Market News 21 August 2017

This isn’t a headline that I would have been happy with, if I ran Uber:

‘The ride-hailing company’s board determined Xchange Leasing, a wholly owned subsidiary, is unsustainable and should be sold’

Would you like to buy an unsustainable company?

This opinion won’t stop an investment banker seeking a fee to try and sell it.

Investment Opinion

Rates Up? – I see Alan Greenspan must have been missing out on highly paid engagements on the speaking circuit lately so he recently reached out for some more media attention and offered his view on interest rates; he stands with the team forecasting higher interest rates for both short and long terms.

Not only does he predict that interest rates will rise but he declares that once they do move (a key point of uncertainty even for him) they will move fast and then he goes on to extrapolate the breadth of the impact on the values of most assets.

Greenspan stated that in his view shares are not experiencing a bubble in pricing but bonds are (is that reconcilable?) and once the bond bubble bursts share prices will feel the splatter.

Alan Greenspan was one of the longest serving governors of the US Federal Reserve, surely he knows what happens next, right?

Well, if he was that good at managing money he wouldn’t need to seek out the attention of the media and paying roles on the speaking circuit. It may be all about ego, but I’ve never thought of Greenspan as egotistical and at 91 years of age I doubt he cares what others think of him.

One problem with Greenspan’s dire warnings is that he made the same warnings last year. I don’t recall if they had reached ‘dire’ on the emotional scale at that point or not but his warning was clear; interest rates are going up.

Half of the readers will agree with him.

He might claim a slow drifting victory because the US Fed Funds rate has indeed gone up, and then with a little help from the newly elected President long term rates increased also, only to decline again ever since the Christmas peak.

In the middle of the news item there was a brief rebuttal from an investment bank economist who reminded Greenspan that he was quoted as saying he was ‘puzzled by the low rates and low inflation for decades’.

Being ‘puzzled’ doesn’t make for good press so Greenspan has decided to re-assert his position by making a decision.

Just as I did a few weeks ago, when I compared bullish and bearish comments from respected investors (Baron and Gross) there is a contemporary foil for Greenspan’s latest predictions and they come from no less eminent a person than the US Federal Reserve stable also, the current vice Chairman Stanley Fischer.

Fischer’s current view on interest rates disclosed an angst that interest rates appear stuck at historically low levels even though the Fed has been tightening monetary policy and this may well in turn signal that the growth potential of the US economy is limited.

This concern would be consistent with the various analysts who conclude that excessive debt levels suppress economic growth. Weak economic growth does not bring with it confidence about employment and incomes needed to fuel more inflation.

Again, one respected voice serves, but an equally well-respected voice responds with equal and opposite force (should we be consulting with physics professors? – Ed).

For just another moment I’ll dwell on the negative risk, being the potential for rising interest rates.

Long-time readers may recall me talking about why I don’t think NZ fixed interest investors have much to worry about from the ‘bubble pricing for bonds’ for two reasons, one of which doesn’t require my opinion on interest rate direction.

The average duration (average term) of fixed interest investment by New Zealanders, and I mean those who are getting financial advice, is very short (probably 2.5 years, or less) and thus will only incur a modest change in value during periods of rising interest rates.

The situation is even less volatile for unadvised investors for these folk hold 90% of the country’s cash in bank deposits of 12 month terms or less! Alan Greenspan’s opinion about damage to investment values from rising interest rates is irrelevant to these people, and hence the majority of our economy.

If I am correct about advised investors having a 2.5-year average life for their fixed interest portfolios then Greenspan’s prophecy will also have very little impact on these investors either (maybe a temporary 5 cents in the dollar value loss from a short sharp 1% lift in interest rates).

Visibility over thousands of investors and market experience gives me plenty of confidence with this impact statement. In fact, I think my estimated 2.5-year average life is too long.

Witness the impact of recent bond offers; Wellington Airport had little trouble filling its shorter-term bond offerings between 4.00% - 4.25% yet when they offered a longer-term bond at 5.00% it attracted only $25 million demand from the public (by contrast a professional investor bought $50 million).

Witness again the recent bond offer from Infratil with dual (and duelling – Ed) terms on offer. The 5-year term raised $100 million at 5.65%, alongside the 8 year term at 6.15%, which raised only $43 million.

Investors who chose the 5-year Infratil bond based on concerns about rising interest rates must hold the view that returns on future Infratil bonds between the years 2022 – 2025 will yield a little above 7.00%. I think that’s a bridge too far, as does the market now given that they will buy the IFT250 8-year bond at a yield of 5.50%.

NZ’s retail investors, and apparently their financial advisers, have an aversion to longer term fixed interest investing and therefore have only a modest exposure to loss of value if interest rates do rise quickly. These people will feature within the group of 50% who agree with Alan Greenspan’s warnings.

Factoring in my personal opinion (low interest rates for longer yet, being years not months) I think a focus on short term investing is delivering lower overall returns to investors.

Note to self, which I hope Google will remind me of when they introduce an automatic bring-up facility based on reading my emails; remember to re-visit the ‘Tortoise and the Hare’ calculation of short term fixed interest investment versus long term fixed interest investment next year, and the year after.

I am backing the tortoise.

Post Script (with relevance): The Reserve Bank's survey of expectations showed respondents see annual inflation at 1.77 percent in one year, down from 1.92 percent rate in the prior survey three months ago. In two years, it is seen at 2.09 percent, down from 2.17 percent. (emphasis mine)

Volatility – From time to time we have commented about the behaviour of the ‘VIX’ being the Volatility Index for trading on the S&P500 shares index in the US.

Today I am drawing to your attention to another measure of volatility, this time in US Treasuries (bonds), named ‘MOVE’ after the firm that established the measure; Merrill Lynch Option Volatility Estimate.

To be sure, we can witness volatility everywhere, across almost all data gathered and thus across all tradeable assets in financial markets. We can even measure volatility in the speed of snails across Agapanthus if we are patient enough.

The point of highlighting the ‘VIX’ and now the ‘MOVE’ indices to you is because they measure activity in the world’s largest share market and bond market and this, you’ll recall, is influential to all other financial markets around the world.

Our most recent comments drew your attention to the surprisingly constant decline in the volatility of the US share market (measured by VIX). I speculated that the rise of investment allocation to Exchange Traded Funds (ETF) may be contributing to a decline in the volatility of markets.

At the time, I also noted that the respect for Warren Buffet’s successful bet against active fund managers may have provided some influence for the trend of investors toward those ETF investments.

The MOVE volatility index displays about 30 years data. It has centred around the 100 value, which may have been the index start point, and the range is 46 to 200. I expect that by this point you have guessed that the index is at the 46 level as I write.

Just like the VIX index, MOVE has been declining in volatility since 2008 (crisis times).

Initially even the North Korean nonsense was barely visible on these volatility indices but this has finally changed and lifted following Donald Trump’s colourful responses to the North Korean behaviour.

It remains hard for me to reconcile such low market volatility but I shan’t complain because stability is better for investors, whereas volatility is better for traders who extract value from natural holders of investments.

Maybe the low cost of money (interest rates), the pursuit of low fee investment options and the ongoing good financial performance of companies is resulting in less volatility?

Regarding company performance I read this useful quote last week:

‘With 87 per cent of the companies in the S&P 500 having reported their earnings for the past quarter, a blended rate of the actual results and analysts’ forecasts indicate that earnings rose 10.1 per cent per share year-on-year, according to FactSet’.

A 10.1% year on year improvement in performance is very impressive, especially after such a long run of positive performance.

Investment News

Vital Healthcare (VHP) – within the latest update from VHP about its admirable properties and tenants there was a quote that said it all for me:

‘Vital lifted net rental income 31 percent to $89.7 million in the year, which included $13.8 million for a lease termination receipt. Expenses rose 52 percent to $22.1 million, driven primarily by management and incentive fees on the back of strong revaluations. Incentive fees totalled $12.3 million in the year.’ (my emphasis)

The sharp increase in the size of the portfolio has delivered well, for the external manager, whose incentive fees alone were one seventh of the net income of the investors’ portfolio (ie where the real risk lies).

Then, probably with a celebratory tone, the manager declared that they will maintain the VHP dividend at 8.5 cents per unit in 2018.

That is a disappointment, not something to celebrate and indicative of the impact of third party management incentives.

It also supports the advice and recommended action outlined in our recent VHP article.

Heartland Bank – HBL continues to deliver upon its growth ambitions, reporting its $60.8 million annual profit and half cent increase to its dividend for the past year.

HBL enjoyed growth in all areas of the business and now forecast a 2018 profit of $65m - $68m.

HBL’s share price has continued to lift in recognition of the ongoing performance by the bank.

Kevin Gloag has published some detailed comments and financial advice on the Private Client page of our website for those who seek financial advices services from us.

China – State entities with excessive debt have again been causing concern for local and global capital markets but unlike most markets the government has again stepped in to ‘encourage’ banks to convert bad loans to stock.

Apparently, the banks are allowed to exercise some discretion, so businesses that really should fail will be allowed to but clearly the intention is to avoid widespread failure.

Failure or converting debt to equity is a refreshing return to normality after watching decades of not allowing failure across many Western nations.

Remember how quickly Iceland recovered after acknowledging failures and writing off debts?

Index Rules – Those who define the rules for acceptance of shares into an index, such as the US S&P500 are beginning to tighten what is acceptable governance behaviour and what isn’t.

The S&P500 for example will no longer include any business that does not offer voting rights on securities.

Other indices are placing restrictions relating to responsible investment.

These are good developments with respect to improving governance standards and investors’ rights.

Credit Problem – US credit card debt has just passed it previous record high, set just before the Global Financial Crisis in 2008.

The increased use of personal debt may reflect increasing employment confidence but it also discloses the same dangerous behaviours of the past where ‘we’ are willing to bring forward spending as opposed to increasing savings for a rainy day.

Anecdotes like this contribute to my view that it is hard to see interest rates increasing because neither increased employment nor spending to excess have driven higher inflation in the US.

 

ECB – Even though many are calling on the European Central Bank (ECB) to progressively withdraw from buying bonds and injecting liquidity into EU markets they continue to do so.

Last week they purchased significant volumes of Italian bonds.

This got me thinking of an advantage that Europe has over the US in that the ECB could conceivably trend away from buying bonds in countries that are in good financial shape but continue to provide support for those who are not (Italy, Greece, Portugal).

The EU and the ECB can think about strategies for achieving desirable outcomes but the uneven nature of economic performance across Europe implies that in many cases support is not required and thus if provided it just delivers unnecessary subsidies to some.

These acorns should be retained for use elsewhere when required.

Maybe this selective approach from the ECB could be their pathway to a gradual tightening of monetary policy in Europe.

European financial markets are already tuned into this possible development witnessed by a decline in yields for Italian bonds closing in on the lower yields of German bonds (0.25% closer over the past month).

Property Rights – He who holds the property rights shall be King (or she, the Queen).

There is no doubting that the internet is helping to broaden the number of people who will deliver video content to consumers, but the only way to be on safe ground commercially is to control the content (property rights).

There is plenty of rubbish content but consumers will not pay for this.

The following is a statement from Disney:

Walt Disney Co. said it would stop selling movies to Netflix Inc. and begin offering movies and ESPN sports programming directly to consumers via two new streaming services. Shares in both companies fell more than three percent in extended trading. Disney’s chief executive officer Bob Iger said that cutting out third parties was an “opportunity to reach the consumer directly.

This is why Amazon Prime began its own production (e.g. The Grand Tour) and why Netflix must pay for its own high-quality production too, or pay even more to other producers.

Having many customers is one thing, but if those customers don’t wish to pay for content (like my kids) then it is hard to pay for third-party content or production of one’s own content.

In NZ, Sky TV has content and it has customers and is logically spending some time and money on fighting against those who would steal that content. Disney will probably have the same fight on its hands.

Mail – NZ Post is killing off FAST POST as a service. This will impact those who prefer to mail investment activity to us, such as application forms.

We have commented previously about the unreliability of mail when a delivery is urgent and this compounds that risk.

We will comment again in future weeks about how we think investors should respond to this new situation, so as to avoid missing out on investment opportunities.

Ever The Optimist – Trans-Tasman Resources received a green light from the Environmental Protection Authority to mine iron sands off the South Taranaki coast.

TTR says it will now invest at least $600 million into the commissioning of this business which is very good economic news for the Taranaki region.

TTR says it will generate 300 jobs in the immediate area and 1,600 nationwide as well as generating $400 million in annual export revenue.

Congratulations to them on the success after persistence.

Investment Opportunities

Heartland Bank – HBL has announced an offer of a 5-year senior bond to the market.

Heartland have announced the minimum interest rate is 4.50%

All investors are welcome to join our mail list for this offer by contacting us.

The fastest way to hear about new issues is to join our ‘All New Issues’ email group, which can be done via our website or by emailing a request to us to be added to this list.

Travel

Kevin will be in Christchurch on 31 August.

Chris will be in Auckland on 4 September and in Tauranga on 5 September.

Edward is in our Wellington office (Level 15, ANZ Tower, 171 Featherston St) on Tuesdays, available to meet new and existing clients who prefer to meet in Wellington.

Anyone wanting to make an appointment should contact us.

If you wish to be alerted about the next time we visit your region please drop us an email and we will retain it and get back to you once dates are booked.

Michael Warrington