Market News 25 July 2022

Shall we debate introducing a variable tax lever in New Zealand as part of our economic management strategies?

We adjust the Official Cash Rate to exert influence over the price of money. Increased interest rates cost more to borrow and reward more for savings, and vice versa. These relate to how we use capital.

Might a variable tax lever succeed with an increase/decrease to consumption levels? (Managing our cash flows).

No, I don't want it managed by the Reserve Bank, or the Minister of Finance. Maybe Treasury in consultation with the central bank?

In theory GST is the ideal consumer tax to deliver my new policy, but this would affect those on the lowest incomes who don't have discretionary income.

No, I don't want to complicate GST, it is so simple, and thus effective, in its current form. It was one of the good long-term decisions made by the NZ government.

Maybe I need to design a link between my variable GST rate and Working For Families tax credits.

An increase in GST would unquestionably reduce my consumption and with an ounce of luck it would increase government debt reduction efforts.

That's a job for another day.

INVESTMENT OPINION

Tower Co – Business doesn't stop just because economic conditions become uncomfortable, in fact in some areas it speeds up as businesses address new strategies to respond to new risks.

Vodafone and Spark have both sold majority ownership in the towers that serve their mobile communication business divisions (the passive part, being the towers, the attached hardware and the right to use the land).

They have done this to release capital for use elsewhere in their businesses, either to reduce debt or to seek greater returns from equity.

Both have retained partial ownership to exert some influence over the assets and signed long leases (15-20 years) to confirm future use of the assets from the new owners.

Effectively, sale and lease back arrangements retrieve capital through a long term business partnership rather than a bilateral loan agreement using debt from a bank (or other lender).

Accessing these funds have a lower long-term cost than targeted returns on equity.

The second point that investors in the sector might deduce is that our telecommunication companies see new business opportunities to expand into, which is pleasing given that the mobile phone and broadband service propositions were looking saturated.

In my view investors in both Spark and Infratil (Vodafone) should be pleased about this development for their businesses, as should the Commerce Commission given the potential for other communications businesses to access the towers countrywide.

I look forward to reading more about how this capital is deployed in the year or two ahead of us.

FED – This is a big week (again) with the next meeting of the US Federal Reserve occurring tonight and tomorrow night to consider the next increase in the Fed Funds Rate (overnight rate).

The market expects an increase of +0.75% to 2.50% plus some suitably forthright words about the continued presence of inflation pressure in the economy.

A +1.00% change (copying Canada) would startle the majority and thus deliver price declines for shares and shorter-term bonds (higher interest rates). It may see interest rates on longer terms (10-30 years) fall.

A +0.50% change would, in today's light, be viewed as weak and would result in the opposite price changes from the paragraph above.

Accordingly, the safe and sensible move is the one the market is prepared for at +0.75%.

Yes, inflation is still a near term problem, but so too is a recession. When a man with Jamie Dimon's experience (head of JP Morgan Chase) advises that he and his bank are preparing for a recession I think investors should err toward that probability.

I think the public can quickly digest and understand Dimon's concern about rising interest rates, but what none of us have experienced is the effect of Quantitative Tightening (removing the previously printed money from the economy).

I am certain that Quantitative Tightening (QT) will not be a mirror image of Quantitative Easing (QE)!

The voluminous arrival of cheap money was easy to invest, promptly. The progress of pressing the players in the global economy to sell assets and repay that money will be slow and painful.

Some of it won't be repaid, which will lead to write offs and understanding the scale of these.

China's property market disruption (refusals to pay) is beginning to reveal some anecdotes about the difficulties ''we'' will experience with unwinding QE and that is in a nation with highly intolerant governance settings.

Global productivity will need to increase to partly offset these financial write offs but based on everything I read it is hard to imagine sufficient improvements in productivity and frankly the opposite is happening during 2022.

The International Monetary Fund (IMF) still sees a ''growth'' number globally, they are ''substantially reducing their forecast''.

The Bank for International Settlements (BIS) states: ''The path to a soft landing is narrowing; we think it is still a feasible path but certainly not a very easy one''

Jump to your preferred news wire on Wednesday morning and see what actually happened, then set a new course for six more weeks of investment decision making.

Europe – Even the ''wish we weren't compelled to'' European Central Bank (ECB) raised interest rates last week for the first time in 11 years.

The +0.50% increase became the new interest rate reward! (up from 0.00%)

However, of more concern in Europe is the resignation or Super Mario (Draghi) as Prime Minister of Italy in response to the political crisis that has developed in that country.

The EU's long held wish for collective financing, at a common price (interest rate) is back under serious threat with interest rates rising fast on bonds issued by the Italian government.

Italy is not Sri Lanka, or Greece, but this is evidence of the same sort of pressure that is applied by capital markets following periods of poor financial management.

ANZ – After an extended period where banks were selling non-core businesses (insurance, fund management etc) to rebuild equity ratios, in response to demand for more from the regulators (APRA in Australia and RBNZ here), the ANZ seems to be back into buyer mode.

ANZ was simultaneously reported as being interested in buying Suncorp's banking business and MYOB, the accounting business.

The latter was the most interesting and presumably related to data control and additional services to banking customers, although this negotiation has stalled (ANZ withdrew).

The share price of XERO enjoyed a modest lift as the market pondered the bank's sniffing around these businesses, and perhaps in recognition of the ever deepening data knowledge held by these accounting businesses.

The Suncorp purchase is interesting for different reasons.

As noted above, most banking businesses have been exiting insurance businesses presumably as a result of weaker returns on the capital required (to remain as a bank), however, Suncorp's financial group has elected to exit banking and stay in the insurance business.

Nonagenarians, like the Queen, won't be surprised by this decision because Suncorp began its life in the insurance sector (1919) established by the Queensland State Government and expanded into banking.

New Zealanders will know them through local brands that they have purchased: AA Insurance, Vero and Asteron Life.

Banks may no longer look like insurance providers, but they have been maintaining relationships with the businesses they sold, so don't be surprised if the likes of the ANZ offer you a portal to insurance when you visit.

Sorry, some of you will find that last comment laughable, because it is much harder to visit a bank, or talk to them any longer!

If you are an ANZ shareholder, know that your business has the confidence and financial support to expand its banking footprint inside its core market(s).

ANZ PPS – More chat about ANZ then. My banker, and one time employer.

Congratulations are due for the completion of their first Additional Tier 1 (AT1) equity securities offering, issuing $550 million of the ANZ Perpetual Preference Shares in New Zealand.

However, as large as $550 million sounds when you say it out loud, I find myself a little disappointed for them.

Do you recall me saying that I thought they could easily issue $750 million to $1 billion within the scale of their balance sheet and room for more AT1 within the equity mix?

I knew $1 billion was too much to expect. Rabobank's issue of $900 million such securities (old regulations) in 2007 enjoyed a confluence of helpful market conditions, as did ANZ's earlier generation of such securities (ANBHA) which issued $835m with a 9.66% payment as investors faced up to declining interest rates.

Mind you, today's ANZ PPS (ANBHC) went very close to being the first fixed income security item in a long time to offer a return of 7% again after periods of 1-4% for fixed interest investors.

I wondered if backward (time) looking investors (having endured low interest rates) might have viewed this new ANBHC as the crest of a new wave to take advantage of, but no, not really; only 65% of the old demand profile turned up this time.

Why?

The other 35% may have parked their spare cash in dividend paying securities over the past 5 years. This is a reasonable alternative given the equity status of these ANZ PPS (ANBHC) securities.

All New Zealand banks, the Treasurers specifically, will have monitored the success of the Kiwibank (KWBHA) and then ANZ bank offers of AT1 perpetual preference shares; they all need this form of capital to minimise ordinary shareholder equity and retained earnings as capital.

Once the Reserve Bank had settled on its new rules for AT1 capital I was told that collectively the banks would need as much as $9 billion AT1 capital.

This person was concerned at that point that the NZ investment market couldn't provide that much money, in that risk form.

They are being proven correct. Hence my comment that I think ANZ and all other bank treasurers will be a little disappointed by only raising $550 million two weeks ago.

A move in nominal interest rates to 7.50%-8.00% would help raise a little more money, as would a widening of future credit margins to, say 4.00%, but I don't expect this to happen and even then, I don't think this market can deliver $9 billion of gross demand regardless of the (credible) price.

APRA (in Australia) and the Reserve Bank here have removed the Covid era restrictions so banks can increase dividend payments again, but it is possible that they may not do so (as high as some expect) because there may be a need to increase Retained Earnings for increasing the bank's capital base.

The Reserve Bank of NZ will be happy about this outcome. It implies that the natural reservoir of demand from capital markets investors for AT1 capital in NZ can be satisfied by the banks but thereafter it will need to accumulate good old fashioned equity capital from the owners of the bank(s).

All banks are increasing their capital to hit new, more defensive, targets set by the banking regulators.

Side Note – this new elevated level of equity capital is one reason that New Zealand does not need an expensive government guarantee over term deposits in banks (up to $50-100,000).

Australian owned banks might issue more AT1 securities internationally and bring this capital through to their NZ subsidiaries, but this is also a good outcome from the RBNZ perspective because it doesn't press an imbalance in our capital market (savings available for this risk type) and cannot be repaid to the parent without RBNZ (local) permission.

Upon proof-reading this item, it feels a little like trainspotting, sorry, but fixed interest investors should find it relevant as they consider just how much they want of this securities type in their portfolio.

Ever The Optimist

Statistics NZ says that New Zealand's Carbon emissions are lower now than they were in 2019, down 9.60%.

The primary driver (excuse the pun) is a large 11% drop in household transport emissions; EV uptake, Covid, Remote and high oil prices would have helped.

Now’s not the time to become a pessimist and worry that three of these drivers are reversible.

Investment Opportunities

A Quiet Moment – leaving secondary market options available, as they always are.

Travel

Edward will be in Auckland on Wednesday, 27 July (Devonport), 28 July (Ellerslie International), and 29 July (Jarden House, Queen Street,CBD).

He will also be in Wellington on Thursday 25 August (Featherston Street).

He is also planning a few trips for September (Nelson, Blenheim and Napier).

David Colman is planning trips to Lower Hutt, Whanganui and Palmerston North.

Please let us know if you would like an appointment.

Michael Warrington


Market News 18 July 2022

My latest research and client service tour reinforced Chris's recent experience with the poor and declining quality of State Highways in NZ.

As I pondered where the vast sums raised are being spent (from fuel taxes and Road User Charges), because it is not on road maintenance, the answer soon became obvious.

I couldn't see the ''wood for the trees'' because of the orange plastic in the way.

The NZ Transport Agency is spending a large proportion of its cash on orange cones, and thousands of signs asking me to slow down, watch out, change course, prepare for bad conditions etc.

Yet almost every time I see this, the one thing I do not see is humans and machines solving the problem.

So NZTA has Work Safe preparation units, but not actual work units.

My wife is very disappointed with the fact that I have not invested in orange cones or found a way for clients to do so.

INVESTMENT OPINION

FMA Consultation – Is a lack of detailed written research into smaller investment entities and new offerings (IPO) reducing your participation in public investment?

The FMA is concerned about low participation by investors in shares issued by smaller companies trading on the market (NZX), and in new offers (IPO) of shares on the NZX.

The FMA is responding to a concern raised by a Capital Markets 2029 task force.

The concern is that the current regulations influencing financial advisers are hindering investor participation because of a reluctance to meet the obligation of detailed (expensive) research reports for investment opportunities that will only attract small numbers of investors (modest revenue opportunity).

The FMA ponders the merit of issuing Guidance Notes to offer more granular detail to their regulations on the matter and thus free up participation in this sector of capital markets.

There's no doubt that guidance intends to be helpful, but when it comes from a regulator it also adds fishhooks to the regulatory environment.

I'll run my flag up the pole and say that I think in some cases too much regulation is reducing public access to inexpensive financial advice and that adding even more granulated regulatory obligations will increase the problem, not improve the situation.

The FMA says that Guidance Notes can be ignored by the courts, but in all reality they wouldn't, and over time tort and expert witnesses would steer judgments in the direction of the Guidance Notes.

The major financial advice businesses meet and often exceed the regulatory expectations for our sector, but they also present the greatest level of cost to the public seeking financial advice.

This means investors with smaller portfolios avoid the services provided by such large high-quality businesses, seeking financial advice at a lower price point.

More regulation delivers more cost, which is passed through to investors.

The sector can't deliver the public a lower price point if the costs are regularly increased.

Please re-read my opening question.

Please let me know if you feel unable to invest in shares of smaller companies (with financial advice) or to participate in new offers brought to market (IPOs).

I am contemplating making a submission to the FMA in response to its request.

RBNZ – It's beginning to look like we will experience a negatively sloped yield curve again, something I don't recall seeing since early in my career (1985) at the tail end of the aggressive monetary policy that began in the late 1970s with Paul Volker at the US Federal Reserve.

Over the years New Zealand experienced more negative yield curves than many other nations partly because during the Don Brash era we tried an altogether too tricky scheme called a Monetary Conditions Index (MCI) to set our interest rates (1997-1999).

Don and the Reserve Bank were theoretically correct, but not practically so. Something many a politician or business person should take heed of.

The MCI mapped currency and interest rate values to design economic tension (or release) driven by impact on trade pricing (currency) and the price of money (interest rates). It effectively mapped for exchange and trade volatility into our interest rate markets.

It became the antithesis of the financial stability part of the central bank mandate and the MCI monetary policy method was retired (fired) in the mid 1990s.

To be fair, New Zealand had led the way with developing inflation targeting monetary policy strategies (Reserve Bank Act 1989) so the trial-and-error aspect of the MCI shouldn't be criticised too loudly.

We tried, failed, and moved on.

The MCI strategy has been reviewed by many. If you are short of sleep, I downloaded one such review and you are welcome to read it for historical interest.

Back to negative yield curves and what they are trying to tell you.

What is a negative (inverted) yield curve?

What is a yield curve?

A yield curve is a graphical image (remember X and Y axis in maths class) of data plotted on a basic chart. The X axis displays the period until maturity date and the Y axis displays the interest rate (yield). If you Google YIELD CURVE IMAGE you'll 'see' what I am describing.

A ''normal'' yield curve, in an economic vacuum, offers a higher reward for a longer period of time, to reflect the greater incidence of risk over time and some elements of compound return.

You know we don't live in an economic vacuum, so you know it is not as simple as I have tried to describe, but I hope you now have the 'picture'.

A negative yield curve is presented when short-term interest rates are higher than medium and then long-term interest rates. Again, you could Google INVERTED YIELD CURVE IMAGE to see one.

I think I have published this link before. It is a YouTube presentation tracking the evolution of yields on US Treasuries between 1953 and 2019. It is a fantastic 14-minute observation of the subject: what is a yield curve telling you about the economy?

https://www.youtube.com/watch?v=WM-NGndzBFo&t=311s

As you watch it, keep an eye on the shape of the curve's positive slope, flat, negative and the nominal interest rate levels of the era.

Retain a memory of how common the positively sloped yield curve is.

Check out the steep negative of 1979-1980. Most other 'negative' yield curves were merely flat by comparison and this is what I'd expect today because I don't believe central banks will display suffocating increases to interest rates (nor need to).

Check out the 1987- 88 (share market crash) stability of the 30-year yield.

Here is a link to view the current US yield curve (government treasuries):

https://www.bloomberg.com/markets/rates-bonds/government-bonds/us

The US yield curve remains positively sloped from 3 months to 2 years, but then tips into a negative shape between 2-10 years, before rising again to the 30-year term.

Did you notice in the animation how stable the 30-year Treasury's yield was relative to the balance of the yield curve, regardless of nominal interest rates (hold that thought)?

The first part of the US yield curve currently tells you that the market thinks the US cash rate (Fed Funds, overnight) needs to rise to at least 3.00% during the next 2 years.

It then worries about the potential for tighter monetary policy to force an economic recession and this will drive a return to lower interest rates.

The lighthouse that is the 30-year US Treasury is holding ground close to 3.00%.

If you remove the artificial 0.00% interest rate period for Fed Funds from the long data series for the 30-year US Treasury, they have traded with a yield between about 2.50% and 3.50% for the past decade (declining from higher levels in years prior to that).

At this point in the interest rate confusion, I think you should keep a close eye on three things:

How far the US Federal Reserve is willing to increase the overnight Fed Funds rate;

How many long-term Treasuries the Fed will sell back to the free markets and how fast; and

The market yield on the 30-year US Treasury. What is the lighthouse signalling for the longer term?

At today's 3.12% interest rate the longest bond is signalling that central banks will calm inflation and it will settle at 2% or lower. This view is reinforced by the 10-year term yielding below 3.00%.

Financial analysts, headline jockeys and those who control a keyboard, like me, can talk until we are blue in the face about what we believe, but those who are in charge of the trillions of dollars invested in US Treasuries are making updated risk decisions every day for you.

This collective of investors (the market) shows you; they don't tell you and frankly they don't care what we all think individually.

So, today's yield curve acknowledges the fact that central banks are increasing the overnight interest rate and are trying to catch up on being late to the ''suppression party'' but the yield curve also says that it is unconcerned about medium and longer-term inflation (in the US).

You are forced to take your own view when investing your money, and we financial advisers are tasked with helping.

Here in New Zealand, we have little to worry about with this interest rate change debate.

The average duration (a financial reference for term to maturity) of a local person's fixed interest portfolio is very short; a typical range covers 1-6 years (minus three days by the time you read this) and the average is commonly less than 3 years.

This means that this typical investor has very little financial exposure (modest value change) to interest rate movements.

The large, and fast rate of increase to interest rates has in fact been useful; a slow drawn-out move to 5% would have been less beneficial to the reinvestment process for maturing sums or lengthening the duration of a portfolio.

Keep investing.

We are happy to help.

Monetary Policy – Last week delivered two important official cash rate changes for investors to contemplate and react to and the most influential one is just around the corner.

The Canadian central bank increased its Policy Interest Rate by +1.00% (an aggressive move) to reach 2.50% and offered a firm tone about its future intentions.

The Reserve Bank of NZ increased our OCR by +0.50% also to reach 2.50% supported by a calm repetition of the new stance explained in May.

On 27 July we will all discover the next interest rate move from the US Federal Reserve, a decision which had the blow torch applied last week when the latest US inflation data came in at +9.10% YTD relative to estimates of +8.6% to +8.8%.

NZ's latest CPI data was also a little higher than expected at +7.30% YOY versus +7.10% forecast.

The financial markets have already priced in an expectation of +0.75% from the US Federal Reserve but board members seem to be testing the tolerance for +1.00% based on the headlines and debates being held online.

The Canadian central bank opened the door for this +1.00% debate and I suspect the US Federal Reserve is pleased to have the option put on the table for discussion.

There is more risk to investors from this situation (unknown element) than reward, so it is time for patience.

If you are reading this on the beach in Rarotonga (why?!) I'd be ordering another cocktail and not logging into your investment portfolio to make changes until you return in early August.

Buy Now Don't Pay – The speed with which a new service can emerge and almost completely disappear has been redefined by the Buy Now, Maybe Pay Later sector.

Over five years, ZIP.ASX share price rose from $0.50 to $12.00 (years 1-4) before collapsing back to $0.50 (past 12 months).

Laybuy Holdings – LBY.ASX has declined from a peak of $1.75 to $0.05 over two years.

Afterpay investors should be hugely relieved that it sold the business before the music stopped.

The goodwill seems to be only the stickers on the windows of retail outlets using the services.

And to think, many commentaries from 2020 had these Buy Now Pay Later businesses as part of the death notice for mainstream banking businesses.

Ever The Optimist

It is so impressive to see a senior executive using real money to buy ordinary shares in a business that they lead.

There have been a few examples recently, with the latest that caught my eye being Greg Foran buying more shares in Air New Zealand.

I read this not long after he served me coffee on the plane home from Auckland showing that he is keen to maintain an understanding of the customer and staff perspectives within the business too.

ETO II

Medical progress – under the subject of cholesterol-related heart risks (which includes me) I enjoyed reading about gene editing medicines that could (in trial) permanently reduce the level of cholesterol that a body produces (single treatment!).

This may progress fast enough for me to enjoy (results 2023, so maybe a few years after that for consumers?) but will certainly aid our boys.

Here's a link to the company if you are curious: https://www.vervetx.com/

Thanks to a Bloomberg link for this story.

Investment Opportunities

A little down time, and a return to using secondary markets for accessing investment choices.

We have managed to access a further allocation of the 6.95% ANZ Bank Perpetual Preference Shares. Please contact us if you would like an allocation.

Travel

Edward Lee will be in Wellington on Friday, 22 July (Featherston Street)

He will also be in Auckland on Wednesday, 27 July (Devonport), 28 July (Ellerslie International), and 29 July (Jarden House, Queen Street, CBD).

He is also planning a few trips for September (Nelson, Blenheim and Napier). Please let us know if you would like an appointment.

Michael Warrington


Market News 11 July 2022

Toyota revealed some good news last week.

Demand for hybrid vehicles has reached a strong enough level that Toyota is sufficiently confident to decide that going forward they will only produce the favourite Corolla with a hybrid engine option.

Toyota makes this decision with full knowledge about consumer demand (they offer full Battery EV options).

Akio Toyoda (President of Toyota) will be both unsurprised and pleased, given his view that hybrid energy use should be the planets current focus.

EV development is a good thing, but looking forward from here, I think Toyota will be more successful than the likes of Tesla in the vehicle market.

INVESTMENT OPINION

Ukraine - I like that Ukraine is already developing plans for a rebuild.

They know there will be a post war period.

I agree with their claim that this rebuild should be viewed as a ''common task for the entire democratic world''. (Including a few of the oil exporting nations!)

Now we just need the shooting to stop.

RBA – finally wakes up and hikes interest rates harder than at any time in my memory with +0.50% last week on the heels of +0.50% and +0.25% prior to that.

One commentary I read described it as a 'dovish rate hike', being the definition of an oxymoron.

The market has certainly viewed the rate hike as less aggressive than it might have been, although this reflects the youth of financial markets because these steps by the RBA are anything but gentle or dovish based on historical form.

In the 30+ years that I have been monitoring the RBA they have been a model of calm, reasoned and stable monetary policy management. They made New Zealand look skittish and confused in the early 1990's until we settled into a similar model of monetary policy operation.

There's no other way of saying it, but RBA governor Philip Lowe made an error in 2021 when he launched his unwise strategy of making a 3-year declaration for monetary policy (0.10% until 2024) rather than keeping his cards closer to his chest for the inevitable changes the economy would confront.

No, he couldn't have forecast Russia would invade Ukraine, but therein lies the point.

During 2021 he did know about the impacts Covid was having on freight logistics and the economics of tourism (volatile).

Maybe Lowe was inspired by the Italy's ''whatever it takes'' Super Mario (Draghi) and Japan's ''read my lips 0.00%'' from Haruhiko Kuroda?

The all for one and one for all (Unus pro omnibus, omnes pro uno - for the Latin scholars) approach to monetary policy around the world worked for a while, until it didn't, like almost all risks in financial markets.

I see William Shakespeare used the quote in a poem to characterize people who take massive risks.

He was right, all in is now proving to be a damaging strategy.

William Shakespeare for governor then?

Philip Lowe should acknowledge the policy error and move forward with his eyes wide open.

As I said last week, it's nice to be moving away from identical monetary policy settings around the world.

Wholesale – For the second time in three weeks, I find myself complimenting the Financial Markets Authority (FMA) on one of their recent actions but asking again that they go one step further with their regulatory efforts by reminding the public, and the courts, of the public's access to financial advice services.

It is an opportunity missed (so far), after spending a decade developing a higher quality financial advice community (better regulated), if the FMA does not then steer the public toward that advice to help guard against the threats that the FMA observes and confronts.

Last week's threat to the public was another in the misleading and deceptive category.

The FMA made directions against the Du Val Group (DVG) over their promotions of a high yield mortgage fund to wholesale investors and the High Court reinforced the directions when it rejected an appeal.

DVG's offer to the public, with a high interest rate (10%), is part of a programme to fund the property developer, which I suspect became necessary as a result of the stark changes that are occurring to the way banks will lend money.

DVG wisely limited their investment offer to Wholesale investors, hoping to limit their exposure to financial market regulations (disclosure obligations under the Financial Markets Conduct Act) but still managed to upset the FMA.

DVG went close to the designing the right process for self-funding their business but tripped themselves up when they used too much emotive wording in their public promotions (incorrect risk descriptions and comparisons, absence of fees).

My applause for the FMA relates to their challenging the incorrect risk descriptions and comparisons being used in trying to attract investors (lenders), but I do not applaud the debate about fees in the directions made by the FMA.

Clarity on risk matters.

I explained recently that the Australian regulator (ASIC) is so concerned about how higher risk investments are presented to the public that they now insist that such offers (higher risk) involve financial advice (recall Westpac restricted access to its recent offer of subordinated securities to clients of financial advice businesses).

Whilst I prefer the Caveat Emptor model, supported by helpful regulations and financial advice, I do wonder whether the Australian approach is appropriate for the highest forms of risk.

Another consistency with the Australian approach (more need for advice when an item is complex) can be seen in New Zealand with Heartland Bank's (HGH) successful method of serving the home equity release product to the public.

When offering home equity release mortgages HGH insists that the public seek financial advice and discuss the service with wider family members before participating.

In paragraph 73 of the judgment Justice Gault agreed with the FMA that wholesale investors are not inherently more sophisticated than non-wholesale investors (indeed reaching for the dictionary the court also observed that some wholesale outliers may even be ''stupid or ill-equipped''!)

This all reinforces my preference (logical and biased) that the FMA should be pressing the public for more exposure to the financial advice community.

The public doesn't really need much financial advice when placing a low-risk investment such as a bank term deposit, but they do when they draw more risk into their portfolio in the hunt for higher returns.

I do not think the FMA should attempt to protect the public by re-writing the law using guidance notes. They try to do so with this item:

Wholesale investors are defined in law and, broadly speaking (we need to be more specific, not less - Mike), are people or organisations who have sufficient previous investing experience that means they don't require disclosure. (bold emphasis is mine)

The FMA has just finished arguing in court that wholesale investors are not sophisticated, but this guidance note goes close to trying to define them as needing to be!

This is a mistake. It draws the FMA, and then the courts, into a debate about 'sufficient investment experience' and likely then leads them into an attempt to issue guidance notes about appropriate reward for risk scenarios.

Relative risk and reward outcomes are both grey zones that the regulator should avoid defining (they change constantly) and instead they should steer the public toward the financial advice services that are widely available.

That's my financial advice promotion over, neither misleading nor deceptive.

On the subject of expression about fees though I think the FMA erred.

In my opinion the FMA was incorrect with its assertions about fees, where they conflated the subject of fees with returns for risk.

DVG said 'no fees charged', '10% reward to investors' and all other rewards go to DVG. 'Risks are defined in the disclosure documents'.

This is simple enough to understand.

In the DVG case the FMA blended the equity and lending risks when they considered how to calculate a share of rewards between DVG and investors and what might be hidden fees.

The FMA was attempting to reveal gains beyond 10% that they could describe as a fee to DVG.

The FMA challenged DVG for advertising ''no fees'' with the offer.

The relevant paragraph in the court findings (78) is:

Ms Cooper (for the FMA) submitted that the right to retain profits amounts to a fee. Even if it were not strictly a fee, the representation of no fees would still be misleading because Du Val earns any and all returns above the fixed return to investors. The FMA acknowledges that the General Partner also carries the risk of loss but does not consider this is relevant. (bold emphasis mine)

I think the FMA stance here was a silly argument to attempt. The FMA literally describe return on equity risk but then conclude it should be described as a fee to a person or entity who lends money to the business.

The Appeal Court was not required to make a decision on the matter of fees.

The court declined the appeal and observed (interestingly) that the term ''fee'' is not a term in statute or instrument with legal construction and thus couldn't be challenged as a failure of applying the law.

The court described the FMA's reasoning about fees as inapt (not suitable or appropriate in the circumstances) but because there was no error of law there was nothing more to conclude, because the appeal was brought on the basis that the FMA made errors of law.

I agree with DVG position on fees from paragraph 77 and I suspect the judge did too.

Mr Salmon (for DVG) submitted that a right to retain profits exceeding a fixed rate of return is not a performance-based fee because it does not fit within the definition of that term in the Financial Markets Conduct Regulations 2014 (the Regulations), the ordinary meaning of fee does not include retained profits and a reasonable wholesale investor would not be misled by the representations. He submitted that a reasonable investor would understand that Du Val is carrying on business to make profits, not out of kindness, and that the fixed rate of return means that the General Partner bears the risk of the Mortgage Fund's return being lower than 10 per cent and retains profits over and above the 10 per cent. He submitted that Du Val does not charge fees, and that the obverse would mislead.

As I say, I think the FMA erred in trying to redefine returns on equity as fees, but I am pleased they won their debate about misleading and deceptive behaviour when presenting risk (investment products) to the public for investment.

Meeting a definition of being a Wholesale investor does not deliver an aegis that protects you from risks confronted by all investors and thus you too should seek financial advice.

Credit Margins – being the additional reward for risk relative to a risk free (or low risk) benchmark have been widening during 2022.

Even though nominal interest rates on longer terms have fallen sharply over the past two weeks (worries about recession) I would expect credit margins to widen further, especially if fixed interest investors (lenders) reflect on the rising incidence of default (failure to meet financial obligations).

Russia has been squeezed into default following its invasion of Ukraine.

Sri Lanka has defaulted on obligations after mismanaging its economy. They will be followed by other poorly governed nations.

Argentina looks to be in financial trouble again. Long time readers of Market News may recall me saying that when I was over there on a 'research trip' businesses preferred that I paid them with US dollars than paying in Argentinian Pesos.

Lenders of US dollars won't want Bitcoin as payment from El Salvador.

Zimbabwe is trying to give up on its own currency and plans to issue gold coins to its citizens. The problem is that it will cost $650,000 Zimbabwean Dollars to buy one (at the time of writing) if it weighs one ounce. With 200% inflation the cost will be $675,000 by the time you read this!

China's property developer dominoes continue to fall with three of the largest five developers (Evergrande, Kaisa and Sunac) defaulting on debt obligations. Last week the sixth largest being Shimao Group which failed to meet payments on a US$1 billion bond.

So that you understand the spin:

What they said: citing ''market uncertainties over debt refinancing'' and ''challenging operating and funding conditions''.

Translation without spin: No one will lend to a high-risk business carrying too much debt and experiencing negative cash flow and unable to sell assets.

It implies that Shimao shareholders don't have sufficient wealth to support their own business, otherwise they would have stepped in before this point.

Using lending as the higher risk, higher return, part of a portfolio (as opposed to ownership through shares) can be a cliff like experience; everything seems OK, until suddenly it is not.

The rising number of debt defaults will increase the failure ratios per credit rating and in turn this will (and should) widen the credit margins that lenders demand for future loans.

It is a good outcome for investors.

Until 2022, credit margins had become unreasonably low, so returns on subordinated and complex securities were unreasonably close to returns on simple, senior bonds from robust borrowers.

Wider credit margins mean investors should be paid properly again for the risks they are taking; you can see part of this influence in the credit margin being offered on the current perpetual preference share from ANZ.

Ever The Optimist

Synlait Milk has reinforced Fonterra's forecasts by increasing its own to $9.50 per kgMS for the year ahead.

This feels conservative relative to ASB forecasts that $10.00 is a chance.

Investment Opportunities

ANZ Bank – completed its offer of perpetual preference shares, issuing $550 million and setting the distribution rate at 6.95% for the first 6-year period.

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

Any investor who would like an allocation please contact us.

Travel

Chris will be in Auckland and has times available in Ellerslie (Ellerslie International) on Tuesday, 19 July.

Edward Lee will be in Auckland on Wednesday, 27 July (NorthShore - venue TBC), 28 July (Ellerslie International), 29 July (Jarden House, Queen Street, CBD).

Please let us know if you would like an appointment.

 

Michael Warrington


Market News 4 July 2022

US Independence Day.

A day off from the 2% to 3% daily price volatility being experienced in the US financial markets over recent weeks.

The +3% days for the US share market are as concerning as the -3% days because they display a very unsettled state for capital markets.

Volatility is one form of risk for investors. More risk should drive more reward.

If more reward is unlikely to come from more revenue, then it must come from lower entry pricing.

The best outcome from this scenario is to see a gradual decline in the daily volatility of the market's pricing, followed by a return to some longer term business planning.

Traders win during periods of higher volatility, not investors.

INVESTMENT OPINION

Environment – The only person who didn't contact me last week with an alternative perspective, or thesis, about the Roe vs Wade decision by the US Supreme Court was the Pope.

However, one helpful citizen did steer me to another more immediate influence the US Supreme Court may have on matters relating to the environment, which might be a problem far sooner than my concern about losing the wide support of the public.

The Supreme Court heard a challenge from West Virginia against the Environmental Protection Agency (EPA) claiming it is over-stepping its authority in trying to put caps on greenhouse gas emissions from power plants.

The White House argues the Clean Air Act gives the EPA broad powers. That act, though, was written long before climate change was identified as a threat and the fact that Biden is hastily writing new regulations on the matter implies the President knows that the EPA's legal authority is tenuous.

If the Supreme Court finds against the EPA, the outcome is that regulating emissions would likely require the involvement of Congress (new law) and the current division in politics doesn't bode well for the smooth passing of such legislation.

Such a decision would certainly slow down the emissions suppressing efforts in the US.

We all knew that making such significant changes over short time periods was going to be difficult but it's a shame to see situations such as this where 'we' find ways to make the difficult even harder to achieve.

Post Script: The US Supreme Court found in favour of the West Virginia, and against the EPA, curtailing the EPA's federal powers.

Inflation – How's inflation going now?

Up, by definition.

The headlines would have you believe it has hitched a ride aboard Rocket Lab on the way to the moon (see ETO).

I don't share that view.

I rather like a view that I read last week (in John Mauldin's work I think) that described the current painful spike in inflation as a single surge catch up from the period when prices were being artificially suppressed by unsustainable opportunity costs (0.00% interest rates and plentiful funding supply).

A business such as Uber could justify lower prices and losses as they pushed to build a business when the cost of money was close to 0.00%. However, the share increase in the price of money has for the time being killed off loss leading as a business strategy.

Loss leading, followed by loss making is no longer being tolerated by bankers (lenders) and capital providers (shareholders).

Businesses are trying to discover if they have a future when they set pricing at a level that yields a profit. This process may take 12 to 18 months to be revealed clearly, and the revelation will involve the surprising failure of some well known brands.

If you and I stop using such businesses, or buying their products, based on the new ''inflated'' pricing they will have their answer; businesses will fail, case closed.

This theory should make sense to you if you remember reading any articles during 2020 and 2021 about 'zombie businesses' only surviving because the cost of money was almost nil.

These zombie businesses need to be removed from the economy. Staff and capital need to be redirected into more productive areas (a few more nurses would be nice – Ed).

Next, I looked to the behaviour in the global oil market, through the lens of the price of oil.

The price of oil was declining early last week from its highs (about $125) down to nearer $100. This is helpful, although it was rising again late last week.

If it holds relatively stable for a while (weeks), even if it is around the $100 price, that too would be helpful with respect to the inflation debate; no longer a runaway train.

The runaway train metaphor is not going to happen. Oil producers do not want to suffocate consumers and put them out of business and we are seeing anecdotal signs of this now.

One example from last week was about the UK fishing industry who report that it is becoming marginal as to whether they set sail as often because to pay the diesel costs is to ask the crew to accept pay that is below the legal minimum wage (although they are paid based on a share of profits from the haul).

Presumably the higher prices required from fish sales would result in lower demand from the restaurants and consumers. The fishermen know this and thus are preparing for fewer trips.

At a diesel price of GBP£1.08 per litre they are planning fewer trips. At GBP£1.15 per litre that will cancel trips.

OPEC won't suddenly feel sorry for these fishermen, but they will have tuned into this problem for the demand profile of oil and will be aware of similar economic pressure elsewhere.

Bloomberg published a useful chart displaying gross oil consumption in the US since 1945 (about 600 million barrels of oil). The volume rose reasonably constantly until 2007 (3.25 billion barrels) as economies expanded, it then plateaued and is now showing modest signs of decline.

A decline is logical given the efforts (and subsidies – Ed) now going in to establish more renewable forms of energy in conjunction with the environmental goals now in play. 

Indeed, it seems that oil use per capita is declining in the US because their population has grown from 280 million in the year 2,000 to 335 million now, yet oil consumption held around 3.25 billion barrels per annum.

This data is another anecdote that OPEC members will be alert to.

Do you remember that not long ago (2019) Saudi Arabia did the unthinkable for me and floated some of the shares in Aramco, the jewel in the nation's economic crown?

You don't sell the crown jewels unless you hold a view that it is an asset in long term decline.

The Saudis couldn't have guessed that three years later they'd be enjoying such high pricing again, but here we are, such is the range of unknowable things.

This view, of a very long-term decline, suggests to me that they will not want to be responsible for any acceleration in the global build rate of renewable energy supply and hasten a sharper decline in the use of oil as a global energy source.

If they do have such a concern, about more renewables, then they have all the more reason to increase oil sales at current market pricing.

All of these influences contribute to why I expect to look back on oil pricing between $100-$135 between 2022 and 2023 and not $150-$200 per barrel.

The last indicator of interest for you is the opinions about inflation from the interest rate markets, where many thousands of minds that control many trillions of dollars are placing their current 'bets'.

Long term interest rates jumped sharply immediately after the US Federal Reserve changed the tone and tightened monetary policy with a three-pronged attack, including large Fed Funds increases (+0.75%), reductions to the size of the balance sheet ('unprinting' money) and using threatening terminology in public statements.

The 10-year US Treasuries jumped from 3.00% to 3.50%. The positive slope on the US yield curve increased (higher rates for longer terms).

Financial markets accepted that the inflation fight was 'on' and that the arsenal had changed.

However, in less than two weeks the yield curve had flattened again (2-30 years only has a difference in yield of about 0.25%) and within the forward dates on that yield curve (between the 5th and 10th year) displayed yield declines (3.28% to 3.23%).

Within two days of me writing the paragraph above, yields on US Treasuries had fallen further: 2 years – 2.83%, 5 years - 2.88%, 10 years – 2.88%.

That's a 0.62% yield decline on a 10 year bond in less than two weeks, which is extraordinarily aggressive.

This is the market expressing a view that inflation will not be a problem five years from now and that interest rates will need to be declining again from that point, if not sooner.

In the face of inflation between 5% to 8% the statement makes it sound as if I am standing on the bridge above Huka Falls and the outcomes are clear (which they are, beyond the falls) but the reality is that analysts are sitting in an open top barrel, yet to reach the falls, with constantly changing perspectives.

The barrel loaded with financial experts reaches the next standing wave on July 27 (US Federal Reserve FOMC meeting on monetary policy).

Even though I am leaning toward the conclusion that inflation pressures will settle by late 2023, life jackets are still recommended.

Difference – Viva la difference, as they said at the Bank of Japan (BOJ).

While the US Federal Reserve has accelerated with its interest rate hikes, and the Bank for International Settlements (BIS) is urging the same action from all central banks to get in front of inflation (positive real yields), the BOJ has reinforced its stance of alternative monetary policy theory and will hold interest rates at, or around, 0.00% (it actually said present or lower levels!).

BOJ governors are not fools, and whilst they say they are monitoring the weakness of the Yen they also say they will not use it as an influence for monetary policy decisions.

The weaker Yen helps with the value of exports (revenue for the country) and slows imports (a better balance of trade), so the low interest rates may be part of an intentional trade strategy.

The BOJ seems keen to reduce the proportion of the nation's tepid growth (GDP) being spent in other economies.

As I understand it the Japanese are great savers and thus the country is less dependent on international lenders than the US (or New Zealand for that matter) for financing its government.

It also means that the 0.00% interest rates harm domestic savers (negative real returns) whilst the BOJ tries to assist Japanese producers with the same policy.

Again, this seems logical to my simplistic economic mind.

An investor gains more reward by offering its capital to Toyota for a 1.60% dividend than offering it to the Japanese government for 10 years (0.22% per annum).

A very interesting trichotomy is developing across global central banking, and as I said at the start ''viva la difference'' because the lock-step copy-cat monetary policy used over the past decade hasn’t played out very well.

Ever The Optimist (we are in need of more this week)

The irrepressible NZ business, Rocket Lab, has launched its NASA sponsored rocket (CAPSTONE) from Mahia and is on its way to orbit the moon.

The launch could be watched live online, so I did.

As the NASA director sad. ''it is remarkable what Peter Beck and his team have achieved in such a short time and at such a low cost''.

In less than five minutes the rocket was travelling at 10,000 kilometres per hour, in 9 minutes it was 25,000 km/h and apparently once it leaves Lower Earth Orbit it will reach 11,000 kilometres per second!

You can re-watch the launch here:

https://www.rocketlabusa.com/live-stream/

I've added it to my bucket list to be in Mahia one day to observe a Rocket Lab launch.

Tell your children this story and point out to them there is nothing they can't achieve from a standing start in New Zealand.

ETO II

A business called Climeworks in collaboration with Carbfix, based in Iceland, have increased the capacity of its carbon capture facility by a factor of 10x to 40,000 tons per annum.

The plant captures carbon from the air (Direct Air Capture), mineralizes it and stores it underground.

For scale perspective, Statistics NZ reports Auckland's annual emissions at 11,000 kilotons so major cities will need multiple DAC facilities to establish meaningful contributions to carbon reduction (for the marginal volume that trees can't cope with).

I see a need to add a visit to Iceland to my 2023 research tour.

ETO III

I was in Auckland last week and think the inner city is gradually coming back to life.

There were far more people, and more traffic, than last time I was there.

Auckland Airport has done a good job with work on its property during the Covid downtime.

ETO IV

Banks continue to deliver robust profits. (You couldn't avoid winding people up – Ed)

Surely this is much better news than the opposite?

A strong performing, successful, banking sector is vital to our economic activity and collective success.

Would you rather live in Venezuela or Zimbabwe and try to operate on US dollar cash to avoid your local currency?

Investment Opportunities

ANZ Bank – offer of a perpetual preference share (Additional Tier 1 capital item) formally opens today 4 July 2022 and closes on Thursday 7 July.

If you wish to invest you should now be on our list seeking a firm allocation.

The interest rate margin has been guided to 3.25%-3.40% which based on today's benchmarks implies a return for the initial 6-year period of a little over 7.00%.

The actual rate set will occur on Thursday7 July.

The offer documents are available on the Current Investments page of our website.

 

Travel

Chris will be in Auckland on July 18 pm(Takapuna) and 19 (Ellerslie), pleased to meet with investors.

Please let us know if you'd like an appointment.

 

 

Michael Warrington


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