Ignore Those Bears

This month the US Government completed its first auction of 30-year bonds in five years. The US Treasury confirmed a yield of 4.53% for the 2.1 times oversubscribed, $US14 billion issue, which was supported by continuing strong foreign demand. The last time the 30-year bond was auctioned, in August 2001, the yield was nearly 100 basis points higher at 5.52%. This is a truly remarkable result, considering the potential inflationary implications of an oil price of $US65 a barrel.

I think the bond auction illustrates three important themes, which support my positive views on equities as an asset class. First, the strong foreign participation in the bond auction is a clear indication that Asian central banks remain willing to recycle current account surpluses into US Treasuries, so funding the huge US trade deficit. The result is the continuation of the virtuous circle of low US bond yields supporting consumer spending, and the ongoing strength of the US economy and corporate profits.

Second, the 4.53% yield on the auction confirms that inflationary expectations remain low. Despite the huge surge in energy prices, core US inflation last year was just 2.2%, unchanged from 2004. Clearly, inflationary fears remain inconsistent with the pricing of bond yields and the rate of underlying inflation. My conspiracy theory is that the Fed is continuing the inflation rhetoric and the prospect of higher rates to prevent a serious deterioration of the US dollar. I believe the Fed is very close to the end of the rate tightening cycle, which will prompt a rally for US equities, particularly cyclicals.

Finally, the continuation of low bond yields is compelling for equity valuations and the profit cycle. Headline inflation in the US is nearly 3%, and the 10-year bond is hovering around 4.35%, so the "real" bond yield is less than 1.5%. The trailing price/earnings multiple (P/E) for the S&P500 is 16.5 times, which implies an earnings yield of 6.1%. This represents the widest equity risk premium in 17 years (that is: equities are very cheap on a risk-adjusted basis). Clearly, low bond yields and earnings growth are keeping equities as the asset class of choice, and when investors work out that global interest rate rises are coming to an end, you will see strong interest rate sensitive equity performance.

THE CLOSE historical correlation between US and Australian bond yields means the outlook for domestic bond yields and equity valuations remain favourable. Despite similar inflationary fears in Australia, the latest labour market and CPI statistics suggest otherwise. All the recent ABS and private employment data confirms that the annual pace of domestic jobs growth continues to slow. As a result, I think slower employment growth, and the Federal Government's labour market reforms suggest the Australian economy is very near the peak in the wages cycle.

Also, Treasurer Peter Costello has confirmed that the "pass through" effects of the strong rise in energy prices have been minimal (negative refiner margins are currently crunching retail petrol pump prices, while BlueScope Steel is cutting the price of hot rolled coil steel by 20%). Further, the Reserve Bank’s quarterly statement last August expected wages growth to moderate in line with employment and core inflation to peak at about 3% later this year.

Consequently, despite consensus market expectations of a further 50 basis point rise in domestic interest rates this year, we continue to believe that inflationary fears are exaggerated, that bond yields will be low by historical standards, and that the Reserve Bank's interest rate policy will remain on hold for the foreseeable future.

This remains a key reason for my bullishness on the outlook for the bank/insurance/asset management sector, which forms part of my "barbell strategy". 5% fully franked dividend yields plus 10% earnings growth: that beats unfranked bond yields of 5%. The other positive is credit growth, which has remained surprisingly resilient.

Bank industry fundamentals remain sound, the economy has clearly bottomed, and credit growth has remained resilient. Despite the end of the housing boom, and concerns for bank earnings, credit growth has held up surprising well. I think the positive outlook for credit growth will be the key to the performance of the bank sector this year.

The latest monthly banking statistics from the Australian Prudential Regulation Authority confirm that credit growth continues to surprise: up 1.2% in December. Total system credit growth appears to have stabilised around 13%. Also, just as importantly, the rate at which housing credit has fallen is moderating, and it now appears that home lending has stabilised at 0.9% a month. The decline in home lending has been arrested by an increase in affordability, the return of new home buyers, historically low 2.5% vacancy rates, and continuing strong wages growth. I believe house prices have bottomed, in NSW and Victoria.

However, although credit growth remains strong, its composition has changed. The decline in housing credit growth has been offset by strong growth in business borrowing '” up 1.7% in December compared with 0.7% the month before. Annualised business lending is now growing at the fastest level since 1989, and well above the historical average of 12%. The main driver of the strong business credit growth remains capital expenditure and infrastructure spending by the mining sector.

The bullish outlook for domestic equities is another positive for the banking sector. The Government’s proposed abolition of the 15% superannuation contributions tax is expected to deliver an extra $3.3 billion a year into super; wealth management earnings flowing from this '” and from likely cross-selling of bank products '” could boost bank earnings.

THE PROSPECT of strong metal prices extending beyond the short term has caused some excitement on the market, but don’t be fooled into thinking short-term upgrades mean analysts have become "true believers" in the sustainability of the cycle. Long-term consensus forecasts remain virtually unmoved, and if you believed the consensus long-term forecasts, and the forecasts out to 2010 for average prices, you'd be selling every commodity stock you owned.

For example, let’s look at the leading commodity analyst’s forecasts for copper. In 2006, he sees an average price of $2.20 a pound; in 2007, it drops to average $1.60, in 2008 to $1.35, 2009 to $1.20, and in 2010 to $1.20. He sees a long-term copper price of $1.10.

This guy is considered "bullish" because he's more "bullish" than every other pessimist. I would call him the "least pessimistic", rather than the "most bullish". My point is that if you regard his copper forecasts to be accurate, then you should be selling any shares you own in BHP Billiton, Rio Tinto, and Oxiana because this is the peak in the copper price and it's going to halve over the next five years.

This short-term commodity price forecast upgrade cycle has gone on for 24 months now, yet nobody dares forecast medium-term, let alone long-term commodity price sustainability. The upgrades simply chase the spot prices in a lagging way. The first person to truly buy into and forecast the extended super cycle, will make their clients a fortune, and we won't see the peak of the commodity cycle until we see "consensus" long-term commodity price assumptions rise significantly.

It is amazing: the guy who is "the least pessimistic" is called "the most bullish". I'm happy to stay the course here, and you should too as more and more people get off the train too early, scared by the short-term volatility.

READING the weekend press confirmed my belief that you are considered smart if you’re bearish. It was hard to find a single positive comment from a fund manager, analyst or finance journalist. I know good news doesn't sell newspapers, but the stuff I'm being fed by the press often feels like it's about another market. It's completely out of whack with the fundamental reality of Australian equity earnings growth, dividend growth, or balance sheet strength.

Everyone wants to be the guy who calls the top; everyone wants to be that hero. Yet again, everyone is confusing "overbought" from a short-term trading perspective with "overvalued" from a medium-term fundamental perspective. "Premature bearishness" will cost you performance, as it has for the past 24 months, and while I acknowledge investment themes are narrowing a notch, I still believe we can generate double-digit returns employing the "barbell" strategy in large-cap Australian equities.

Now I'm going to be away for a couple of weeks on annual leave, but I don't want you to do anything silly while I am away! Don't get brainwashed by the non-believers, or scared by volatility. Don't get too hung up in the minutiae of historic interim results. Don't "over-trade". Stay focused on high return-on-equity quality and collect some interim fully franked dividends along the way.