Market News 21 December 2020

 

 

*** MERRY CHRISTMAS ***

This is our final Market News for 2020. Thank you for allocating some of your time each week to digest our investment perspectives.

We close our offices tomorrow for the Christmas break and a subset of staff will return on Monday 11 January. You can reach us via email throughout.

For the past few days I have been pondering what I’d say in this newsletter, where I reflect on the past year and try to help you with looking ahead to 2021, but initially no strong threads entered my head.

No tapestry formed.

Maybe my brain is tired after the incessant weaving of brand ‘Covid19’ into every assessment of every situation?

Covid Schmovid; the sun rises every new day and we resilient humans get up to get on with it, as we must, so we do. That won’t change.

This latest pandemic reminded the current generation that health matters, and that risks to our health are ever present, but it also reminded us how clever our scientists are and how awesome our healthcare workers are.

The world’s reaction to Covid19, good and bad, made the pandemic the latest significant disruption to global economics and thus to financial markets, felt by you through the huge fall (again!) for interest rates and the oversized gyrations in share prices.

Like you, during 2020 I would rise every day and wonder what was in store for us from a perspective of investment risk. I still do, it comes with the job, but in March and April the scale and speed of the changes (information and reactions) was well into the 4th standard deviation (99%+) which was disruptive for all.

Information helps to develop knowledge but a lot of the information that I saw between March and about June this past year was often sourced to inexperienced guesswork and irrational forecasts.

Why make bold forecasts when you don’t even understand your starting point?

I was reminded that experience matters.

It certainly mattered to me during 2020, just as it had during the Global Financial Crisis in 2008/9, so my experience and instincts mattered far more to me than much of what I was observing from the tarot card readers.

I need to tip my hat to an old industry friend (as in I’ve known him for years, not describing his age!), David Beattie (a Principal at Booster Funds); Dave said something publicly back in April and the title was all I needed:

‘This Too Shall Pass’

Four words carried more value than the tens of thousands of other words that had occupied my mind rent free and reminded me to rely on my own experiences, and instincts, as I responded to your many welcome enquiries as we all confronted the volatility of 2020.

If I may blow a dusty old trumpet; since prior to the GFC we have been urging investors to buy long term fixed interest investments to protect against the increasingly aggressive stances being taken by the world’s central banks. (do you remember the by-line ‘Strong, Long and Liquid’?)

Central banks are still playing from the same music sheet but they have turned up the volume.

Remember this influence during 2021. Interest rates are remaining low.

Warren Buffett also deserves thanks from investors for his simple guidance:

Be greedy when others are scared (and the opposite); and

With interest rates this low (nominal and real) it is impossible to believe that owning good businesses can lose on relative performance (a long-term forecast).

The volatility in March and April was unquestionably very high, and thus disturbing for investors but Warren was correct, it threw up some excellent investment opportunities.

As share market prices bounced they made more and more sense relative to the collapsing cost of money (interest rates).

Finally, the scientists, bless them, have begun to deliver vaccines in spectacularly short time frames and in doing so have shortened the period of economic damage from ‘unknown’ to a few short years, possibly only two.

If you then remind yourself that assets (and liabilities) are valued based on a Time Value of Money (TVM) principle, where less time means less influence on value, then you should be developing a new more settled confidence with your investing.

The pharmaceutical companies will make many more billions from their Covid19 vaccines over the next few years, and they deserve every cent of it.

When I started this newsletter I genuinely wondered if I could write it without mentioning the term ‘Covid19’.

Clearly that was impossible but let me point out to you that it is yesterday’s story. Let it go and look forward.

Review 2019 Xmas newsletter

I re-read the 2019 Christmas newsletter in preparation for this one, and pondered the tone and its predictions for 2020; they were increasingly cautious but still optimistic for investors.

Side story: As it happens, I was on my research trip in Japan last December and Kevin kindly finished off the 2019 Xmas newsletter.

I was very unwell for three days upon my return to NZ very late in 2019 and as the scientists now trace the Covid19 origination date further back into 2019 I now wonder whether I already have antibodies for this virus!

I see we predicted the repayment of the final ‘old style’ subordinated bank bonds for clients riding this value wave. However, this repayment was stopped in its tracks when the Reserve Bank instructed ANZ and Kiwibank to not repay and to hold this ‘equity’ until Covid19 outcomes were better understood.

The irony in this declaration is that the Reserve Bank no longer respects these bonds as being suitable as equity on a bank balance sheet.

This situation was a good reminder for investors that even things that are intended to happen can and do change (risk).

Goodness, I had forgotten these paragraphs from 2019:

‘I enjoyed watching Infratil’s new strategy for the decade ahead flower’;

And:

‘The move away from underperformers, and undersized investments toward a little more risk, well measured against demographics and politics, has delivered a high revving portfolio to admire’.

Prophetic indeed.

It rather implies that the Chief Investment Officer of the Australian Super Fund reads Market News but was very slow to act on my advice!

I can even have a free laugh at the closing paragraph:

Most of you have enjoyed a lift in wealth via the value of your shares. You’ll all have your favourites so enjoy them whilst they are in high performance mode because ‘winter is coming’. (smile)

Actually, it was Autumn in NZ and all hell broke loose, yet we are now back ahead, financially, by the same time (Xmas) a year later.

How bizarre.

Good Stuff Bad Stuff

I copied across the Good Stuff and Bad Stuff labels but have elected not to record lists this time.

You know most of the bad stuff, and have marvelled at the good stuff.

Global politics is a bigger problem (long term) than the pandemic.

Scientists can beat the pandemic, but we don’t have a logic based response to the political situation(s).

The problem that was developing in Hong Kong in 2019 exploded into a disaster in 2020 and made clear the excessive intentions of China on the world stage.

I can’t off hand think of any political situation that actually improved during 2020, unless you want to count single party government in NZ?

As I said, my head is full and I’d quite like to empty some of it out over summer so that’s all for thinking about good and bad stuff.

Actual market performance during 2020?

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

NZX50

2015     6042

2016     6888

2017     8146

2018     8683

2019   11241

2020   12874 +14.5%

ASX200

2015     4938

2016     5438

2017     5980

2018     5565

2019     6813

2020     6643 -2.50%

DJIA (USA)

2015   17375

2016   19216

2017   21140

2018   24100

2019   28135

2020   30052 +6.81%

Nikkei (Japan)

2015   18712

2016   18350

2017   22457

2018   21190

2019   24013

2020   26672 +11.07%

Shanghai (China)

2015     3523

2016     3208

2017     3277

2018     2586

2019     2967

2020     3353 +13%

FTSE (UK)

2015     5946

2016     6746

2017     7348

2018     6778

2019     7353

2020     6503 -11.5%

EuroStoxx

2015     3186

2016     3052

2017     3561

2018     3058

2019     3731

2020     3495 -6.32%

You may have expected to see all share indices had doubled year on year but several are lower (Australia, UK and Europe) and armed with this data one can’t align share market performance with handling of the pandemic.

Look at the scale of movement for some between 2015 – 2020!

Here are the movements in 10-year government bonds:

USA

2014   2.25%

2016   2.39%

2018   2.85%

2020   0.89%

Canada

2014   1.89%

2016   1.63%

2018   2.08%

2020   0.71%

Spain

2014   1.81%

2016   1.55%

2018   1.47%

2020   0.00%

France

2014   1.03%

2016   0.79%

2018   0.70%

2020  -0.38%

Germany

2014   0.78%

2016   0.33%

2018   0.25%

2020  -0.62%

Italy

2014   1.94%

2016   1.98%

2018   3.13%

2020   0.51%

Greece

2014   7.17%

2016   6.53%

2018   4.23%

2020   0.60%*

Switzerland

2014  -0.30%

2016  -0.15% 

2018  -0.14%

2020  -0.53%

United Kingdom

2014   2.01%

2016   1.40%

2018   1.27%

2020   0.22%

Japan

2014   0.40%

2016   0.04%

2018   0.04%

2020   0.01%

India

2014   7.93%

2016   6.21%

2018   7.46%

2020   5.95%

Hong Kong

2014   1.81%

2016   1.52%

2018   1.92%

2020   0.75%**

Australia

2014   3.11%

2016   2.83%

2018   2.43%

2020   0.97%

New Zealand

2014   3.87%

2016   3.25%

2018   2.41%

2020   0.90%

Observations:

New Zealand interest rates are now the same as the US and Australia after being well above them for most of my career;

India looks like it may become an interesting economic case study in the years ahead;

*Check out interest rates in Greece, once the basket case that no commercial business would lend to;

**Is the risk of lending to the Hong Kong government really this low?

You should be familiar with our view on interest rates: lower for longer than any investor could reasonably hope against. Take another look at the rightmost column above.

A Review of my 2020 predictions

2020 predictions

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.

Confirmed. Underlying interest rates fell fast toward 0.00%, pausing to bounce around between 0.25%-0.50%.

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.

This didn’t happen because the central bank delayed its demand for increased equity with a bank and to put the boot in the central banks started buying up bonds themselves, thus driving down long term interest rates for most risks.

Interest rates on bank term deposits slumped below 1.00% and this opened a pathway for companies to raise debt via bond issues yielding between 1.50% - 2.50%.

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.

A lucky tick (thinking of the NZ and US share markets). If you ignore the Covid19 part in the middle I was right (myopic state of mind – Ed)

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.

The +14.50% increase (index) is not small by any measure and many of you hold some shares that increased by 50-100%! Definitively not small movements.

We’ll have to tolerate some volatility in our wealth…

The understatement of the decade.

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.

How did you get on ignoring the noise in March and April??

Economics

These are the words I used last year, and I can’t think of any better ones with respect to 2021:

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 (too much).

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.

2021 Predictions

Predictions are the hard part of this gig, and frankly it is unwise to make any that are too specific, let alone to do so in public.

There’s probably an FMA regulation against it; misleading and deceptive etc.

Nonetheless, investment decision making is always a forward-looking practice and thus it requires advisers, and investors, to try and form views about probabilities in the months ahead.

It is vital that investors define their own investment rules to align with their needs and to manage their portfolio accordingly. Don’t speculate too far away from these rules. This will help you with not being overly disrupted during future volatility in financial markets.

Interest rates – well, they cannot fall much further. They sit very close to 0.00% in NZ and are well below inflation and inflation targets.

The RBNZ wanted our banks to be prepared (legal documentation) for negative interest rates but other than attempts to defend the NZ dollar I don’t see negative interest rates featuring for NZ retail investors.

The positive slope on the NZ yield curve will reward longer term investing. Excessive amounts of short term fixed interest investing will create a sea-anchor like drag on returns.

Regardless of interest rate levels investors need to maintain an allocation to this asset class. It adds stability to a portfolio; remind yourself how you felt in March and April 2020.

Shares – It is time to be more selective with who you choose for your larger share investments.

Businesses with ‘highly probable revenues and profit margins’ are the closest to being ‘perfectly priced’ using very low interest rates. If the revenues cannot increase much and the interest rates can’t decline much, then the share price must be priced close to its upper decile.

This situation does not imply ‘sell’, but it does mean lower running returns from such shares in the period ahead.

Businesses with imperfect revenues and/or imperfect margins are likely to have imperfectly priced shares (check out A2 Milk for an example) and thus present more opportunity for investors. However, imperfection implies more risk and a more difficult decision-making process, which with some bias means investors are wise to engage with financial advisers!

When I consider share indices, it is hard for me to imagine the NZ index finishing 2021 higher than it is now. We have plenty of good cash flow businesses (impacted by interest rate changes) but few with impressive growth ambitions.

I can however imagine the US, Chinese and Australian share indices rising during 2021 given the financial and political support being continuously rolled out in those jurisdictions.

Patience – I think patience will be rewarded via opportunistic investing.

During the past decade getting on with full investment was rewarding for investors. Now, having some cash resting in a short-term deposit at near 0.00% still provides you with option value to be able to act when appealing opportunities emerge (new bond offers, dips in share market pricing etc).

Those who make investment decisions from the basis of good investment rules will cope well regardless of what 2021 brings.

Keep it Simple – There have been a variety of more complicated investment offerings emerging and whilst many are trying to open up avenues to new risk types (and earn annual fees) for the most part I view them as also complicating your investment portfolio.

Given that the playing field is ‘unusual’ at present I prefer a policy of keeping things simple with investing.

We are happy to help.

Thank you

Thank you to all who have sought financial advice and arranged business with Chris Lee & Partners during 2020; we are very grateful.

We were very pleased by the success of ‘remote Chris Lee & Partners’ during 2020 and hope you didn’t notice any change in service.

We’ll be back next year (from 11 January) to help you tackle 2021’s questions, challenges and opportunities.

Have a very Merry Christmas with your family and friends and give yourself permission to enjoy some of the savings you worked so hard to accumulate.

Kind regards from all at Chris Lee & Partners.

Michael Warrington


Market News December 2020

Kevin Gloag kindly offered to write this week's Market News, giving him the opportunity to describe 2020 to you from his perspective.

When making decisions, such as those required by investors, sourcing as many good quality opinions as possible is important, so I look forward to reading Kevin's (below).

Before you get to those thoughts though, the Infratil (IFT) situation allows me to ask you an important question:

If I removed 'hold' as an option from you, should you sell IFT shares or buy more?

I'll not answer the question in this forum as that would constitute financial advice, but I'll give you a clue; it has nothing to do with trying to guess the IFT share price over coming weeks.

The situation with the Australian Superannuation Fund offering to buy Infratil, at a price not seen by shareholders before, presents a wonderful conundrum for IFT investors to solve.

What is your perspective of your investment, and its place in your portfolio?

What is the perspective of Australia Super?

Why has this situation developed so fast?

What is the perspective of the IFT board of directors?

There is a lot of water yet to flow under the bridge, but the answer to my question is already known in my view.

OK, another clue; remember that investors must always look forward.

Next week it will be my turn to use Market News to cover off 2020 and to contemplate 2021.

Kevin Writes:

2020 has been a very disruptive year for many people and quite a bizarre year for financial markets.

A big correction (price decline) was followed by a big recovery (for most stocks), and the speed and extent of the recovery has surprised most people, including the writer.

All the disaster scenarios being spouted by economists for unemployment, economic contraction, falling house prices and business failures never eventuated. I accept that things would have been much worse if the Government hadn't come to the rescue, but frankly over the past twenty years central banks and governments coming to the rescue has been the only constant!

It was interesting to observe in the media the disaster scenarios being promoted by some of our leading economists, although a lot of this sensationalism was clearly attention seeking.

When economists and other self-appointed experts are wrong it usually means a better outcome, so people are happy and quickly move on, leaving these high profile 'forecasters' largely unaccountable.

Because we are all so heavily influenced by what we see in the media we need to be cautious about accepting without question the views and opinions of perceived experts. (Especially that Warrington character)

Truth is most of them know little more than you when it comes to predicting the future.

May I remind you there are only two groups when it comes to predicting the future direction of financial markets:

Those who don't know, and those who don't know that they don't know.

---

The swift recovery of our share market, and global markets, has been almost entirely driven by record low interest rates and surplus liquidity and 'free' money supplied by governments. (it is, of course, not 'free').

The odd business has done better and grown its earnings, Fisher & Paykel Healthcare is one obvious example, but generally speaking most of our listed companies haven't done anything better this year than last year and the only thing that has grown has been their share price.

Following the global financial crisis in 2008 we observed global central banks printing copious quantities of money and driving interest down to zero and below in an attempt to revive their economies.

The hope was that businesses would borrow the cheap money and invest for growth, creating jobs, improving productivity and wages, and growing their countries out of recession.

As we all know the money didn't reach businesses and create economic growth, instead it went into asset markets and pumped-up equity and real estate prices which disproportionately favoured the wealthy, who own the most assets.

In the face of recession and economic uncertainty businesses tend to hunker down, not look to grow, and banks tighten up lending criteria making it more difficult for businesses to borrow.

What I describe above is now happening in NZ with our own Reserve Bank printing money to keep interest rates low and pour money into the economy through the banking system.

Like their global counterparts our banks have tightened up their lending criteria to some sectors, including business and rural lending, although in NZ's case the Government is providing direct support to businesses on very friendly terms.

I suspect what some of these businesses need is more owner's money (equity) not more debt and I hope there is a reasonable credit standard for eligibility for the government business loan scheme.

Because we've had the benefit of observing the side effects of quantitative easing for nearly a decade, particularly in Europe and the US, we shouldn't now be surprised to see our share market and property market march higher even in the face of so much economic uncertainty.

Our rising property prices are not only being fueled by cheap money but a supply/demand imbalance which looks unfixable for the time being as we simply don't have the resources to build a lot of houses.

The national medium house price has increased 20% year on year, a far cry from the collapsing housing market predicted by many 6 months ago.

We recently relocated to Jacks Point near Queenstown.

Queenstown only has two industries – tourism and construction, with tourism accounting for 64% of all jobs. (Construction 35% and financial advice 1%? – Mike)

The town attracted 3 million visitors per year, 60% of them from overseas and international tourists contribute 63% of all tourist spending.

When Covid arrived, it was estimated that the Queenstown economy would shrink by around 25% and that 1 in 4 jobs would be lost.

We seldom go into Queenstown itself but when we do you can usually find a park and the town doesn't seem busy. No queues outside Fergburger tells a story of its own.

Certainly, there are a few more Kiwis drifting in and out and it will get busy for a time over the holiday period but with no overseas arrivals and none in sight you would expect that many tourist-related businesses must be hurting.

On the positive side of Queenstown's economy the construction sector is run off its feet and after a brief stutter post-lockdown the property market is on the charge again with properties selling well above RV and very strong buyer demand.

While we need more houses and the construction sector is a major employer what we're seeing down here, and throughout NZ, is cheap money at work and house prices are going to follow share prices and grow at a much faster pace than the real economy, and more importantly wages.

The rewards won't be evenly spread, and prices will move further outside the reach of many first home buyers and rents will increase, driven by higher prices and supply shortage.

Mike often growls (me?, growl? – Mike) about the misallocation of money into NZ residential property instead of the real economy but in the current low interest rate environment it's going to get worse and bring with it all the problems associated with a housing market which is out of step with what we earn and what we can earn from it.

With so much money being pumped into the system some people believe that the inflation we are experiencing in asset prices will eventually show up in consumer prices.

I don't believe that demand-driven inflation will pose a problem, but NZ depends heavily on overseas manufacturers and there is growing evidence that a lot of what we import is getting more difficult to source and more expensive to land in NZ, so we could easily start importing inflation.

A surge in demand for sea freight, reduced shipping capacity and container availability and backlogs at key ports are creating big delays and adding to freight costs which NZ businesses will feel as we enter 2021.

For example, the cost of a 40-foot container from Asia has jumped from $750 to $4,000 and changing shipping routes, increased handling and more expensive air freight are all adding to costs.

Building supply merchants believe many products will increase in price between 5% - 8% as early as February/March next year so you could expect these increases to be passed down the line.

As your average Kiwi DIYer I have recently experienced difficulty sourcing some fairly basic items and it's always the same story – “we're waiting for our next shipment and not sure when it might arrive.”

Rising inflation would create an interesting conundrum for the Reserve Bank, when increasing interest rates is not an option; or not one they'd like to exercise.

They might adopt the same approach as our politicians have for rising house prices and try and talk it down, muffled by having their heads in the sand.

---

On a lighter note, our staff annual long/short picking competition concluded recently and I am at duty to report that I finished last trailing behind even the office ladies, which has provided much enjoyment and great hilarity for some of my colleagues.

In Kevin's defense, and for safety in numbers, I was second last - Mike

It's good fun, it reminds us all how hard forward-looking decision making about investment can be, and I stress that it is akin to flipping coins for who buys the next round, and NOT for how one develops investment theses.

Simply, each person in the business picks a share they expect to go up (long) and one they expect to go down (short). The person with the biggest percentage gains, both up and down combined, wins.

Because it is so rare for me not to win this competition, I thought I would review my performance and see if there were any valuable lessons to be learned and shared.

The details of the stocks selected by others are kept confidential but I'm happy to disclose my hand.

My long position was in A2 Milk with a start price around $14 and my short position was in Pacific Edge (PEB) with a start price around 12 cents.

About 3 months into the competition, I was well in front with A2 approaching $20 and PEB around 10 cents and in my opinion 'circling the drain.'

From that point on things went bad.

Picking PEB was obviously my downfall as the share price then jumped 600% handing me a 600% loss and the wooden spoon.

My history with PEB ultimately became my Achilles heel.

I purchased a small shareholding in PEB more than 10 years ago when its share price was around 20 cents.

I was a true believer in their technology, it all made sense to me - a diagnostic product for the early detection and management of bladder cancer that was accurate, cost effective, non-evasive and was being heralded as world leading technology by some of the world's respected medical journals.

Soon after building a testing laboratory in the US and positioning for growth in the world's largest healthcare market PEB announced it was targeting $100m in annualized revenues within 5 years.

Subsequently each half-yearly result announcement became a festive event as we all waited with bated breath to watch PEB plot its way to $100m in annual revenues.

Five years and 10 reporting periods later PEB was generating barely $2m in annual revenue.

They were still talking up their prospects and promising great things while tapping their shareholders for $20m a year to fund their losses and I was losing the faith, fast.

I hung in for another 2 years then sold when the share price was 24 cents.

I have never regretted selling and if PEB can finally provide the commercial nous to match the undoubted quality of its cancer diagnostic products they might finally deliver for their shareholders and for the NZ science community.

In terms of learning from the experience PEB was a silly short because it's share price was already on the floor and I was basically betting on them going out of business, which was probably what I was hoping for (in the game) rather than what I thought could happen.

I believe that the key to PEB's future growth is convincing more urologists to use its technology not just reimbursement approvals from the major Healthcare providers. Reimbursement approvals are only useful if urologists are using the products.

It appears there is still considerable resistance from many urologists and medical professionals, who prefer other testing procedures.

I note that PEB's operating revenue for the most recent 6 monthly reporting period was $3.3m or say $7m annualised – not quite $100m yet but inching closer.

I see some of the big broking firms talking up their prospects so a revenue 'growth spurt' must be imminent.

PEB's stark turnaround this year is a nice anecdote for me to conclude with, and represents a nice summary for 'what was 2020 for investors?'

I'll not be drawn on my game picks for 2021!!

Have a good Xmas and a happy New Year

 

Kevin Gloag

Chris Lee & Partners


Market News 7 December 2020

When you live in NZ most global news looks relatively large in scale.

Disney has announced staff cuts of 32,000 employees!

Rest easy though, if you're a shareholder, I've checked the list and there's no sign of Messrs.' Mouse and Duck on the list.

INVESTMENT OPINION

Subordinated Bank Bonds– appear to be back on the menu for investors.

Last week Kiwibank broke ranks from the collection of patient NZ banks, who are waiting for confirmation from the Reserve Bank of New Zealand about new regulatory settings for what counts as equity, and they issued some new subordinated bonds.

To be recognised as equity on a NZ bank balance sheet subordinated bonds must meet new definitions, and their rollout has also been delayed by Covid19 when the central bank cut some banks slack by postponing the launch of various new obligations.

Let’s not forget that the central bank became more focused on printing money and lending to banks themselves during 2020!

Here’s a little reminder for you about equity on a bank balance sheet, that supports lending they can offer to the economy:

Shortly, banks will be required to have about 16% of their balance sheet as equity;

A dollar loaned by a bank must be supported by a certain proportion of bank equity;

The amount of equity required is a function of the risk of the loan (capital adequacy measure);

For example a loan of $100,000 with a risk weighting of 100% (say a tractor loan) would require $16,000 of bank equity plus $84,000 that they could borrow from anyone, including you through term deposits and senior bonds.

Banks will be allowed to populate the 16% Tier 1 equity requirement (minimum) with different types of securities:

1)    Common Equity Tier 1 - Ordinary Shares and Retained Earnings;

2)    Perpetual Preference Shares (Additional Tier 1 equity – up to 1.5 percentage points); and

3)    Subordinated bonds (Additional Tier 2 equity) will be in addition to the 16% minimum Tier 1 requirement.

Items two and three on this list are cheaper than item one, so banks use as many as the regulators will allow (maximums are defined).

Item three will receive the least change between the old regulatory regime and the new one, so Kiwibank has decided that today’s nominal interest rates make it attractive to issue subordinated bonds (AT2), eight months ahead of the proposed launch of the new rules.

I think they are right.

As it happens, the terms and conditions for AT2 bonds are a little more complex now, than they will be after July 2021.

Today, the bonds can legally be written off, or converted to ordinary shares in a bank (you cannot enjoy the pleasure of owning ordinary shares in Kiwibank….. yet).

From July 2021 the AT2 bonds, including this new series, cannot be written off or converted to ordinary shares, they simply become debt like obligations that rank behind senior debt of the bank (term deposits, senior bonds).

Before you get too excited about the higher yields on AT2 bonds for the simplicity of being 'close' to term deposits, please remind yourself that you rank behind at least 84% of the banks obligations should anything go wrong and the bank fails.

In reality the majority of bank lending (mortgages) demands less equity than my tractor example above which rather means that these subordinated bonds probably sit behind something like 94% of people the bank owes money to.

This visible risk is why Kiwibank agrees to pay investors an interest rate that is 1.50% higher on AT2 subordinated bonds than on bank term deposits.

The probability of default by Kiwibank is very low but the terms of subordinated bonds (AT2), and Preference Shares to follow (AT1), mean investors will be in immediate trouble if the bank did default on its obligations.

Part of Kiwibank's willingness to lead the pack issuing 'new' AT2 subordinated bonds may be because theirs cannot be converted into ordinary shares in the bank, so it won't be difficult for them to retrospectively 'adjust' (simplify, improve) the terms and conditions of the bonds once the new regulations begin (probably July 2021).

It would be more difficult for a bank with shares listed on the NZX or ASX to retrospectively adjust the terms and conditions of their bonds.

Home team advantage, for those that do not have ordinary shares held publicly?

Perhaps, which could mean that TSB Bank is the first to copy Kiwibank if they like what they see?

Heartland Bank is listed on the NZX so they'll wait, as will the major banks.

Are you pleased to see subordinated bonds (AT2) back on the menu for investment selection?

Will you be pleased in 2021 when Perpetual Preference Shares (AT1) are offered, with even higher relative returns?

Have they lost their lustre with interest rate benchmarks so far below inflation at present, relative to the apparent rewards offered by other asset classes?

The answers to all these questions and more (sounding like a reality TV host – Ed) will be answered by your friendly financial adviser.

Scams – The Financial Markets Authority, through its Scam Monitoring department, advises there has been a steep increase in the number of scams being issued under respectable brand names in the finance and investment space.

I do wonder how one displays experience in their CV when applying for a job in a Scam Monitoring department; caught out several times?

I have two thoughts that I hope will protect you:

Don't engage with any unsolicited requests;

Ask for help.

Financial advisers can help you to assess some of the unsolicited approaches.

Get a financial adviser! (not biased at all – Ed)

Forward Looking – When making each new investment decision you are always looking forward (or should be) searching to define what happens next.

What are you certain will happen?;

What is probable to happen?; and

What is possible?

Each of these questions then needs a timing element, because the when of a pending financial impact has an important impact on what today’s value should be.

I may have covered this thinking previously but I am doing it again now to highlight for you that financial markets are already looking well past the 2020 impact of Covid19.

Covid19 is very close to being the judder bar that we are on the downside of (departing) and the remaining reverberations are the financial equivalent of a vehicle's suspension.

For the sake of accuracy, the 'suspension' isn't in great shape, so it will take all of 2021 for us to understand the reverberations, such as increased border restrictions (health monitoring), increased travel and freight costs and inconsistent government reactions but the pandemic itself is yesterday's story from an investment perspective.

Of far greater influence now, as it usually is, the world is focused again on the financial pressure being applied by central banks (monetary policy) and government spending (fiscal policy) and how long (important time factor) they will keep these flood gates open.

Political egos are becoming a more serious problem than Covid19 now too and lastly, the real long term problem; managing the outcomes from climate change.

You'll be reading about Covid19 for a long time yet, especially from governments who have enjoyed the escalation of power that it gave them for population control, but it really is not your primary focus as an investor any longer.

As one investor succinctly put it last week (Bloomberg article) – We are long-term investors. We are looking though the rising Covid19 case numbers and short-term economic weakness.

New travel expenses – Vaccines seem to mean that we will progressively be able to return to international travel, but be warned the costs will be much higher in future.

There will be additional obligations, which will add more costs, and there will be less flights, which will also mean higher costs.

Coming to NZ, already a long journey, will be far more expensive for those in the world's most populace nations, making the choice to come that much harder.

Evidence of transport costs can be seen in the financial reports of exporters.

When I was reading F&P Healthcare's admirable profit results recently the item that stood out the most for me wasn't their net profit, which clearly benefited from the Covid19 situation, but the damage done to profit margins by the currently disrupted transport systems.

FPH described a loss of 2.00% from their Gross Margin due to Covid19 impacts on border control and freight costs for getting their product to market.

My estimate of this sum is about a $5-6 million increase in costs, which are now 'stay in business costs' given that the majority of FPH product is sold to elsewhere in the world.

Covid19 has been a very tolerable double edged sword for FPH, but the increased transport costs will be a serious problem for other businesses (and prospective travellers).

Airport revenue – Having been hit as hard as any business in the post Covid19 world my comments above about the pending unavoidable travel obligations leave me pondering a new revenue stream for airports;

Measuring, storing and reporting data against new regulations for travellers.

Climate Regulation via ETF – Last week I spoke about the potential for regulators to force change upon business through banking regulations, and specifically to press for change that should result in climate improvement.

When I say press, I really mean punish undesirable behaviour.

Last week I read of an influence that was one step better because it involved investors consciously demanding that businesses change for the benefit of the planet's climate.

The article spoke about the emerging pattern of decisions by the world's largest fund managers to oppose or abstain if companies put motions to shareholders that are climate related and in particular may worsen the climate outcomes.

Exchange Traded Funds (ETF) have become an enormous part of the investor pooling with the three largest, BlackRock, Vanguard and State Street now managing US$15 trillion collectively.

The biggest, BlackRock, is reported as owning at least 5% of 97.50% of the companies that make up the US S&P500 index, which seems to imply that the big three hold somewhere between 10-15% of all these companies.

Their reach is global too because these three are reported as managing 80% of all ETF funds globally!

The article was frustratingly focused on the 'big is bad' theory and proposed that the large funds be forced to break up into smaller fund management businesses. I think this opinion misunderstands the more important points of value:

Scale has massively reduced the fees paid to the sector by investors, leaving more reward with those investors; and

There is a huge opportunity here for investors (through consolidated ETF voting) to drive the behaviour change that results in businesses becoming net contributors to improving climate related performance.

This second point is where the leverage lies and politicians would be much smarter if they try to work with the ETF sector instead of trying to break up their existence and thereby undermine the leverage that already exists to succeed with the cause!

If ETF managers can display to their investors well researched reasoning for the way they vote, or demand change from a business, those fund managers will surely attract even more investment from the public. It should be a reasonably virtuous spiral.

Then, politicians would witness true public sentiment on the matter, and real change in behaviour from business, without the need for much additional regulation from government.

With all due respect, having the NZ government announce a climate emergency will not drive change in the way businesses operate.

In my humble opinion James Shaw would be far more effective if he had passed a simple change to the Companies Act that required directors to attest to a Climate Improvement test relating to their decisions, in the same way they must sign off that a business is solvent.

James,

Item 4 of the Companies Act is - 'Meaning of Solvency Test'

May I suggest that you add in a new Item 5 – 'Meaning of Climate Improvement Test'.

Then make directors sign off the test, every year, in their Annual Reports and have an obligation to place the item on the agenda at Annual Meetings.

With this in place, James, you could then focus your efforts on a new regulation added to the Financial Markets Conduct Act demanding that licensed fund managers (Managed Investment Schemes) report to their investor clients on the actions they took to ensure target investments were meeting their Climate Improvement obligations under the NZ Companies Act.

Simple really. Just shine a light on the roadway and lean on the oversized stick.

I sometimes wonder why our MP's make governance look so difficult.

 

EVER THE OPTIMIST

Christmas trees are up and that means 2021 is just around the corner.

The fresh start will be nice.

Investment Opportunities

Infratil Bond – The Infratil offer of 6 year bonds yielding 3.00% remains open for investment.

If you would like a firm allocation please contact us, then submit your application form to our offices.

Ryman Healthcare Bond – has announced that its offer of senior bonds for a 6 year term opens today (and closes this Friday).

The minimum interest rate is 2.50% with the final interest rate being set on Friday.

This is a fast moving bond offer, booked by contract notes, with Ryman paying the transaction costs.

If you would like to invest in this offer please contact us prior to 5pm on Thursday to confirm the amount you wish to invest.

We will issue confirmations either late on Friday or early Monday and payment will be due shortly thereafter.

Kiwibank Subordinated Bond – Kiwibank issued $275 million of its AT2 subordinated bonds last week with an initial interest rate of 2.36% until December 2025.

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

You can expect more of these bonds to be issued during 2021.

TRAVEL

Our offices will be closing on Tuesday 22 December and returning on Monday 11 January. If you have some business that you'd like to complete prior to Christmas please act now.

Thank you.

Mike Warrington


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