

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Not to be outdone, the Australian bond market has joined the international rally. This week saw Australian 10-year bond yields drop to below 3%. Just as some commentators speculated that Australia’s debt had the potential to “spiral” out of control like a eurozone member, the bond market decided that Australian debt was actually lower risk.

Long-term bond yields can be predictive of where shorter-term rates are heading. I would suggest that now the threat of a slowing Australian economy is being focused upon by bond markets, and again this suggests that interest rates will continue to decline.

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The last two monthly trade account reports show that foreign trade has slipped back into a significant deficit. Indeed, the August deficit of $2 billion was truly awful. However, the current account deficit (income and trade) of Australia is no worse than it has been for over 20 years. Arguably Australia needs foreign capital to fund its growth. We are a developing country with substantial growth to fund. It is just unfortunate that our $1.4 trillion superannuation pool cannot be mobilised to fill the gap.

The RBA will be attempting to force down the A$ through active market activities. Normally foreign exchange markets would do this in response to poor trade data but they are currently corrupted by QE programs. A lower A$ will offset commodity price declines and lower interest rate settings will support this policy target by the RBA.

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Whilst Australia is growing, so too is the percentage of net foreign liabilities to GDP. Clearly foreign debt makes up most of these liabilities and this grew steadily throughout the first decade of the 21^st century. A significant part of this debt is represented by the borrowings of our banks that funded Australian household debt with European sourced wholesale debt.

The level and cost of their overseas borrowings does inhibit the ability of Australian banks to pass on interest rate cuts. Therefore the RBA may need to be fairly aggressive in cutting overnight rates to get Australian borrowing rates down.

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Today Australian banks have borrowed about $600 billion from offshore, and that represents about 30% of our gross foreign liabilities. The effect of accessing foreign funding was to allow our banks to increase housing loan approvals consistently between 2002 and 2007. Arguably housing lending increased too quickly and aided a residential price boom. More generally, credit in Australia approximated GDP in 2000 but rocketed to 160% in 2007 before the GFC shook the confidence of borrowers.

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When the GFC hit, the Commonwealth government provided excessive assistance to first home buyers. This policy has meant that those householders with debt actually have a lot of it. The RBA clearly knows that the household sector is split between those that have no debt (retirees) and those with too much (young families). It appears that household debt reduction may now be the focus of policy settings, and so lower interest rates should result.

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The good news for house owners is that residential property has been a resilient asset, with all regional markets experiencing price growth over the last seven years. There was a correction, for a while, during the GFC , but price rises have generally re-emerged.

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The effect of the GFC was pronounced on household wealth, when both property and financial assets declined together. Despite this, it is clear that household wealth has grown over the last 20 years and this reflects the sustained steady economic growth of Australia. The following chart suggests the rapid growth in net household wealth from 2002 to 2007 was a speculative bubble caused by excessive credit. The credit remains but financial assets have been deflated, and so the RBA can reduce interest rates. Also tougher credit controls by the banks suggest that credit growth will remain muted despite lower rates. This is also a feature of many overseas economies where a savings cycle permeates.

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So, in summary, there is no doubt that the debt/excessive consumption cycle is over as households become more prudent and an ageing population is forced to save more for their future. From an investment perspective this suggests that dynamic growth in the western world may not return for quite a while. Indeed, significant earnings growth for Australian companies is unlikely unless there is a sustained depreciation in the A$.

I again reiterate that this is not bad news for the broader equity market. Rather, the concurrent outlook for lower interest rates should focus investors’ attention on sustainable yields in the equity market. This has been an increasing theme in the market in recent months.

So the recent lift in the value of debt and hybrid securities appears both justifiable and sustainable, and particularly because I suspect that the RBA will continue to cut rates in response to the extreme policy settings overseas.

John Abernethy is the chief investment officer at Clime Investment Management – one of Australia’s top performing fund managers specialising in income and value growth portfolios. Register for a complimentary portfolio assessment.

Average Yield: 8.20%

Weighted Portfolio Return

Since June 30, 2012 8.40%

Since Inception 7.28%