Chris Lee & Partners Ltd

Market News 30 January 2017

I have another anecdote for you that timing is important with investment.

The previous developer of the Five Mile area in Frankton, Queenstown, went bust (sadly wasting a lot of other peoples’ money) but the current developers could not be happier with the flood of people now using this new shopping area.

Another observation is that I would be very reluctant to invest in rental car businesses.

It seems to be an industry that can easily be caught with excess inventory, inefficiently used, and I observed a substantial risk of damage judging by the usage patterns of a variety of the users.

INVESTMENT OPINION

 

BIS on Paradigms – The Bank for International Settlements asked an open question in a recent article ‘Has there been a paradigm shift in interest rates?’

Again I feel as if I am getting old because I think ‘new paradigm’ has been used too often in financial markets as commentators reflect on recent data or try to forecast pending data. Perhaps this is just the development of my personal wisdom, I’ve been around long enough to be able to distinguish between the guesses (hopeful headlines) and the reality.

I decided to look up the Oxford Concise definition of paradigm

Paradigm: an example or pattern of something

I wonder what pattern the BIS analyst thought was changing?

Financial markets are always changing and therefore so are the patterns; the pattern always depends on the timeframe, or length of cloth, from which you try to draw your pattern.

If the BIS simply analyses the long term interest rates (say the US 10 year Treasuries) over the last quarter of 2016 they will indeed see a violent change from a declining interest rate (1.36%) to an increase of 1.20% up to 2.56% for the same bond. This rate of change is indeed extra-ordinary, and the scale of change is significant, until you look at data over a longer period of time.

When you widen the range of observation you find the same rapid upward moves, with many that are larger, in many years: 2013, 2011, 2008, 1998, 1995, 1993, and on it goes as you search back in time to the start of the post ‘gold standard’ era.

You also witness significant declines in yield.

Wait, maybe that’s a pattern too?

The ongoing decline for interest rates since the highs of 1981-1984, driven by the intense fight against inflation, appears to have been aided by the Chinese decision to increase its participation in global economics, followed by its disciple nations.

President Xi Jinping may be trying to clamp down on how China participates but additional labour supply is no longer just a China and South East Asia story. Huge advances in the ease of travel and the emergence of the internet (Tim Berners-Lee 1989) have ensured the redistribution of labour across the entire planet.

Given the poor financial state of the majority it is hard to imagine that labour costs will rise out of control in the foreseeable future. Developed nations rapid uptake of automation (robots) adds further weight to my argument.

Trump claims he will bring back jobs from China but analysts state that 80% of the ‘lost jobs’ are now replaced by ‘robots without passports’, not foreign citizens.

My point (whew – Ed) is that longer term interest rates are driven by inflation, not vocal politicians or central bankers and I haven’t yet seen enough new information to have me believe that inflation is likely to move out of control to higher levels.

Without a shortage of labour and perhaps access to excessive spending power from another source (queue: debt) I don’t yet see where the higher inflationary pressure comes from.

I described above why I don’t think there is likely to be a shortage of labour and you’ve all read plenty about the excess of debt in the developed world so this ‘energy for spending’ must be on the wane.

If the world collectively decides to write off debt that seems unlikely to be repaid, as Iceland did to re-start their economy, then, maybe, there would be room to ‘go again’ and it might drive above average inflation. However, no investors will happily write-off investments of this scale just so the poorly behaved (financially) can ‘go-again’ and no central banker will thank them if it frees up unbridled inflation again.

So, are global interest rate markets likely to form a new pattern?

Over a short time frame my opinion is no, but longer term, yes I think we will experience a pattern that meaningfully differs from the pattern of the past 32 years.

I think investors can see that deflation will be fought at every turn when feared so from an inflation perspective we can set our basis for inflation between 0% and 3% which is fortuitously the rough target of many central banks.

Investors will then add an acceptable after tax return to reach what they consider to be an appropriate nominal return from their fixed interest investment. This item will vary based on the credit risk of the borrower.

The elevated risk of underperformance by a large pool of borrowers globally should see widening credit margins. Where a 1% real return from the NZ government may be acceptable it may require 2% real return from a very strong borrower (such as a bank) or 3% real return from a strong utility, but it may require a 5% real return from a subordinated loan.

If I put these two factors together (stable inflation plus a real return) it seems likely to me that we have seen the lower bound for interest rates but after a lift to reflect less fear of deflation interest rates should settle within a broad range for a long period of time. That range might be 4.00% - 6.00% range for long-term (non-government) senior bonds in NZ.

The new paradigm that the BIS ponders may well just be markets holding within that new range for a very long time rather than maintaining the old declining trend or establishing a new rising trend, but we won’t know this for a few years yet (Smiley face).

If I am correct, which I’ll report back on in 2025, investors should come out well by investing in longer term bonds because it seems likely to me that long term interest rates will remain higher than the alternative (short term interest rates) and one should increase their attention when longer term interest rates are 5.00% or higher on senior bonds (my expectation of the upper half for returns from this asset type).

As the months pass by I shall be curious to read items from those who are more fearful than I with respect to an ongoing bearish market for interest rates.

Bank Deposits – why banks’ must pay you more for deposits in future and companies will issue more bonds locally.

Effective from October last year the US government (Securities Exchange Commission) forced changes on US Money Market Funds (MMF), which is dramatically reducing the amount of money available to invest in bonds issued by NZ banks and companies.

The new rules were logical and in summary instructed these short-term money market investment funds not to create an unmanageable mismatch between assets and liabilities i.e. not buy long term corporate bonds and compromise the ability to payout any cash demanded by depositors.

Several MMF were forced to close the doors to repayments during the Global Financial Crisis, which was exactly the same problem as some mortgage funds experienced here in New Zealand.

The new rules allow a MMF to hold a value of $1.00 per unit of depositor funds if they invest in very short-term assets themselves and in US government bonds that are always easy to sell or borrow cash against, even in a crisis. Any MMF which holds other investments, such as bonds issued by a NZ bank or company, must revalue the fund’s units each day and thus investors lose the surety of being able to withdraw $1.00 per $1.00 deposited.

Unsurprisingly the new rule has seen a large move toward MMF holding government securities and an assured $1.00 value and away from the funds that might compromise that $1.00 value when under duress.

Until October 2016 the US MMF had been very big investors (via Private Placements) in bonds issued by investment grade entities around the world.

The removal of this source of demand from the market for NZ borrowers forces them to consider alternatives, which logically starts with local deposits by banks and locally issued bonds by banks and corporates. This, along with the new flexibilities provided by the Financial Markets Conduct Act, are the reasons we have alerted you to the likelihood of more frequent issuance of bonds during 2017 and beyond.

This is good for NZ investors both with respect to variety but also to what I hope will deliver slightly wider credit margins (higher returns) for local fixed interest investors.

Long term bank deposits close to 4.00% don’t cut it anymore.

Conflict – Chris Liddell stood down from his role as Xero Chairman almost immediately after being appointed to a role in politics (Trump’s advisory team) but by contrast sitting UK Member of Parliament George Osborne has accepted a part time role with the world’s largest fund manager (BlackRock).

Osborne sees no conflict in simultaneously allocating his diary across the regulator and regulated. He’s not alone but it looks dreadful.

I wish it was naivety that delivered such decisions but it is simply greed.

I don’t understand how the Code of Conduct for an MP allows this to happen.

Osborne misunderstands the drivers of the US election, so he will not understand when he is voted out of his role as MP.

In the meantime Osborne’s fellow MPs must be casting daggers in his direction for implying that the role of an MP is a part time job.

Investment News

China – We shouldn’t be surprised to learn, as we did today, that at least one Chinese Province (Liaoning) has been lying about its economic performance but like any crime it is deflating once disclosure confirms the reality.

Many international analysts had questioned China’s economic growth rates citing that they did not match other measurable data such as energy use, freight movement and banking but the reported growth rates still seem to be the artificially inflated ones.

The most recent quoted Chinese growth rates were +6.7% per annum (bang in the middle of the 6.50%-7.00% targeted range) but the alternative measures say 4.0% or less. During 2016 China reported three sequential quarters at +6.70% growth and just to be different they reported +6.80% for the final quarter of the year. Forgive me being skeptical but this data series is statistically ‘improbable’.

Surely many of the assumptions about China’s high growth rate being required to service its dangerously high debt levels will become a significant concern when we factor in the confirmed dishonesty around the economic growth data from at least one province.

People don’t exaggerate debt numbers so clearly this factor from the debt to income ratio won’t change.

Many of the analysts that I read present China’s debt levels as one of their top concerns for financial markets immediate future (1-3 years) and this news about data fraud, whilst not surprising, will escalate their concerns.

I expect that the data from Liaoning will now change to lower levels (as will the population – Ed).

China II – Here is a hyperlink to a good, brief, story at the Financial Times about capital flight out of China. https://ftalphaville.ft.com/2017/01/19/2182669/chinese-capital-flight-is-back/

It discusses three main drivers for capital movement and concludes that the movement of savings (wealth, however gathered) out of China is the most likely driver for the scale of money movement at present.

The clear move to a Financial Account deficit coincides almost perfectly with the arrival of Xi Jinping as President.

China has enjoyed 35 years of increased economic interaction with the world since 1978 when Deng Xiaoping opened up the economy to foreign investment. The inflow of capital was immediate and we all know the general story of rapid growth that followed.

If those in control of significant funds in China, earned or taken, are now trying to rush that money out of the country this must have a negative impact on the country’s economic performance.

Given the strong-arm tactics being deployed by Xi Jinping he is hardly likely to back off and allow the markets to have more control; the opposite is more likely.

Mind you graph 5 in the article, which displays how Chinese Yuan is now the dominant currency used for purchasing Bitcoin (previously USD), may well validate why Xi Jinping is clamping down on corruption in China.

If the capital flight is more related to the movement of ill-gotten wealth than the behaviour of global investors then China’s Financial Account deficit should return to a more neutral point over the next year or two. If not, then surely China’s growth will decline faster than it is already doing and may well trigger the debt defaults that analysts already fear.

Post Script: The strict new regulations controlling capital movement appear to be working as the December 2016 data shows a significant decline.

India – I see Apple is considering establishing a manufacturing base in India, no doubt attracted by the labour cost plus the scale of the population for selling Apple products to.

At face value this seems appropriate, until you read of Apple’s demands for a string of financial incentives from India before they agree to set up.

So, Apple wants financial incentives from India so it can then also route its revenues to Ireland and the Netherlands to further avoid paying much tax anywhere!

I think India would be wise to avoid this one-sided proposal or perhaps respond with an additional tariff of their own on Apple products if they wish to sell within India?

Ever The Optimist – Employment conditions have improved, from a good base.

The Westpac-McDermott Miller Employment Confidence Index rose 2.6 points to 112.7 in the December quarter, adding to an 8.5 point increase in September and taking the measure to its highest level since 2009. A reading above 100 indicates optimists outnumber pessimists.

What I enjoyed reading the most though was that the greatest change in confidence came from the regions, which are clearly benefitting from stronger agriculture markets (stronger dairy and fruit & vegetable prices particularly). Tourism growth must have helped more broadly.

We need the regions to continue outperforming the cities both for the sake of the country’s Balance of Payments and to draw some of our population away from the Auckland vortex.

ETO II – One anecdotal measure of the growth success NZ is enjoying from tourism can be seen in flight data.

It was phenomenal to read that over the past 10 years Air NZ passenger volumes delivered to Queenstown has grown from 375,000 each year to 1 million in 2016.

I know this delivers demand/supply problems but that is a high quality problem to have.

ETO III – I am pleased to read that NZ wishes to return to the negotiating table with Sri Lanka to try and expand trade activity between our countries.

Most others seems to be focused on India as the largest in the region, and we should join this queue too, but with a population of 20 million (almost the same as Australia) I’d be happier to prioritise Sri Lanka and move faster with greater exports to this region.

Investment Opportunities

Wellington Airport – offer of senior, unsecured, bond maturing on 16 June 2025 paying interest at 5.00% per annum remains open (due to close on 14 February).

We have an allocation, which we are distributing to investors on a first come first served basis.

If you would like to invest please contact us to secure an allocation before delivering an application form to us (scanned and emailed, or hard copy, are acceptable).

The offer document (pdf form only) is available on the Current Investments page of our website.

Travel

Edward will be available in Auckland (Remuera) on 17 February.

Michael will be in Auckland later in February (dates to be confirmed).

Anyone wanting to make an appointment should contact us.

Michael Warrington

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Market News 23 January 2017

For two years I have watched Trump’s emergence and then surprising election as President of the United States of America with a recurring mental headline of ‘Good Grief’, but this all changed last Wednesday morning in a 15 second radio announcement; New Zealander Chris Liddell has been appointed to Trump’s close team of advisers.

Regular readers will know of my respect for Chris Liddell, a past workmate who has achieved impressive things and always approaches goals with a serious intent to succeed.

I would describe Chris as being apolitical (I speculate that he left General Motors on a principle of being misled about the likelihood of becoming CEO) which makes his appointment by Trump entirely consistent with Trump’s intention to govern differently.

Good leaders surround themselves with even better people. I have no doubt that Chris Liddell is more clever than Trump, but perhaps Trump is going to be a better leader than cartoonists would have us believe.

We may sadly, in the interim, lose Chris from his role as the Chairman of Xero. (perhaps he could sign up the Trump Organisation of businesses as clients before he leaves the board? – Ed).

INVESTMENT OPINION

 

The following is a quote I read and like (Howard Marks, within a John Mauldin newsletter) and I present it on to you because it is directly relevant to making investment decisions. Howard offered the quote generally after a conversation about the US Presidential Election.

Experts may be right more often than the rest of us, but they’re unlikely to be right all the time or anything close to it.

I’ll add to his quote by stating that one should further discount the expert’s conclusions if that person remains employed as a requirement of meeting their own financial obligations.

Howard relayed other quotes that he likes, including these two that I also like:

‘Anyone who isn’t confused doesn’t really understand the situation’ (TV news anchor from a prior generation, Edward R. Murrow); and

No amount of sophistication is going to allay the fact that all of your knowledge is about the past and all your decisions are about the future. (former GE executive, Ian Wilson).

I’ll offer investors another thought of my own: Anybody who explains to you what will happen tomorrow should be asked to leave the room today.

If you think of these quotes when donning your investment cap you’ll be approaching your next decision from the best perspective. If you then refer to your own investment policy settings, that we encourage all investors to establish, you’ll find investment decision making easier.

Investment News

Trump – Donald Trump has been inaugurated and he now holds the ‘salt shaker’.

The floor is his.

Let’s see if we can keep up with his beating of the drum.

So far I have very little idea whether the Trump Presidency will be good or bad for economics and investment but I am concerned about the rapid rate of change being proposed because the public dislike rapid change even if they temporarily believe the changes are appropriate.

UK Banking  – Sir John Vickers, the man who lead the UK’s independent commission on banking, is warning UK banks that they may have passed the recent stress tests (some didn’t and have been instructed to raise additional equity) but Sir John warns the banks that none of them are sufficiently prepared for the next crisis.

Yes, he said ‘the next crisis’ and I think he is right, it is when, not if.

You don’t have to look far for a cause, say Italy, to develop concerns about potential sources for crises of confidence in banking.

Many observers, including us, felt the UK stress tests didn’t warrant the use of the term ‘stress’ because the analysis was very modest in the tension applied. Sir John himself criticised the stress tests as not rigorous enough. The bankers’ will understand what tension is once the Italian banking sector fails, after hiding behind lies and deception as they are currently.

We are pleased to be sitting, and investing predominantly, in the NZ and Australian banking environment which presents relatively strong equity ratios and uses Risk Weightings at least twice as conservative as those in the UK (and Europe).

Gold still attracts – Regardless of Bitcoin and other Blockchain generated payment schemes gold isn’t a dead commodity yet within financial markets.

The Bank of International Settlements (the global banking regulator) still accepts gold as collateral for secured lending to central banks and interestingly its ‘Gold Swaps’ (financial markets label for the loans) have increased significantly during 2016.

BIS activity in Gold Swaps had dropped to zero in 2015, after a large spike during the Global Financial Crisis, so I am rather curious about the drivers for the lift in activity in 2016.

Heartland Bank – Unless you are an avid reader of Australian media you may have missed that Heartland Bank (through Heartland Seniors Finance) received the ‘Best Reverse Mortgage’ award in Australia for 2016.

Once I understood HBL’s move into this sector and the potential of this service I developed a view that it will be a long burning business for the bank and should slowly increase in size with the demographics of the current retired generation.

However, its growth is surprising me with its speed.

The property market price movements are leaving many people with a high asset pool but not necessarily a high cash flow through their bank account. Home Equity Release loans can bridge this divide between one’s personal balance sheet and their accounts.

Some of the rapid growth, especially in Australia, may relate to the new asset testing rules impacting the net payment of Australian Aged Pension but this asset testing policy from government is clear and is unlikely to change.

Good business is usually made up of a collection of small wins and HBL will be pleased with the evolution of its Home Equity Release business.

Unemployment – The International Labour Organisation, an organisation representing information from 187 countries tells us that unemployment is rising and is about to reach 200 million people globally.

In some areas of the world we are being told that employment is improving and unemployment is declining (US, Canada, Germany, NZ…) but apparently overall unemployment is rising according to the ILO.

I’ll wager that the ILO thinks I am missing the point by reporting this as only 2.80% of the reported global population.

The ILO correctly cites that global economic growth rates continue to disappoint, which according to the World Bank data series are about 2.50% currently and have been declining post the volatility of the Global Financial Crisis.

The anti-globalisation thrust of Trump and his international disciples won’t help global economic growth rates and the rise in use of robotics won’t help employment (‘the share of tasks that are performed by robots will rise from a global average of around 10% across all manufacturing industries today to around 25% by 2025’ – Boston Consulting Group).

Extrapolating the influence of robots, if Trump is opposed to the likes of Mexicans and Chinese ‘taking US jobs’ then surely he will be anti-robotics too for they permanently claim far more jobs than other countries do. And, robots don’t have citizenship, or emotions, so Trump can say whatever he likes but the robots won’t be listening.

According to most sane analysts that I read the high, and rising, levels of government and personal debt will add a further drag to the economic growth potential. This makes sense to me because at some point debt must be repaid (or defaulted on – watch Italy during 2017) and the accelerated consumption of the past generation should begin to slow; although there are no signs of it yet.

All the while the global population continues to increase (+1.10% at 80 million p.a.) and the rising nominal level of unemployed people seems to indicate there won’t be enough productivity to go around.

I am certain that employment and poverty forecasting isn’t that simple to deduce but surely the negative trending indicators are a concern all the same.

If the ILO and Boston Consulting Group are even half correct then the global threat of more inflation and higher interest rates should continue to be modest (unless you are a resident of Venezuela – Ed).

Flash Crash – The Bank of England and the Bank of International Settlements looked into the ‘flash crash’ (9% decline) in the pricing of GBP versus USD on 7 October (Asian time zone).

They both found that there was no single reason for the crash, no person or organisation to hold responsible for such undesirable market conditions. However, they continue to learn more about the drivers of these irrational price moments in financial markets.

From my perspective it may not have been a single event but it did reflect the rising incidence of algorithmic (computer instructed) trading action in coincidence with banks reducing the trading risk tolerated by real staff within the organisation (tighter capital allocation rules as bank regulations tighten).

Clearly the computer algorithms weren’t that clever and the shallow pool of humans in the ‘wrong’ time zone for trading GBP and USD proved a problem. The computer trading occurred too quickly to wake up more experienced London based traders.

I am not suggesting improved bank regulation is a cause of the crash because much of the new banking regulations around equity increase and risk assessment makes good sense but the reduced involvement of thinking humans clashed with the poor thought and execution of the computers.

I remain more than a little suspicious of the initial large seller (human) who consciously chose the Asia time zone (lowest market liquidity for GBP/USD) to launch their large, aggressive, sell order which then triggered various computer based sales which pushed the markets much further down in price. Was this the desired outcome of the initial seller?

Whatever the intentions of the various traders, one likely outcome from the enquiry will be more regulatory influence.

In response to this incident the BIS Foreign Exchange Global Code Committee plans to amend the developing FX Code to place some additional responsibility on banks, as the major market points for FX trade execution, for monitoring market activity. Specifically to include a market participants' obligation to consider the disruptive consequences of their trading activity, governance around algorithmic execution of trades, and how market participants might best determine the low (or high) point of pricing in a flash event.

‘Such events have the potential to undermine confidence in financial markets and impact the real economy and it is important for policymakers to continue to develop a deeper understanding of modern market structure and its associated vulnerabilities.’

We can’t allow the machines to have too much influence and banks’ will be expected to monitor client trading activity more closely including reconciling it against a market Code of Practice.

Not Alone – We often wonder about what we don’t know when making investment decisions and sometimes conclude that there is a subset of investors who always know more and judging by their wealth continuously win with their investment decisions.

Instinctively you know this isn’t true but a headline last week may comfort many; one of the world’s most prescient investors (traders) admitted he can get it wrong too.

George Soros disclosed that he had made investments seeking to profit from falling markets based on a Trump victory in the US elections. He wasn’t alone with this dire expectation.

However, Soros lost close to US $1 billion as a result of this investment decision.

I am neither taunting Soros, nor telling investors to be satisfied with investment losses, just grateful for the honest disclosure that makes us all feel normal with respect to our own investing.

Blockchain – The European Central Bank is to develop a proposal to consider in mid-2017 for establishing a Euro-wide payment system with immediate settlement.

The service would use the blockchain technology, just as Bitcoin does, and endeavour to reduce fees to below 1 cent (regardless of payment amount) and thus remove credit risk from the payment (i.e. payment cannot fail).

The messages to take from this are simply:

Bitcoin will have many more blockchain based payment competing with it in future;

Blockchain has quickly gained respect as a new transformative technology for processing and storing data; and

The way we pay people in future will evolve faster over the next five years than the past fifty.

In my view, you should prepare for the following in relation to the way you manage payments and receipts in future:

The removal of cheques from the payment system;

Cash will remain available but only in smaller notes (especially if the India experiment is successful);

Online banking will continue;

Payment instructed (and perhaps received) by your smart phone, but not necessarily linked to a bank for clearing the payment; and

Payments and receipts linked to one or several Blockchain ledger(s) arranged via some medium (probably a smart phone, but India was discussing finger-print for their payment system). Much of this is yet to be understood, because the developers haven’t reached the point of understanding what they are producing yet!

It is a 50:50 mix of exciting and uncertain.

Post Script: The recent strong run up in Bitcoin appears to have been driven by Chinese. Every time I hear of the Chinese dominating a market I speculate that it relates to large volumes of money trying to exit Chinese Yuan (real estate around the world, businesses like the purchase of UDC) and it seemed that Bitcoin had become another asset of choice.

This changed swiftly last week when the Chinese authorities visited Bitcoin exchanges in China to check that they were completing all the necessary Anti Money Laundering checks and regulatory reporting.

Chinese concerns about Bitcoin use will be shared by all other central banks and governments given the current inability to closely regulate digital currency use.

Ever The Optimist – My participation in the venture capital space to learn more about developing business lines in NZ has been very useful. In the past NZ didn’t seem very effective at supporting start-up businesses but that is changing, with the support of one or two major corporates (such as SPARK), many wealthy investors, governance support from experienced folk and clubs amalgamating smaller investors (like me).

Statistically I understand 90% of such start-ups fail (it remains a high risk market space), so it is nice to read about those who push on and seem ‘probable’ to succeed (as Flick Electric did last year, with more to come from them).

Another such start-up that I had attended a presentation for reached media attention last week confirming its third round of funding ($3 million, which is significant) and moved itself from the ‘possibles’ to the ‘probables’ for business success.

The business name is POSTR and, in summary, it helps mobile phone users sell the advertising space that is their ‘lock screen’ through an agreement with their mobile phone service provider (accept advertising in return for small rebates on monthly cost of running the phone).

It will be nice if one day we begin to see some of these businesses reach the point of being large enough, with imminent profitability, to list on the NZX for any final funding requirements and increased liquidity for investors.

Investment Opportunities

Wellington Airport – offer of a new senior, unsecured, bond maturing on 16 June 2025 paying interest at 5.00% per annum remains open  and is due to close on 14 February.

We have an allocation, which we are distributing to investors on a first come first served basis. If you would like to invest please contact us to secure an allocation before delivering an application form to us (scanned and emailed, or hard copy, are acceptable).

The offer document (pdf form only) is available on the Current Investments page of our website.

Travel

Chris is moving around the country making presentations relating to investment and to update holders of the SCFHA securities. The schedule can be seen on last week’s Taking Stock.

Kevin will be available in Christchurch on 2 February 2017.

Edward will be available in Auckland (Remuera) on 17 February.

Anyone wanting to make an appointment should contact us.

Michael Warrington

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Market News 16 January 2017

Here we are again, back at the start line.

US Politics will dominate the stage this year and so far there has been plenty of guessing about where the Trump Whitehouse (Plaza? – Ed) will take us.

This approach by the analysts is entirely consistent with the Trump approach of guessing as he goes.

Thus far I find it unimpressive that the leader of the world’s most powerful nation thrusts his personal expectations about policy (shoot from the hip via Twitter) in front of genuine policy setting processes.

I know the ways that we communicate are evolving but I don’t find Trump’s use of social media in his role as President as appropriate. He is no longer operating from the ‘locker room’ but he is behaving as if he is.

It will be a period like no other.

INVESTMENT OPINION

 

UDC – ANZ has now agreed to the sale of UDC, ending an era for the non-bank deposit taker and the large pool of retail investors who supported the business over a long period.

This is a very big news item for NZ fixed interest investors.

All banks have been on a strategic path toward increased equity on their balance sheets and this has brought into the spotlight any business divisions or assets that were capital hungry or performance light.

Relative to ANZ’s ability to use less capital for home mortgage lending UDC was capital hungry with our estimate that the majority of UDC’s lending demands roughly 100% Risk Weighting capital measurement relative to the bank’s average Risk Weighting of more like 50% (half of the equity capital required for the same amount of lending).

ANZ Chief Executive Officer, David Hisco, offered a courtesy headline to the media that ‘the sale of UDC is consistent with our strategy to simplify the bank and is a good outcome for customers and staff’.

I think one should focus on the words ‘strategy to simplify the bank’ and this strategy is for the bank’s shareholders and how the bank uses the capital available most profitably.

It is a sea change for ANZ to reach the point of selling UDC.

It can’t have been that complicated to run UDC given the very long term ownership (36 years of 100% control) and the consistency of governance between ANZ and UDC. I think we will find that the sale has a lot more to do with an ANZ view that they cannot see a way to make a satisfactory stand-alone return on equity from UDC over the next decade.

I speculate that about two thirds of UDC’s profit margin is a function of ANZ’s presence as owner (brand value of ANZ to UDC) so the residual <1% return on assets by UDC simply isn’t high enough and the bank must believe it is easier to sell the business than try to expand the stand-alone profit margin.

On the flipside of ANZ simplification it does appear to me that the buyer, HNA Group of China, is trying to complicate its own strategy, having started its life as Hainan Airlines in 1993.

HNA is clearly not sticking to its knitting.

Things change. That is normal in business. Understanding the change is what I am focused on.

In fact the duration of unchanged UDC ownership by ANZ is the unusual aspect of this story (starting with a 20% shareholding in 1965), through some huge regulatory changes, various financial disruptions and the 2008-2009 financial crisis.

Now we, especially those who invest with UDC, must develop a new understanding of the future for the UDC business following such a significant ownership change. ‘Bank owned’ meant a lot to investors, as it should have.

Importantly, in the near term, Standard & Poor’s has described for us their view about the new risk of the investment in UDC, outside ANZ control; UDC’s credit rating has been reduced from ‘A-‘ to ‘BBB‘ Negative Outlook whilst regulatory approvals are sought. Rather shockingly S&P go on to say that if the sale is approved the credit rating will then fall to between ‘B+’ and ‘BB+’ dependent on the influence of HNA.

It is our view that UDC has a book of very good lending assets under the governance of ANZ bank, so these conclusions from S&P are a revelation.

A brief side story if you’ll allow me – I once (7 years ago I think) commented in Market News that UDC’s interest rates were too low and that without ANZ support its credit rating would be more like the other similar deposit takers (say ‘BBB’) and thus investors deserved higher interest rates (ie not just in line with bank deposits). They certainly deserved higher interest rates for longer terms because the longer the term the greater the window of risk that ANZ might sell UDC.

In response to my comments I received a call from the senior most ANZ executive responsible for UDC (I’ll leave unnamed) who wished to poke me firmly in the ribs for my inappropriate views in public.

My views may have been unhelpful to them but today’s news confirms that my opinion was not inappropriate.

UDC has a very large deposit base ($1.6 billion). If the sale proceeds then a very large proportion of those depositors, un-matured at the time approval might occur, will continue to receive an interest rate set against a ‘AA-‘ credit rating but then be lending to what may be a ‘BB’ risk type.

We do note however that should the sale to HNA proceed investors will be offered the option of either withdrawing their funds or transferring to a similar investment at ANZ.

This announcement from S&P is a dramatic change in credit risk in anyone’s language.

The heritage of UDC (United Dominions Corporation (South Pacific) Limited, established by a German banker who escaped Nazi Germany in 1938) is nice to know and is a useful lesson in the development of banking and finance in NZ, but today’s regulations are completely different and the sale is the next significant evolution for the business.

Does the sale confirm that NZ regulators prefer that banks reduce higher risk lending or just the fact that ANZ allowed UDC’s lending margins to decline too far so risk adjusted returns became too low?

The sale of UDC may herald the return to growth in the non-bank deposit taking sector with the purpose of lending on higher risk categories typically being avoided by the major banks.

Are the regulatory risk settings correct?

I am not so sure that they are if the result is ANZ concluding the sale of a good lending business such as UDC is an appropriate decision.

Heartland Bank may be disappointed to have missed the purchase of UDC but the price paid by HNA clearly exceeded the point of financial merit for Heartland Bank (or GEM who recently purchase GE Money’s NZ assets).

As a shareholder of HBL I thought UDC would be a nice asset to have, but I do not mind that they have missed out on the purchase as it reinforces my view about the quality of governance and management at HBL. They are not interested in winning deals for the sake of ego; everything must make financial sense.

I now hope that HBL will reassign a little of its cash to competing with UDC Head-on, using their competitive advantages (local, bank, supportive depositor base).

NZ borrowers are primarily driven by price (low interest rates) but until HNA explains how it plans to keep UDC’s cost of funds down I don’t see how they’ll be able to avoid an increase in loan interest rates. Couple this to HNA not having the ‘local’ factor, nor ‘bank supported’ and it seems to me that the door is wide open for competition on the lending front.

Losing clients has plenty of precedent, but one with direct relevance is Face Finance. It was set up originally to compete with UDC, it became partly owned by South Canterbury Finance. Face Finance loans were sold to Nomura post SCF’s failure. Nomura surely hoped to retain and build on this loan book but the complete opposite happened; most loans were repaid early (Nomura profited because SCF foolishly sold the loans at a discount).

HBL shares may enjoy a modest lift given that there now won’t be a large call for new capital and thus access to investment in this well-performing bank is via secondary market purchase of shares from other (reluctant) sellers. (Disclosure – I own a few, as do others around me).

Speaking of UDC’s depositor base, whilst I referred to ANZ’s sale as being primarily motivated by efficient use of bank equity (they quote a net increase in ANZ NZ equity of 0.50% post the sale of UDC) I suspect the sale of UDC also has a funding benefit for the bank.

The numbers published in the ‘sold’ notice imply that ANZ was providing about $1 billion of the $2.6 billion funding for UDC’s lending with the balance coming from UDC depositors (and declining as the bank considered the sale). 62% funding from retail depositors is well below the minimum Core Funding Ratios (bank liquidity measure set by the Reserve Bank) of 75% so it implicitly placed a negative drag on the bank too.

So, given the current ‘retreat to core’ strategy being pursued by the ANZ along with the current regulatory framework the time had come for the sale of UDC, after 51 years of involvement.

Theoretically, and with my blessing (how kind – Ed), the Reserve Bank should now increase the Risk Weightings (equity requirements) for mortgage lending to property investors, by defining them as business loans and not as residential mortgage lending. I am sure the RBNZ and banks’ can come up with a suitable way of catching customers who try to hide property ownership across different entities.

To not change the Risk Weighting settings would retain a perverse outcome where a bank is incentivised, through lower equity requirements, to lend to residential property investors relative to people buying diggers and trucks for real productivity. With respect to Risk Weighting settings owning shelter (one house) rates ahead of productivity but unproductive property ownership should not.

Retirement village operators might also be lobbying the government over this regulatory disadvantage between their business costs and those of private property investors. Businesses like Ryman are, at their core, residential property investors, yet they undoubtedly are business borrowers when they approach banks for funding.

If lending money to Ryman a bank would thus set aside equity for something like a 100% Risk Weighting (roughly $10 per $100 loaned), yet the same bank would set aside equity for a 35% Risk Weighting for the person borrowing money to own 10 residential investment properties (roughly $3.50 per $100 loaned).

In my view this inconsistency needs to be resolved, by the Reserve Bank. Doing so would even the playing field and usefully remove another small strand of inappropriate demand from investment in residential property (as opposed to residents owning property).

HNA will now (once settled later in 2017) govern UDC in a way that is consistent with the regulations set by the Reserve Bank of NZ, which are similar to that for banking.

UDC depositors do not need to make any urgent decisions regarding their deposits with UDC.

UDC plans to write to investors and explain the steps that will be taken later in 2017 if the sale of UDC is approved (including early repayment, switch to ANZ deposit, remain deposited at UDC). Now, however, is a good time to consider one’s future strategy for total exposure to the organisation if it will no longer be 100% owned by one of Australasia’s biggest bank.

It should go without saying that the relative interest rates offered by UDC in future should rise to reflect the decline in the credit rating. They can no longer justify setting them at, or below, bank deposit rates for comparable terms.

 

OCR – Much of what I read or observed over summer didn’t provide me with much new clarity as an investor, or financial adviser, with the opposite usually true.

However, the information I read makes it hard for me to see any more OCR rate cuts in NZ during 2017, or beyond, unless Trump destroys global economic activity as he tries to build Trumpland.

NZ employment and economic activity looks robust for 2017 and 2018 and the US also enjoys strong employment again and has finally begun a cycle of interest rate increases.

I would not stall my investment decisions though because I think long term investments will continue to outperform short term investments, but it does seem that patience will not be penalised as it has been often over the past seven years so we have time to wait for good investment options to emerge.

Investment News

Hellaby – The takeover offer from Bapcor will now proceed as it has received acceptances for greater than 50% of the company and has waived the 90% condition previously set as a limitation of the offer (ie they wanted 100% ownership but will now accept less).

The majority of HBY shareholders elected to reject the advice of their directors (to not sell). HBY directors have now changed that view to 'accept the offer'.

This suggests to me that these investors now feel the directors have done the best job possible of negotiating an exit price (better than those shareholders who urged others to sell at the lower price) for the HBY assets but may also feel that a few past missteps with HBY investment strategy leave them willing to move on and invest their capital elsewhere.

A takeover offer at a premium to long term market pricing is often a good result and better than being forced to sell on market at a discount to asset value if one needs to exit for their own strategic motivation.

Having been successful in gaining control of Hellaby there is now likely to be a flood of additional acceptances and thus the actual number of shares sold to Bapcor will rise significantly.

India – The clamping down on tax avoidance via cash use in India may be working.

India has announced a modest reduction in the expected borrowing that would be required in the first part of 2017 and some commentary is trying to link this to increased tax collection, which may be influenced by the attempts to reduce the presence of the cash based black market.

The Indian government is also actively promoting the use of its own new non-cash based payment system ‘BHIM’ so there is a serious intent behind these payment and tax collection reforms.

The government’s popularity is reported to have lifted significantly in response to tackling corruption this way.

These developments will be interesting to monitor for other nations with mysteriously large volumes of high value Notes (cash).

Global Trade – has taken a knock as anti-globalisation parties rise to more dominant roles in the political arena, but the single party Chinese are wisely doing the opposite and have just sent their first ‘all the way to the UK’ train (12,000 miles over two weeks).

Democracies may lose ground, economically speaking, if their voters become too ‘selfish’ in their expectations.

Ever The Optimist – Beyond India (above) other tax collectors continue to push back against the corporate world. This is a good development with respect to fairness between those with savings and those without (wealth distribution) and central governments of the world need to ensure it continues.

Ireland still needs a severe clip around the ear for siding with the corporate world.

Last week the U.S. Supreme Court declined to hear Dow Chemical Co's bid to revive its claim to more than $1 billion in tax deductions based on partnerships the company entered into that lower court said were created primarily to avoid tax liability and had no legitimate business purpose.

Good. Keep it up.

Investment Opportunities

We are expecting 2017 to be a busy year for new investment offers, especially in the fixed interest category. There seem to be three main drivers of this; reduced bank lending, the threat of rising interest rates and robust economic activity.

General observation of who is gaining the most from the robust economic activity should draw our attention to the most likely borrowers. For example both Wellington and Auckland Airports are describing large development pipelines and this will require funding.

Such borrowers would be wise to consult with their advisers about preferred terms and conditions (maturity dates, interest payment months etc) to ensure maximum demand for each offer.

Wellington Airport – offer of a new senior, unsecured, bond maturing on 16 June 2025 paying interest at 5.00% per annum remains open  and is due to close on 14 February.

We have an allocation, which we are distributing to investors on a first come first served basis. If you would like to invest please contact us to secure an allocation before delivering an application form to us (scanned and emailed, or hard copy, are acceptable).

The offer document (pdf form only) is available on the Current Investments page of our website.

Other Possible New Issues – Debt securities owned by retail investors which mature, or may be recalled, during 2017 include the following:

March - Fletcher Building is likely to roll its capital notes (FBI100) and Meridian has a senior bond maturing (MEL020);

June – Infratil (IFT160) has a senior bond maturing and Vector (VCT070) has a capital note that may be rolled over;

September – ANZ Bank (ANB090) and Auckland Council (AKC050) have senior bonds maturing;

October – Auckland Airport (AIA110) has a senior bond maturing and we hope to learn that Rabobank will be repaying its RBOHA securities;

November – Infratil (IFT170) has another senior bond maturing;

December – Powerco (PWC090) and Trustpower (TPW130) have maturing senior bonds, Kiwibank has a Tier II bond arriving at a year five review (possible repayment, or roll on until 2022) and Credit Agricole reaches the 10th year of its CASHA securities which we hope will be repaid at that point.

Beyond these maturing securities there will be a high volume of maturing bank deposits and the ownership changes for UDC and F&P Finance will likely result in some movement of investor money.

Investors in our database will hear from us in the lead up to the maturity date (or Call date) of each investment.

Beyond these possible deal instigators we hope to see other companies’ list bonds or notes on the NZX to raise money, especially those which are expanding their businesses (e.g. AIA, WIAL, CNU and possibly the retirement sector operators).

It seems highly likely that we will also see regular visits to the market by the banks both with subordinated (capital raising) securities and with senior bonds.

Just because the months of February, April, May, July and August aren’t mentioned above it doesn’t mean that new offers won’t emerge in those months, in fact if I was a speculator I would suggest that the next deal to emerge will be in February with subsequent borrowers all competing for space on the calendar as they did last year between September and December.

Travel

Chris is moving around the country making presentation relating to investment and to update holders of the SCFHA securities. The schedule can be seen on last week’s Taking Stock.

Kevin will be available in Christchurch on 2 February 2017.

Edward will be available in Auckland (Remuera) on 17 February.

Anyone wanting to make an appointment should contact us.

Michael Warrington

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