Summary: The correction in the $A, should it accelerate, increases the risk that Australia will encounter higher inflation.
|Key take-out: It is unlikely that inflation will sweep across the world in the foreseeable future, but it is likely the $A will continue to weaken and that inflation will arrive here.|
|Key beneficiaries: General investors. Category: Income.|
I have mentioned previously that I have been surprised by the capital gains and therefore the performance of my income portfolio over the last 12 months.
The target portfolio income yield was 8% and I anticipated fairly nominal capital gains. The inclusion of high-yielding quality shares, which were trading below my assessment of intrinsic value, gave the portfolio an acceptable spread of risk.
Today I am reviewing the portfolio by asking some fairly simple questions. These are:
- Have recent economic events, which include a cash rate adjustment by the RBA and the decline in the $A, changed the risk profile for some securities?
- If I was setting a new income portfolio today and still seeking an 8% yield, would there be any securities that would not be acquired?
To begin with the economic outlook, I must say I am concerned with the adjustments that are likely to move through the Australian economy. The correction in the $A, should it accelerate, increases the risk that Australia will encounter inflation in the coming year or so. This is most clearly shown by reference to the following chart (figure 1). In it we see the competing effects of tradable and non-tradable inflation on the ultimate reading of inflation. Over the last six years the strong $A has resulted in the deflation of imported consumer items (mainly from China and Korea) that offset, to an extent, the relentless rise in prices of non tradables (eg. utility, health and education costs).
Figure 1. Non-tradables and tradables inflation
Sources: ABS; RBA
There is no doubt that inflation remains fairly benign across the developed world and the Federal Reserve Chairman Ben Bernanke has recently testified quite strongly that inflation is not a foreseeable risk for the US. Over in Japan the central bank and government are actually attempting to turn Japanese deflation into a 2% reading in inflation. Across Europe the economies are scorched with massive unemployment.
Figure 2. Core Inflation* - Advanced Economies
Source: Thomson Reuters
In the UK we have inflation sitting above 3%, but through the magic of quantitative easing the yields on government bonds are well below this. Bond investors in the UK are receiving a negative real yield, but they have now done so for over three years.
Figure 3. Central Bank Holdings of Securities
Sources: RBA; Securities Industry and Financial Market Association; Thomson Reuters; central banks
Whilst inflation is benign, many economic historians are struggling to understand why it is so. Economic theory suggests that the printing of money should create inflation. In my view there are various reasons as to why the present environment does not match that of history. These include:
- QE is happening right across the world and not in an isolated economy. The offsetting effects of this are perverse and it takes a massive QE, like Japan, to have an inflationary effect;
- Unemployment levels sprang up significantly after the GFC. There is no wages push in the developed world, save for Australia;
- The emergence of China as the world’s largest supplier of cheap consumer goods has seen deflation exported to the world economy; and
- The pegging of the Chinese currency to the weakening $US has added to the effect of point 3 above.
This leads to an explanation as to why inflation has not occurred, but also leads to the question as to when it will?
It is unlikely that inflation will sweep across the world in the foreseeable future, but it is likely the $A will continue to weaken and that inflation will arrive here. To this point I note the following chart of Chinese inflation. It shows that inflation continues to fall and it has been dominated by the effect of food prices. Non-food or manufactured consumables have lifted at a fairly low rate of about 2%. However, the outlook is for a continuing lift in wage and energy costs, which will translate into higher inflation.
Figure 4. China – Consumer Price Inflation
Proposed portfolio moves
The following table shows that the projected franking enhanced yields for Telstra (7.8%) and CBA (7.13%) have fallen below my target of 8%. Both companies have given the income portfolio excellent total returns, but I have decided to exit both securities within the next few weeks at the following prices, if they reach that level.
Figure 5. MyClime Valuation – Commonwealth Bank of Australia
As far as a switch into a new security, I believe it is time to look at pure hybrids or debt securities. One that looks interesting to my eye is Suncorp Unsecured Perpetual Capital Notes (SBKHB). These were issued in 1998, when $170 million was raised at a face value of $100.
SBKHB offer an interest rate of 0.75% over the 90-day bank bill swap rate (BBSW), reset and paid each quarter. The distribution rate paid by SBKHB is therefore referred to as a ‘floating rate’, in that it is influenced by prevailing cash rates. As cash rates increase, so does the distribution rate, and vice versa. With the current 90-day bank bill swap rate tracking at about 2.8%, following the addition of the 0.75% margin, SBKHB are currently paying out annual interest of about $3.55 on the face value of $100 per security. However, with the securities trading at about $62, this equates to a running yield of about 5.7%.
SBKHB is a subordinated obligation of Suncorp Metway Bank, a wholly owned subsidiary of Suncorp Group Limited (ASX:SUN). The notes are effectively treated as a class of preference share ranking in priority to all ordinary shares in the event of a wind up.
An important consideration for investors is the longer-term potential for redemption. SBKHB are incrementally losing their usefulness as Tier 2 capital for Suncorp Metway Bank, due in large part to APRA’s Basel III regulatory framework in relation to hybrids. Effectively, over the next 10 years SBKHB will progressively lose their capital weighting.
SBKHB therefore offers the longer-term possibility of potential capital upside should SUN decide to redeem. However, please note that I do not view this as a near-term possibility. Given SUN’s sound level of capital, the perceived risk of non-payment is also relatively low. SBKHB has in fact paid a distribution every quarter since listing back in 1998.
Whilst I may well be early in my call on inflation, I do perceive that income-focused investors need to be cognisant of the increasing risks of owning fully valued shares in the quest to chase yield.
John Abernethy is the chief investment officer at Clime Investment Management. If you are a sophisticated investor, wholesale investor or have $500,000 or more to invest, Clime is offering you a free portfolio assessment or opportunity to discuss your portfolio and investment options with John Abernethy. Click here to register your details.
Clime Income Portfolio Statistics
Return since June 30, 2012: 28.81%
Returns since Inception (April 24, 2012): 27.51%
Average Yield: 7.37%
Start Value: $118,757.19
Current Value: $152,975.79
Dividends accrued since December 31, 2012: $3,818.89
Clime Income Portfolio - Prices as at close on 23rd May 2013
|Hybrids/Pseudo Debt Securities|
|Company||Current Price||Margin over BBSW||Running Yield||Franking|
|High Yielding Equities|