Chris Lee & Partners Ltd

Market News – 28 January 2019

Confession:

It’s still January and it is hard to read financial market information with any vigour as we address topics of importance for you in our newsletters.

It is even harder to take politicians seriously after clearing one’s mind of some of the nonsense over summer.

INVESTMENT OPINION

Good Debt Bad Debt – If you are a regular reader of our newsletters, or a wide variety of global economic commentary, you will have seen multiple items about the excessive level of debt use globally.

Each commentary summarises the scale of the debts and presents one of a variety of concerns about the potential for a future dilemma or worse, disaster.

I don’t subscribe to the disaster theories, but there is undoubtedly a large dilemma developing and when the tide turns, as it always does between confidence and fear, investors are going to be hurt.

Our ongoing question is who?

Debt use enables people to bring forward investment or consumption.

Bringing forward investment is sometimes a good use of debt (‘good debt’). In moderation this debt is affordable and can advance productivity and profits for the economy and the investor.

For example, 50% debt use to fund a property that enables a manufacturer to operate, paying rent at higher ratios than interest rates would be considered good for each of the economy, the owner of the manufacturing business and the property investor.

At a stretch I could describe a mortgage on one’s home as ‘good debt’ because it brings forward one’s ability to secure control of their shelter and it should then encourage a high savings rate to repay the mortgage.

In a NZ context though I would describe the increased debt use to own residential investment property (i.e. more than the one you need to live in) as being ‘bad debt’. It adds little to NZ’s productivity and thus the nation’s income. I don’t doubt that the investing has been profitable, so investors will see it as ‘good debt’ (certainly better than financing consumerism - Ed) but it hasn’t added to NZ’s financial health.

Kevin Gloag reminded me that property investors do generate employment (trades, property managers etc), do pay taxes and do provide shelter for temporary property use. Agreed, but the use of debt by those who can afford the most has contributed to pushing house prices (cost of shelter) away from NZ’s median income (affordability).

Now that I think about it, the central bank might disagree with me on residential debt too given that the higher housing prices have, on average, increased the scale of equity in the housing stock, which is used to secure bank ending, and thus aids financial stability (less likelihood of debt failure).

All debt used to advance consumption is bad debt.

New Zealand’s private debt use is far too high (our government is in good shape with good strategic plans to reduce debt ratios) but I don’t think NZ debt use will be where our next financial dilemma emerges.

It’s possible that NZ will end up with a greater social dilemma if interest rates on debts increase (see recent item on Reserve Bank proposals for banks) and this reduces even further the scale of discretionary spending within our economy.

New Zealand is also a village scale economy in a global context, so our excessive debt use will not be the trigger for the next financial dilemma.

So who has a large enough scale of debt to cause concern?

The US does.

China does.

Japan does.

In the US and Japan the excesses are Government debt and in China it is corporate debt.

Europe will join this list if they keep subsidising errant children (member states).

These, for those who prefer not to focus on such data, are the world’s four largest economic countries/regions, by a very wide margin.

The debt ratios in these countries and regions are the reason that the most influential assessors are publishing their concerns; namely the World Bank, International Monetary Fund, Bank of International Settlements, US Federal Reserve etc. They need persons of financial influence to take notice and begin to change debt use strategies.

The Chairman of the US Federal Reserve has reached the point of voicing publicly that he is ‘very worried about it’ (US debt levels) and that ‘it is a long run issue that ultimately we have no choice but to face’.

If developing nations follow the US example and are unable to reduce debt ratios during periods of robust economic growth will they ever find the political fortitude to do so?

When I was in Laos I saw example of the Chinese desire to invest large sums into property and infrastructure development, but the benefits seemed to go to them, not Laos (hydro electric), and the prices for new property were beyond the local population, so maybe some of this is ‘bad debt’ use.

A company director travelling in Sri Lanka recently reported the same thing to me, high levels of lending and investment from Chinese sources, sometimes into assets of questionable use (first world assets in third world countries) and concluded that someone is going to lose a lot of money when we come to our senses (excessive bad debt use for unwanted assets).

People who have travelled widely will have seen examples of this from the past through great expanses of property that now sit, rotting, and going to waste. Somebody paid for this waste.

There is a debate in NZ about whether or not we should approve of the Chinese investing in our communications network. NZ is not symptomatic of first world assets for a third world nation, but, the Chinese behaviour of wide global investment and ‘economic support’ is witnessed by its desires to invest in NZ also.

These wide ranging investment strategies of China’s are supported by heavy increases in debt use by that country.

Good debt?

Bad debt?

Trump or no Trump, the US are not unintelligent. The trade threats will have been carefully calculated (even if poorly announced – Ed), including debate around the scale of China’s debt use and the productivity of their investments.

A weakening Chinese economy may become a serious problem for…. All of us.

Initially I had considered a weaker Chinese economy as a frustration for our export community, and that would still be the case, but if it also leads to rapid declines in asset values elsewhere this will lead to anxiety among bankers.

Anxious bankers reduce their risk tolerance for lending, as currently being witnessed in Australia, so maybe in a world of ‘cheap’ debt (3-4%) our future problem will be an inability to borrow, regardless of the price, and not our ability to service interest costs?

If you have a $10 asset with $7 debt and the bank demands repayment of $2 can you access the funding to repay them?

Investment with debt use means that all borrowers are operating at the margin. If they are willing to leverage this asset to 70% ($7 of $10) then sure as eggs they’ll carry similarly high debt ratios elsewhere. They don’t store cash earning at 1.75% or gold bars as an insurance policy against changes to bank lending policy.

Hello, it’s the BNZ here, we are calling in $2 of our loan thank you, repayable by imminent date.

High debt use broadly implies that the $2 won’t be easy to find, without selling assets, at the same time as everyone else is realising the same problem elsewhere.

This has turned into another ramble about the well known perils of excessive debt use, but I am trying to identify where the tension will show up and how it will affect you, as our client the local investor.

As a general statement, avoid the highly indebted.

INVESTMENT NEWS

Fees – The brief tussle between a financial adviser and Fisher Funds (owned by TSB Bank) over excessive fees (on old Tower funds, taken over by Fisher Funds) is another helpful reminder to all investors to maintain an awareness of fees and to test whether or not the service is required relative to such fees.

If investors have a preference to self-manage all, or part, of their investing we are always happy to help. Our business model is all about helping people to keep their overall investment costs down.

Tax – You can see plenty of headlines about the Tax Working Group but the appropriate stance is not to make any new investment decisions based on the headlines; to do so would be speculative and unwise.

Inflation – Inflation monitoring must now be a tedious part of an economist’s job.

It’s hard to get excited about analysing plus or minus 0.1% variance relative to expectation as was the case for the December 2018 quarter (+0.1% for +1.90% per annum).

This was slightly weaker than central bank expectations.

If anyone can add some energy to the data it would usually be Cameron Bagrie (http://www.bagrieeconomics.co.nz/), another work mate from the past, but the word that jumped off his email to me was ‘balanced’.

I was expecting a response like ‘growing as fast as a Cherry tree in Central Otago’.

He had a little fun by describing the economy as ‘Driving Miss Daisy at 30 Km/h below the speed limit’.

Alongside the speed watch theme, the ANZ Truckometer set up under Cam’s watch also reports less speed in the economy.

If you’re in the business of engaging economics consultants you’ll enjoy the clear explanations that Cam provides.

So, other than government spending push, council charges and insurance, inflation is hard to spot.

I debated with Cam regarding what I see for the younger generation and that the expense of property (own or rent) is claiming a large portion of the discretionary spending power that may have driven some inflation in the past.

Maybe.

We won’t get a lot of inflation if highly indebted businesses start discounting prices to secure important cash flow to service debts.

This is consistent with our view of low and stable interest rates for the foreseeable future.

Coal – Confirming the error of rushing to change, government policy in this case, Genesis Energy has used an above average volume of coal recently to generate electricity to keep the lights on and industry running.

Yes, coal, the great battery pack for rapid provision of electricity when our renewable resources come up short.

Would the government’s MP’s rather be defending their position to angry business and citizens right now, if the lights had gone out, or be explaining to perfectionists the need to deliver evolutionary change in our energy markets?

We all know what is desirable, but it is best that we do not cut off our nose to spite our face and coal is a very effective back up energy store for the NZ economy.

It is also a reminder about investment diversity. Is there a best electricity generator in NZ?

The Market – The NZX and the FMA have launched a review of capital markets with a 10 year outlook and a focus on developing the growth and good health of the NZ market place.

It’s good to see this being launched by the two market regulators because both our businesses and our savers need a broader and deeper market to try and support a virtuous spiral, which in turn benefits the economy/employment/finances/taxes.

I don’t subscribe to the doomsayers views of our market, but it is fair to say the equities sector of the market needs to expand.

As I have said previously, I must be old or must have moved around a lot, because this work group will be chaired by another old work mate, Martin Stearne, a great choice.

I look forward to reading their findings in the last quarter of 2019.

Index Investing Giant – The man who launched one of the world’s largest fund managers, Vanguard, Jack Bogle died mid January at 89 years of age.

Bogle spent almost his entire professional life explaining to investors that ‘you get what you don’t pay for’ as he followed a strategy of minimising investment expenses for investors.

Vanguard’s collection of Mutual Funds and Exchange Traded Funds now manage US$4.9 trillion dollars! One of their largest competitors, Black Rock manages US$6.28 trillion. That’s quite the success story for ETF and minimised fee investment strategies.

It’s always a shame to see industry leaders die but Jack Bogle’s legacy will last a very long time. It is surely destined to do so when the offering was ‘higher service at a low price’.

In an industry that spends most of its time trying to extract very large sums (billions) from its clients it is refreshing to read that Jack Bogle spent his time trying to reduce his personal income and continuously give away money he felt he did not need. He was reported as having wealth of US$80 million by the time of his death.

Wouldn’t it be nice if our Kiwisaver managers adopted this approach to fees?

EVER THE OPTMIST – NZ start up company (well, a ‘moving on’ company – Ed) Rocket Lab has convinced the US Defence (Defence Advanced Research Projects Agency) to contract them for launching satellites.

This continues the very impressive business success of this exciting business ‘launched’ in NZ.

I really do want to attend a launch on the Mahia peninsula one day.

INVESTMENT OPPORTUNITIES

Trustpower – TPW alerted the market to expect a new bond offer from them which we now expect in early February.

We expect them to offer a term longer than 5 years and we have a list for investors wishing to participate.

TRAVEL

Kevin will be in Christchurch on 31 January.

Edward will be in Nelson on 19 February, in Napier on 25 February, and in Auckland (Remuera) on 8 March.

David will be in Palmerston North and Whanganui on 18 February and in Kerikeri on 4 March.

Chris and Johnny will be in Christchurch in February, based at the Airport Gateway Motor Lodge, in Roydvale Avenue - 20 February (pm) and 21 February (am).

Chris may be in Auckland in February - dates to be advised.

Michael will be in Auckland on 7 February.

Mike Warrington

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Market News – 21 January 2019

In 1964 the US Surgeon General issued the government’s first report warning that smoking may be hazardous to health.

55 years later consumers maintain high demand levels for smoking.

If this is how the population behaves when personal health is at risk, what chance do we have of achieving significant consumer changes when focus is far wider than our immediate health?

My point is to be more than a little careful about the investment assumptions being presented under the banner of ‘being green’.

INVESTMENT OPINION

Lime Scooters – Following on from the comment above, and from the principle of ‘how might it change investment?’, last week whilst I was in Dunedin I decided to research Lime Scooters.

I had the time, the smart phone and a credit card. It really was that simple, and now that I’m an account holder it will be simpler.

Until now all I knew was what the disgruntled public and ACC had reported publicly; amplified as usual by the media headlines.

Now, I have travelled 20 kilometres on a Lime scooter through a mix of harbour side tourist trails (one excellent use for tourism) and through short inner city commutes (a use that still requires some settling in).

The scooters themselves are excellent. Robust and so simple to use.

The App is easy to use, offers plenty of data about the scooter and your usage but most importantly shows you where the closest scooter is, if you can’t already see one, which we usually could.

The solution for charging and redistribution is clever because it offers payments to anyone wishing to register to collect scooters with flat batteries, re-charge them and then put them back out in strategic zones. It was common to see scooters lined up nicely and as out of the way of pedestrian flow as possible.

So far they seem to operate with almost zero real estate required (outside of the US where they are made) and zero permanent staff (in NZ). That’s two of businesses greatest costs eliminated.

Yes, the day after my research a person crashed into a truck and was seriously hurt, but there is no way to regulate against stupidity (riding at 2am in the morning in the wrong direction on a road).

In my view council’s should love scooters, not be fighting against them as some seem to be doing. Council’s around the country are ‘pinching’ roadway from drivers to expand the potential cycle lanes; this is ideal space to offer to electric scooters.

Some city councils are discussing reducing inner city speed limits to 30 km/h, which I initially thought was another unnecessary imposition on ‘me and my V8’ but now I can align it with my maximum speed on an electric scooter; perfect.

There does need to be some work done to get scooters off foot paths in the CBD. The tourist trail was fine, as were suburban foot paths, but it’s a nuisance to pedestrians in the CBD and frankly not much fun for the rider also.

Electric scooters will undoubtedly reduce the use of one’s own car within the inner city (if you live and work there) and reduce the use of Uber (investment risk), although I see that Uber recognised the threat and has invested in Lime. With more than a few lazy bones I have never been tempted to use the cycle hire services (in Wellington) but I will use Lime Scooters again.

See, I am certain the the current US Surgeon General would remind me that exercise is good for my health, but that won’t convince me to use a single gear bike to move around the city.

Another investment theme springs to mind, albeit modest in scale: sales of back packs will increase because it is the only practical way to carry things around. The tiny wheels do not gain from sufficient centrifugal forces to maintain stability on a scooter to aid any imbalance!

The scooters can be geo-blocked and thus will not operate in such areas, such as the University campus, so users need to try and come to some agreement with the council through sensible behaviour and avoid having the CBD geo-blocked because they are such an excellent tool for the 500-1,000 metre inner city trip.

The usage of Lime scooters in Dunedin was very high. Society is changing, again.

Greater Fool – I read another news item that alerts me to investment markets being toward the extreme end of risk taking.

A business has been set up in the US to syndicate ownership of rare art pieces.

The value of art relies on scarcity value and the rise in extreme wealth of the few.

There is no cash flow return from these investments and thus to some extent they rely on the ‘greater fool’ theory to make a profit via future sales.

Another view might be that scarcity investing is another way for society to pass real cash from those who have far too much to those who don’t.

Greater fool?

Greatest Cash?

Same same, but different.

If the extreme prices of scarce assets are driven up alongside society’s extremities of wealth it is incongruous to think that people who do not have extreme wealth should buy assets where the pricing is set by extreme wealth.

The business that offers this syndicated ownership of art (Masterworks) isn’t in it to help investors, they are in it for fees and perhaps to support the wider market demand for scarce assets like art.

My point is not to draw your attention to art as a form of investment but to highlight another anecdote that places us at a near term extreme for asset pricing; the market needs a collection of the less wealthy to band together and pay a new extreme to those with more serious wealth who happen to be trying to sell.

It will end in tears for the new syndicated investors in art.

INVESTMENT NEWS

Interest Rates – The US financial market is displaying that it is pleased with the recent soothing commentary from the Federal Reserve and currently believes the US Fed Funds rate will stop at 2.50% and stay at that level for the next five years.

We have expressed our opinion on interest rates frequently that we expect nominal and real interest rates to remain low for an extended period of time (years).

The US yield curve agrees with us at present.

UDC – So, the end has come for UDC finance as a vehicle for the public to invest with. No new investments will be accepted and by mid 2019 UDC (read ANZ) will decide whether or not to repay all investors (and offer transfers across to ANZ bank deposits).

It is disappointing for the investment community to learn of this news from such a long standing New Zealand finance business.

It will have been very disappointing to the ANZ to see so much goodwill erode to the extent that they were unable to sell the business at a price they felt was credible. They have clearly concluded that it is more profitable to keep the lending (for now) and reduce costs by removing the public funding option (deposits/debentures).

This is the same path trodden by those who purchased Fisher & Paykel Finance.

Interestingly this is one of the unintended consequences of the tightened regulations for non-bank deposit takers (over $20 million in size). The tighter regulations were essential but the best businesses have closed down (the worst failed).

So many NZ investors have enjoyed the use of UDC for a portion of their fixed interest investing and they will now need to migrate across to the ANZ bank or ask their financial advisers to help them select different options.

We had long felt that UDC’s interest rate offers were too low, being the same as the major banks but with more risk in the potential for change; change that we are witnessing now. However, the closing of the investment door proves that UDC was not taking advatange of investors through lower interest rates, they really do have even cheaper options for their funding.

Investors can continue to use banks for their lowest risk deposits but we have speculated that these interest rates may yet fall again, relative to inflation, if the central banks proposed increases to equity proceed.

The closure of UDC is sad news, but alongside lower interest rates from bank term deposits the public will be ever wiser to connect with the financial advice community to maintain good returns from their investment portfolios, and we will be pleased to help.

IKEA – So IKEA has built its marketing hype very well and just as the media were becoming desperate (to provide free column centimetres) the company has delivered a presentation confirming they are on their way to NZ.

However, the timing is fluid at ‘2-10 years’ away confirming for me that IKEA has pounced on a marketing opportunity and is still measuring the potential for success for our slowly growing population (about to breach 5 million during the next tax year).

I apologise for measuring it the population by tax years but it flows from a funny talk-back call I heard on the way home who drew a parallel between population numbers and tax payers!

As a consumer, I’m pleased to see the presence of another serious price competitor (using scale to assist on price).

As an investor I do not find this IKEA announcement disruptive at all relative to the competing risk types that we can invest in.

The arrival is slow. Certainly slow enough to provide competitors with ample time to manouvre their own offering to remain competitive.

The willingness to arrive in NZ confirms the confidence that our 5 million, and rising, population can and will support offline retail businesses, and it will do so by visiting their stores. Intelligent businesses will use those stores as inventory and push their online service alongside the bricks and mortar shops.

Profit margins in retail are sufficient, and sustainable, to attract IKEA to our shores.

This condidence in the retailing business should re-affirm one’s confidence in investment in commercial property with retail leases and fear that consumers will retreat to 100% shopping from their lounge on an iPad.

Green Investing – Investors with an environmental focus seeking shares in ‘green’ industries won’t have been thinking of BP and its famous logo, however, BP shareholders will nonetheless be pleased by the gradual increase in BP’s share price recently, aided by announcements that the company has discovered an additional one billion barrels of oil in the Gulf of Mexico.

BP knows that some folk are pushing against use of fossil fuels (and that councils in NZ want bicycles to control the roads – Ed) and this might reduce demand for fossil fuels, but BP is investing very large sums to pursue oil because they know how the majority of consumers will behave.

What is impressive is that the new discoveries are a function of better technology and not new oil fields. My hope is that clever scientists and engineers will also continue to develop better technologies to tackle other global preferences including our impact on the environment, health, food etc.

Oil remains essential to the global economy, but it will be nice if we see new technologies helping us to use it more efficiently and thus reduce our ‘foot print’ on the earth (a strange analogy to use, oil and walking – Ed).

Of more interest from this BP Story might be the ongoing rise of oil supply from non-OPEC nations, the US in particular, because this has a significant impact on political power, which is already changing faster than disconnected tectonic plates.

Brexit – Que sera sera, and it is looking like ‘whatever’ will be delayed.

EVER THE OPTMIST – It’s contenious, genetic modification, but because evolution also happens naturally I happen to be excited about the progress made by Professor Andrew Allan with delivering apples with red flesh.

Allan isn’t claiming commercial rights, he describes as belonging to all of New Zealand based on his employment with Plant and Food Research NZ, but beyond knowledge will lie commercial opportunites for NZ.

If I understand critics of genetic modification correctly they are concerned about letting some dangerous genie out of the bottle but at times I wonder whether we could be any more damaging to our planet than we already are (without GM).

Science and technology developments, tested for wide application, usually add value to a situation, not the opposite. Environmental damage is typically advanced by the opposite, narrow, selfish, lazy and untested behaviours.

Well done Professor Allan.

ETO II – The NZ economy cannot be in bad shape judging by NZ Refining’s report of a new record throughput of refined fuel.

INVESTMENT OPPORTUNITIES

Trustpower – TPW alerted the market to expect a new bond offer from them in late January or early February. We expect them to offer a term longer than 5 years and we have a list for investors wishing to participate.

TRAVEL

Kevin will be in Christchurch on 31 January.

Edward will be in Nelson on 19 February, in Napier on 25 February and in Auckland (Remuera) on 8 March.

David will be in Palmerston North and Whanganui on 18 February.

Chris and Johnny will be in Christchurch in February, based at the Airport Gateway Motor Lodge, in Roydvale Avenue - dates to be advised.

Chris will be in Auckland in February - dates to be advised.

Michael may be in Auckland in the early part of February.

Mike Warrington

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Market News – 14 January 2019

What goes around comes around, if you’ll excuse the forthcoming pun.

My youngest son has discovered records and spent a proportion of the Christmas and New Year period explaining it to me and singing its praises.

INVESTMENT OPINION

Volatile – It was easy to ignore the computer screen and financial market headlines over Christmas but some of the changes were so significant that they reached the general news and arrived in front of my eyes all the same.

Share market swings of 2-3% became the norm for the US in recent weeks, which is definitely not normal, and investors don’t want it to become so either.

The days when the US Dow Jones Industrial Average was -500, then -600, then +1,000 then +800 made it look like a summer game of monopoly at the bach (crib – Ed).

Various political leaders are behaving in ways that are unhelpful in a global context and I view this as a relatively serious problem and it is likely to be the driver of more undesirable volatility during 2019.

Trump’s grizzling about the head of the US Federal Reserve briefly made him look like Turkey’s Erdogan, who meddles with everything, but this is a behaviour that the US must not copy unless financial disaster is their ambition.

These political risks are precisely why central bank independence is so important.

The US Fed is ultimately more influential than temporary political leaders and it has begun to spell out its intentions for interest rates and the central bank’s balance sheet during 2019 and 2020, which may see rates settle around 2.50% and $600 billion per annum coming off its balance sheet.

Certainly, 2.50% is the level the wider financial markets believe is the high point for interest rates that the economy can cope with at present displayed by the yields on most terms hovering either side of 2.50% (excluding the 30-year Treasuries at 2.98%).

The market is still forming an opinion about the impact of the $600 billion annual tightening of liquidity within the financial system but logically the combination of the two will have a dampening effect on economic activity and wider asset prices.

Hopefully this recent explanation from the Fed about their position will reduce some of the market’s concerns about the rising cost of money and contribute to a little more stability in market pricing.

The NZ banking landscape is changing (again) – and I think it will be for the better with the financial resilience of banks improving, and the cost of debt use increasing.

Late in 2018 the Reserve Bank of NZ proposed some very important new regulations for the volume and quality of equity that banks must hold and, if the rules are brought into force, they will introduce the most significant change to the cost of debt in a very long time.

The new regulations will have a suppressing impact on the NZ economy, especially the speculative property sector and debt funding in any other unproductive sectors of the economy. I would like it to suppress debt fuelled consumption too, but I doubt this will be a visible outcome because consumers already agree to pay extra-ordinarily high interest rates to bring forward the timing of their shopping.

Adjusting the equity required for banking in NZ is another macro-prudential tool for the central bank and I like the use of such tools to guide the behaviours sought within the economy relative to the previously blunt, singular, use of only moving interest rates.

You may recall that I’d also like to see NZ introduce a Debt to Income (DTI) ratio regulation. Banks already monitor payment risk of their clients but I’d like to see the central bank introduce an obligation of more equity held by the bank if a client’s DTI ratio exceeded certain boundaries.

The ANZ had already been addressing growing concerns about a weaker economy by 2020 but they immediately responded to the RBNZ announcement by declaring their new expectation that NZ’s Official Cash Rate (OCR) will now be cut to 1.00% (from 1.75%) by 2020. Yes, they have stuck their neck out and declared that our OCR will be cut, not increased as many investors hoped, and clearly ANZ thinks the new banking relations are ‘probable’ rather than ‘possible’ for introduction.

You can read the full detail of the RBNZ proposals on their website here:

https://www.rbnz.govt.nz/news/2018/12/reserve-bank-proposes-that-bank-owners-bear-greater-share-of-financial-systems-risk

The documents are well written and easy to read, but in short, the RBNZ proposes that NZ banks only use ordinary shareholder funds and retained earnings as equity (no more use of complex subordinated bonds although Perpetual Preference Shares may still qualify) and that the amount of equity held be lifted from 10.50% to between 15-16% depending on the systemic importance of each bank.

At first glance this looks as if banks will need to find an additional 5.00% of Tier 1 equity over the next five years, but in fact it is a tougher obligation than that. It is more like an 8-10% change because the banks have simultaneously been told that they can no longer use complex subordinated bonds as part of the Tier 1 equity capital mix.

Side story – If confirmed, the changes mean that NZ banks will repay all their complex subordinated bonds (such as RCSHA, ABNHB, KCFHA etc) over the next two to three years, something we always felt was likely, hence our previous views that these bonds delivered attractive risk/reward characteristics (both the first and second generations of such securities).

So, use of subordinated bank bonds, with the possible exception of Perpertual Preference Shares, to access additional reward for risk may become a thing of the past, which in turn might need investors to increase their use of investment in property entities and other shares to seek out their higher cash flow based returns.

For clarity, the RBNZ is asking for feedback on whether or not to allow the use of perpetual preference shares in future, so the new regulations may mean that ASB’s perpetual preference shares become less probable for repayment.  The central bank is considering whether to allow perpetual preference shares as part of Tier 1 capital to support banks that are community owned (such as TSB, SBS, Co-operative) because they cannot call on shareholders for additional capital in times of rapid growth (or unexpected loss).

Maybe this could become one of the RBNZ regulations; only community owned banks can use perpetual preference shares, meaning all other banks must call on their owners for capital.

Side Story 2 – It would be useful if such community banks could engineer a zero withholding tax category for such perpetual preference shares because this would provide a nice connection between registered charity investors and community-based banking operations.

Back to the new regulation proposals.

The initial reaction to the RBNZ proposal from global credit rating agencies is that the proposal is extra-ordinarily conservative relative to global peers, possibly positioning NZ banking to cope with all predictable financial stresses (1 in 300-year event!).

The analysis was written from a perspective of being ‘too much to ask’ but I happen to like the intent being presented by the RBNZ. The phrase ‘Switzerland of the Pacific’ has been used in the past when we didn’t deserve it, but under the newly proposed framework such financial respect would be deserved and frankly provide fantastic surety of finance to the NZ economy without any risk of government intervention being required.

If our government, both red and blue, can hold the line on fiscal balance (or surplus) the combination should be quite impressive for New Zealand’s long-term prospects.

The higher real cost of debt (higher interest rate with no change to underlying inflation) resulting from the new tighter regulations for equity in banking should also create a trend to slightly lower debt use within the economy, which would also be a commendable outcome.

The cost of debt would increase, without a change to underlying interest rate markets, because within each dollar loaned by a bank there would be more bank shareholder money (the expensive portion). Previously the mix of a $1.00 loan might have been about 10 cents of bank equity and 90 cents borrowed by the bank at current interest rates. A move to 16c and 84c increases the cost of the $1.00 being loaned.

My rough, back of an envelope, math estimates that a mortgage interest rate might increase by between 0.50% - 0.75% purely as a result of this change in equity demand on bank balance sheets. (additional $5,000 p.a. on an Auckland mortgage? – Ed)

To repeat myself, I think this regulatory change would be a good development for the NZ economy, albeit create some short term economic drag, as ANZ considers likely. An increase in the real cost of debt should reduce its use on unproductive investment.

A few of our clients won’t enjoy me linking this development to NZ’s passion for investment in residential property but nonetheless it is true that this development will further increase the costs for such investment, especially upon those with the highest debt ratios.

We’ve talked before about the ongoing arrival of these new financial tensions for investment in the residential property sector.

A higher real debt cost will demand that all investments require higher rates of return to justify their presence. Higher rates of return only come via lower purchase prices or higher productivity rates (assuming healthy competitive pressure on profit margins).

Ironically one negative aspect of increased equity on bank balance sheets, and the subsequent decrease in bank default risk (stronger credit ratings), is the potential for lower interest rates to be paid to investors who lend money to the banks via term deposits and bonds. So, without a change to inflation, it is possible that fixed interest investors will receive lower interest rate returns when they invest in the banks.

If the banks must carry more equity on their balance sheets, they will seek higher returns to align with that new equity and this will come from wider profit margins between the interest rates offered on deposits (lower) and loans (higher). They’ll find it hard to charge more in fees and sell new products after being kicked around the park during the Australian and New Zealand Reviews into banking practices.

The ‘broker’ in me hopes that the development of higher debt costs within the economy but lower interest rates on bank deposits will see more companies issuing bonds to access more of their funding directly from investors like you because bond interest rates should revert to a level well above bank term deposit rates; a relative reward situation that hasn’t been seen for a few years.

I guess it could also lead to a return to more use of mortgage trusts and lawyer arranged mortgages.

Time will tell.

Higher relative debt costs should also instigate a slight retreat in ‘fair’ prices for shares (increased real costs, opportunity costs for investors etc) but that will be a little hard to spot within the overall volatility of the market.

On another important point, I’ll guess that the current review of Kiwisaver has not looked at the influence of this new RBNZ proposal, but they really must do so.

Kiwisaver’s purpose is to encourage greater savings. Repaying a mortgage is a form of saving. If the RBNZ proposals to increase bank equity are installed the increased relative cost of a mortgage will become a more important form of saving than Kiwisaver.

In an ideal world people should do both (Kiwisaver and mortgage repayment) but if one’s mortgage incurs a real after-tax cost of say 5.25% p.a. this is greater than reliable returns from higher risk investing in a Kiwisaver Growth fund (there’s no value in retaining a mortgage alongside a Conservative or Balanced fund). Under this scenario the only logical amount to contribute to Kiwisaver would be the $1,042 to capture the government contribution of $521.

I do not consider this to be an unintended consequence of the RBNZ proposal, which remains good in my view, but it is a side effect that will show up because of our highly indebted economy (personal debts).

Maybe Kiwisaver funds will need to consider setting up mortgage trusts to access the higher risk adjusted returns that are coming as a result of the RBNZ Proposal?

For repetition, this is a big news item for investors to consider.

In conclusion:

Dear Adrian Orr, yes please to your new proposals for more purity in, and larger ratios of, equity on NZ bank balance sheets.

INVESTMENT NEWS

Infratil sale – IFT has sold its investment in NZ Bus exiting this public transport business after the disruptive changes introduced under the ‘new’ Public Transport Operating Model.

It took a while to settle the new contracts but once done the long-term contracts were attractive to new investors and IFT was happy to sell them the business and apply its capital elsewhere to businesses with better prospects, such as the Canberra Data Centres and Tilt Renewables.

The NZ Bus sale price was above the book value reported in the interim accounts so should be viewed as a pleasing outcome for IFT investors.

EVER THE OPTMIST – I haven’t spotted any easy ETO items, which may be because I wasn’t watching for them, but the weather has been nice in Wellington and the Phoenix are unbeaten over eight straight games which gives more and more reason to attend their home games at the stadium.

INVESTMENT OPPORTUNITIES

Trustpower – TPW alerted the market to expect a new bond offer from them in late January or early February. We expect them to offer a term longer than 5 years and we have a list for investors wishing to participate.

TRAVEL

Kevin will be in Christchurch on 31 January.

Edward will be in Napier on 4 February, in Nelson on 19 February and in Remuera on 8 March.

Michael may be in Auckland in the early part of February.

Mike Warrington

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