Chris Lee & Partners Ltd

Taking Stock 25 July 2019

Asked to define government corruption most people would likely focus on the personal feather-nesting of politicians, or maybe senior public officials.

The accusation would be that once in power corrupt politicians dishonestly arrange a “corner” on a government deal, craftily hiding their illicit gain behind something like a “Panama” trust, Panama being a state that denies inspection of the “trusts” that grubby lawyers create for the corrupt.

Of course, feather nesting takes many other courses and corruption has many other definitions.

If a President was to “pardon” his closest supporters or mates, having them released from jail, or put them into highly paid government positions, those acts might ignite discussions about corruption.

A Governor General who exploited his privileges by making profits from trading in tax free cars allegedly imported for personal use might meet a threshold that implied corruption. Equally any such office holder who demanded cash payments to endorse grubby businesses would raise eyebrows.

Cronyism is a form of corruption. In Greece family members of politicians have regularly been awarded sinecures - paid positions requiring no work or even attendance at workplaces. Some European Union auditors still chuckle at the payroll of the main Athens Hospital which some years ago was paying generously 47 gardeners. The hospital had no gardens.

This sort of diversion of Crown money allegedly remains mundane in Italy and many Eastern European countries.

Heaven knows how many pages would be needed if this newsletter sought to describe the corruption in South Africa, whose Prime Minister has purloined billions, let alone other places, in the Middle East, Venezuela and indeed most of South America, Asia and, particularly Putin’s Russia.

Remarkably, the voters seem to be forgiving, even uninterested, providing their living standards are incrementally improving.

The modern focus of anti-corruption policemen is not politicians. The attention is on money laundering, the process by which funds from illegal activities are brought into the official banking system, enabling the money to be used without police intervention.

Funds from the proceeds of drug dealing, sales from unofficial arms dealing, money from burglaries and other illicit, untaxed activities might be hidden through the use of crypto currencies or laundered through the knowing or unknowing assistance of international, mainstream banks.

The desire to prevent that cleansing of soiled money has led to the tedious and cumbersome laws that require all of us to submit repeatedly to the process of revealing data that proves we are not money launderers; guilty until demonstrably not guilty.

In Europe the countries whose banks have done the most to facilitate money laundering are Britain and Germany, in that order.

This is hardly surprising given that London, at least until Brexit occurs, is the hub of Europe’s financial activity, legal and illegal, Germany being its likely replacement after Brexit.

British and German banks have been fined multi billions of Euros for their deliberate cheating in pursuit of massive “corners” for facilitating, for example, the cleansing of money for Russians, whose theft of state assets had to be converted to cash through the Western banking system. Deutsche Bank, for one, shifted tens of billions of such dirty money.

There is no evidence that British or German politicians have benefitted personally but their countries gained from transactions that were profitable, thus taxable, yet still highly illegal.

In this context it is risible that the big countries in Europe point an accusatory finger at the minnows, like Malta. The attention focused on Malta is a diversion, a bit like watching a village cricket game instead of the World Cup final, but it has been fascinating to gain an insight into why Malta is in the discussion.

Malta’s rapid ascent on the list of suspects gained momentum with the activities of its right-wing National Party which arrived after the long reign of Dom Mintoff, who had led Malta into becoming a republic, nearly fifty years ago, easing out of Britain’s control.

When Mintoff’s Labour Party finally was voted out of power, the National Party, so full of lawyers, accountants, bankers, landowners and others of wealth, took over.

Two transactions then took place or were proposed that were of interest.

The new government declared that the national electricity grid was a liability, not an asset, and sought to sell the grid for a single Euro.

The second transaction related to the building of a new national hospital, a project whose cost over-runs (nearly four times budget) contrasted curiously with the minimal costs of a simultaneous project, the building of massive headquarters for the National Party. To this day there is still a desire to test the origin of the concrete used at the new National Party headquarters, the suspicion being the concrete might have the same qualities as the remarkably expensive concrete used at the hospital.

Whatever, the fine hospital was built, the political headquarters were completed at minimal cost, and the taxpayers met the costs, or so it is still argued.

But the sale of the electricity grid became an election issue. National lost the election.

The grid had been powered by Libyan crude oil under a forty-year deal arranged between Mintoff and Libya’s Gaddaffi, in exchange for Malta’s agreement not to drill into an oilfield that Libya is draining, between Libya and Malta. 

National wanted to sell the grid for one Euro.

Labour gained power under the leadership of a handsome young man, barely forty, Joe Muscat, who wanted to shift Malta into the twenty first century.

His government did not sell the grid for a Euro. It sold 33% of the grid to the Chinese for 330 million Euros and arranged for the Chinese to rebuild the grid so it could be fuelled by LPG from the previously Russian state, Azerbaijan.

The Chinese were paid for their work not in Euros but with physical gold.

The Russians agreed to supply a huge ship, moored at a purpose built pier, to store the gas and feed it to the grid.

In amongst all these dealings, other arrangements allegedly involved “corners”, with at least two government ministers, and perhaps the wife of a minister, needing a new Panama Trust to accommodate their circumstances.

The ousted National Party, aided by a brave, strident female investigative journalist, alleged the Panama Trusts were linked to the Azerbaijan supply pricing contract.

Just last week, in an act apparently of retaliation the Labour Government announced a judicial enquiry into the sale of government assets by the National government many years ago, three former Ministers suspected of graft.

To date there has been no evidence offered to a court. The Panama trusts have not been broken, no politician has lost his job, nor has a link between the trusts and the Russians been established.

Meanwhile Malta’s cost of electricity has fallen significantly, it owns two thirds of a grid worth a billion Euros, and the environmentalists will disapprove less of the LPG than they disapproved of the crude oil. Malta does not have rivers or enough wind to turn turbines.

Muscat’s government seems embedded in power, winning by handsome margins, and has gone on to introduce risky innovations, using tax concessions to attract international businesses, including the global internet gambling providers, and it now sells its passports and its citizenship to wealthy moguls, a strategy not much different to New Zealand’s. The sale of passports is also an activity that invites suspicion in Malta.

Yet the revenue from passport sales has hit ten billion Euros, enabling Malta to reduce its sovereign debt level which had soared after the EU had required Malta to contribute tens of millions towards the Greece bail-out.

The new businesses have created skilled jobs, lifted wages dramatically, led to full employment and have created a high level of self-esteem in the young.

Only two decades ago Malta lost many of its brightest young people because it provided only low-paid, menial jobs, especially in the case of young women, who were steered into lace making industries or left to clean or wait on the tourists.

Since Malta’s transition the young people of European countries where jobs are scarce, wages low and the climate sub optimal, produced a flood of applications to move to the little Mediterranean island, the newcomers happy to take up the menial jobs, now referred to as “slave labour” by the critics.

Just last year 13,700 youngsters from OUTSIDE of Europe (places like Venezuela, Libya, Colombia, Nigeria and Brazil) applied to move to Malta in pursuit of a job, a lifestyle and an escape from tyranny.

Malta now has one foreigner for every seven Maltese citizens, a ratio exactly double the European average.

To many Maltese citizens the new wealth, the new availability of skilled jobs and career paths, and the retention of its bright young people have been a gift that results from the lively risk-taking, (but allegedly corrupt) Labour government.

The woman journalist who sought to uncover corruption died two years ago, murdered by an explosion of a bomb placed under her car seat, detonated by a cellphone signal.

Three unsavoury-sounding men have been charged. Until their case has been heard the Prime Minister Muscat will not succumb to pressure to hold an enquiry into the bombing.

The victim’s family believe the police knew of the intentions of the three men yet did not warn the journalist. From this belief has emerged the theory that the politicians were complicit in the plot.

The trial, following last week’s arraignment, will be watched with great interest by the European media. 

Meanwhile Muscat, now 45, believes his job is done, his ambition fulfilled, and seeks a high profile role in the EU, applying his energy and imagination to solve problems on a scale much grander than that of tiny Malta.

The Labour government seems assured of many more years in power, its National opposition publicly conceding that it has no show of winning the next election, or even the one after, given the popularity of Labour and the infighting in National.

The allegations of corruption remain on the table. The judiciary seems independent and adjudicates when a case arrives.

Malta’s daily newspaper, owned by National Party stalwarts, seems almost hysterical about another decade of Labour government, and clearly is unperturbed by any local defamation laws. In its columns last week, The Times of Malta stated the Prime Minister was “devious”, “dishonest” as well as “corrupt” and omitted to mention that otherwise he was a jolly good fellow. 

All of this is confusing.

Generally, in corrupt countries the people disrespect the courts, they fear the police and the army, and their mutterings and mumblings are muffled by closed doors.

This is not the case in this ex British colony where violent crime is negligible, where social services are generous and where clearly the media has great protection.

Yet a stroppy right-wing journalist’s life was ended by a car bomb.

A visit from Sherlock Holmes or Dr Watson might be justified.

This week a European audit of Malta’s anti money laundering behaviour produced a report of roughly E minus.

Malta has been given a year to sharpen its protocols or face substantial fines. Russian and Saudi Arabian money always comes with a risk.

 _ _ _ _ _ _ _ _ _ _ _ _

Three cheers, perhaps four, for the chief executive of Mainfreight for his thoughts on inequality.

Big business can address the problem, he observes, by allocating more of profits to the staff, rather than to shareholders. He proposes meaningful bonuses for the moderately paid staff who make a real effort to help the company succeed. A bonus of $10,000, 5,000 or even $2,000 makes a difference for those on wages or salaries that barely meet living costs.

Mainfreight in many ways is the leader that others should follow.

Its strategic plans have a 100 year horizon.

Its international expansion has overcome short term pain and helped the company become a genuine global operator.

Its executive ignore all the academic nonsense that stems from greedy MBA enthusiasts, such as the need for chief executives to move on every few years, and the need to over reward those who come and go, often before the damage they cause becomes visible.

One hopes the people in charge of Fletchers and Fonterra are paying attention; too late for the workers at Mainzeal.

 _ _ _ _ _ _ _ _ _ _ _ _

One hopes it is not also too late for the people at ANZ Bank.

I suspect the strategy of employing a former politician, John Key, to chair its NZ board was cynical, and based on his previous media image. There is no doubt that for many years Key enjoyed the warmest reception from an obsequious media scrum who welcomed his cheerful common touch, gazed enviously at his apparent wealth and resonated with his larrikinism. There is no doubt that he had a real skill with the media.

During the same period the ANZ was mostly lauded for its leadership under the late John Anderson, a true giant amongst bankers. Despite its unwise handling of the ING high yield cash funds that it so childishly over-sold (along with many financial planners) the ANZ was the media’s go -to bank, its economist Cameron Bagrie a man who spoke in words that the media understood.

Anderson has died, Bagrie has moved on, and those days of adoration have gone. Media affection is fickle.

Once an emperor is demonstrably recognised to be without any fine silk those who cooed about the silk will feel foolish and will run the fellow out of town.

The ANZ and Key will be aware of this danger.

My expectation is that the ANZ slate will soon need to  be cleared, perhaps leaving it to an unscarred, popular woman to take over as its public face, allowing Key to resume his life away from critical scrutiny and allowing the ANZ to find better ways to satisfy its customers and rebuild media respect.

The bank may begin this endeavour once its culture audit is completed. It will find that true transparency is not the same as token attempts to close down media scrutiny.

Key has no need for what his role at ANZ has delivered to him.

If his wisdom is in alignment with the wealth Merrill Lynch provided him, he might choose to retire, visit his children in Europe, try to break eighty on the great golf courses in Hawaii, and allow ANZ to tidy up its own messes. Surely that sounds more attractive than being beaten up each week, by reporters.

 _ _ _ _ _ _ _ _ _ _ _ _

The European media rarely mention New Zealand but the recent accomplishments of the NZ one day cricket team, the NZ netballers and the golfer Ryan Fox, in the British Open golf, have led to much comment about a nation that punches above its weight.

Also lifting the NZ profile were a New Zealand couple who finished second in a most competitive Scrabble competition on the tiny island of Malta.

A news director, Patrick Piercy and his wife Penelope Christoffel, lost narrowly in a competition, won, quite remarkably by their daughter Helen and her partner.

There are many ways of making a noise in Europe.

 _ _ _ _ _ _ _ _ _ _ _ _

Travel

Kevin will be in Queenstown on 23 August.

Chris Lee

Managing Director

Chris Lee & Partners Limited

 

 

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Taking Stock 18 July 2019

Any business, indeed, any country, that does not carefully consider “right sizing” risks failure caused by inappropriate, unsustainable growth. 

Ask the former CEO of Fletchers, Hugh Fletcher. If he has yet dismounted from his high, ivory horse he would today recognise the havoc created by Fletchers when under his leadership Fletchers sought diversity and scale without heed to its limited capital base; financial capital, human capital and intellectual capital.

Fletchers all but collapsed through misguided pursuit of growth, motivated by delusions of global grandeur. 

Perhaps Fonterra would admit to the same failings as might Brierley Investments, Equiticorp and most of the childishly run property companies of the 1980s.

Today New Zealand needs to apply its mind to what are appropriate levels of growth, not just in areas like dairy farming but perhaps most obviously in tourism, where exciting but uncontrolled growth may not be our greatest opportunity but may be our greatest threat.

Will our country eventually turn off the tap of “free” 15 per cent GST revenue from tourists, by failing to maintain the very standards that attracted those tourists? 

In the past I heard accolades from tourists that included the words, clean, green, friendliness, low crime, empty roads, cheap, clean motels, great food at affordable prices, low cost national parks and tolerance of foreigners. I am not sure I have heard those words so often in recent years. 

I have suggested before that our tourism industry leaders should fly out to Malta to seek its help in solving the problems of exponential growth in tourism. Malta certainly has to deal with the problem.

Its rising standards of living and its rising national wealth followed the implementation of growth and wealth creation strategies.

Its first strategy was to exploit its wonderful weather by providing tourist facilities for those who could afford to chase its sunshine, its heat and its seas, the latter relatively clean because of its low population.

The second was to sell its excellent educational system conducted in the international language of English, to the wealthy, ambitious Eastern Europeans who could afford to give their youngsters an education that would give them access to global careers.

The third was to sell its languid lifestyle and generous social services to the extremely rich, supplying the Maltese citizenship and passport in exchange for a million Euros and a commitment to buy a house in Malta or create employment in well paid jobs.

The fourth was to sell its highly educated and skilled work force, in areas like engineering, mechanics, medicine, dentistry and, more recently, in software.

The biggest emphasis was on tourism. Malta, a country which last month reached the population milestone of 500,000, now attracts three million tourists each year. As a ratio of tourists per head of population, this is six to one.

Imagine New Zealand catering not for four million tourists per year but for thirty million, six times our population.

Imagine our need for hotels, motels, rental cars, roads, road barriers, international language signs, restaurants, adventure operators, ferries, sewerage and water systems, airport runways and customs officers.

How does Malta cope?

The truth is that Malta copes but with increasing discomfort, growing numbers of its villages frustrated by the constant development (last year was a record year for construction), the road building, the dust, the traffic jams, the car parking problems etc. The locals do not celebrate the success of the strategy as much as they did, when there was such an obvious need to create wealth and jobs.

All of its strategies have succeeded, leaving many wondering why yet more growth is desirable.

The selling of education to Eastern Europeans remains controllable and attracts little criticism.

Indeed, two new international educators have just signed a deal to come to Malta and pay the Maltese government handsome royalties for the licence to educate another five hundred foreign students at a site long abandoned. They will build the facility with local companies providing the construction services.

The selling of skills has worked brilliantly. Malta services aircraft for major airlines, like Lufthansa, and is now a country highly regarded for its development of technology and software.

The risky strategy of attracting the world’s internet gambling providers has created highly paid jobs and lifted wages generally, enabling young people to develop lucrative careers, and in the process lifting the tax take.

And the sale of passports too has been astonishingly successful. Last year nearly 2000 people of significant wealth each paid a million Euros to gain citizenship and access to the social services and health system, the latter having short waiting lists. Two billion Euros for Malta would be like twenty billion for New Zealand. Handy!

The countries providing the biggest number of new immigrants were, in order, Russia, Saudi Arabia and China. One in seven people living in Malta today was not born in Malta. The average for Europe is one in fourteen.

Russia and Saudi Arabia. Hmmm.

The two billion of passport revenue enabled Malta to reduce its debt to GDP last year from 51 % to 45 %, one if the lowest ratios in the world, comparable with Australia and barely a third of the debt level of its neighbour Italy. Malta’s success seems the more spectacular because of the contrast with its neighbouring island, Sicily, just a twenty-minute flight away. The southernmost Italian island, Sicily has low living standards, effectively no social services and precious little support from the wealthier North of Italy.

Sicilians now eye Malta in much the same way out of luck New Zealanders used to line up Australia.

Sicilians are excellent restaurateurs. There are now many such restaurants in Malta, whereas just ten years ago they were rare.

Sicily is, of course, noted for the informal groups who “supervise” its society.

Russia, Saudi Arabia and Sicily.

Hmmm.

The result of all these successful strategies is that Maltese salaries have doubled in less than a decade. Pensions are generous. Education, right through to tertiary level, is free, providing exams are passed. Pensions begin at 65, though for policemen they can begin after 25 years service.

There is no unemployment. Indeed, Malta is forced to import people from Eastern Europe, Italy, Greece, Turkey, even Venezuela, to service the tourists.  Many speak no Maltese and very little English. Young Maltese people do not want the relatively low wages paid to waiters and hotel staff.

The talk of peak tourism is widely reported in the excellent daily paper, The Times of Malta, and dominates discussion in cafes and town squares. I called in on a club for the local brass band people, discovering its Sky Channels displayed events like Wimbledon. At the club my table talked of little else but tourism. 

New Zealand should be observing and listening.

Of course, the locals acknowledge the growth in incomes in a country so blessed by the weather Gods. Good incomes make the midday siesta more affordable!

Yet there is one more result of all this rapid change that now enters cafe dialogue. 

In a country which for centuries has enjoyed the leadership of the Roman Catholic Church, Malta has always maintained values that separated it from countries that worship the dollar (or Euro).

It has never been a contender for lists of corrupt countries.

The serious crime rates are a tiny fraction of its neighbour, Sicily, but the combination of internet gambling, new immigrants from countries where corruption is rife, and politicians singularly focussed on creating wealth may result in new challenges.

Malta’s Labour government is now attacked every day in the clearly independent, brave daily Times, to the extent that one wonders what defamation laws protect the public officers.

Having delivered jobs and higher wage packets, the Prime Minister Joe Muskat seems to have no energy left to answer simple media questions. As an example, he was pestered for months to explain the role in the public sector occupied by a man Muskat has used almost as a personal envoy, meeting with war lords in Libya and elsewhere.

Muskat would answer that he knew the man worked in the public service but had no idea which of the thousands of roles he occupied. How could a busy Prime Minister know where every Tom, Dick and Sebastiano worked!

Last week Muskat cracked. Ok, alright, yes, the man is in my personal advisory team. Ok? But not telling what he does.

Muskat has grown Malta’s economy at a scarcely believable pace; no unemployment, doubling of average wages, tourism numbers growing, construction everywhere, house prices and rentals rising.

Malta is the fastest growing economy in Europe averaging five per cent in recent years, whereas the likes of Germany and France average less than one per cent.

Malta’s population is also the fastest growing in Europe, though not from its birth rate, though that, too, is relatively healthy, despite the new desire of women to pursue careers ahead of motherhood.

As is the case in most highly educated countries women are having fewer babies, and at a later age than was the case ten years ago.

Yet the people seem unsure that all of these advances should continue at an unchecked pace. 

Is exponential growth an opportunity or a threat?

I expect you might get the same conversation in the cafes of Queenstown, Wanaka, Waiheke Island and Auckland’s North Shore.

Right sizing might soon become an election issue.

 _ _ _ _ _ _ _ _ _ _ _ _

As its departure from the European Union closes in the British might believe that Europe is twitching at the prospect.

What I detect is a fear of a much scarier event.

The collapse of Italy, inevitably leading to the breakup of the EU, is what the capital markets regard as the cause of sleeplessness. By comparison Britain’s problems are minor.

The eighth biggest economy in the world, third biggest in Europe, behind Germany and France, Italy’s disintegration is more like an 8.0 on the Richter Scale, compared to Britain’s mere 6.0.

Italy’s debt level is high, fifty per cent worse than Britain’s, but its inability to tax mafia revenue, and its failure to understand the need to live within its tax revenue, is what is leading the bond markets to sidestep Italy. Without the guarantee of the European Central Bank, Italy would be unable to raise money, just as was the case with the much smaller Greek economy eleven years ago.

Italian government debt is largely owned by the Italian banks, which effectively invest depositors’ short-term savings into long term Italy government bonds. We all know the danger of borrowing short term money and investing it in long term assets. The danger is reduced if the long-term assets are liquid but if there are no buyers for those assets the lack of liquidity becomes an overwhelming threat.

The banks might as well have lent call money on ten-year property developments, just as South Canterbury Finance, St Laurence, Strategic and others so stupidly did in New Zealand ten years ago.

Italy constantly breaks the rules that must be obeyed to retain the ECB’s support. Its annual budget deficits always exceed the limits.

The extreme limit to the annual fiscal deficit is supposed to be three per cent of GDP. To get there Italy needs to increase its VAT to 24.2 per cent. Currently it is 22 per cent, a fairly scary figure set so high because that form of tax is at least theoretically unavoidable, even for habitual tax cheats.

The Italian government committed to this new higher figure to ensure some of its rolled over debt continued to be guaranteed but now the government has the guarantee, the talk is that the VAT rate will not be increased.

If Italy loses the guarantee through this constant vacillation the guarantees of the likes of Germany, France, the Netherlands and, still at this stage, Britain, through the ECB, would be tested. 

As an aside it is still unknown how much Britain will have to pay to extract itself from its existing guarantees, but the amount may well be nearer a trillion than the tens of billions it thinks it must pay as the cost of exiting Europe.

The bond market observes Italian ten-year bonds, still guaranteed, selling at around two per cent. Without the guarantee that rate might be double figures, as was the case with Greece during the worst of its travails. If the Italian banks had to cash up its government bonds at any sort of discount, let alone a huge discount, there would be a wipe out of Italian bank deposits. 

Italy is the only country in Europe to have made no productivity gains in the last decade. Its unemployment is high. Its youth unemployment is diabolical. High percentages of adults return to their parents’ homes, unable to earn let alone afford independence.

Because it is a national sport to evade tax, Italy’s ability to cater for the unsuccessful is nil.

To save Greece ten years ago the ECB, the International Monetary Fund, and others had to find three hundred billion Euros. That really tested the system.

To save Italy would cost at least ten times that amount.

The capital markets in Europe dismiss that as impossible. The best case scenario is that the Italian people go through a decade of austerity even harsher than suffered by their Greek neighbours.

There would need to be an end to the corrupt practices, cronyism, tax evasion, Mafia black markets and general indifference to the views of creditors.

When Britain exits the EU these matters will dominate the front pages. Are the problems solvable?

Will Italy revert to its own currency, watch that new currency revert to Zimbabwean levels, and then observe the type of poverty that leads to civil wars and possibly territorial wars?

 _ _ _ _ _ _ _ _ _ _ _ _

Britain, meanwhile, faces changes it is ill prepared to address.

Its years of austerity, with public sector wages restricted to one per cent annual increases, has simply deferred the cost of maintaining its assets.

For example, it has not replaced thirty thousand police. It has 8100 miles of roads that require some six billion pounds to restore the surfaces to a safe level.

Britain has contributed much to the world, especially to places like Malta and New Zealand, but its state of dilapidation is alarming.

Huge job losses are announced every week, William Hill, Ford and Deutschebank the latest to foreshadow thousands of layoffs and this is before it confirms its exit from the EU.

One change its people seem to embrace is the forecast of temperature changes as the world’s climate adjusts.

The British are being told that their summers will be as hot as Barcelona’s, within fifty years.

Will John Cleese have Manuel working in shorts and jandals?

Given the grave issues Britain faces it is surely sobering to hear German analysts dismissing the relative problems in Britain as being minor, compared to what Italy faces.

 _ _ _ _ _ _ _ _ _ _ _ _

From abroad may I add three cheers for the Financial Markets Authority and the litigation funder, LPF.

As a result of FMA work, LPF is now funding a case against the ANZ Bank for its lack of banking diligence while providing bank accounts to the Ponzi scheme crook, David Ross.

The litigation will examine the responsibility of a bank to ensure its account holder behaves legally.

Is it credible that a bank would not have known that Ross was intermingling client money with his own, and using it to pay bills?

Is it credible the bank would not have been observing the new client money being used to pay out existing depositors?

If these matters were adjudicated in court, highly valuable law would be created.

One might want to place a small bet that before the court ever gets its chance to adjudicate, the matter might be resolved without any admission of legal liability.

Pardon me for my cynicism.

TRAVEL

Kevin will be in Christchurch on 24 July and in Queenstown on 23 August.

Chris Lee

Managing Director

Chris Lee & Partners Limited

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Taking Stock 11 July 2019

Chris Lee writes:

The ANZ Bank has responded to the Reserve Bank’s desire to double bank capital, unsurprisingly taking a position of opposition.

Its New Zealand Chairman John Key, and its Australian CEO Shayne Elliott, clearly believe the Reserve Bank’s aspiration figure (of 16% capital to underpin assets) is uncommercial.

Perhaps unwisely, Key has asserted that the Reserve Bank does not display the cost/benefits of the higher capital required, and alleges that New Zealand’s GDP will fall dramatically.

I am unsure that Key’s stage of maturity as a bank chairman, makes him an ideal participant in a battle with the bank supervisor.

Elliott is talking from an Australian viewpoint.

Perhaps the compromise that Key and Elliott might consider is a secured pledge to insert capital upon request, up to the level that Reserve Bank identifies as desirable.

Such a request would be prompted by more difficult times than currently apply here, the ANZ as an example, producing $2 billion (roughly) of nett profit, with only modest levels of bad debt.

Its credit card lending rates handsomely reward, perhaps over-reward, the unsecured personal lending while its housing loans have lean margins but extraordinarily low levels of bad debt.

Like all banks, ANZ will be watching the unemployment levels. Those who borrow to buy houses cannot repay if they lose their jobs. Unemployment is the harbinger of housing defaults, and falling housing prices.

Key also chatters about dairy lending, as though the banks could recall dairy loans by e-mail or phone call.

The reality is that in tough times, any bank that seeks fast solutions to dairy loans will find itself pilloried by all sectors.

My expectation is that the Reserve Bank will be doing most of the talking. The 16% level may be negotiated down to 14%, or even 12%.

The ANZ in New Zealand may decide it needs a new chairman, as well as a new CEO, if its communication with the Reserve Bank proves fractious or unhelpful.

I have always regretted that the career path of the best commercial bankers never includes a stint in the Reserve Bank, enabling a better sharing of perspectives

.

The divide we have been the public and private sectors remains a chasm.

Meanwhile, one imagines Rabobank is preparing to be a winner, if the ANZ cannot improve its communication with the Reserve Bank.

Might the French bank, Credit Agricole, also be casting an eye towards New Zealand, again?

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Johnny Lee writes:

Are we approaching a tipping point?

Following this month’s Quarterly Survey of Business Opinion, the current consensus view from the market is for interest rates to bottom out at 1% this year, barring any uplift in market conditions. Subsequent releases, around the employment market and commodity prices, reinforce this opinion.

Already this year, we have seen investors flocking to shares as returns from term deposits, and the local bond market, continue to fall.

The tipping point I refer to is the falling participation of retail investors in the NZX-listed bond market, largely driven by declines in the interest rates on offer, as well as falls in supply of issuance and an increasing lack of discernment from larger investors. Bonds issues that may have failed to gain traction five years ago, are closing oversubscribed, with scaling imposed on those wanting to invest.

The message we are hearing from a growing number of investors is clear – headline interest rates are too low. Coupled with market expectations that rates are likely to fall further later in the year, the shift from fixed interest markets towards equities will likely accelerate.

One outcome of this will be a greater spotlight on annual management fees – investors in bonds earning 3% would (and should) feel large annual percentage fees on long-term bonds are unjustifiable. Skill and research, leading to real added value, should be rewarded. Transactional-style relationships should not incur ongoing fees.

Three other likelihoods seem obvious to me, all of which point to lower interest rates.

Firstly, if the Government decided to implement its proposed deposit guarantee scheme, interest rates offered on term deposits must fall further, as the ‘risk’ component of the risk versus reward equation falls to zero. Banks will be somewhat constrained by their own needs, but the premium offered by New Zealand banks over their overseas counterparts will diminish. As New Zealanders tend to invest in short-term bank deposits, this impact will flow through reasonably quickly, and affects a range of parties – less money earned, means less money spent (and taxed).

The current system promotes investor diligence and value in financial advice, discourages moral hazard and ensures efficiency from both investors and borrowers. One does not require a long-term memory to recall an instance where a deposit guarantee scheme produced a poor result, by incentivising the wrong behaviour.

Secondly, if the Reserve Bank’s concurrent proposal to increase capital requirements on banks was to proceed, one logical outcome would be a widening of deposit rates and mortgage lending rates. Increasing the cost of doing business does not increase the willingness of shareholders to accept lower returns.

Lastly, the Kiwisaver juggernaut will continue to grow, increasing in size by over $5 billion a year, of which close to a billion will head to New Zealand and Australian equity markets, with another billion heading to New Zealand fixed interest products.

This last point is worth exploring. Of the approximately $50 billion invested in Kiwisaver, almost ten billion is sitting in cash, earning close to (or below) zero after fees. Another almost fifteen billion is invested in New Zealand and overseas fixed interest markets – most of it abroad. These fixed interest funds have increased in value, as underlying rates have fallen, but this source of momentum, presumably, has a finite lifespan.

The fact that half of funds in Kiwisaver, ostensibly a Government-subsidised retirement vehicle, is invested in cash and fixed interest, illustrates a deficit of advice in my opinion. A third of Kiwisaver investors are under thirty years of age. There would be few reasons for anyone, let alone someone in this age bracket, to decide to invest in (or be allocated by default) to Conservative schemes where 25% of the funds managed is held as cash.

The good news is that, slowly, Kiwisaver investors are gradually moving away from the Conservative funds, which is seeing the largest number of outward transfers as investors increasingly move towards Growth funds.

This gradual shift of invested capital from fixed interest markets to equity markets has seen some portfolios grow immensely this year, with the gross index up over twenty percent. Shareholders of income producing stocks, including the energy sector and the listed property trusts, have seen the majority of the gains.

This returns me to my tipping point – investors chasing income are finding themselves in a crowded field, as various market forces combine to drive interest rates lower. Investors should be diligently watching these factors play out, as they will be important drivers to the level of returns offered in future.

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David Colman writes:

At a Reserve Bank of New Zealand (RBNZ) monetary statement a number of years ago I recall a question, from the floor to the speaker at the time, was asked 'why do we want inflation?'

The answer would have been along the lines of 'a certain level of inflation drives growth by encouraging spending today to avoid paying more in future'.

Essentially the answer solidified my view that the RBNZ has the same motivation of most central banks, which is to foster slow and sustained increases in prices to keep businesses in profit.

The theory, simply, is that a country full of profitable businesses can employ the population who then spend their wages on the products and services, provided by the businesses in a virtuous cycle of ever increasing prices and growth. Right now the cycle is not-so virtuous, as despite many profitable businesses, we are not seeing inflation at levels the Reserve Bank desire.

Annual inflation is calculated by changes in value of the Consumer Price Index (CPI) which is an index comprised of various costs attributed to a variety of expenses including larger weightings to housing, food and transport.

The Reserve Bank, in its ongoing balancing act with inflation, uses the Overnight Cash Rate (OCR) as its primary tool to keep inflation at a level greater than one percent and below three percent. In simple terms, if inflation is shown to be slipping below one percent then the OCR must surely be cut, if inflation is seen as rising above three percent then the OCR must surely be raised.

At the time of the question above, I noted the RBNZ insistence that using a variety of tools was required to maintain financial stability, but have seen mainly the OCR used to achieve this goal. Altering the loan to value ratio for mortgages and requiring banks to hold acceptable levels of capital being other tools used.

The CPI has only been above two percent once since 2011 (in March 2017, the CPI was measured to have an annual increase of 2.2%).

Under Graeme Wheeler (RBNZ Governor from September 2012 to September 2017) the OCR was both increased and reduced numerous times in an effort to push inflation towards two percent, with limited success.

The OCR was then left at 1.75 percent from November 2016 to May 2019. Acting governor Grant Spencer did not touch the OCR for his 6 month term and current Governor Adrian Orr recently presided over the drop in the OCR to its current low of 1.5%.

For many years there has been deterioration in fixed interest returns, and due to asset price increases, lower yields. Bonds and shares continue to gain value, with property still rising across much of New Zealand, while interest rates (heavily influenced by the OCR) look to fall further.

Coming back to the ‘why do we want inflation?’ question, we could hypothesize that by extension, encouraging spending encourages borrowing to fund the spending.

The housing market in particular is the recipient of funding and we have seen the consequences of a lower CPI out of step with major gains in asset prices, and increased levels of debt.

Borrowers continue to further benefit from lower rates at the cost of savers.

New Zealand is deemed to be about as fully employed as it can be, with historically low 4.3 percent unemployment, yet we are not seeing wage increases or spending behaviour that can push the CPI in the direction the RBNZ is mandated to pursue.

If we are ever to see higher fixed interest rates of return than today, we will need to see inflation return, or at least inflation from the variety of goods and services constituting the CPI, rise meaningfully towards the two percent midpoint.

March CPI was 1.5% and the June figures are widely expected to be similar or lower still.

Today the RBNZ awaits the back-lit shadow of inflation to rise. At which point they can stop clenching the looser monetary policy controls.

The committee next meet on August 7th, with finger poised purposefully on the lower OCR trigger. The bright red switch to raise the OCR remains beneath a dusty Perspex cover for now.

TRAVEL

Kevin & Johnny will be in Christchurch on 24 July

Kevin will be in Queenstown on 23 August.

Chris Lee

Johnny Lee

David Colman

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Taking Stock 4 July 2019

David Colman writes:

Are we experiencing a slow countdown before the detonation and demolition of real rates of return from fixed interest investments? Many may feel they are in the 3…2…1… part of the countdown before interest rates are effectively zero.

The interest rate doomsday clock atmosphere has been pushing New Zealand income investors towards higher-risk assets such as shares in companies that benefit from lower borrowing costs.

In turn this has elevated the sharemarket to new highs, and new issues of shares have only trickled through to listing on the NZX, with companies looking at alternative ways to raise funds such as using crowd-funding platforms.

Crowd-funding from the perspective of the company seeking cash is an attractive and low-cost way to sell its dream.

A company with or without a business case can be set up in New Zealand cheaply. It can choose to raise money from the public via a crowdfunding platform with little more than a vague business plan, no tangible assets, and the promise that equity in the company will gain in value.

A bank would not provide finance to a company so easily and neither should an individual.

I urge desperate growth investors tempted to look for investment opportunities through crowd-funding offers to be very cautious.

Contributing money to a crowd-funding offer involves enormous risk. It is not suitable unless the contributor has a high tolerance for risk and can afford to hold shares that may be very difficult to sell at any time in the future. The offers may be relevant to people with knowledge of the company and the sector it operates in, with uninformed contributors taking a huge leap of faith.

Snowball Effect, which is a New Zealand crowdfunding platform, appears to be restricting offers more often to wholesale investors which, in my view, is a sensible move.

Wholesale investors are required to provide evidence that they have a high net worth and are knowledgeable, experienced investors who can accept losses and understand the high-risk nature of the offers available on the Snowball Effect website.

Snowball Effect still includes Andrea Moore as a successful offer on its website.  However, the $750,000 given to Andrea Moore soon evaporated and the company was liquidated, with no recourse available to the duped contributors. That is not a successful offer in my view.

Investors contributing to these offers must be aware they have negligible rights to compensation, regardless of the actions of the company before or after it has taken investors’ money.

Crowd-funding tends to heavily benefit small company founders versus new shareholders.

Some NZX IPOs can also have similar risks but at least offer investors a degree of transparency, liquidity and are regulated.

An NZX-listed company is bound by continuous disclosure rules, has a secondary market for the shares to be bought and sold and must meet reporting standards.

Regardless of the regulatory environment, new issues should also be evaluated with caution, with special attention required where scant details are provided (see Johnny’s description of Cannasouth below).

An atmosphere of desperation should not entice a well-prepared investor to deviate from their investment policy to take desperate measures.

Please contact us if you would like to discuss your investment policy.

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Johnny Lee writes:

It would be safe to assume that very few clients who read this newsletter would have chosen to support the listing of medicinal marijuana company Cannasouth, which listed on the exchange to what could generously be described as disappointment.

Following its listing at 50 cents, the stock soon traded down to 36 cents, before finishing the day around 40 cents. It is now trading below this point.

It is our first new equity listing for some time, and was not of a size that should have struggled to fill in an environment where cash is plentiful and returns expected are modest.

Investors questioning the mind-set of people selling shares, day one, at levels below the IPO price would do well to recall that the company had earlier raised capital at prices that represent a substantial discount to the listing price.

These early buyers have done well. The buyers of the IPO, who chose to accept the company’s offer at 50 cents, have not. Its case was not aided by the release of a report by Share Clarity, and circulated among the media, with a fairly honest appraisal of the company shortly before its listing date.

Perhaps the biggest losers from this listing have been the queue of companies in the same space, many of whom were anticipating capital markets to be helpful in their ambitions for growth. They now face the challenge of clearly defining and justifying their valuations, as investors have been shown that if existing shareholders are not subject to an escrow arrangement, they will have no compunction in regards to capturing any potential personal gains.

It also highlights the value of a strong lead manager, who can put skin in the game and ensure an investor’s objectives align with their own.

Many companies within this sector have chosen to use crowd-funding to raise capital, a path I view as too lightly regulated, and best suited to enthusiasts of the specific product being marketed, and those with very intimate knowledge of the companies raising the capital. The local brewing sector has also chosen this path for growth.

Ultimately, Cannasouth’s story is not yet concluded, and the company now has enough working capital to start executing the strategy outlined in its investment statement. Investors were sold a long-term vision, and they will be expecting management to achieve that.

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While the New Zealand Stock Exchange will be pleased to welcome a new company onto its exchange, and a new sector for investors to consider, the bigger news will be the launch of the Port of Napier float, expected to conclude over the next two months.

Further details on the Port of Napier float have emerged.

The offer is expected to open around 15 July and be tradable on the stock exchange by 20 August. The offer is likely to include very generous terms for full-time staff, including a priority allocation of $5,000 worth of stock and interest-free loans. Hawke’s Bay ratepayers will also be given a guaranteed allocation of $2,000 worth of stock, while Iwi will be given preferential access.

By giving staff a stake in the company, Port of Napier hopes to engender a greater sense of responsibility among staff for improving the productivity of the port.

Simple arithmetic suggests that, should residents mostly decide to participate in this offer, the remaining allocation will not be large. Readers interested in investing will likely already be pragmatic about the availability of the offer, and the implication this carries in regards to pricing.

Should the process conclude with the Hawke’s Bay Regional Council receiving a cheque of around $200 million, while maintaining control of a strategic asset, divesting itself of both risk and debt, and perhaps bolstering the wallets of local ratepayers, the outcome would represent a win-win for the Hawke’s Bay region. Other councils may be casting a glance to their own balance sheets.

For the NZX, this is nothing but good news, exemplifying the role of a stock exchange as a means of connecting those seeking capital, and those wishing to invest. The politics of the move will be of no relevance to the exchange.

The other positive news for the exchange is the welcoming of a new NZX participant, Sharesies, as a participant on the exchange.

Sharesies has spent the past six months strengthening its team, hiring capital market veterans and building a modern platform to allow it to compete in the broking world.

Sharesies, which made headlines last year for selling a small stake (16%) to TradeMe, aims to target a sector that the main NZX brokers have so far neglected, being those who require no advice and wish to invest incrementally as they accrue wealth.

Endeavours to make capital markets more accessible should always be commended and applauded, especially when orchestrated by people of high moral standards.

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The fickleness of cryptocurrencies has been in full view over the past fortnight, as Bitcoin has seen enormous swings in value following the release of Facebook’s intentions to offer a competing product, Libra.

While some saw the announcement by the world’s fifth largest publicly-listed company as an endorsement of cryptocurrencies, others saw it as a competitor in a space Bitcoin has largely dominated. The market responded by leaping 20%, before falling 20% a day later.

Facebook would not be the first group to target disruption to our monetary system, but it certainly represents the largest one to attempt it. Nor would the world’s fourth most popular website be the first to eye the billions charged on foreign exchange by global banks as a market welcoming of disruption.

Facebook has several advantages – the global trading platform and marketing tool already exists. In theory, Facebook probably has the best AML system in the world and knows more about its users than any bank could dream. Businesses already operate using its infrastructure.

Libra, like PayPal, will not pay interest, while investing the reserve held, into interest-bearing products. Initially, this amount is expected to be small and to cover upkeep of the system.

Libra is expected to ‘go live’ next year.

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We are following the recent news regarding Nufarm, and have posted a research piece on our client-only page with our thoughts.

We have also published an article on the client-only page of our website covering Exchange Traded Funds, and their usage in New Zealand.

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TRAVEL

Edward will be in Remuera on 9 July and in Albany on 10 July and has two appointments left.

Kevin will be in Christchurch on 24 July and in Queenstown on 23 August.

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