The Big Shift

The picture above shows leverage at work. A shift in expectations in equity markets can have a very similar effect, and last night the investing world woke up and realised their inflationary expectations are simply too low. It did appear the game of leveraged pass the parcel ended last night, with leveraged players all looking at each other and realising the music had been turned off for a while.

In the highly leverage-on-leverage world we operate in, small shifts in inflationary expectations can have dramatic market effects, and that's exactly what we saw unfold last night and today in global equity markets. What you are seeing is some equity risk premium being priced back into global and domestic equities, and this process will make many short-termist, instant gratificationist, and leveraged investors very uncomfortable for the next few months.

The reason inflationary expectations are such a large influence is basically because of leverage. Bond yields play a huge role in funding the leverage game, and rising bond yields due to rising inflationary expectations force some leveraged players to reassess their leveraged positions. Rising interest rates have an exponentially higher influence nowadays due to the unprecedented use of leverage in the investing world.

They key reason for our recent caution has been our view that the world was too nonchalant about inflation, and in turn, interest rates. We have consistently written that the commodity prices we see today must have second-round inflationary implications, and that the "Goldilocks " scenario of inflation-free global growth was simply a "fairytale".

The "Goldilocks" scenario has been the one priced into equity markets, particularly the Australian equity market where industrial stocks have previously priced out any equity risk premium over government bonds. What we are seeing now is some equity risk premium being priced back in, and rightly so.

The "big bad inflation wolf" is going to attempt to blow your investing house down, and you can see today that if your investing house (portfolio) was made of "sticks" it basically got blown over. There were "lobster pots" everywhere. "Brick" portfolios fared somewhat better, but not without some collateral damage.

The key to successfully negotiating corrective phases in equity markets is, first, to be prepared; and, second, to keep a cool head as all around lose theirs. You must stay calm, focused, and unemotional, which is easier said than done.

For people like me writing investing strategy, the key is not to believe your own advertising. I can't get caught up in the hype of the correction, and I must not make the mistake of getting more and more bearish as prices correct. When you have successfully forecast a corrective phase, albeit a couple of weeks early, the biggest mistake I can make is to get more bearish as the correction sets in.

My job is to wade through the trading damage, and send you in the direction of the highest quality, long duration, high return on equity, high barrier to entry, quality management, quality asset, quality balance sheet companies, that have already corrected to levels that reflect an appropriate risk premium.

Remember, I only ever forecast a "trading correction", one where "risk" is priced back in. All we ever forecast was a "trading correction" based on leveraged liquidation, and that is what we are in the middle of.

However, the events of the past few days do have a lasting impact on investor confidence, particularly leveraged and retail investor confidence. You will not see an instantaneous bounce back in prices and confidence, and I suspect you'll have to wait until we get 2005-06 earnings confirmation in August before confidence returns.

Anyhow, I hope you are all well positioned for this corrective phase. I have attempted to warn you of the current corrective phase, and now I will attempt to hold your hands through the volatility and find some solid, appropriately priced, medium-term investing ideas.

Insurance and regional banks

It was clear from the recent NAB interim that the bank is recovering strongly, and although management considers the restructuring process is only halfway complete, the earnings recovery appears firmly on track. The sale of non-core assets continues, with the divestment of the Irish banks, and the speculation is the UK assets will be next. The balance sheet recapitalisation has begun, and it is possible NAB will have up to $5 billion in surplus capital within the next two years.

In this context, it was very interesting to see the comments made by NAB’s chief executive, John Stewart, comments after he appeared on Business Sunday. He raised the prospect of future acquisitions for the first time since the ill-fated AMP takeover in 1999 and actually lamented that the bank missed out on a bargain when the acquisition bid failed. When asked if general insurance was something the NAB would be interested in, he replied: "It could be." He certainly has previous experience, after establishing a general insurance business while working for Woolwich before the Barclays takeover.

There is no doubt that Stewart was "crystal ball" gazing, and can envisage an Australian banking landscape dominated by five gorillas fighting over three bananas. It is clear with the entry of the foreign banks into the domestic industry, that "plain vanilla" banking has become very competitive and margins continue to contract. In the future, bank profitability will be driven by the ability of the majors to differentiate their services, and income streams, into higher margin products. I think the two obvious areas for the banks will be general insurance and wealth management.

Clearly, Stewart was only replying to a hypothetical question, however I think it is inevitable that the major banks will initiate the final round of consolidation within the insurance industry. An insurance takeover by a major Australian bank would also force QBE's hand considering they are underweight domestic exposure to personal insurance. It would certainly be logical for QBE to use their strong share price as a currency of acquisition. Stewart's comments are a reminder that industry consolidation could happen a lot quicker than the market is expecting.

The insurance industry is ripe for rationalisation . The claims environment remains benign, the sector is generating surplus capital, and the domestic market is mature. The top five insurers control about 75% of the local market and it is generally accepted that the ACCC would allow a final round of consolidation. Unlike the four major banks, which are restricted from merging under the "four pillars" policy, only standard competition rules apply to insurance mergers. In addition, insurance stocks should benefit from rising interest rates with much of their portfolios in fixed interest to meet "short tail" claims. I think IAG and Portman will be great places to hide with the Australian equity market correction.

However, we expect any consolidation in the insurance industry would also lead to similar takeover activity in the regional bank sector . We think the two sectors are inextricably linked through Suncorp-Metway, and the company's successful implementation of the bankassurance model. Suncorp-Metway's attractiveness is product differentiation, a strong market share in personal insurance and wealth management, and a strategic banking presence with exposure to the high-growth Queensland economy.

The main strategy and earnings driver for the big banks over the past decade has been cost cutting through staff reductions. However, it remains clear from the comments by the Commonwealth's new chief executive, Ralph Norris, as the 'Which New Bank’ program (essentially a cost-cutting exercise) draws to a close, the new focus will be on revenue growth. CBA's new strategy is expected to reinforce the commitment to customer focus, through the branch network. The aim of the big banks will be to leverage their customer base by cross selling products and services, particularly wealth management and insurance. The recent comments by John Stewart suggest this could also be achieved by industry consolidation.

Southern Cross banking analyst T.S. Lim, in his sector strategy presentation, The inevitability of regional consolidation, believes that consolidation will primarily be driven by the banks' desire to maintain earnings growth. His expectation is that big bank strategy will be to re-emphasise sales and service, in order to drive earnings. Consequently, he thinks regional banks offer, the strategic appeal of the right demographics, a strong sales and service culture and the revenue synergies of an expanded product portfolio and cross selling opportunities, for the big banks.

The next battleground for the major banks will be wealth management and insurance, and any insurance sector consolidation will lead to a major rationalisation of regional banks. Such consolidation will surprise on the upside and the price action will be violent, because the stakes in an increasingly competitive environment are very high. I think the best way to play the inevitable consolidation is through Suncorp-Metway and St George Bank, considering both have very strategic market share positions in their respective states.

In deteriorating earnings environment for industrial shares, I think the regional banks, with robust earnings growth, exposure to the strong wealth management outlook, dividend yield and supported by the prospect of industry consolidation, will prove a very defensive investment. I recommend accumulating Suncorp-Metway and St George Bank into weakness.

Be patient, be prudent

I continue to urge you to be patient and be prudent. Don't rush to buy everything that has fallen in price. There is not going to be an instant recovery from this corrective phase. We need to trawl through the trading damage methodically, wait for the global brokers to panic, and selectively add high quality names to portfolios on a stock-by-stock basis. The damage will be exponentially larger in mid and small-caps, and next week we are going to focus on some strong mid and small-cap ideas that are 20% cheaper than last week.

It is amazing how my jury duty has coincided with the corrective phase arriving, and I suspect some value investors hope the trial never ends!

Just make sure you portfolio doesn't end up looking like the truck at the top of the note.