Kohler's Week: Australia, Yields, Oil & Yemen, Buffett Vs Asset Allocation, Insurance, Covata, Fortescue

Last Night

Dow Jones, up 0.2%
S&P 500, up 0.24%
Nasdaq, up 0.57%
Aust dollar, US77.5c

Oz political economy

I gave a talk to the Australia Israel Chamber of Commerce in Adelaide on Wednesday. Here is a summary of what I told them:

The chances of a recession are rising, as reflected in the resumption of the decline in bond yields to record lows (see chart below of the five-year bond yield).

The reason for this is the failure of business confidence, and therefore investment, to pick up in 2015 – in fact it has deteriorated. In turn this has been caused by the failure of Australian politics to become rational.

Economics and politics seem to be stuck in a feedback loop: weak business confidence equals weak economic growth equals deteriorating tax revenue and budget deficit equals unstable politics equals weak business confidence, and so on.

How did we get here? In my view it began with the replacement of Kim Beazley as ALP leader with Kevin Rudd, who turned out to be popular at first, then crazy – and worse, incompetent. Three years later the Liberals replaced Malcolm Turnbull with Tony Abbott, which was, in fact, a rebellion led by Nick Minchin against the emissions trading scheme that Rudd had proposed and Turnbull agreed with. At the same time the Henry Tax Review was published, proposing the first coherent tax reform program for a long while.

Within six months the politics of both climate change and tax reform – the two most important issues of the time for business – were thrown into disarray by political weakness and incompetence. Whatever you think of the science of climate change, the issue has been atrociously handled in Australia from the beginning and in such a way that businesses don’t know whether they are coming or going.

In early 2010, Rudd abandoned the ETS and plucked a resources rent tax out of the Henry Report. Energy policy, including the renewable energy target, and tax policy have never got back on track, and have been the prime causes of business uncertainty and low confidence and investment ever since.

Before and immediately after the election in 2013, business confidence picked up because of the prospect of the “adults” being in charge again, as Tony Abbott put it. Unfortunately he and Joe Hockey totally botched the 2014 budget by mixing a series of difficult budget repair measures with some ideological ideas that were either not thought through or not talked through. As a result business confidence has deteriorated again and capital expenditure has dried up.

Australia’s key task of replacing the resources boom with something else has thus gone begging (housing construction, which is booming, is not enough because the things being built don’t employ people beyond the building of them).

Business confidence and investment won’t recover unless there is a reason to.  The possible reasons are:

  1. Stable, reforming politics plus infrastructure investment by governments to lift productivity;
  2. Rising domestic consumption;
  3. A resumption of accelerating Chinese economy growth;
  4. Currency devaluation.

The only one of those you might count on at the moment is the last, and even that is looking shaky because the US dollar cracked a week ago following the bearish Federal Reserve statement and a series of downside economic surprises in the US.

If the US dollar doesn’t resume its upward march, then to get the Australian dollar below US70c the RBA would need to cut the cash rate significantly – to 1 per cent. But it won’t do that because of the potential for a Sydney house price bubble.

This is why the risk of a recession is rising in Australia.


Why are people buying five-year bonds at a yield of 1.84 per cent when inflation is 2.2 per cent? Because they expect to make a capital gain by selling them to another mug before the five years are up. The same goes for the bonds being traded at negative nominal yields in Europe.

It is a classic bubble: pass the parcel and musical chairs. But as JM Keynes said, “Markets can remain irrational for longer than you can remain solvent”.

The European liquidity boom has only just begun, which will extend the global hunt for yield, possibly for another two years. The move into high-yield equities is well established in Australia, but in Europe and elsewhere it is just getting going, with a new rush of money into dividend-only index funds.

Just as Australia was early in identifying equities – and specifically banks – as yield plays, we could be early the other way if the economy continues to deteriorate. The best investments in the past two years have been bank shares and negatively geared property because of declining interest rates, but a recession here would bring that party to an end because bank profits would fall with rising impaired loans, and mortgage lending would dry up. But in the meantime, RBA attempts to prevent a recession by cutting interest rates will keep the party going for a while longer.

Eventually PEs will start to fight with yields (that is, valuations will be cut in anticipation of lower earnings before dividend yields start rising) and then payout ratios will come into play. With dividends commonly at 80 per cent of profit, there is not much room for earnings to fall without dividends having to be cut. Once that happens, income investors who have been propping up sharemarket capital values will Come to Jesus, and realise they own equities, not fixed interest securities, and run away before they lose too much money.

Hopefully the currency continues depreciating, Joe Hockey brings down the perfect budget next month, consumers start spending, business start investing and none of the above happens, so we can continue to enjoy the capital gain fruits of the global yield panic.

Oil and Yemen

The oil price went above $US50 on Thursday, because of what’s going on in Yemen, but then this morning it dropped around 6 per cent, back below $US50 again – not so much because the situation in Yemen changed, but because the chances of a nuclear deal with Iran seem to have improved. Iran has been exporting one million barrels day under the sanctions, but has been producing up to 3mb/d over the past year and storing it offshore, either in tankers or other storage facilities. Some put the amount it has in storage at 30 million barrels. 

So if sanctions are lifted, Iran has the ability to flood the market with oil and keep it flooded for quite a while. It’s that potential that hit the price of crude this morning.

Nevertheless, the situation in Yemen is worsening by the day and the latest news is that Saudi Arabia is bombing the place in an attempt to restore the toppled government. The United States, embarrassingly, ran away a week ago. Only a few months ago President Obama cited Yemen as an example of how well things were going in the Middle East, but it clearly is nothing short of a disaster.

Unlike Syria, Yemen is not a civil war: it is a confrontation (not yet a war) between Saudi Arabia and Iran, as regional leaders of the Sunni and Shi’ite sects of Islam respectively. Yemen is not only strategically important to Saudi Arabia and its oil facilities because it sits on that country’s southern border, it is important for the world because it potentially controls access to the Red Sea and therefore the Suez Canal.

The Iranian-aligned Houthi tribe now has control of the former South Yemen and with the US unwilling to do anything about it, the Saudis themselves have decided they must. 

This has become very dangerous indeed. Following the re-election of Binyamin Netanyahu in Israel, the rhetoric against Iran in both Israel and the US has been stepped up. Meanwhile in the real world of the Arabian Peninsular, Saudi Arabia will soon have to decide whether to send troops into Yemen to seize control of the country back from the Houthis, because air strikes won’t do it. At that point Iran will need to decide whether to come to the defence of its puppet regime.

If that happens, the final contest between the Sunnis and the Shi’ites – between Saudi Arabia and Iran – could be the final result.

Here is a BBC guide to the confusing array of actors in Yemen, courtesy of Dennis Gartman:

The Houthis: Zaidi Shia-led rebels from the north, who seized control of Sa’naa last year and have since been expanding their control. Zaidi Shi’ia was the first of the Shi’ia sects and are followers of Zayd ibn Ali as the first of the true Caliphs after the death of Muhammed.

President Hadi: Backed by military and police loyalists, and by militia known as Popular Resistance Committees, President Hadi has tried to fight back against the Houthi rebels from his stronghold in the south but has apparently fled the capital.

Al-Qaeda in the Arabian Peninsula: This is perhaps the most dangerous offshoot of al-Qaeda, AQAP opposes both the Houthis and President Hadi, making the situation there all the more confused and confusing.

Islamic State: This is the Yemeni affiliate of ISIL and has only recently emerged, seeking to eclipse AQAP and having openly fought with AQAP, which again makes the already confusing situation more confused and confusing by the hour. 

Buffett Vs Asset Allocation

I had lunch the other day with a young man who is a devotee of Warren Buffett and has started an investment fund in which he is trying to emulate the Oracle of Omaha. He and his dozen or so high net worth investors are all heading off to Nebraska for the Berkshire Hathaway AGM ("Woodstock for Investors”) in May to listen to Buffett and Charlie Munger for six hours and generally soak up the atmosphere.

So what does it mean to emulate Warren Buffett? Well, buy whole companies and never sell them. It isn’t private equity because those funds have a five-year time horizon for owning businesses, and it definitely isn’t asset allocation. That’s why Buffett is the most admired and least followed investor: he buys companies and doesn’t sell. My lunch companion has bought one business already (a horse transport company) and visits at last two businesses for sale each week looking for another one. He says about 1 per cent of the firms he looks at fit the bill.

But it got me thinking about Buffett and asset allocation, which are actually opposing investment methods.

The problem with investing in equities is that although they perform best over the long term, it depends when you buy. For example, if you bought an Australian ASX 200 index fund in October 2007 it took six years for you to get ahead and at this point you have made a compound annual return of 2.3 per cent, including dividends. Your capital is still underwater and will be for years.

The Financial Times published this chart during the week, of the longest periods of negative returns for each share market:

Australia’s is about 17 years and in the case of Austria it’s almost a century. All of the major European countries have seen periods of negative returns that extended for a lifetime.

And share indices are subject to survivor bias – that is, they measure the companies that last. Many companies go bust or fall out of the indices, and they might be the ones you hold, so individual portfolios can obviously do much worse, as well as better, than the index.

But an ordinary investor can’t do what Warren Buffett does, and buy whole companies away from the ups and downs of the market, and never sell them. The rest of us are stuck with the market, which is where asset allocation comes in.

A portfolio manager named Mebane Faber of Cambria Investment Management of the US has published a book that examines how a dozen asset allocations have performed over the 40 years between 1973 and 2013. All of the various allocations limited the impact of share market declines during that period, but only one managed to beat equities – a portfolio advocated by former Pimco CEO, Mohamed A El-Erian. It was 51 per cent equities, 23 per cent bonds, 13 per cent commodities and 13 per cent property.

Over the 40 years El-Erian’s allocation gained 5.96 per cent a year in real terms, but at one point dropped 46 per cent. Interestingly, all of the portfolios produced similar returns over the 40 years and similar volatility.

If you’re happy with 5-6 per cent per annum real returns, asset allocation – that is, putting about half your money into things other than equities – can reduce volatility, but even then timing is everything. You can still be hit by a fall of nearly 30-50 per cent (e.g. 1987 and 2008) which can take a long time to recover from.

As a small investor, the only way to fully protect yourself, and do a Warren Buffett, would be to invest through an unlisted fund that invests in unlisted assets such as private companies or infrastructure. But they’re hard to find. My lunch companion is shy and didn’t want me to identify him, but if you write to me at ak@eurekareport.com.au I’ll pass on your details to him. There’s also Infrastructure Partners Investment Fund, which had a false start last year but is back on track. It’s an unlisted retail fund set up to invest in Utilities Trust of Australia, the wholesale-only fund managed by Hastings Investment Management, which invests in airports, ports and water assets.   

And then there’s cash. Fund manager Rhett Kessler of Pengana Capital sent out a note this week that contained these comments:

"The Australian stock market has risen almost 9 per cent calendar year to date, valuations are high and rising, and increasing our focus on capital preservation. Our cash holdings within the fund have risen to almost 30 per cent, due to the scarcity of attractively valued opportunities for us to invest. We believe cash is a valuable, low risk, income producing option to take advantage of future opportunities. 

"Furthermore, we have begun to take out some ‘insurance’ via the acquisition of ASX All Ordinaries Puts. We do not look to actively trade such instruments, nor do we hope we ever need to use them, but we do feel the current environment warrants their inclusion as downside protection in the event of a market correction."

Puts? Yes, you can take them out as insurance against a big fall but it’s a bit complicated and you’d need to a broker to help you. 

But in my view cash is the best insurance – better than bonds in the current environment that’s for sure. Bonds are securities too, and they are high priced at the moment. Apart from that, it’s unlisted property, infrastructure and, if you can do it, businesses.


But the question is: do we need insurance, however it’s done?

I’ve discussed the prospect of a recession in Australia, which is now material and rising, but not yet above 50 per cent I’d say. 

Then there’s the question of where the global equities cycle is at – no matter what happens with the Australian economy, the world trend cannot be escaped.

We are either at the end of a global cyclical bounce…

… or the start of an American structural break-out…

… or both. Most likely both.

As we learnt in October 1987, a cyclical reversal, even a horrible one, can still take place within a structural bull market. What’s more, they are very hard to predict or anticipate. That’s because the main precondition for such a correction is that no one predicts or anticipates it.

The main thing to bear in mind is that the global/American bear market that began in 2000 ended about two years ago after 12 years. Structural bull markets are not normally two or three year affairs, although we have never experienced monetary policy like this. Zero interest rates and QE have created a sort of make believe world like the Truman Show, where normal rules possibly don’t apply. 

I remain a structural bull, but a cyclical bear awaiting a correction. My “insurance” is 26 per cent in unlisted investment and 20 per cent in cash. 


This week’s (sole) CEO interview on video is Trent Telford of Covata, which is a data security business listed on the ASX but run out of Washington DC, where Trent lives.

On Thursday he announced a 10-year deal with Cisco, whereby the internet equipment giant will “white label” Covata’s Safe Share encryption platform and pay Covata a licence fee. Before Thursday’s trading halt, Covata’s share price had already doubled in March, from 25c to 51c, and when the trading halt was lifted the shares shot to 60c and settled back at 55c, up more than 7 per cent.

Trent Telford started the company in 2007 and backdoor listed it last year. He owns only about 4 per cent now and the biggest shareholder is David Teoh’s TPG Telecom with 15 per cent. TPG put in $10 million of the $45 million that has been spent so far in building the business (costs are running at about $13 million a year) and revenue is only now starting to arrive.

The business is based on a patented encryption system that protects specific data rather trying to put up firewalls that hackers can get around. 

It’s very interesting and well worth hearing what Telford has to say. As always I haven’t researched the company, so this isn’t a recommendation. You can watch the video and read the transcript here.


I met a global pricing expert from Germany for a coffee this week, and among other things we talked about Andrew Forrest and Fortescue, and the matter of iron ore pricing. 

Twiggy made what is now an infamous speech in Shanghai this week in which he called for the big iron ore miners, including Fortescue, to get together and restrict production to get the price up. The hounds of hell promptly descended upon him, including an ACCC investigation into whether he broke the law merely by saying that, and iron and steel industry luminaries, including Sam Walsh of Rio Tinto, have lined up to disown and ridicule him.

But as I asked the German pricing expert: “Forrest is not an idiot. What was he trying to achieve?”

There was much teutonic shrugging of shoulders. “People trying to set up cartels to control prices generally operate behind the scenes,” he observed, "rather than make public announcements. He only managed to appear desperate to his competitors, who will now redouble their efforts to drive him out of business.”

"Maybe he was trying to let his customers know that he’s in trouble and if they’re not careful Fortescue will be out of business and they will be stuck with BHP, Rio and Vale only again.”

Or then again, maybe he is just an idiot.

Readings & Viewings

Video of the Week 1: Can this be real? It looks real, but it’s the most unbelievable penalty shoot-out in soccer you have ever seen.

Video of the Week 2: Star Wars, starring Christopher Pyne – the Fixer. Very funny.

Tesla: just another car company. Excellent piece in the Wall Street Journal, bursting the Tesla bubble (mind you, I want one of them).

Ten investment quotes to live (and invest) by.

Explainer: bond yields and what they tell us about the economy.

My piece this week on the coming reforms to financial planning.

"To be blunt about it”, the Fed has artificially steepened the yield curve.

The Fed is scared, and won’t raise rates any time soon.

Currency concerns everywhere.

Why the euro may have hit bottom.

How the ECB saved the eurozone without spending a single euro.

The real risks in Australia’s financial system.

Dirty Deals: How Wall Street’s predatory deals hurt taxpayers (pdf).

In our horrifying future, few people will have work, or make money – Robert Reich.

These buildings in New York are “vertical money”.

The real reason Jeremy Clarkson was sacked: the BBC hated his politics.

…Rubbish. He was sacked because he punched a subordinate.

Meet the 26-year-old who is giving Thomas Piketty his most credible challenge.

Sisi and ISIS – opposite in both name and behaviour. Really interesting comparison of Egypt’s President and the new leaders of global terrorism.

More on Egypt’s Sisi – Islam’s improbable reformer.

Greece’s central bank governor says exiting the euro is not an option.

The virtues of Germany and vices of Greece.

Fascinating article about Facebook’s plans to eat news publishers.

Australia’s digital economy is worth $71 billion, or 5.1 per cent of GDP – bigger than agriculture, retail and transport.

A linguistic examination of World Bank economic reports – and, yes, they have gotten more and more opaque.

Phillip Adams: the day I nearly killed Malcolm Fraser.

Really interesting yarn about dogs, and Cesar Millan.

How to take the cap off a bottle of beer with nothing but a piece of A4 paper.

Some Saturday morning blues – Hound Dog, by Big Mama Thornton. "You ain’t nothing but a hound dog, Been snoopin’ ’round my door. You can wag your tail…But I ain’t gonna feed you no more.”

Great description of The Wizard of Oz.

Last Week

By Shane Oliver, AMP

Investment markets and key developments over the past week

Share markets have had a rough week with uncertainty about the Fed, profit taking in US tech stocks, nervousness ahead of the coming US March quarter profit reporting season, worries about the Saudi air strike on Yemen and uncertainty about Greece all weighing. US, European and Australian shares all fell with Japanese shares roughly flat. Chinese shares managed to gain though helped by expectations for more monetary easing. Bond yields were little changed, but a slight fall in the US dollar saw most commodity prices rise and oil up on Yemen and the Australian dollar break above $US0.78c.

Should we worry about the conflict in Yemen? The short answer is no. It seems every time there is a conflict somewhere in the Middle East there are fears of a disruption to oil supplies and a wider conflagration and so oil prices spike and investors worry. The Saudi airstrikes against Iranian backed Shia insurgents in Yemen is no exception. Yemen produces hardly any oil (just 125,000 barrels a day) but it borders the Bab el-Mandeb strait which sees nearly 5 per cent of global oil production pass through daily and so some fear this may be disrupted and more generally that the conflict in Yemen will lead to a broader Saudi (Sunni)/Iranian (Shia) conflict. Of course lots of things could happen regarding Yemen and there could be a further short term spike in oil prices. However, Yemen probably won’t cause a major problem as Saudi Arabia is unlikely to want to get involved in Yemen on the ground and its best hope to limit Iranian influence in the Middle East is to ensure oil prices stay low so it will likely act against any significant oil price spike by increasing oil production. So Yemen is likely to be just another distraction.

Major global economic events and implications

US data provided something for Fed hawkes and doves. On the hawkish side were strong readings for home sales and the March Markit manufacturing and service conditions PMIs along with a fall in jobless claims but on the dovish side was another soft reading for durable goods orders possibly reflecting the dampening impact of the strong US dollar. Core CPI inflation was a bit higher than expected, possibly providing confidence that inflationary pressures may be bottoming but it’s too early to read too much into this. The overall impression remains that the Fed is on track to raise interest rates this year but it’s a more likely to occur in September rather than June.

Eurozone data continues to impress with further gains in manufacturing and services conditions PMIs pushing the composite business conditions indicator to its highest since May 2011 and a continuing pick up in money supply and bank lending. This is all backed by stronger business confidence readings in Germany, France and Belgium and a further gain in eurozone consumer confidence. Eurozone shares remain very attractive.

While eurozone and US PMIs were solid, the Japanese PMI unexpectedly fell. However, other Japanese data wasn’t bad with stronger than expected household spending, a slight fall in unemployment and rise in the ratio of new jobs to applicants and stronger small business confidence. Underlying inflation remains too low though at around 0.3 per cent year on year if the impact of the sales tax hike is excluded. The BoJ looks like it will need to do more which will lead to another leg down in the Yen.

China's March flash manufacturing PMI also unexpectedly fell. It remains in the same 48 to 52 range it’s been stuck in for the last four years now, so no reason to get to concerned but it does reinforce the view that Chinese economic growth has started the year on a soft note and that more monetary easing is needed. Expect the People's Bank of China to cut their 12 month benchmark lending rate to around 4 per cent this year, from 5.35 per cent currently.

The overall impression is that global growth is continuing but it remains just below trend and uneven as highlighted by the various PMI's.

Australian economic events and implications

The Australian financial system is strong, but with some risks. The RBA's six monthly Financial Stability Review (FSR) characterised the Australian financial system as performing strongly with relatively low risks regarding household sector finances generally and corporate lending. However, it did express ongoing concern regarding residential property prices and investor lending in the biggest cities and highlighted risks around commercial property reinforcing the need for banks to maintain lending standards. Since RBA Board members were briefed on the latest FSR at the last Board meeting and yet the RBA still expressed an easing bias at that meeting, it does not alter our expectations for a further interest rate cut in the months ahead to support the broader economy. Rather it continues to fall to the prudential regulator, APRA, to ensure that bank lending standards are maintained.

Regarding commercial property, yes yields have been falling as values have gone up relative to rents, but it’s worth noting that the gap between bond yields and commercial property yields remains well above where it was prior to the GFC and is actually very high by historical standard. You can't say the same thing about residential property yields though!

Next Week

By Craig James, Commsec

Plenty to watch in the lead up to Easter

It may be a holiday-shortened week but there is still plenty to focus on this week. In Australia a number of top-tier economic indicators are released. Also expected to be released is the tax white paper. In the US, the focus is on Friday’s jobs report. And in China, the Purchasing Manager’s survey is issued.

In Australia, the week kicks off on Tuesday with the weekly consumer sentiment. Sentiment has been rising – albeit modestly – over the past fortnight. In addition the Reserve Bank issues the money supply and other financial aggregates including private sector credit (lending), while the Housing Industry Association releases figures on new home sales – a useful indicator on the state of home building.

The is no consensus of economist forecasts for the data releases although private sector credit probably grew at a modest rate of 0.6 per cent in February, taking annual growth to a 6-year high of 6.2 per cent. Housing and business credit will continue to be the main drivers while personal credit continues to struggle. A lot more interest will be in the measures of housing credit, especially investor home loans.

On Wednesday, the CoreLogic RP Data home value index is released alongside the Performance of Manufacturing index. Housing markets across most capital cities are relatively balanced. However the focus will be on the outsized growth that continues to take place in the Sydney market.

Also on Wednesday, the Bureau of Statistics (ABS) will issue data on dwelling approvals and detailed estimates of engineering construction activity.

Dwelling approvals are holding at record highs, and given that this is effectively the first indicator of the home building pipeline, it is clear that actual residential building will remain strong over the coming year. Unlike mining, increased home building lifts a lot of boats across the entire economy.

On Thursday the Bureau of Statistics (ABS) will issue the February international trade data (exports and imports) and February figures on job vacancies – a forward-looking gauge for the job market. Also on Thursday the March inflation gauge from TD Securities and the Melbourne Institute is issued. The trade data – while important – has lost relevance for investors. So the main focus will be on the inflation gauge.

If inflation remains well contained, then the Reserve Bank will have few qualms about cutting rates again. The main worry is not whether another rate cut leads to a lift in inflationary pressures but whether it will add to property market risks.

Housing indicators dominate in the US

There is the usual bevy of economic indicators for release in the US with employment statistics dominating the headlines later in the week. In addition, data on manufacturing activity in China is released on Wednesday (purchasing manager indexes).

On Monday, personal income and spending statistics are released along with pending home sales and the Dallas Federal Reserve manufacturing index.

On Tuesday, the Case Shiller measure of home prices will be released with consumer confidence data. Home prices are tipped to be up 4.7 per cent over the year to January, up modestly from the 4.5 per cent annual gain to December.

On Wednesday February data on construction spending is issued with auto sales, the ADP national employment index and the ISM manufacturing index. The manufacturing gauge is tipped to ease from 52.9 to 52.4 in March – but above the 50 line that separates expansion from contraction. Construction spending is expected to have lifted by 0.3 per cent in February. And in terms of the ADP jobs report, economists tip a 240,000 lift in private jobs – a precursor to Friday’s official job report

On Thursday, the Challenger job layoff data for March is released together with factory orders, the usual weekly figures on claims for unemployment insurance, and February trade data (exports and imports).

And on Friday in the US, the pivotal non-farm payrolls or employment data is released. Last week Federal Reserve policymakers said that the timing of any rate hike will be data dependant. Big data like the employment report will play a pivotal role in when rates are lifted. Economists expect that around 249,000 jobs were created in March – a healthy result. The jobless rate is expected to be steady near 5.5 per cent.

In China, the National Bureau of Statistics will release both the services and manufacturing purchasing manager’s surveys on Wednesday. HSBC will release its equivalent manufacturing gauge on Wednesday and services gauge on Friday.

Sharemarket, interest rates, currencies & commodities

Each month, there is much speculation about the cash rate, and therefore the implication for variable interest rates. But this ignores the fact that many businesses are more focussed on the swap market and thus longer-term fixed rate loans. And the yield curve shows that rates are arguably the lowest businesses have ever seen.

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