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Market News – 14 October 2019

I have just read the first optimistic thing relating to Fonterra in a long time; Fraser Whineray has accepted an offer to join Fonterra’s senior executive ranks, departing his role as CEO at Mercury Energy to do so.

Fraser’s move is not about the money. He has some history in the sector (Dairy Board and Puhoi Cheese) and will surely hold some strong views about adding value for NZ to one of our largest export businesses.

Good on him.

If you happen to be a Fonterra investor, don't count your chickens (cows – Ed) too soon. 

Fraser doesn’t start until 2020 and 'good things take time' in the dairy sector.

INVESTMENT OPINION

Budget Surplus – Decision making is always a forward-looking exercise, but on occasion one must allow themselves time to reflect on the success or failure of past decisions.

Without wanting to get too far into which period of government influenced what results, New Zealand should be very pleased with its recent budget surplus (the cash part, not the revaluing of the rail business). The reality is that collective fiscal governance in NZ has been well led by both 'colours'.

Higher tax revenues may imply a conclusion of being over-taxed, but I suspect it also means IRD is getting better at collecting taxes that were once avoided. 

Displaying that we can collect a surplus of tax is a far stronger position to be in than the many nations with ballooning future liabilities and no political fortitude for increasing government revenue to begin solving their problem.

Actually, Japan deserves compliments for its political fortitude on tax reform having introduced and progressively increased its sales tax, one of the most effective taxation methods, as they try to tackle Japan’s enormous government debt burden.

I see they passed this tax increase into law just prior to the Rugby World Cup and next year they have the Olympics to add even more consumers into the mix.

Japan’s only mistake was that unlike New Zealand’s simple and effective GST application they have agreed to certain exemptions for their sales tax.

But I digress…

Governments are notorious for wasteful spending, so I don’t want ours to simply search for ways to spend more and certainly not for short term excitement (sugar rushes). Longer term infrastructure requirements (ably assisted by private investors in Public Private Partnerships) and perhaps increased savings toward ACC and Superannuation obligations appeal to me.

If there’s room, then sure, personal income tax cuts to reposition some money back into the hands of those who are most active within the economy would be useful.

It would be nice if we could afford to increase the net income for those on the lowest incomes to counter the uncontrolled price increases the public endures from barely controlled council spending and now huge increases from the insurance sector too.

As the global trade wars expand NZ is going to be very grateful for the fiscal prudence of our government. 

Business Confidence - I am looking at an ANZ supplied chart that overlays economic growth (GDP measure) and business confidence (Quarterly Survey of Business Opinion).

The correlation is not quite 100% but it’s well over 90%.

The recent decline in business confidence is steep, with a gradient only mirrored by troubled periods such as 2008, 2000 and the mid 1990’s.

I understand why some commentary concludes that we talk ourselves into some of our own economic problems, but in fairness the businesses are looking forwards when they make today’s investment decisions, so their lead indicator should be heeded.

Based on weaker economic opportunities businesses are investing less money. 

The businesses don’t necessarily expect to earn less money but they cannot see clear opportunities to increase their revenue and want to steer a conservative course with financial resources just in case revenue declines.

It would be logical for investors to respond to this signal by managing their investment risk taking in much the same way; don’t expect an increase in revenue or profits from the businesses that you own. It may happen, but the business group is telling you of its improbability.

Business Confidence II – Here are a couple of news items that deserve to add confidence;

Christopher Luxon will now offer his skills to the NZ parliament; and

The current CEO of Walmart in the US, New Zealander Greg Foran, has accepted the role as CEO of Air NZ. This is an outstanding hire by the company and should inspire other NZ businesses to think big when trying to secure new executives.

Trade War – Donald Trump began the trade disruptions based on the sound principle of wanting better financial balance between trading nations.

In truth he wants the US to sell more than it purchases, but from a starting position of the opposite happening just striving to reach a balanced outcome was a good initial focus.

However, political tension has escalated rapidly as various nations fight back, not wanting to cede ground to the detriment of their own economy, no matter how fair balanced books sound.

The situation has now become worse as political ideology has reached the forefront, making financial outcomes a secondary consideration; witness the fiery debate about freedom of expression regarding Hong Kong and sports (NBA) being drawn into the fire.

Those who held out hope that the ‘trade war’ would be settled prior to the 2020 US elections are going to be disappointed. 

Economic activity seems likely to slow as nations try to do less business with each other, but this will likely be compounded by reduced spending (increased saving) by consumers as they worry about their future employment and personal incomes.

Watch the once bustling Hong Kong economy slow to a crawl.

The interest rate markets, tracking lower again, have been expressing stronger expectations that the forecast weaker economic results are coming to pass.

Canary - I hope this story from last week isn’t a canary in a coal mine.

A modest sized hedge fund (US$4 billion) in Korea has frozen investments in the fund and suspended withdrawals.

The fund invested in higher risk bonds, using leverage (this is what hedge funds do) so to be experiencing a run of withdrawals and then to suspend these it confirms that the fund was beginning to lose money on its higher risk bonds, exacerbated by the leveraged position.

You would have thought it was hard to lose money in a bond market with falling yields. To do so implies that the higher risk bonds were too high risk and the borrowers failure to meet obligations, even off very low interest rates, discloses that we may have reached a tipping point for this sector.

It is a long while ago (2007) when Bear Sterns failed under the weight of failed lending to higher risks, a year prior to the Global Financial Crisis, but we said at that point ‘there is never just one cockroach’. 12 months later the infestation became more obvious than any dared believed was possible.

This quote sounds familiar - 'We made this decision through consultations with regulators in order to minimize the losses of investors'. (how generous - Ed)

The fund’s name is Lime Asset Management. This might leave a sour taste I thought.

Then I looked up their website where they present an acronym for LIME - Legendary Investment Management Entity. A bit too cute.

At this point I am beginning to think their legend won’t be what they imagined when they boasted so openly in public.

I hope they turn out to just be a sour fruit and not a canary.

Mortgages – The huge decline in nominal interest rates is now delivering negative real returns (below inflation) and with bond yields now well below bank term deposit rates professional investors are considering other options for lending money.

Simplicity Kiwisaver fund is the first to declare that it will start acting as a mortgage lender, with the potential to currently offer a low rate of 2.95% under certain conditions. 

This strategy will come with additional administration costs but with returns of 1.00% or more above the strong bonds they currently invest in it’s definitely an avenue worth pursuing and adds value beyond the fees charged by the fund.

I also observe that Simplicity intends to have restrictions for both Loan to Value Ratio (LVR) and Debt to Income (DTI) which should make it clear to the Reserve Bank that they are dragging the chain by not adding DTI to their regulatory demands from our banks.

I had thought that this move would quickly be copied by other Kiwisaver providers, but given that the largest funds are owned by banks it is far more likely that Simplicity has alerted them to the opportunity to sell some of their own loans from the bank’s balance sheet into the Kiwisaver fund, if they haven’t already thought of this themselves (seems likely - Ed).

New Zealanders had hoped that Kiwibank and the other small banks may have led the charge for reducing the influence of Australian owned banks in the NZ economy but given the rate of growth of savings in Kiwisaver, it may well be these vehicles that increasingly localise our lending market.

ACC – ACC’s disclosure that its levies may need to rise in response to lower interest rates is the reality of the situation for many businesses, especially insurance businesses.

ACC defines its liabilities based on estimated incidents of expense to the 'insurer'.

ACC then tries to match its assets, and forecast income from the asset, against those liabilities.

Falling interest rates (and earnings on shares) are a double-edged sword because they reduce the real income available to the fund and increase the present value of probable future liabilities.

In response ACC needs a greater asset level very soon to ensure that they have sufficient assets for the new valuation of known liabilities and to try and generate additional income as part of the payment obligations now budgeted over the year ahead.

This very same situation is impacting all other insurers.

It feels perverse to be told that lower interest rates is another reason the insurance sector is increasing the levies that they expect me to pay. My investment income has gone down, and my insurance costs have simultaneously gone up.

Low, or zero, interest rates are more than just a problem for income of passive investors. It is a problem for consumers too.

Further, any managed funds with defined payout agreements, such as Government Super Fund (GSF) in NZ and National Super (but not the NZ Super Fund) ensure that the government suffers at least twice under the weight of lower investment returns. Remember that the government in this instance actually means our taxes, so we take another hit, or our children do.

I once commented about the merit of teaching the Time Value of Money to secondary school students to ensure that they understand the leveraged implications of the movement in interest rates. It’s not just a subject isolated to one or two hundred professionals in banking and financial markets, it reaches us all.

The past decade, and quite likely the one ahead of us, provide excellent material for real life examples that students can learn from.

In the meantime, I suspect that you intuitively knew that if your expenses were not coming down, but interest rates (returns) were, you were worse off in today’s financial terms and thus you either needed a greater level of savings or to contemplate capital spending in retirement.

Spot Survey - Given the decline in returns, both interest rates and dividends, are you willing to spend capital to retain your preferred spending levels?

Supplementary question: if the answer is yes to spending capital, do you prefer to manage the decline yourselves or have this coordinated for you by others?

Standing Proxies – A large proportion of you have made use of this new service and issued Standing Proxy instructions to Computershare and Link Market Services to have the NZ Shareholders Association represent you at meetings.

Well done. Your action has added significant influence to the NZSA’s formal voice with NZX listed entities.

If you haven’t yet appointed the NZSA as your Standing Proxy we strongly encourage you to do so, especially if you are not one to bother presenting your own voting at such meetings.

We have the forms and guidance notes here if you’d like to receive them. (Just drop us an email to ask).

Those who have appointed the NZSA as Standing Proxy holder have been a little surprised that they continue to receive voting information from the registries, inviting them to vote.

The registries are obliged to issue this to you for each event. 

You still have the right to exercise your vote (step in front of the NZSA) if you wish to, however, having appointed the NZSA to act on your behalf it seems unlikely that you’d want to do so.

So, with your Standing Proxy instructions in place you can simply ignore the invitations to vote that you’ll continue receiving, comfortable in the knowledge that the NZSA is going to exercise a voice on your behalf.

If you’d like to know who the NZSA is voting, and why, then I would encourage you to subscribe and become a member. http://www.nzshareholders.co.nz/

EVER THE OPTIMIST

After recently attending a 2019 venture capital evening I was energised by the younger generation’s potential to create new business opportunities.

Convincing investors will be harder than they think, but the enthusiasm can be infectious and based on my assessment a quarter of them did indeed have compelling propositions and were very likely to attract investor demand.

INVESTMENT OPPORTUNITIES

Infratil Bond – The offer of the 10-year bond (IFTHC) remains open, with its annual reset interest rate, and will close this offer on 13 November. This bond pays an interest rate of 3.50% until December 2020 (then reset annually).

The free option that the interest rate cannot fall below 2.50% is beginning to look more attractive.

The extension to this tranche’s closing date is to provide a rollover opportunity to people holding the Infratil bond maturing 15 November 2019 (IFT200). Rollover applications would need to be submitted to us prior to 13 November.

The public can still invest new cash into this bond (IFTHC). 

Argosy – has announced that it is issuing another senior, secured ‘green’ bond for a seven year term. We have uploaded the term sheet and presentation to our website under ‘current investments’.

Argosy have set a minimum interest rate of 2.85% which will be fixed for the seven years.

Argosy are paying the brokerage costs on the bond. Accordingly clients will not have to pay brokerage.

If you wish to have a firm allocation for this bond please urgently contact us no later than 5pm on Thursday the 17th of October. Payment will be due no later than the 28th of October.

Z Energy– is next in line with a maturing bond (15 November 2019) and we look forward to learning about their decision on whether or not to offer these investors a new bond to roll their maturing funds into.

TRAVEL

Chris will be in Christchurch (tomorrow) Tuesday 15 and 16 October.

Edward will be in Auckland (Remuera) on 16 October & Nelson on 12 November.

Kevin will be in Ashburton on Wednesday 6 November.

Mike will be in Auckland on 7 November.

Mike Warrington

Chris Lee & Partners

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