Summary: The ability to lock in a 3.85% rate for 30 years was enough to bring technology giant Apple to the capital markets last week. The Australian government has the same opportunity to borrow low-cost funds over a long term to fund strategic investments across rail, roads, port and other national infrastructure.
|Key take-out: In tapping global markets, Australia’s economic growth and social policy initiatives could be funded away from simply raising taxes.|
|Key beneficiaries: General investors. Category: Income.|
The decision by the Reserve Bank to cut cash rates and bring them to historic lows followed some extraordinary policy pronouncements in Europe by the European Central Bank (ECB) in the previous week.
These announcements will positively affect the value of the securities in my income portfolios, and this is starkly evidenced by the interest rates that were secured by Apple Inc. in its recent extraordinary bond issue.
The RBA decision was belated and forecast by myself a few months ago. I said then, and I reiterate now, that the Australian economy is slowing to a walk under the high $A, which in turn is caused by massive offshore QE programs.
Frankly, the 0.25% cash rate adjustment is not nearly enough, and cutting interest rates by themselves is not the answer.
Australia needs a co-ordinated policy response that encapsulates both fiscal and monetary settings. I suspect that next week we will see that our government has no stomach for hard strategic policy initiatives, and I do not mean bringing the budget back to surplus. Rather, there needs to be recognition that Australia is a dynamic developing country and not a developed country. The difference is significant because recognition of this simple fact would stimulate our government into a growth expenditure cycle that anticipated compounding population growth of 2% per annum. A debt-funded capital investment cycle would stand Australia aside from the disaster of Europe. Right now it is the ramifications of the disaster in Europe that can be put to our advantage.
To understand this we should review the table below to see the extraordinary bond issues undertaken by Apple Inc. in the US capital market last week.
Noteworthy is that Apple was able to set a weighted average bond maturity for $17 billion at a weighted average yield of 1.811%. In this raising people masquerading as capital managers provided Apple with $3 billion for 30 years at 3.85% fixed. The money was not raised by Apple for investment but rather to return capital to shareholders. That alone should have resulted in Apple paying substantially more for this debt then it did. But we live in absolutely crazy times and it suggests an immense opportunity for the Australian government.
My point is simple. If world capital managers are so bereft of places to invest, then the Australian government should have the fortitude to access this capital at historically low rates. For instance, imagine if the Australian government borrowed $50 billion of 30-year capital to create a fund for the National Infrastructure and Development. The cost of funds of (say) 3.5% p.a. fixed for 30 years should be well covered by the returns on strategic investments across roads, rail, ports, airports, learning institutions and hospitals. Those strategic investments would propel growth, generate employment and translate into higher tax revenue. The investment returns above cost could be diverted into our National Disability Scheme. Economic growth and a significant social policy initiative could be funded away from simply raising taxes. Sounds logical, but don’t expect that to be announced next Tuesday night.
The missing link in the world’s QE policy is the direction of the newly created capital into growth projects. Filling the debt holes of governments is not enough. History shows that government debt can only be dealt with in two ways. The preferred route is via growth, and the alternative is default. In 1945 Australian government gross debt stood at over 150% of GDP. That debt did not stall Australia’s growth and we did not default. Rather, a sustained period of economic growth resulted in the debt being easily managed down.
Australia was then, and is still now, a developing economy that is hampered by a lack of vision rather than a lack of opportunity.
European solution creates a bond asset bubble
The low-cost borrowing opportunity above is absolutely caused by QE across the world. Indeed, last week the ECB introduced a new concept that has potential to blow more air into yield markets, and investors need to be aware that interest rates may well go lower.
Source: ECB, Fulcrum Asset Management
The above chart shows that the ECB has a number of arms to its policy settings. In particular, it sets the rates it will pay on bank deposits with it (now zero) and the rate it will lend to banks who need liquidity (1.5%). Last week the ECB declared that it will consider dropping deposit rates to a negative rate and said it is prepared to lend unrestricted amounts to banks for as long as the debt crisis is maintained.
These are extraordinary statements and it explains why the junk government bonds of Europe are rallying. Italian 10-year bonds are now yielding below 4% despite the massive government debt load and its declining economy. A similar picture is seen in Spain despite its 26% unemployment. In normal circumstances default would be very possible in Italy and very likely in Spain – but these are not normal times.
The ECB is deliberately driving European banks away from depositing funds with it and pushing them into bonds across Europe. Further, its unlimited lending facility is presenting banks with an interest margin when they buy high-risk bonds. But these high-risk bonds are underwritten by the ECB and so we have a fortuitous circle that has no end in sight.
The result is that yields in Europe are tumbling as they are in the US and Japan. Apple cleverly became a beneficiary and so will the owners of the securities held in my income fund. Indeed, after a brief pause I suspect that high-yielding shares will go higher and the perpetual hybrids of Australand (ASX:AAZPB) and Multiplex (MXUPA) will also move much higher in price.
Remember, this is not about the rationale pricing of risk but the perverse result of monetary policy that is not supported by fiscal strategy. There will be a time to jettison yield securities for either the safety of cash or better, pure equity opportunities – but not just yet.
John Abernethy is the chief investment officer at Clime Investment Management.
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Clime Income Portfolio Statistics
Return since June 30, 2012: 31.06%
Returns since Inception (April 24, 2012): 29.74%
Average Yield: 7.18%
Start Value: $118,757.19
Current Value: $155,648.25
Dividends accrued since December 31, 2012: $2,613.79
|Clime Income Portfolio - Prices as at close on 9th May 2013|
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