Hong Kong riots, the banks, and Telstra

All of us are enjoying the rise in the sharemarket including the recovery of bank stocks.

However, we should be aware that a good portion of this rise in equities is related to the fall in interest rates. 

When bank term deposit rates fall below 2 per cent it means the yield on shares, property and infrastructure assets becomes more attractive. That, of course, increases the value of those assets and the rise being reflected in both the sharemarket and in residential property.

Philip Lowe, the Governor of the Reserve Bank of Australia, is telling us that interest rates are going to stay low for a long time. Therefore, embedded into our valuations is an extended period of very low interest rates. 

So, unless too much of our money is tied up in bank term deposits, we are feeling good. We are being told by the ‘experts’ that this situation will last for a long time.   

When you are aged in your late 70s, like me, whenever something unusual happens and people say it will last for a long time you remember how often that has been wrong in the past. However, the reverse is also true, that booms last longer than bears will forecast. 

A common fallacy

One of the common fallacies in past decades was the statement that “there is a shortage of share script” which pushes up values of shares. There is always a reversal around the corner when people start talking that way. At the moment, I am very nervous about the valuations of technology stocks which often do not take into account the risks. It reminds me of the mining boom of the 1970s. But the game is unlikely to change overnight, so it is interesting to ponder the events that could end this wonderful time for equities investment. 

The most obvious event risk is overseas, where trillions of dollars are being stored on a negative interest rate basis. In addition, high-risk securities are yielding much lower interest rates than is normal. 

One day the market might reverse and people might simply exit those securities to boost the market price-related yields. I was fascinated to read during the week that the current CEO of the National Australia Bank (soon to be chairman), Phil Chronican, warns about taking Australian interest rates into negative territory. As I read that warning I couldn’t help but recall that once interest rates fall below current levels banks will find the going harder. They are under great pressure to pass on the lower rates to home loan mortgage borrowers, yet their costs don’t fall by the same amount. 

Banks and Telstra

My second warning point is that in Australia we are very big on bank shares and banks are going to be under pressure partly because of the lower rates but also partly because the regulators are going to pursue them with zeal. In addition, rivals are starting to emerge in some of the most lucrative areas of banking, such as foreign exchange. There, Airwallex is rapidly taking international currency business. Basically, the Airwallex people devised a technology that would sit on top of the bank legacy systems and enable business to transact currencies at a far lower cost in 130 countries. It is Australian technology that is backed by big global investors including MasterCard. 

And then we have a group of NAB executives that have started Judo, a new bank backed by overseas capital. Judo is aiming at the NAB core business of small business lending. 

One of the best banking executives at NAB is Anthony Healy. He oversees small business lending and is in the process of greatly improving the NAB operation in this area including a movement into cash flow lending. 

But Healy will need to be on his game because he will be competing against some of NAB’s former top business executives. Of course, Judo will be attacking the other banks as well. 

What this illustrates is the banking business is being disrupted and there will be more of these sorts of events. The sharemarket is not accounting for these sorts of risks in bank shares. At current valuations, the sharemarket is also assuming victory for technology companies in the fields they are attacking. We are not sufficiently considering the risk.

Another beneficiary of lower rates is Telstra, one of the more obvious yield plays. However, Telstra needs to invest heavily in 5G because that is where the future is. Many brokers are now forecasting a big fall in Telstra dividends which would disappoint a lot of people, but for longer term Telstra shareholders, it does make sense. Telstra must become a major player in this new market, a market that enables phones to communicate with ‘things’ including appliances and household goods.  It also enables much faster downloading of data. Telstra CEO Andy Penn is urging the NBN to lower its prices while secretly hoping it won’t because that will mean an even bigger boom in 5G which is where Telstra is investing.  

Around the world

Globally, the area that disturbs me most is the Middle East. This could easily turn very nasty and push up the price of oil sharply to change the inflation equation dramatically. And, of course, if China is sluggish for an extended period and our dollar falls far enough, that too will make low rates less sustainable.

These are not forecasts, but alerts, to the dangers that always emerge when there is a boom attached to a particular economic event, which on this occasion is low interest rates.

As my regular readers know, for a long time every morning the first thing I would look at is the US 10-year bond rate.

I still do that because it is a very convenient monitor of the interest rate-driven boom that global equity markets are enjoying. However, these days, there is a second area that I am now following very closely – the Hong Kong riots.

I know you will say, what on earth is causing me to monitor that event? If I was an Australian Hong Kong resident right now – and there are about 100,000 of them – I would be thinking seriously about making an exit back home. Many have not been home for a long time and built up considerable wealth in Hong Kong. If the riots continue, China will move in with much more strength. China is already blaming western countries. It will not be a good place for Australian citizens to be.

So, our population here is about to be boosted by Hong Kong residents who are now looking around very seriously. First, they are transferring their money, while they still can, and then they are thinking seriously about an exit.  

In theory, this may all happen in the next few weeks, but usually it takes a lot longer. China has now clearly resolved to take whatever action is required to stop the protests. Once President Xi goes down that track, the freedoms in Hong Kong will be reduced, and people and money will flow into Canada, Australia and other parts of the world. 

If that happens, the Australian population will rise faster than currently projected. Much of that growth will be centred in Melbourne and Sydney and will boost the housing markets in both centres. Again, it is one of those thins that usually takes longer to play out than you think, but it is so important that you need to follow it.