Chris Lee & Partners Ltd

Market News 16 December 2019

*** MERRY CHRISTMAS ***

This is our final newsletter for 2019.

We close our offices this Wednesday, 18 December, for the Christmas break and re-open on Monday 13 January.

Review 2018 Xmas newsletter

I re-read the 2018 Christmas newsletter in preparation for this one, and pondered the tone and its predictions.

I see that I cut and pasted a few expectations from 2017 and repeated them in 2018. I could almost do the same again with some of the thoughts because so many themes have rolled on into 2019, certainly the monetary policy ones.

Of note, the US Federal Reserve tried to lift interest rates and by mid 2019 they were succeeding. However, all other central banks of substance were doing the opposite by cutting interest rates and by mid 2019 the game was up (or rather it was down) for the US central bank too.

Frustratingly we were right on the button with our expectation that political tensions would escalate during 2019; if anything we were a bit modest with our views and there are plenty of areas of concern on the political stage.

Another comment last year that rang true again during 2019 was that the 10-year US Treasuries yield seemed uncomfortable under 2.00%. 

During the first half of the year the market disputed this fact as the yield plummeted to below 1.50% and had all the 'here and now' commentators predicting recessions starting in the US. However, by the time Christmas has rolled around the yield is back up to 1.82% 

Maybe 2.00% is the 'factory reset' position for US 10-year Treasury yields for now?

A little stability would be nice.

Nonetheless the general theme of 2019 was of lower interest rates and stronger share market pricing.

What was the Good Stuff from 2019?

Rising share prices will have pleased our clients, and it is good news, but alongside lower interest rates the higher share prices herald lower incomes in the future.

The things I gained the most pleasure from were the real wins for our clients.

Our greatest highlight was when ASB Bank announced the repayment of their perpetual preference shares (ASBPA and ASBPB), returning the full dollar plus final interest to investors.

Many of our clients had purchased this investment at discounted prices ranging between 70-90 cents in the dollar and regularly debated the potential for repayment so the payout crystalised some very impressive returns.

We were chuffed for these investors.

Genuine investment wins don't come along often, it's usually just a slow careful grind to extract value, but the ASB repayment was a proper win, especially as it sat within the lower volatility fixed interest section of a portfolio. 

The ASB repayment was the icing on the subordinated bank bond cake that our clients have been enjoying for several years. 

We think this story book of subordinated bond value will end in 2020 with the repayment of the two remaining Tier 1 securities on the market from ANZ (ANBHB) and Kiwibank (KCFHA).

Another significant victory for investors, which didn't deliver more cash into their pockets but added huge value, was the arrival of the Standing Proxy votes service introduced by the NZ Shareholders Association.

This is a service that all retail share investors should be using.

The majority of share investors do not exercise their votes when presented with the opportunity to do so. Assigning those voting rights to the skilful and aligned NZSA representatives adds huge leverage to the views of retail investors at the Board table. 

Collectively the retail voice should become larger than most of the institutional investors on most share registers.

In the past the only names you would find on a Proxy list were the Chairman and the company's directors but now the NZSA appears on all lists. This is the respect they deserve.

If you haven't yet assigned a standing proxy to the NZSA you are strongly encouraged to do so. We have the forms if you'd like copies.

Make your vote count.

Globally the debate about the divide between the rich and the poor continues, as it always will, but the current extremes are a concern again. 

I am pleased that here in NZ we are making proper commitments to increase our minimum wage levels and it's even better to see many businesses trying to earn a badge of respect by going one further up to the 'living wage' level.

We still have a large mountain to climb with the pricing of accommodation.

The other evolving thread of new regulations securing longer term change are those linked to good environmental behaviour.

During the early part of my career there were plenty of moments of 'green washing' to place oneself on a pedestal the height of a 10 cent piece but 'this time is different' and, unless you're Australian, governments are pursuing new measurable obligations that they expect businesses and communities to meet.

I hope NZ continues with its environmental improvements and that a semblance of cohesion develops around the world, otherwise . . .

Plenty of NZ businesses have delivered very good results, but I enjoyed watching Infratil's new strategy for the decade ahead flower, witnessed by all shareholders and bondholders.

The move away from a few of the underperformers and undersized investments toward a little more risk, well measured against demographics and politics, has delivered a higher-revving investment portfolio to admire.

Most of you have experienced a lift in wealth via the values of your shares. You'll all have your favourite investments; enjoy them whilst they are in high performance mode, because 'winter is coming' (Game of Thrones joke sorry).

Bad stuff in 2019

Political tensions escalated globally and there is no way to put a positive spin on this. It has been, and will continue to be, a disruptive influence.

Depending on who you believe, the renegotiation of trade outcomes between China and the US was necessary and it took someone as unconventional as Donald Trump to launch the change.

Trump's unconventional approach quickly turned a strategic battle into a war and at present the egos of Presidents Trump and Xi look incapable of bringing the temperature back down to that which belongs around a negotiating table.

Once they - if they - both realise they need each other, and none of us needs global domination from either of them, maybe progress can be made. 

Sadly I don't expect this to be an outcome we can look forward to during 2020.

I'll guess that China thinks it can make Donald Trump look silly in front of his electorate. 

How could it do more than Trump does to himself? 

His electorate loved that he planned to 'drain the swamp' and they're hardly going to mind that he stands up against a foe such as China (Make America Great Again).

The Republican Party's willingness to express solidarity with the democratic movement in Hong Kong should tell you all you need to know about the freedom of choice stance they expect US voters to support when voting next year.

Hong Kong became one of 2019's most serious political problems.

China sat quietly for 22 years and the moment it asked Hong Kong's government to start inserting 'motherland' fish hooks into HK law it sparked a wildfire. China has underestimated the expectations of the population and clearly kicked over a hornets nest.

The right thing to do would be to contemplate maintaining a workable long-term solution.

The wrong thing would be to send in the Chinese tanks.

Having waved the aggressive propaganda flag of lining up tanks and troops on the border and demanding that protestors stand down, President Xi won't be wanting to stand down and appear weak. It's just not his style; he didn't even display the social skills of humour when someone made fun comparing his image to Winnie the Pooh.

It will be a disaster if Hong Kong becomes President Xi's Tiananmen Square.

Brexit rolled on as the non-violent version of a major political disruption. We should be grateful that the weapons used were verbal via rebuttal, criticism and oftentimes mockery.

We all wish it was only short-term politics so we could laugh it off, but Britain's exit from the European Union will take more like a decade to settle into its new routines. They'll be fine, but it will be very disruptive to many for longer than they'd like.

For our investing clients we didn't like seeing interest rates fall sharply. 

Interest rate declines of 1.50% in a single year for long duration investments (3-7 years) is aggressive and about as steep as you've experienced over the past decade and it's happened from nominal interest rate levels that you thought it should be impossible to fall from!

The sharp declines for interest rates confirm that the majority are clearly concerned about the performance of most economies in the immediate and medium term future.

Actual market performance during 2019?

Here is the table I use regularly for displaying annual performance of a few major share indices (at the time of writing):

Index           2015     2016    2017     2018   2019  Change

NZX50       6,042     6,888    8146    8,683   11241    +29%

ASX200     4,938     5,438    5,980    5,565    6813    +22%

DJIA (US) 17,375  19,216  24,140  24,100  28135    +16%

Nikkei        18,712  18,350  22,457  21,190  24013   +13%

Shanghai      3523    3,208    3,277    2,586    2967   +14%

FTSE(UK)    5,946    6,746    7,348    6,778    7353    +8%

EuroStoxx    3,186    3,052    3,561    3,058    3731  +22%

The New Zealand market outperformed its larger peers with Australian and European markets also performing well for the year. The UK market lagged, yet still grew, under Brexit clouds which look to clear next year following the English (the Scottish not so much) election of Boris Johnson.  

And, here are the movements in 10 year government bonds:

Country  Dec 2014    2015     2016     2017     2018     2019

US               2.25%   2.21%   2.39%    2.34%   2.85%  1.82%

Canada       1.89%    1.47%   1.63%   1.90%   2.08%   1.58%

Spain           1.81%   1.73%   1.55%    1.41%  1.47%    0.43%

France         1.03%   0.92%   0.79%    0.62%  0.70%    0.00%

Germany      0.78%   0.57%   0.33%   0.32%  0.25%   -0.29%

Italy              1.94%   1.64%   1.98%   1.71%  3.13%   1.26%

Greece         7.17%    8.62%  6.53%   5.45%  4.23%   1.40%

Swiss          -0.30%   -0.20%  -0.15% -0.16% -0.14%  -0.59%

UK                2.01%    1.84%   1.40%    1.26%  1.27%  0.79%

Japan            0.40%    0.30%   0.04%   0.06%   0.04%  -0.02%

India              7.93%    7.82%   6.21%   7.07%  7.46%  6.78%

HongKong     1.81%    3.02%  1.52%   1.92%   1.98%  1.71%

Australia        3.11%   2.82%   2.83%   2.51%   2.43%  1.18%

NZ                 3.87%   3.55%   3.25%   2.76%   2.41% 1.60%

The New Zealand rate has fallen further against the US rate but is now significantly above the Australian rate. Greek and Italian government bond rates have fallen dramatically. Returns from government bonds are practically at record lows across the board.

Review 2019 predictions

I am going to go with share markets lower by the close of 2019. 

Not even close, which is a nice failure to report to investors who are wealthier now than they were last Christmas.

Investments with less certainty of success will underperform in such volatile markets.

I had expected uncomfortable markets to encourage investors away from their riskiest investments toward the most reliable, thus driving share prices of weaker companies lower.

This didn't really happen as the major share markets continued to rise so tone remains confident.

There are more questions being asked of the companies with nonsensical financial positions of strategies for long term losses as they pay for some ethereal promise of Xanadu successes 10 to 20 years in the future.

Uber is an example, with its share price declining in a bullish market. 

Tesla seems to teeter on the edge of being another to sell more promises than products.

WeWork finally proved that investors have said 'stop the bus' to stupidly priced IPO share offers with no prospects of ever making money.

Will cannabis businesses go up in smoke in NZ? (sorry, again).

Cash flow will be King.

This is always true. Seek it out in all of your investments.

Beyond good financial control within the companies you own, falling interest rates have assured rising share prices for those companies with the most reliable revenues.

Sometimes they will not be as dynamic, or volatile, as the young upstarts delivering leverage by selling via technology but typically the young and the upstarts are easier to threaten as newer and faster uses of leverage are found.

If you have made a healthy profit on an investment not enjoying reliable margins and high cash flows may I respectfully suggest that you bank a little of your profit and place in the boring corner.

I think the interest rates you see today in NZ will be the interest rates you see come Xmas 2019.

Wow, I was so very wrong on this one, much to the frustration of investors.

What today's investors would do for the luxury of bank term deposits between 3.75% and 4.00% now!

Bitcoin – crypto currencies will continue to suffer lost value in 2019.

As I write, this is wrong. Bitcoin is almost double its value from last Xmas, but after a strong midyear surge the price is falling again, fast.

Every move it makes is fast. It is not a mainstream currency and never will be.

I'll stop commenting about bitcoin here because it's not a constituent of a credible investment portfolio.

2020 predictions

Here we go again, sans togs hoping the tide doesn't go out to reveal financial predictions for the folly they are.

We can all use mathematics to make calculations within a closed circuit, but financial markets, economics and businesses are not closed circuits; they are prone to emotional interception from many irreconcilable angles.

Nonetheless, you want to hear a few guiding thoughts, so here they are.

Interest rates

Benchmark interest rates may yet move lower during 2020. 

Short term fixed interest investing will unquestionably deliver the lowest running returns (cash flow) within a portfolio. Call accounts should be for emergency funds, and funds about to be spent only. 

Plan your year's spending as best you can, hold aside those funds, then invest the rest for longer terms.

It is possible that some bond yields may increase (back above 2.00% and maybe toward 3.00%) if the Reserve Bank of NZ's new capital regulations are forceful enough, because if banks retreat from some funding the pricing of such loans will rise.

Shares

I don't expect share price indices to retreat.

I was wrong guessing shares would move lower in 2019 and the same conditions exist now so until someone removes the wrong JENGA piece I expect to see the share market rise again in 2020.

There is nothing as productive for investment returns as owning a good business at present. 

I think the share pricing increase, if it happens, will be smaller now as this prediction is dependent on cheap money, not with an expectation of robust economic growth and higher profits.

We'll have to tolerate some volatility in our wealth, but the cash-based returns from businesses (dividends) will exceed those on offer from interest rates, making it very hard to migrate one's investment risk in the more conservative direction of more bonds and fewer shares.

This same logic is true for the most profitable companies. Their shareholder returns are enhanced by share buybacks which adds demand to the buyside for such company shares.

As we now frequently say, please manage your investing to your own set of investment rules. 

Doing so will reduce your propensity to be a trader and the less you feel inclined to make changes to your portfolio the more you'll be able to ignore the noise of volatility, which can be an unpleasant tune.

Economics

Wherever you look economic performance is weakening.

This isn't, and can't be, good news for the potential profits of business, nor for the inflation central banks are hoping for, which in turn drives interest rates.

The weakening economic trend, and near zero interest rate environment, is increasing Government conviction in various jurisdictions about the merit of increased fiscal spending to provide a new pillar of economic support.

Business will gratefully sell services to these government purchase orders. 

I'm not an economist but I'll guess that $1 of fiscal spend will be wasted when it only buys 50-60 cents of economic growth.

I hope our government doesn't join this fiscal pump behaviour. 

If the government would like to simultaneously encourage more saving in NZ and deliver projects needed by the economy they could offer up some new Public Private Partnerships.

I'm not holding my breath, or hopeful cash, aside.

Good luck with navigating 2020. Use a compass and get financial advice.

We are happy to help.

Thank you to all who have sought financial advice and arranged business with Chris Lee & Partners during 2019; we are very grateful.

We'll be back next year to help you tackle 2020's questions, challenges and opportunities.

Have a very merry Christmas with your family and friends and remember to enjoy the savings you worked so hard to accumulate.

We'll see you all in the New Year.

Kind regards from all at Chris Lee & Partners.

Michael Warrington

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Market News – 9 December 2019

Given that the scale of population has a direct bearing on the health of our planet, how long will it be before this topic reaches the top of the political debate?

Demographics have long driven investment returns in certain sectors, so it's a subject of interest.

INVESTMENT OPINION

Look under the hood – I was pleased to read that the NZX will investigate share trading on Smartpay's register in the days and weeks leading up to its recent sale announcement.

Smartpay's share price almost doubled on the day of the announcement. Interestingly it then started to subside, disclosing that someone was willing to sell shares and take profits (trader?) before they'd even digested the details of the corporate action.

I get very tired of seeing share prices move unusually only to then be followed by an influential piece of news in the hours or days that follow.

Information often carries power and it seems to be a common human trait that people like to display a position of power by showing they know something the listener does not.

Sometimes in financial markets the information is shared to present a financial gain opportunity to another person, and sometimes it will be to try and crystallise their own gain. Either way, the abuse of secrecy is very poor form.

Most NZX transactions cannot occur without a CSN (there are a few exceptions). The NZX issues CSNs and thus controls them. All transactions on the NZX thus have binding information for review (date, time, stock, price, CSN, broker).

If a person arranges a trade they cannot escape being part of such an enquiry.

If evidence can then be gathered from third party sources about exposure to confidential information aligned with the person behind the CSN, then that person should be in serious trouble.

The NZX house is in order with respect to what they can discover from trading activity.

NZX listed companies have obligations around continuous disclosure to the public arena, via the NZX.

What I don't know is whether or not an NZX listed company operates under NZX regulations that require them to operate traceable processes when handling confidential (non-public) information. Who gained access to disclosure and when?

We will know that progress is being made on better handling of confidential information, and personal integrity around share trading, when we don't see so many unusual share price movements prior to the disclosure of sensitive information.

Tax Code – The world's lack of preparedness can be seen in recent comments from US Federal Reserve Chairman Jerome Powell that US tax code doesn't contemplate negative interest rates as an outcome on savings and investment.

The IRS has found a way to apply tax to crypto currencies, as has our own IRD, so they will surely find a method for taxing interest rates regardless of which side of 0% they sit.

The tax man always cometh.

Too much Money – There are continuous signs that central banks have left too much money in circulation, intentionally because these are not foolish people, and it is resulting in the long-term anchoring of interest rates at low levels.

In areas where central banks may not be injecting as large a surplus of liquidity the savings rates are very high, such as in South East Asia and China. Japan is an exception.

Bond issues in New Zealand are raising large sums easily.

International bond offerings (senior bonds from strong borrowers) that I read about are always attracting bidding 2-3x larger than the volume of bonds being offered.

China offered a small teaser last week, offering US$6 billion sovereign bonds as they continue to build a Chinese benchmark pricing curve (3, 5, 10 and 20 year terms of government bonds) and within hours they had US$20 billion of bids.

In NZ you may have felt hurried as bond offers to the public progressively shortened from periods of four weeks to two weeks, and now 10 days.

The Chinese deal appears to have been announced in the morning and completed that afternoon, leaving investors scaled and pondering 'what is next?'.

The excessive demand from investors, even though it was the first time they had offered a 20-year bond (gradually moving longer), meant the pricing (cost) was lower than expected. The pricing estimates were for the Chinese sovereign bonds to yield about 0.60% - 0.80% higher than US Treasuries but the actual yields were only 0.35% - 0.70% higher.

You may recall that NZ government bonds now trade at yield below US Treasuries, which was an impossible thought during the first 25 years of my career, yet now it appears to be deserved respect for the consistent fiscal prudence displayed by our government (helped by the Fiscal Responsibility Act from the 1990s).

NZ's 5-10 year government bonds offer yields about 0.35% - 0.50% below US Treasuries and our Debt Management Office also has no problem attracting demand when they offer new bonds to the market.

If superannuation funds are, as predicted, short of funds to pay for the promises made to employees, and returns remain as low as they are now, those funds will be forced to hold a higher proportion of very liquid assets so they can easily sell some when required to ensure cash reserves align with immediate financial obligations.

Frustratingly this locks in those underperforming superannuation schemes into lower returns.

Guardians of NZ Superannuation have the luxury of the opposite being true, their investment timeline remains decades long without the sea anchor of defined payment obligations. Their task is simply to build as big a fund as possible over a very long period to support the otherwise taxpayer-funded National Super.

The NZ Super fund may well have purchased some of the new Chinese sovereign bonds, but I'd get they didn't take an overweight position like some may have been forced to do (witness the bidding demand).

I know you no longer want to hear about why the deeply unattractive interest rates of today seem likely to remain low, or lower, but it's best that the truth doesn't hide in the shadows.

Environment – Whilst a growing number of people globally are trying to steer regulators and consumers toward better behaviour with respect to the environment, the Organisation of Petroleum and Exporting Countries (OPEC) is trying to undermine each other with oversupply.

They meet regularly to discuss their cartel, sorry, collective efforts to ensure that a goldilocks volume of oil is supplied to the global marketplace to ensure that they receive a 'fair' (managed – Ed) price for their oil.

The problem is that most nations, at times of cash flow shortage, are guilty of oversupply to try and secure a higher share of the oil consumer's dollar that year. Those reported as oversupplying the market this time are Russia, Iraq, Kazakhstan and Nigeria.

Rather than protecting the planet they are focussed on protecting their cash.

Saudi Arabia's Prince Abdulaziz bin Salman has had enough and will no longer compensate for the oversupply of others by reducing their exporting. This is the Saudi version of its trade war.

As with many such economic and trade tensions you can see the likely impact in the market's pricing. The oil price fell 5% on this news.

Trade tensions have always existed but the past tolerance expressed by many is waning and resulting in ever firmer responses.

We all hope that these battles stay on the balance sheet and off the physical battlefield but it's hard to see the environmental lobby winning out over these international tensions; unless there is sufficient change by consumers whilst leaders squabble.

Selectivity – It has been good to see a few deals fail when they are brought to market in the US, with the WeWork share float being one of the more highly publicised.

It's about time financial markets, and investors within, were prepared to reject deals that just don't make sense.

RBNZ Changes to Bank Equity Obligations – Kevin Writes

The changes to the capital framework for banks announced last week were largely in line with the RBNZ's initial proposals, with a few subtle tweaks, and I think overall it is a good outcome for all stakeholders.

The RBNZ's main objective is to strengthen the banks through higher capital requirements, aka 'more skin in the game', and better protect all New Zealanders in the event of a banking crisis, which they believe is inevitable. (I suspect they mean global banks, not NZ's banks, but affecting us.)

Their new rules should definitely strengthen the banking system and with minimal side effects, in my opinion.

While the RBNZ has stuck to its guns with the 'big four' banks requiring a minimum Tier 1 capital requirement of 16% of risk weighted assets (RWA), including a Prudential Capital Buffer of 9%, it has set the bar lower for the smaller banks, or non-systemically important banks (including Kiwibank), at 14% of RWA.

It has also decided to allow up to 2.5% of the Tier 1 capital requirement to consist of redeemable, perpetual, preference shares (Additional Tier 1 capital) which is up from the 1.5% allowed under current regulations. The current Tier 1 capital requirement is 8.5%, including the current capital conservation buffer of 2.5%.

It seemed that banks' subs were destined for extinction under the RBNZ's initial draft proposals, but they have decided to allow them in the new framework, which could provide a welcome option for income investors.

Preference shares were a popular regulatory capital instrument in the 1990s and early 2000s until initially redeemable preference shares and then perpetual preference were excluded from the regulatory capital framework because they behaved too much like debt and too little like equity.

New global bank regulations introduced in 2013, known as Basel III, required that all regulatory capital be able to absorb losses in times of distress or non-viability. This effectively signalled the end of preference shares as qualifying regulatory capital and our banks progressively repaid those still on issue, the repayment of ASB perpetual preference shares earlier this year being the most recent example.

We seem to have done a complete circle and I will be interested to learn the finer details of these new redeemable, perpetual, preference shares.

I think pricing will be important with the new preference shares. When investors take equity type risk they should receive equity type return, although increasingly we see yields on higher risk subordinated bonds closer to senior bond returns than dividend returns. 

Because our banks can meet the minimum capital requirements of Basel III entirely from common equity Tier 1 capital, the highest form of capital, the preference shares wouldn't need to meet the Basel III standards and could be treated as simply another layer of protection.  

Allowing preference shares as Tier 1 regulatory capital is a win for bank shareholders who seemed likely to have to stump up with either new capital or a reduction to dividends.

It seems that nearly half the $20 billion of new capital required over the 7 year transition period could be raised through issuance of preference shares, which would provide a significant cost saving for the banks and should lead to a much smaller impact on lending rates, thus benefiting borrowers as well.

Tier 2 capital will be retained under the new framework but unlike current Tier 2 instruments they will have no contractual conversion or write-off features.

From my perspective the most meaningful reform in the RBNZ's package is in the area of risk assessment and calculating risk weighted assets.

The 2019 reforms should finally level the competitive playing field and reduce the significant cost advantage that the big four banks have enjoyed over the smaller banks for more than a decade.

Currently NZ's big four banks use their own internal models, known as the Internal rating Based (IRB) approach, for measuring credit risk and calculating the amount of regulatory capital they must hold.

All other banks in NZ calculate their capital requirements using the Standardised Model approach, prescribed by the RBNZ, which results in them holding significantly more capital against the same type of credit risk exposures as the big four.

For example, Kiwibank, using the RBNZ prescribed standardised model, holds nearly twice as much capital for a standard home loan as the ANZ, which can use its own accredited internal model.

Even amongst the big four banks there is no consistency when measuring risk, with the ANZ using a risk weight of 19% across its standard home loans, ASB – 27%, Westpac – 28% and the BNZ – 30%. The risk weight for the same loan under the Standardised Model is 35%.

Under the new rules the big four banks cannot have capital lower than 85% of what they'd have if they used the RBNZ models and they will be required to report to the RBNZ, and the public, what their capital ratios are using both their own models and the RBNZ models.

Unsurprisingly NZ's big four are amongst the most profitable banks in the world, all achieving return on equity of around 16%, nearly double that of Kiwibank and NZ's other smaller banks.

Allowing the big banks lower risk weights is probably because of their scale and importance to the NZ economy but this is outweighed by the inconsistencies and opaqueness of the internal models approach, in my view.

I strongly believe that a more consistent and standardised approach to calculating risk weights is long overdue, not only in NZ but globally, where average housing risk weights of 5% in Sweden and 55% in Ireland makes a mockery of not only the regulators but any meaningful global comparison of bank capital adequacy.

Why hasn't the global regulator (Bank for International Settlements) ever tackled the inconsistencies in risk weighting assets? They've made noises about it but never acted. Can of worms maybe, they know what's under the bonnet of the European banking sector and perhaps don't want to go there?

Overall, I think the RBNZ's capital reform decisions are fair and equitable for all parties and a job well done.

Footnote: After another year of strong gains in most asset classes, mostly courtesy of lower interest rates rather than any financial wizardry, I was reminded that when it comes to predicting the future direction of financial markets there are only two groups – those who don't know and those who don't know that they don't know.

Merry Xmas

EVER THE OPTIMIST

It's very nearly Christmas.

INVESTMENT OPPORTUNITIES

Synlait Milk Bond

The interest rate was set on Friday at 3.83% for the 5 year subordinated bond.

We may be able to access a further small allocation on request. Please contact us ASAP if you would like to invest in these bonds and we will enquire about getting a further allocation.

Thank you to all who participated in this bond offer through Chris Lee & Partners.

TRAVEL

Chris Lee & Partners offices will be closing for the year at lunch time on Wednesday 18 December and reopening in the New Year on Monday 13 January.

Mike Warrington

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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

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