Market News 28 September 2020

Debt may be cheap (it is – Ed) but in my view the best thing your children and grandchildren can do to offset the disruptive behaviour of others is to repay debt faster (save money).

To do so is to gain control sooner whilst all around them lose their heads and borrow more (governments, councils, businesses, consumers).

The price of money is low, but the price of services and products must rise if we are to sustain current asset values and the rising scale of promises being made by politicians.

It’s a vicious circle; the cheap price of money is supporting higher asset prices and poor spending decisions by regulators. Central bankers respond to the economic threat with … cheaper money.

Proposed tax increases are evidence of such a ‘price increase’ (at least it’s an attempt to gather acorns).

Increased regulatory obligation is a ‘price increase’ (sick leave, worksafe obligations, insurance outcomes etc);

Rising asset values deliver ‘price increases’ to gain suitable rewards on capital at work (keep an eye on what you pay for a Flat White).

Central bankers don’t mind these price increases; they are now actively encouraging inflation (madness).

If the world’s governments refuse to ‘gather acorns again for the next winter’ (Winter is coming – Ed) then we must do so at a personal level to put ourselves in the ‘bottom right’ quadrant on the grid monitoring risk (y axis) and control (x axis).

The low financial reward from holding surplus acorns will be less relevant than having the acorns.

INVESTMENT OPINION

AML – Extrapolated from my thoughts above, and after reading a global report about the ongoing failure by regulators and bankers to control money laundering, I pondered this question:

Does the hugely expensive AML regulatory framework add value to the world or subtract it?

Would these same financial resources be better used in tax revenue or invested in improving climate outcomes?

US pressure via the G7 and the power of the US dollar through to the Financial Action Task Force (FATF) has seen 141 countries agree to a implement legislation to restrict money laundering and other criminal behaviour.

It’s an admirable goal, but the problem is that it is failing (ineffective), making the vast volume of resources used look wasted.

A recent report on AML effectiveness from the Basel Institute on Governance (BIG) headlines:

A lot of countries may have strong AML/CTF systems in place, but in practice they are not working.

That summary makes one pause to reflect on the inconsistency; strong but ineffective.

A third of the surveyed countries scored a zero for effectiveness!

I happen to like that AML obligations improved the accuracy of our client relationship, and taught us ways to be alert to inappropriate financial behaviour, but the ongoing external costs are excessive.

Usefully the BIG (cool acronym – Ed) report highlighted NZ and Australia as the lowest risk jurisdictions in the Asia region. So why do our regulators dislike the use of ‘low risk’ as a definition in our Risk Assessments?

I sense the need for an open letter to Hon. Andrew Little, Minister of Money Laundering (you know what I mean):

Dear Andrew,

Please start treating AML regulatory obligations in the same way that the government handles Covid19 behaviours; specifically, whilst our AML risk profile is low please reduce the regulatory imposition.

NZ is reported as being ‘low risk’ in AML terms, so let’s move to a ‘low’ intensity setting for AML monitoring, just as we have with our current Covid19 reactions.

AML levels one to four, placing us currently at AML level one.

Under our new level one AML setting your first action could be to change our external audit obligations from every two years to every five years. You’d save us all many thousands of wasted dollars.

I’d rather direct our annual AML costs to the government in taxes, or new employees, or tree planting schemes, than to finance an industry (auditors, application providers, consultants) that is being described as ineffective.

By the way, did you read my 2019 article on AML where I was concerned that the administrative obligations were a resistor to competition to serve the public (higher prices the result)?

The public finds it too hard to sign up with more than one service provider, and they know it.

If you’d like to chat in person just reach out. Mrs Google will find me.

Sincerely, Michael

The collective ‘we’ need to use the Covid19 situation to remind us of the need to use our valuable but scarce resources more effectively than we have been.

No, sorry, this discussion doesn’t present you with a relevant steer for managing your investment risks, but I am certain that all of you would appreciate a little less AML tension when interacting with NZ businesses.

Blockchain– It’s been a while since I read about new progress in the Blockchain programming space but I had two recent reminders that this technology is alive, well and expanding in use.

One story was a local one where a start-up business plans to use it to expand the potential of a business sector that is currently sticking to its old inefficient routines established many decades ago.

I need to be careful not to disclose the business, or sector, just to let you know that use of Blockchain technology will become more apparent to you over time and it will add value to the process of registering ownership and payments relating to asset transactions.

What I see should make transactions much more efficient to settle and thus remove some of the more expensive, inefficient aspects of doing business.

I’ll create an unrelated example for you:

You want to buy a Toyota Corolla and deliver payment (your cash, or borrowed);

Toyota wants to sell you a Corolla and receive your payment.

At present Toyota expects you to pay, wait until the funds are cleared, then advise the motor vehicle register as seller, as do you the buyer. Then you may drive away.

If the Motor Vehicle Register moved into a Blockchain environment and allowed you to link payments to transactions, the car purchase could be securely completed in 15 minutes at the dealer’s desk.

If financing was used to purchase the vehicle their financial interests could easily be attached to the transaction and the registration of the vehicle; again, 15 minutes.

Drive away.

The other article discussed how the Bank for International Settlements (central bank to 62 of the world’s central banks) is hiring many more experts in Blockchain.

They can see how quickly this technology use is expanding within the financial settlement environment and need to be expert in its application.

Specifically, the state that these experts digital currencies, tokenised securities and any token-based payment systems.

The BIS is the top of the financial regulatory tree, so you should interpret this as ‘Blockchain settlement of payments and asset registers is coming’.

If it improves security, simplicity and price (lower) then it will be a success.

Infrastructure – I hope Auckland doesn’t rush into building its additional harbour crossing because big contracts don’t appear to be delivering very well elsewhere.

CPB HEB has performed rather poorly with timing and cost blow outs on the Transmission Gully road and now I also see their name linked to delays and cost blow outs for a Western Link tunnel in Melbourne.

Either these engineering projects struggle to meet cost benefit hurdles or the contractors are actually experts in the courtroom but not in the field.

We can’t afford to be saddled with financial waste on this scale (multiple billions).

Heartland Bank (HGH) – Home equity release, or reverse mortgages (sounds like repayment – Ed), were once dirty words, but not any longer.

Former Australian Treasurer Peter Costello is even calling for greater use of the service to ensure asset rich people are not boxed into a cash poor position under current economic conditions.

At an emotional level I understand why a person, or their children, would feel awkward about spending money that draws down on the net ownership of the house, but this thinking feels a couple of decades out of date.

Retired homeowners have far more equity in their homes than they would ever have imagined and that equity is now many multiples of their discretionary annual spending sums.

Allowing some of that inflated equity to support lifestyle is a useful tool.

Heartland Bank would unquestionably argue that its day has come; conditions are nearing perfection.

From a business sense HGH is biased, of course, but that doesn’t make the proposition any less true and the facility will allow equity to pass down from the senior generation to other younger generations, via consumption.

Sure, sometimes children could be the providers of this cash by progressively buying a house from the parents but this is not the norm in society. All properties have increased hugely in value, but not all of the next generation can support parents financially.

The collapse in interest rates not only fuels the underlying value of the property but it is reducing the financial cost (interest) and the debt that is being built up to offset against the asset.

I haven’t asked Heartland Bank but I’d guess that some of the Home Equity Release borrowers would have more net equity in their homes today than when they started borrowing five years ago!

I started this paragraph after reading HGH results and then spying Peter Costello’s lobbying.

Kevin Gloag has written an update of our thoughts about HGH which is posted on the Private Client page of our website.

China– There is now a constant flow of messages from many political leaders reminding us that the freedom enjoyed by financial capital markets in the past is over.

The economic problem has been compounded by Covid19 which is simultaneously restricting the movement of human capital.

This particular story shouldn’t surprise you, but it is disturbing all the same:

President Xi issues 'important instructions' to all regions to boost party control over private enterprise and rejuvenate the nation; all firms will need employees from the party to boost law abidance and moral standards.

The statement seeks to improve CCP control over private enterprise and entrepreneurs through United Front Work ‘to better focus the wisdom and strength of the private business people on the goal and mission to realise the great rejuvenation of the Chinese nation.’

Maybe they are genuinely concerned about the few becoming richer and the poor not benefiting?

Or maybe it’s simply all about power (you have to ask? – Ed).

Chairman Mao, Chairman Xi…. same outcome?

Long Term Thinking Please – Whilst New Zealand, and other countries, threw in hurried employment subsidy schemes and then almost immediately debated how to exit them, Germany displayed the merit of better long-term planning (a truth for business and government).

Germany has extended its more effective Kurzarbeit scheme until the end of 2021.

Kurzarbeit pays a lower hourly rate to an employee for the hours that an employer temporarily does not require from the employee, such as during periods of downturn.

Employees receive less total income, but they remain employed, their burden to the state is less than being unemployed and the employer is positioned to expand activity immediately, as required by demand.

Dr Oliver Hartwich of the NZ Initiative described the German scheme back in the early weeks of our Covid19 lock down experience. I imagine he disclosed it as an option for our government to consider.

In April this year Grant Robertson had to move faster than developing such a new policy, but I’d like to think he simultaneously launched a review of the German scheme and its long term potential for use in NZ.

Employers would unquestionably take on more employees if they knew the government offered financial flexibility to this cost centre when trying to run a successful business. 

Covid19 won’t be the last incidence of NZ needing employment support.

I’d like to see Covid19 drive some better long term thinking, and decision making, for New Zealand Inc.

 

EVER THE OPTIMIST

Reserve Bank figures show credit card billings dropped a seasonally-adjusted 5.8% in August.

Sure, Auckland’s second lockdown helped, but I am hoping that there will be a Covid19 inspired slowdown in spending as people accumulate a financial buffer.

Investment Opportunities

Oceania Healthcare – OCA has announced an offer of new 7-year bonds (maturing 19 October 2027) and we anticipate in interest rate around 2.25% (note the recent bond from Summerset as a guide).

Interest will be paid quarterly.

The deal opens and closes next week; it is a fast-moving contract note offer with OCA paying the brokerage costs (clients do not pay costs).

If you wish to invest in this bond offer, please act now and join our list (email or phone) with a firm request prior to 5pm on Thursday 8 October.

As we learnt last week with the Auckland Council bond offer early responses gain some benefit. Those who joined our AKC list early did gain access to AKC bonds even though the council closed the bond offer mid-week.

The other two bonds being discussed publicly (Port of Tauranga and Vector) are being offered to Wholesale investors only with very large minimum holding amounts.

TRAVEL

David Colman will be in Lower Hutt on Wednesday 7 October.

Johnny will be in Christchurch on Wednesday 7 October.

Kevin will be in Christchurch on Wednesday 21 October.

Michael will be in Auckland briefly during early Monday 19 October (in the city).

We have now planned our final three seminars, entitled No Hiding From Risk.

Tauranga – September 29 – 11:30am - Tauranga Yacht Club

No restriction on numbers.

Please note: Due to restrictions on groups over 100 in Auckland, we cannot admit anyone who has not re-registered for our Takapuna or Mt Wellington seminars. Please do not assume that your previous registration has carried over.

Auckland – October 5 – 11am - Mt Richmond Conference Centre

North Shore – October 6 – 11am - Fairways Event Centre, Takapuna

Chris is available for client meetings after each seminar. Please contact our office to arrange a time.

Please let us know now if you would like an appointment in your town.

 

Thank you.

Mike Warrington


Market News 21 September 2020

No election views from me.

I promise.

INVESTMENT OPINION

Duration – 30-year bonds have finally arrived in New Zealand, which is excellent news for the maturity of our market.

One might have guessed the NZ government to be the first issuer of 30-year bonds, but no, Auckland Council has led the way offering a bond with a fixed rate of 2.95%.

Up until this point I would have expected all but the ACC and Guardians for NZ Superannuation Fund to be scared off by the 30 year term but, au contraire, the demand was so large and so fast to present itself that Auckland Council closed the offer early.

The plan was to open last Monday and close on Friday, but the deal was closed on the Wednesday afternoon.

I can think of two opposing perspectives here:

Auckland Council and the lead managers of the deal will be very pleased about the result; but,

Some investors will feel they missed out on the opportunity as a result of the immediate and unexpected change to the timeline for the offer.

I can sympathise with both opinions.

Once you decide that you wish to borrow a large sum of money you just want the deal done.

If you are an investor you want to understand the details and have some time to assess the opportunity as it relates to your portfolio. Most would, and should, seek financial advice. All of this typically takes days, not hours.

Did Auckland Council mislead the market with the offer?

A little. Especially for retail investors, which add breadth to a register, but legally, no, they did what it said on the tin.

Retail investors have only recently settled in to understand why bond offers changed from being four weeks long to only four days (fast moving, often booked by contract note) yet last week they were told to understand the fine print, which said:

Council may allocate Green Bonds (including oversubscriptions) to those persons during the offer period or once the offer closes at Council's discretion.

Yes, I confess, I made that script intentionally finer.

The Financial Markets Conduct Act enabled these fast moving deals under its same class as existing quoted debt securities category, which has been a very useful flexibility option for capital markets.

Historically I thought four weeks was a good time frame for these offers, but on reflection I think at least two of the weeks were wasted and we have been proving that one week is plenty.

Is two days plenty?

No. It is not.

Retail investors are an important part of the market, and thus the funding options for all capital markets users, so shutting some out simply through extremely short time lines is unhelpful.

I will counter my own argument a little though by saying that clients receiving financial advice found it much easier to enquire and conclude whether or not they should participate in such an offer and as a result these folk were very well positioned to participate in the Auckland Council bond offer.

Retail investors are important players, but in my unquestionably biased view those investors gain advantage by seeking financial advice during their investment process. (*see Post Script)

Auckland Council has reminded investors that timeliness is important with decision making. I'll remind investors that access to financial advice, and operating to an investment strategy, makes decision making easier; if its easier decisions can be made faster.

Prompt responses were rewarded in this offer, and will be in most offers.

An investor on Monday last week who knew they had a need to add to a fixed interest sub section of the portfolio, and/or to add to the duration (average life) of that fixed interest portfolio, would then only need financial advice specific to the bond on offer for its suitability.

Default Risk – Auckland Council. Debts serviced by the rating base of the council (unquestionably reliable);

Terms of the loan – Very simple, fixed term, fixed rate. Senior debt without complex terms or conditions;

Maturity Date – 30 years (*more below);

Liquidity – Excellent. All investors and the Reserve Bank currently consider including council bonds in their portfolios.

Yield – 2.95% (*more below)

The discussion between an investor and financial advisor will then have focused on the 30 year term and the defined reward.

A good financial advisor should quickly have been able to explain how the 2.95% reward was fair, based on a variety of relativities.

This leaves the debate focused on the 30-year term. This is the driver of the volatility (another risk) within the investor's portfolio. The market pricing of a 30-year bond has far more volatility than the pricing of a 1-year bond.

Think of the 1 and the 30 as being the length of string on two pendulums.

Typically we invest in fixed interest assets for their price stability to offset the higher volatility carried in property and shares asset types. So does a 30-year bond add volatility, or stability, or both?

Even after you accept this additional volatility, making a 30-year investment decision turns your head upside down because almost everyone starts to align it with their life's runway and quickly become short sighted.

I understand, but it's not the right way to decide whether or not to include such a bond in a portfolio. A fixed interest portfolio still requires diversity across borrowers and across time, without limiting that time range.

To try and limit the time range of your fixed interest portfolio is to take a strong, or very strong, view about the future direction of interest rates.

If one dislikes the notion of a 30-year bond now, I'd wager that the same person would have disliked 30-year bonds 10 years ago when yields were much higher.

People who invested in 30-year bonds in 2010, and kept them, have very broad smiles on their faces today and have slowed the decline in the incomes they receive and are sitting on escalated bond values should they need to sell an asset to raise money.

Is the falling interest rates gig up?

Is 2.95% unreasonably low?

I simply don't know, but the market just agreed to lend Auckland Council $500 million over 48 hours based on those terms so the collective view today is that 2.95% for 30 years is OK.

That being the case, there is a loud message that investors need to digest that the investment community, which is very wide and deeply ingrained with skill, thinks interest rates will remain low for a very long time indeed.

You can see the ramifications of this view showing up in all other asset classes too.

I have two hopes as a result of this successful Auckland Council 30-year bond offer:

More councils will copy them and provide more such bonds to investors; and

More of the public will engage with the financial advice community (hopefully you – Ed).

*Post Script – Two days after the close of the Auckland Council bond offer we saw an email from another broker / advisor offering these new AKC130 bonds at a secondary market yield of 2.35% supported by a tension building recommendation to act quickly.

A 0.60% yield movement on a 30-year bond equates to a new purchase price of $112.86 per $100 of bonds.

In my opinion having the new bond owner and this broker claim a 12% gain in 24 hours should stretch the minds of the integrity unit at the FMA, if the person who wrote their recent FMA bond tutorial document truly understands the bond market.

If this development is OK, then there is something dysfunctional about the way our bond market operates (illiquid) and rewards participants (excessively).

Heartland Group (HGH) – Announced a good profit result in the face of elevated loan loss risks from Covid19 and announced an unexpected surprise by declaring a dividend to shareholders.

Heartland Group enjoyed sufficient income from its Australian operations to deliver the dividend. Heartland Bank (part of the group) will have retained its profits, not passing a dividend to the group, as requested by the NZ central bank.

HGH also announced a new funding programme in Australia to support its expanding Home Equity Release business activity there.

We will take a closer look at the result and Kevin Gloag may update our research article on the private page shortly, to factor in the latest news.

Paper Money – Regulators want use of paper money to decline, mostly to improve monitoring but now also because of its role in the Covid19 contagion.

You’d have thought the public would be on board with the second reason, but central banks are in the midst of ordering the production of more paper money than usual, right now.

In a related article an analyst presented a chart of data that was also counter-intuitive; during periods of increased paper money in circulation, inflation falls.

Strange but true (according to that data – Ed).

GDP – The large negative GDP data released last week for the second quarter (March – June) was of no surprise to anyone. However, GDP predictions have become more volatile than financial markets, which is saying something.

I remind you of the excellent GDP live service. I hope Massey University has found a sponsor and won't close the facility. I still don't understand why Treasury doesn't fund it.

http://gdplive.net/Dashboard

GDP Live seems to be witnessing a rapid lift in GDP for the September quarter, hopefully bringing year to date GDP back 'up' to only -1.25%, a period including Auckland's second lockdown.

A return to a neutral, or a small positive annual change for GDP by the December quarter, seems to be a credible expectation.

Now, more importantly, we need to resolve how the country will complete next year's harvest in the horticulture sector and avoid an unnecessary pot hole (a new economic term? – Ed).

 

Proxy Voting – It's voting time again on many of your shares.

As interested as I am in many of the items even I tire a little of participating in exercising my votes.

This makes it even more important that (if you haven't already done so) you appoint the NZ Shareholders Association as your Standing Proxy.

Then, they represent you and your vote at all future meetings when you are invited to vote.

There are forms to use when appointing a Standing Proxy.

We have those forms, plus populated examples; please ask us for them and we'll be pleased to email them to you.

You complete the forms and send one to Computershare and the other to Link Market Services.

Whilst a Standing Proxy is in place you retain your right to vote. If you elect to vote on an issue your action trumps that of the Proxy, however, I'd suggest that the reason for appointing a Standing Proxy is so that you no longer have to consider the minutiae being addressed at the meetings.

The ultimate way of thanking the NZ Shareholders Association for their efforts made on your behalf is to become a member and pay their subscription (modest).

You do not need to be a member to appoint the NZSA as a proxy but it is a nice thing to do.

EVER THE OPTIMIST

EROAD continues its international expansion and is a business 'NZ' should be proud of.

We need more such businesses, and to have them widely available to investors. So many companies are removed from our access through the process of takeover (witness Metlifecare currently) without replacement businesses being added to the market often enough.

I see plenty of start-ups via the venture capital environment but at this stage very few of them make it to NZX listing. Most strive to sell the entire business to others, once established.

It was nice to read that ERD is the opposite; it is being approached by companies asking EROAD to buy them.

ERD will now be listed on the Australian Stock Exchange (ASX) simultaneously with the NZX.

It has taken advantage of the recent increase in the ERD share price, that better reflects the business's evolving success, and raised $50 million new capital to both bring new Australian shareholders onto the register and to fund the accelerated development of the business.

If you happen to be an ERD shareholder we encourage you to read the company's presentation updating the market on the current situation and I'd suggest dwelling on the page 06 slide to enjoy what ongoing sales growth looks like. It's a nice chart.

Investment Opportunities

AKC130 bond– Auckland Council completed the issuance of $500 million 30 year bonds at 2.95%. It was a very successful transaction and we hope other councils will follow their lead.

For my amusement, I like the NZX ticker code for this new bond – AKC130 – being the 1st bond issued for a 30 year term in NZ.

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

Port of Tauranga – Is having a presentation of recent company performance and 'may' follow this with the issuance of a 5-year senior bond.

However, the bond offer is targeting institutional investors ($500,000 minimum).

Armed with an ''A-'' credit rating the market is likely to lend POT money at about 1.10% which should, if nothing else, please shareholders of POT (current dividend over the past year is an implied 2.35%).

Debt costs for strong business are quickly becoming statistically irrelevant relative to other business risks.

TRAVEL

David Colman will be in Lower Hutt on 7 October.

Johnny will be in Christchurch on 7 October.

We have now planned our final four seminars.

Timaru – September 24 – 1:30 pm - Sopheze, Caroline Bay

Tauranga – September 29 – 11:30am - Tauranga Yacht Club

Auckland – October 5 – 11:00am - Mt Richmond Conference Centre

North Shore – October 6 – 11am - Fairways Event Centre, Takapuna

Chris will be able to meet individually with clients after each meeting.

Those who have not confirmed their attendance would help us immensely by confirming their plans now.

Thank you to the 1,100 people who have attended seminars in Kapiti, Wellington, Christchurch, Nelson, Palmerston North and Napier.

The seminars are entitled ''No Hiding From Risk''.

Please let us know now if you would like an appointment in your town.

 

Thank you.

Mike Warrington


Market News 14 September 2020

Last week I enjoyed a ride around a variety of places in the central North Island.

The good news is that farming country looks to be in great condition and was filled with happy new lambs and young cattle.

Small and medium sized towns looked active and the roads were busy.

Business people that we spoke to were realistic about the economic situation but most carried smiles, which makes all the difference.

INVESTMENT OPINION

Bonds – You may need to pass this Market News on to your friends or family because you already have a good understanding of bonds and you include them in the Fixed Interest section of your portfolio.

The Financial Markets Authority has discovered, through one typical government department, surveys that only 6% of New Zealand investors include bonds in their own investment portfolios (excludes investments held by Kiwisaver, which unquestionably includes bonds).

Outside of Kiwisaver we estimate that only one third of New Zealanders have an investment portfolio (most savers are paying off mortgages with other money). Could it be possible that only 1.8% (6% of 30%) of New Zealanders know what a bond is, in investment terms?

It's possible that if 6% of all New Zealanders actually invest in bonds this means only 20% of our estimated 30% of Kiwis that invest use bonds in a portfolio. That's still a very disappointing proportion.

The FMA is clearly concerned enough about the situation because they completely ignored my suggestion that they back off, stick to regulation, and leave financial advice to financial advisors. They went ahead and produced an educational piece anyway - titled 'FMA Bond Guide – Bond Voyage' (that's fun).

The heading used to promote the new document was 'Bonds – The overlooked asset many New Zealanders don't invest in'.

They do if they seek financial advice, so I hope the next publication encourages those who need the help toward the helpers.

Initially there were a few things in the material that made me cringe (bonds are not an asset class, they are a product that fits into the Fixed Interest asset class) but remember that I am an aging bond guy so I was always likely to find mistakes and excessive simplicity.

Nonetheless, I am going to go out on a limb and promote their material to you because it has educational value, independence, and it stands the tiniest chance of encouraging the unadvised to reach out and ask (us) for financial advice.

Our clients know that education is a significant part of our client service offering, so this new document fits into the 'nature, scope and purpose' (FMA buzz words) of our business.

Here is the link to the FMA announcement: https://www.fma.govt.nz/news-and-resources/media-releases/bonds-the-overlooked-asset/

Inside this article you'll find a link to download the educational document (Bond Voyage). Go ahead, download it and wait for a rainy day.

We have also uploaded a copy under the education corner of our website for clients.

I feel for the FMA here (that's a first – Ed) because there's little that's more difficult right now than teaching the public how to invest in fixed interest assets (bonds, deposits, notes etc) as interest rates fall to between 0.00% and 1.50%.

Readers will have some fun with the guidance that 'bonds pay regular interest'.

Not in most of Europe they don't and the premise is evaporating fast in NZ.

Read the section titled 'How do you make money from bonds' and 'sale of the bond on the secondary market for a profit' with a grain of salt. I don't think this section helps you, in fact the opposite will be true and if I had been the editor I would have left it out.

Delving into bond pricing explanations and bond trading as an investment technique is always unwise in this domain.

I am only left with one meaningful gripe. Under the question 'Where can I get help?' they have not listed Chris Lee & Partners contact details. Seriously, though, they only use the term financial advisers once in this section, yet for a document about investing in bonds directly they suggest that readers contact a fund manager!

You know we are here. You know we encourage clients to use bonds and we explain how and why they should do so. Give us a call.

Interest Rates – After pondering how unfortunate was the FMA's timing with their document on how to invest in bonds I found my mind wandering to the deeper question of 'what value is fixed interest investing under the current risk and reward conditions?'

With nominal interest rates below inflation fixed interest investors now receive a negative real return. Investment involves the pursuit of positive returns for risk, not negative.

However, negative real returns isn't reason to evacuate the asset class altogether because it still offers price stability to a portfolio, something that is absolutely necessary to align with defined pay outs (liabilities) in future.

If a person forms an assured position of being able to meet all future expenses without any need to sell assets, such as a person receiving National Super and Government Super Fund entitlements, then they have the luxury of investing with elevated risk and to pursue positive real returns.

An investor who has no need to sell an asset and spend capital can ignore market volatility and focus on the quality of the investments owned.

In the past, when interest rates sat above inflation, which was normal because an interest rate is typically a construct of inflation plus a positive marginal return for a mixture of risks, investors would move wealth between Fixed Interest assets and ownership assets depending in risk and reward conditions.

When ownership of property or businesses (shares) was considered to be 'cheap' (above average reward for risk) an investor would reduce the weighting of investment in Fixed Interest assets (bonds and deposits) and increase the holdings in Property and Shares.

If they were proved correct by a subsequent increase in the value of Property and Shares the investor would progressively take some profits and migrate these increments into the Fixed Interest section of the portfolio.

If Property and Shares then became excessively priced on the markets an active investor would strategically reduce their investments in these two asset classes, simultaneously increasing their Fixed Interest investments (reducing the portfolio risk profile) and then sit tight, hoping the gyrations in value would deliver another cycle of such investment opportunity in future.

Whilst this investment strategy can still be employed one can no longer enjoy a positive real rate of return whilst parking higher proportions of their portfolio in Fixed Interest assets; there is a negative drag.

This negative drag is part of the reason investors are surprising many analysts by paying more than they have in the past for the same shares, even in the face of a Covid19 triggered global recession.

As it happens you can feel the same drag when you hold too much cash in a call account only earning 0.15% relative to investing the sum that you do not foreseeably need into longer terms at higher interest rates.

Holding some emergency cash on call is always wise, and this lost return is an appropriate insurance premium to assure you that you can and will meet all financial obligations over the months ahead.

Given that we must hold some of our wealth in Fixed Interest assets, even if that sum is shrinking, how do we react and invest if the yield curve is flat and returns for all terms are below inflation?

Plenty of people hope that the current conditions won't last for long, but hope is not an acceptable strategy in my view and the hope for higher interest rates is at very long odds as it flies in the face of the very firm intentions of central banks the world over.

Central banks are aggressively suppressing interest rates both through movement of official overnight interest rates to near 0.00% and more importantly by purchasing medium and long term bonds until the yields on those bonds decline to levels below inflation.

They are not hiding any cards, they are clear that they want an excess of cheap funding to play a role in supporting new employment until inflation returns, and, unlike in the past where they liked to use economic models to predict the emergence of inflation now they are beginning to say they will not respond until inflation is poking us in the eye.

When will that be?

At this juncture nobody has the bravery to make predictions and I don't blame them.

Investors know, 'do not bet against the Fed'. Investors always make more money by investing in alignment with the Fed, which means it is unwise to make investment decisions today on the expectation that interest rates will increase in the years immediately ahead of us.

Yes, years.

This current rising price for Property and Shares assets implies that investors are respecting a new asset allocation rule: limit the proportion of your wealth that receives negative real returns.

The Fed rule and the negative real returns rule do not bode well for allocating funds to the Fixed Interest portion of your portfolio, yet it remains an important asset class.

Longer duration Fixed Interest investing (say 10 years+) has more price volatility than shorter terms. 10-20 year bonds have similar price volatility to property assets (interest rate change multiplied by remaining term). In the past this helped because often a bond price would increase as Property and Share prices decreased.

That neutralising effect is less likely now as interest rate sits close to 0.00%.

If you are feeling technically minded and would like to read an article on the subject from an expert, take yourself to this link: https://www.ardea.com.au/duration-is-now-an-expensive-insurance-policy/

The article is written by the firm of yet another friend from my employment history who is now the Chief Investment Officer there. I hope he doesn't mind me directing you to it.

If Fixed Interest investing no longer offers a reward protection against Share market price movements then in theory investing for terms beyond 10 years (more volatile pricing) has less appeal, other than to perfect asset and liability matching (holding cash for exact terms to match your desire for spending at that point).

Shorter terms of 180 days out to 9 years remain important as a stabiliser to a portfolio, but he overall sums invested are likely to be changing.

Interestingly a 0.00% long term interest rate environment also means that a share price will more closely reflect the probable and possible net earnings of a business because a nil interest rate, with apparently nil volatility, implies less influence on calculating a fair share price for a business, which sounds rather 'clean' as a concept.

Any business that can display rising cash based earnings in the future, and/or an ability to increase prices in the event of more inflation is going to be very appealing to investors over the years ahead of us. (you make it sound so simple – Ed).

What might you do?

Ponder the impact of 0.00% - 1.00% interest rates on your portfolio;

Read the article about interest rates from Ardea Investment Management;

Try and develop a strong understanding of your future liabilities Outgoings) for up to 10 years;

Engage with your friendly financial adviser to keep the chess pieces on the move.

EVER THE OPTIMIST

Several clients have discussed the potential of holidaying in a horticultural area of NZ and participating in the harvest season to help, to try something completely different and to earn a little pocket money whilst in the district.

This is an outstanding idea and I hope what I am hearing is the tip of a very large iceberg.

I'd also like to believe that other business sectors could manage their workloads so that some of their staff could earn extra cash by spending down time from their primary job helping in the horticulture sector (paid).

Investment Opportunities

Summerset – The new 7 year bond issued by SUM last week was very well received and had its interest rate set at 2.30%.

2.30% for 7 years may seem challenging to most, including me, but in the face of bank deposits threatening to fall below 1.00% the SUM type of bond is a credible option for a portfolio.

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

SEMINARS

The postponed Timaru seminar is now planned for Thursday 24 September, at Sopheze on the Bay, beginning at 1.30pm.

The postponed Tauranga seminar is planned for 11.30am on Tuesday 29 September, at Tauranga Yacht Club.

Any plans for Auckland must wait until Covid levels allow.

To ensure that we have correct numbers to comply with any Covid levels, please let us know if you wish to attend either seminar.

TRAVEL

Edward will be in Napier on the 28 and 29 of September. He has hired the boardroom of The Crown Hotel as his usual spot inside Mission Estate is undergoing renovations.

David Colman will be in Lower Hutt on 7 October.

Please let us know now if you would like an appointment in your town.

 

Thank you.

Mike Warrington


Market News 7 September 2020

The investment landscape continues to change, which in this case means moving further from old legally defined rules of engagement.

The concept of operating a business according to local legislation is being tipped upside down.

I am referring to the Chinese business TikTok, popular with users worldwide.

President Trump has blocked US businesses from interacting with TikTok in the US unless it is sold to new US owners.

In response, the Chinese government has said TikTok cannot sell any part of itself without Chinese approval.

Political stalemate.

Corporate law irrelevant?

INVESTMENT OPINION

0.00% – Is a 0.00% mortgage interest rate a fantasy in New Zealand; something out of a Dr Seuss book?

I will not pay you Sam I am, I do not like this financial sham;

A world that is near upside-down leads to bankers with a frown.

Will this madness never end, tell me Sir whose ear I must bend;

If that person delivers more than zero, they shall be to many a hero.

I hope 0.00% mortgages remain a myth in NZ, but I'll not be bold enough to declare it impossible.

It is happening overseas. In Finland one can borrow at 0.00% for 20 years and in Denmark one can borrow at -0.50% for 10 years!

The Reserve Bank of NZ has alerted us all to the potential for the Official Cash Rate (OCR) to move into negative settings come 2021.

Banks are re-writing their financial agreements used for arranging business with institutions and other banks to cater for negative interest rate calculations.

Currently our mortgage interest rates are approximately 2.25% above the OCR (a 2.50% mortgage rate).

If the OCR falls to -0.25%, as several analysts are now expecting after the most recent statements from the central bank, it is easy to see how our mortgage interest rates can fall to 1.50% - 1.75%.

We investors are busy worrying about the potential for returns on our fixed interest portfolios dropping ever closer to 0.00% so the prospect of being able to borrow at such an interest rate is depressing indeed (for investors to contemplate).

Try not to dwell on the prospect too much. Keep investing based on the current conditions but do not factor rising interest rates into your near-term calculations.

Volatility – Diversity reduces volatility in an investment portfolio, so by the same definition the opposite is also true.

Price volatility is a significant element of risk for a portfolio. If you own only five different shares the potential for a large swing in the scale of your wealth is higher than for a person who owns dozens of shares, let alone dozens of investments across different asset types.

Investors should be rewarded for accepting risk; more risk should result in more relative reward. Relative is the key word here.

Today less actual reward is available across the range of risks. Interest rates (nominal and real) continue to decline. Share prices are higher, reducing the relative profit-based rewards available to investors but a gradient of reward still exists across the risk spectrum.

As an investor you would hope that the lower reward environment reflected a lower risk environment, but this is not the case because I think implied volatility (element of risk) is rising.

Over the past 10+ years the relative scale of the world's largest companies means they dominate a progressively larger proportion of share market indices and economic activity.

In an item I read last week Bloomberg reported that Amazon, Apple and Microsoft share prices were responsible for 25% of the share market gains over the past five years (3 of the 9,000 companies in the group!).

It's amusing to see Microsoft left out of the 'FANG' club given the former's huge scale. Older investors may remember that Microsoft had to respond to excessive dominance claims (antitrust lawsuits) in the 1990's and here they are again still dominating.

I'm sure Microsoft will be pleased to see the spotlight on other businesses this time.

The now FAANG club of technology stocks (Plus Microsoft), soon to become FAANGZ with the success of ZOOM for online meetings, currently represent 25% of the S&P500 index in America. In turn, America is far and away the largest investment market in the world.

A similar problem of scale exists on the NZX50 where F&P Healthcare (FPH) and A2 Milk (ATM) together represent 30% of our index. That's also distortionary for investors who thought they were gaining wider diversity by investing via an index.

This enlarged proportionality by the few dominant performers reduces diversity for investors who invest via a market weighted index tracking fund, which by definition increases volatility (risk) for such people, yet rewards are declining.

What to do?

Do you stay in the fund that represents the apparent economic performers, with rising proportions, or do you reset your investing to extract more diversity?

Backing winners is good.

Diversity is good.

What's the right balance?

As ever there is no 'one sized' answer. Fortunately, what I need to say here is that you should seek financial advice specific to your situation and the conditions of the day. (smile)

Even though Warren Buffett tells his wife to simply hold plenty of cash and invest in the index after he dies I can't help thinking that he should adjust that thinking to now take a short position in the lopsided index (with its elevated risk profile) and leave the money in the value adjusted Berkshire Hathaway portfolio.

As it happens, the financial market appears to share my thinking (no pun intended – Ed)

For most of the past 10 years market volatility, as presented in the Volatility Index (VIX), moved around at well below the 20% level (10-15% was common). Yet today the VIX is holding station above 20%.

Volatility spiked to 50+% during early Covid19 lockdowns, a behaviour seen early in all crisis disruptions (the same thing happened during the GFC), and it has been settling lower since late March but is holding stubbornly above 20%.

Failure to fall back below 20% will likely reflect ongoing concerns about Covid19 and presumably the poor behaviour of global politicians, but I also think it must be reflecting some portion of reduced diversity in capital markets and the higher volatility that comes from that.

If you are a student of financial markets and wish to understand the VIX index better, go here for a read: https://www.investopedia.com/terms/v/vix.asp

In the meantime consider other ways to reduce your exposure to volatility if you are being presented with less reward each day.

As I said, your friendly financial adviser will help.

Bond Issues – What is driving the latest rush by borrowers to issue more bonds?

Over the past few weeks all the following entities have issued new bonds to borrow funds (Billions by the first two, hundreds of millions by the rest):

Government;

Local Government;

Transpower;

Housing NZ (Kainga Ora);

Wellington Airport;

Investore Property;

Goodman Property;

Mercury Energy;

Summerset;

Meridian Energy has announced a new green finance programme (everybody is doing this – Ed) so presumably MEL will issue more bonds shortly.

All of the above are large scale bond issuers but smaller businesses are also looking to issue bonds to raise money; witness Allied Farmers confirmed in their intention to issue bonds in their Annual Report.

Everybody's doing it.

The other thing that all borrowers have in common is borrowing money for relatively long terms (beyond 5 years).

The motivations will vary by borrower but the common use of long or very long terms indicates a mix of demanding more stability from their funding and quite likely the expression of an opinion that interest rates set below inflation should be rewarding for the borrowing entities.

Some have borrowed new funding for present spending requirements, the government is definitely in this boat, but others will be reducing their reliance on funding from the banks.

Funding provided by banks, for company borrowers, is usually for shorter terms (<5 years) and currently such bank loans are likely to cost more than the interest rate cost of bond issues.

Bond yields are sitting between 1.25% - 2.25% at present but a bank loan cost would typically still exceed 3% (perhaps even 4%) and it would come with more performance obligations so borrowing via bond issuance wins on all fronts at present.

All people tasked with borrowing money for companies (I'll call them Treasurers) endured a rude shock in March and early April when interest rates spiked up to much higher levels as investors feared a sharp increase in default risk (potential for business failure).

During the violent disruption of capital markets in March and April treasurers' will have been staring at their navels, in their home offices, trying hard to avert their eyes from the computer screen that demanded debt refinancing next month, next quarter and next year.

Many will have been pondering how to make the impossible possible.

Insolvency was the threat if refinancing failed.

Central bankers were the first to come to the rescue, promising to buy any and all government bonds put up for sale.

Professional investment managers were next, recognising that many rewards had become irrationally high for the risk involved.

Our retail clients were close on their tails; in the face of worsening economic conditions underlying interest rates were not going to rise and contemporary bond yields were thus attractive.

Within the space of four weeks all the irrationally high bond yields were gone.

In another month the businesses with less certain cash flows (airports, sports broadcasters, airlines) had raised new equity or arranged assured funding positions and thus the yields on these higher risk options declined also.

Those forecasting weaker economic conditions and lower interest rates were correct. The Official Cash Rate was cut to 0.25% (negative interest rates pending) and longer-term interest rates fell fast.

Bank term deposit interest rates are now close to 1.00% and will fall below this level.

So, in the face of all manner of other financial difficulties corporate borrowers now have the best borrowing conditions any have experienced, or could have imagined, during their entire careers. Treasurers are genuinely surprised, no matter what they tell you from the front of the room at presentations.

In a world flooded with central bank cash, willing to lend to anybody it seems, at negative real interest rates, why would a borrower rush to borrow?

To convert uncertainty into certainty.

To hopefully lock in a logical financial gain; to borrow at a cost below inflation and invest capital for gains that will exceed inflation.

If a business cannot access returns on capital that exceed inflation they should not be in business, and certainly shouldn't be using debt in that business.

Funding certainty happens (beyond equity) once you arrange funding (borrow) for a variety of terms (the same diversity you adopt as an investor) and especially for terms beyond those willingly provided by the banks.

If you can assuredly fund your business for the next 10 years you have developed financial stability with a longer focal point than most company directors can foresee for business strategy.

If the average residual term of residency at Summerset is say, four years, and the company can extend their funding profile to an average of five years then they are in an excellent position with respect to their asset and liability management, receiving equity increases (profits) at each change of ownership event.

The other businesses in my list above all have very long-life assets so they will be very pleased to have extended the life of their funding both for its financial value and to remove the potential for future Covid19 related disruptions.

We've travelled to and from fear in a matter of a few months and now the NZ government, councils, government agencies and strong companies are all very well funded at very low interest rates.

With so much funding now provided by central banks interest rates are not going to rise any time soon, so all of these entities will continue to have very good access to funding at very low interest rates.

EVER THE OPTIMIST

Primary producers continue to hit the home runs for our economy.

Delegat Group wine company again set a new record for export volume (3.27 million cases) and profit ($60 million, up 20% YOY).

Investment Opportunities

Mercury Energy (MCY) – completed its offer a new 7-year bond to the market.

The interest rate was set at 1.56%

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

Summerset – This week's 7-year bond offer comes to you from Summerset (SUM).

The minimum interest rate has been set at 2.30%

SUM will pay the brokerage charges.

We have a list for investors wishing to participate in the offer.

TRAVEL

Seminars

We are beginning to plan our deferred seminars. We hope to run a meeting in Tauranga, though our plans for Auckland must wait until Covid levels allow.

Our Timaru presentation is booked for Thursday 24 September at Sopheze on the Bay, beginning at 1.30pm. Please let us know if you wish to attend.

City Visits

Edward will be in Napier on the 28 and 29 of September. He has hired the boardroom of The Crown Hotel as his usual spot inside Mission Estate is undergoing renovations.

Please let us know now if you would like an appointment in your town.

 

Thank you.

Mike Warrington


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