Market News – 2 December 2019

The Australian Treasurer recently described the ageing population as an economic time bomb.

I think he’ll find he is incorrect, and that this group will turn out to be an economic boon via the extended use of their skills and wealth.

The people who are living longer can offer more to society, for the benefit of the young (learn more but still inherit), for the benefit of the economy (longer access to their productive contributions) and to benefit of the government (greater tax collection from their consumption).

Speaking of Australia, did you see the poor CEO of Westpac lost his job last week and will have to suffer the difficulty of coping with only the $2.7 million severance package.

INVESTMENT OPINION

Global Debt Clock – Apparently the global debt clock, across all forms of borrowing (government, private, commercial, financial markets) has breached US$250 trillion.

According to Trading Economics Global GDP across the 198 nations listed (Kiribati as the smallest on the scale) tallies to US$118 trillion.

If you read much from our sector, you'll know that analysts have been concerned about gross debt levels for many years.

They have also expressed concern when debt begins to exceed 100% of a year's production, so collective risks at 212% would seem more than a little scary to them.

Lenders consider their loans to be an asset, which it will be if the borrower can meet their financial obligations; which is an open question, where the opening is becoming wider.

Sometimes the loans have credible collateral, with property as a common choice, but the pricing of property has reached points that average incomes barely cope with.

Sometimes loans are against sustainable income at credible levels for servicing debts.

Sometimes neither is on offer, yet still the world lends.

Consumer credit and low or nil equity lending must be feeling increasingly exposed.

Whatever one assumes about assets and income of borrowers the relativity to debt ratios continues to worsen.

Rising risk should deliver higher returns, or at least relative returns, yet that's not happening.

The simple response is often the logical one; progressively reduce the risks one accepts when lending money (fixed interest investment).

The heavily criticised calls for increases in equity on bank balance sheets may well be a little ahead of their time, but I think they will prove to be prophetic within the next decade.

The Reserve Bank's evolved proposal for increased equity held by banks will be released on 5 December. This is an important change for bank users, which means all of us.

Kevin Gloag has kindly offered to write Market News next week, maybe he'll explain the new banking regulations to you then. (I am absent on a 'research trip').

General Misbehaviour – Most of the major banks have been found wanting with respect to behavioural performance over the past couple few years, both in Australia and in NZ.

In NZ the ANZ, then Westpac were found to have inappropriately calculated the risks on their balance sheets and now BNZ has disclosed that it too has failed in the same regard. Presumably ASB will follow next?

This broad level of failure across the major banks who were given the latitude for self-defined risk assessments, unlike our small local banks, serves to confirm that the regulatory breaches were not a function of error but were part of an operational strategy.

I have worked with some of these people; they are intelligent and skilful operators and it would be embarrassing if it was true that they had been making the same recurring mistakes across different banks.

I don’t believe it.

Neither does RBNZ governor Adrian Orr. It's hard to question the Reserve Bank's preference for more equity and homogenous methods for calculating risks. More will be announced on this subject next week.

Regular readers may recall us discussing risk weightings with respect to banks.

Lending on a housing mortgage is less risk than lending to buy a cow.

The RBNZ places some definitions around such risks so a bank knows how much equity it must hold against each loan; a mortgage might be 35% risk; a cow may be 100% risk.

If Adrian has his way banks will need 15% of their risk adjusted balance sheet to be equity and should all apply the same risk calculations.

Under my scenario a $100,000 loan on the house would require approximately $5,250 (15% of $35,000) of bank equity and $94,750 from bank deposits (or bonds) on-lent to the mortgagee.

Under my other scenario a $100,000 loan on cows would require approximately $15,000 of bank equity and $85,000 from bank deposits (or bonds) on-lent to the farmer.

The RBNZ wants all banks to fall into line under the same risk assessment models and the same equity ratios, which sounds very fair to me. It's also much more efficient to audit and monitor if you are the banking regulator.

It's the appropriate reaction to the incorrect application of the rules displayed by banks in the past.

Under the same heading of regulatory breaches, but somewhat more surprising to me, are the failures being reported under the Anti Money Laundering legislation.

CBA was fined $700 million recently for its failures.

Financial Intelligence Agency AUSTRAC now alleges a rather sensational 23 million breaches of the AML laws by Westpac. Presumably these are individual payment items over a number of years.

I think AUSTRAC does themselves a disservice by going on to say they will seek fines of up to $21 million for every transaction Westpac did not monitor adequately or report on a timely basis.

I needed to use a spreadsheet as a calculator to resolve this. The screen on my calculator wasn't wide enough. AUSTRAC seeks a collective fine of $483 trillion, a sum that dwarfs the volume of real crime across the planet. Note that the US government debt level is currently approaching US$22 trillion.

$483 trillion is approximately $70,000 for every man, woman and child on the planet.

Such nonsense undermines the concerns behind the claim about incomplete or ineffective AML procedures in a major bank.

The occasionally oppressive nature of the AML legislation on industry, clients and thus the economy doesn't attract many friends so to see a major entity such as a bank struggling with it provides us with some relief.

Much of the crime you see being solved 'out of the blue' on the news has direct links to evidence supplied by the banks. They are demonstrably effective with many of their AML efforts in helping to reduce crime.

Regulators should be working with them, not against them.

Yes, the banks need to make improvements where failures are found, but those improvements are far more likely to occur if the regulators get straight in and drive the developments, financed by the underperforming bank, than by threatening fines at a scale that could solve world poverty and superannuation deficits all at once.

I think our central bank is on the right path with its regulatory simplicity for banking, followed by non-bank deposit takers. I'd like to think that we'd follow a similarly simple, pragmatic, path with AML regulation too.

It may be upsetting to regulators for me to express this view but it would be nice to spend more time and energy on client requirements and less on regulatory requirements (don’t worry the Productivity Commission will be onto this one – Ed).

Unexpected Influence – It would appear that higher relative returns from investment in property and shares is beginning to show up in the quantum of bank term deposits, used by banks to fund their lending.

In one of the ANZ's most recent commentaries (which I hope they don't mind me refering to) they said:

The Official Cash Rate (OCR) has been cut 75 basis points over the past six months and mortgage rates have fallen. But because household deposits are an important source of bank funding (eg for home loans), banks have had to strike a balance, meaning both mortgage and deposit rates have fallen by less than the OCR has.

And as the OCR goes lower (we're forecasting a further 50 basis point reduction by August 2020), we think the pass-through to mortgage (and deposit) rates will diminish.

Indeed, there's a real risk that if deposit rates go lower, household deposit growth could slow markedly as depositors seek higher returns elsewhere. This would mean banks have a lower deposit base from which to provide new loans, reducing the positive impact to the housing market and broader economy.

So even if the price of credit (ie the interest rate) is low, supply constraints (credit availability) can be a significant headwind.

We have been seeing this behavior from investors throughout 2019, an increased rejection of the returns being offered on bank term deposits with the funds being reallocated into other asset classes.

We've heard the conversation about dissatisfaction each time interest rates fell down through the next 'big figure', 7%, 6%, 5% and 4% but the investors usually held the line with their allocations into fixed interest assets, but not any longer.

The journey below 3.00%, currently at 2.50%, which delivers an after tax real rate of rerturn below inflation, has been sufficient to spark a meaningful change to asset allocation for most investors.

ANZ's commentary is evidence that bank Treasurers are seeing the same data and are beginning to focus more closely on the percentage of funding the bank draws from deposits made by the public.

To be fair to the banks they have been trying to hold up returns on bank deposits (I'm not kidding) because the reward for risk from a bank deposit currently sits well above (more attractive than) alternatives from investment in bonds.

A 5 year bank deposit at ANZ bank yields 2.65% today, yet a 5 year senior bond from ANZ, ranking alongside deposits, yields about 2.05%.

None of this makes depositors feel lucky, however, it should paint a more difficult picture for borrowers of money in the years ahead because they know if banks are forced to carry more equity the cost of lending will rise and they’re now being told that the tilt toward depositors (higher interest rates) also implies higher interest costs on debt.

If you just read that as meaning 'double whammy' you have missed the triple event, being, less access to debt finance; scarcity will also increase the price.

Over the second half of 2019 the shrewd and the conservative have been reducing debt obligations to the banks, preparing for the debt scarcity that I speak of.

Why else would property investment entities issue more expensive new shares to repay bank loans?

Why would companies return to the issuance of subordinated bonds if bank funding was cheaper?

Clearly, to me, they are all concerned that the cheaper debt option is going to increase in price and for some not be available at all.

I'd encourage investors to factor this debt access and pricing issue into their own investment thinking. Businesses with excessive debt levels will find funding more difficult and more expensive even though central bankers will be talking in 1-2% interest rate terms.

Businesses without robust cash flow surpluses won't enjoy meetings with their bankers. They'll need more supportive shareholders than in the past.

Global Dividend Changes – A useful snippet for you from TheBull.com.au

Dividends paid by companies across the world to shareholders hit a record in the third quarter, according to a study released Monday, although further growth was likely to be weak.

The amount shareholders received in dividends in the third quarter rose by 2.8 percent from last year to hit $355.3 billion, a record for the July-September period, according to a report by Janus Henderson Investors.

“A slowdown in global dividend growth is underway,” said the report, adding “2020 likely to see a moderation in dividend growth given the global economic environment”.

In the third quarter of last year dividend growth came in at 4.4 percent.

While the United States hit an all-time record for dividends, China showed weakness and Australia saw a decline, according to Janus Henderson, a major player in the asset management industry with more than 355 billion euros under management.

Dividends in the Asia-Pacific region slid by 2.8 percent, with Janus Henderson Investors noting that many firms there distribute a fixed percentage of profits in dividends.

EVER THE OPTIMIST

Meridian has reminded our youth that there is some glamour to be found in engineering.

Armed with the same catchment (Lake Pukaki), but limitations on how to use the consented spill, Meridian Energy's engineers have developed a proposal to increase the energy drawn from the lake by 200%.

I thought this number sounded fantastical too, but they say the consent accesses 545GWh and the potential increase from current is 367GWh. Also illustrated as being the equivalent usage of 50,000 homes.

It sounds as if they plan to recirculate to and from Lake Ohau, or from the canals shortly after the water departs (or pray for rain? – Ed). Whatever the method I look forward to learning the details in due course.

ETO II – Try searching the company name Heliogen.

They say they have developed a method of focusing solar energy so accurately on a single point they can deliver enough heat (energy) to run a concrete plant or steel mill, or to extract Hydrogen from water.

Solar energy will never provide constant supply, but it's nice to see the scientists increasing solar's effective range of use.

INVESTMENT OPPORTUNITIES

Synlait Milk Bond – Synlait Milk Ltd (SML) has announced its intention to offer up to $200 million of a subordinated bond with a five-year term, a minimum interest rate has been set at 3.70% with the final interest rate set on the 6 December.

The offer will be processed via contract and no brokerage will be charged to investors.

We have a list that all investors are welcome to join if they would like to seek a firm allocation of the bonds.

Infratil Bond – continues with its offer of new bonds, but now only with a single maturity date offer:

A fixed rate bond maturing on 15 March 2026 paying 3.35% fixed for the whole term.

The offer documents are available on the Current Investments page of our website.

Please contact us if you wish to secure an allocation.

TRAVEL

Edward will be in Wellington 12 December.

Mike Warrington