US bond market signals danger ahead

I am going to take you on a journey today that will raise issues and try to predict possible future events that you may not have thought of.

We start in the US where I believe we are going to see a boom of great magnitude emerge but there is a very dangerous US twister ahead that could cause great havoc and implicate Australia.

Thanks to the Trump stimulations, the American money supply has been rising by about 20 per cent a year but because of the pandemic the velocity of that money has slowed, and therefore inflation has been kept well under control.

President Joe Biden is dramatically increasing the money flow via his $1.9 trillion package. And the vaccines during 2021 will greatly decrease the risk of infection and therefore reduce the velocity curb. The full impact on the money flood will then emerge. 

The last time we saw something like this was after the first world war in Germany where the money supply had been growing by 20 per cent during the war and that growth continued after the war ended. 

Although Germany was defeated, there was great relief and the flood of money in the country was suddenly given great velocity so inflation took off as too much money chased too few goods. Later it became hyperinflation.

I am not certainly not predicting hyperinflation in the US but the bond market is warning us that there is danger ahead. Skills are already short in the US and that shortage will multiply. 

And that danger is further multiplied by the fact that Biden is planning legislation which will greatly increase unionisation in the US and make independent contracting very difficult. Much of the productivity and labour flexibility in the US is based on independent contracting.

I would be greatly surprised if that cocktail of measures did not produce US inflation in 2022 or the latest 2023 and with that inflation will come higher interest rates.

It is not that the rates will be so terribly high but the percentage increase is substantial given that rates have been at token levels.

Our banks borrow money on the US long-term market and will be affected. Most of them negotiate new loans each year so it will take a few years to flow through, but the expectation will impact much faster.

If US rates rise then those shares that depend on low interest rates to maintain their price will be smashed. Those that are growing rapidly or can benefit from inflation will be insulated. Some will do well. 

I hope this scenario does not come to pass but there are an increasing number of people in Australia and around the world who fear it.

Back in Australia, banks are incredibly optimistic because suddenly sound middle and smaller-sized enterprises are coming to them looking for money to expand or lessen their dependence on China. 

Banks will face substantial losses from those companies that have actually collapsed but have not yet formally recognised their fate – the so-called zombie companies.

For the most part, the banks have huge provisions ready for this eventuality and the rise in house prices means that the old dodgy house loans will not cause widespread losses. The regulators may curb the housing lending rate but they will handle that. 

But what is creating further excitement is that the banks are being approached by US and UK enterprises looking to do further business in Australia. We speak English, we have excellent independent contracting laws, and almost no COVID-19. 

For these enterprises, Australia looks like a much easier place to operate in than the UK and US. A lot of opportunities are going to be created.

But we too, of course, are vulnerable to what might happen in the US and, of course, right now in so many areas of Australia there is a shortage of skills and that might erupt into inflation here. 

My advice for all those taking out large home loans is to fix at least half of the amount at current rates. I have been wrong before but there are pressures out there we haven’t seen for a long time. 

Finally, I hope you don’t mind if I express some frustration. Many years ago, I picked out hospitals as an area for safe cornerstone investing. They didn’t have to dominate your superannuation fund portfolio, but it was a very comforting base that helped diversification in riskier areas.

The company I chose was Generation Healthcare and I was very cross when the Canadians made a takeover bid which the directors recommended. Although I made a profit, this was a long-term investment.

Then I discovered the unlisted Australian Unity Healthcare Fund. And so, the proceeds from General Healthcare and other money were invested in the AU fund.

It has been a great performer but because it is not listed, it doesn’t have the same liquidity as a listed security. But at least until now, the demand is so great anyone wanting to sell can do so.

The fund took on a successful $400 million hospital project in Queensland and has the opportunity for about a billion dollars in potential new brownfield projects over the next 10 years. The fact its Australian owned also adds satisfaction. I understand the interest rate situation, but I was happy to sit pat.

The rewards of that $400-million expansion are now coming through so I was a very contented holder. And guess what? The Canadians are trying to buy me out again.

If they bid a proper price I would take them seriously, but they are trying to get it on the cheap – just a little above asset valuation. And they managed to secure friendly journalists to boost their case. 

The truth is Australian Unity manages the health care fund and that management contract is valuable.

If the Canadians get control, they will manage it and will have secured the asset at only a little above the valuation of the properties. They should be paying a substantial amount above valuation. But the conventional wisdom is that if someone gives you 10 or 20 per cent above the market, you should take it.

It makes no sense in this case because there is so much ahead and the assets are irreplaceable. But the Canadians are masters of the media, and I fear that I will be forced out. There will be a point where I would favourably consider voluntary selling – probably about 40-50 per cent above value which would take account of the value of the management contract.

But instead, they are offering only around 10 per cent above the valuation and reckon they can get the stock. And, who knows, they might be right.

I wish I could write in The Australian about this, but I am too conflicted, so I share my frustration with my Eureka readers. I hope you don’t mind.