Taking Stock 15 August, 2019

Johnny Lee writes:

The Reserve Bank’s decision last week to cut the Official Cash Rate by 0.5% has raised eyebrows, especially following the muted response to fixed mortgage rates by our major retail banks.

Seventeen economists were polled for their expectations of the Reserve Bank prior to the announcement. Sixteen predicted a 0.25% cut. One guessed it would stay the same. Zero expected a double cut. For many years it has been a strategic preference of the central bank not to surprise the market. Orderly markets are good for financial stability.

The announcement was followed by a rather impassioned plea from Governor Adrian Orr, who expressed his hope that New Zealanders would ‘wake up and go and spend’. He would rather deal with reining in inflation than trying to stoke it.

Orr, who is quickly proving himself to be a straightforward and honest communicator, has made it clear that he wants the banks to pass on the cuts, to aid in his efforts to stimulate the economy and prevent the committee from failing to meet its medium-term inflation targets. He recognised the role of financial advisers, warning people that they need to put their money to work, investing productively, as opposed to over-investing in low-yielding products.

One need only glance at the nation’s Kiwisaver asset allocations to see his point. New Zealanders tend to invest with a defensive mindset, with large allocations in cash (returning close to nil) and fixed interest (where returns are falling), some of which is invested abroad, for returns lower than local rates, and carrying foreign exchange risk.

Orr has also made it plain that monetary policy ‘needs friends’. The Government 10-year bond rate, at 1.75% only two months ago, now hovers a fraction above 1%. The cost of borrowing will not be a factor in the Government’s thinking. Perhaps next year’s election will spur a more aggressive approach.

The retail banks’ decision to largely leave fixed term deposit and mortgage rates alone, indicates that the OCR may be nearing the end of its useful life. The Reserve Bank intends to publish research disputing this, believing instead that OCR cuts maintain usefulness even as the rate approaches zero.

Zero should not be considered a limit, as Orr has publicly stated that sub-zero rates are within his scope and under serious consideration.

Negative interest rates hit the headlines again this week, with Danish bank Jyske Bank introducing a negative interest rate mortgage product, effectively paying people to borrow money from the bank on a ten-year term. How this works in practice is that the bank reduces the principal owing by a greater amount than paid by the customer.

On the other side of the coin, Swiss bank UBS was reported to be charging savers for deposits, charging up to 0.6% for deposits above a certain size. Readers would have spent most of their lives with these dynamics reversed, with savers rewarded for depositing funds, and borrowers charged for the privilege of borrowing money.

Negative interest rates may seem paradoxical but are ultimately designed to change consumer behaviour. Savers will face a stronger incentive to spend, and borrowers will be more willing to take on debt to buy assets.

Savers may view the security of a low-risk, negative return as preferable to the alternatives. Lenders may see value in capturing the business of a borrower, as well as stimulating an asset class to which they are overexposed. The alternative to lending at a negative rate may be an even lower rate of return.

In New Zealand, we still enjoy some room to manoeuvre before reaching these levels. Mortgages and bank deposits, for now, are mostly (just) north of 3%. However, signs are continuing to emerge that interest rates could continue to be driven lower.

ASB Bank recently completed a $600 million capital raising of five-year money at only 1.83%. Westpac’s $900 million haul last month at only 2.22% shows that markets are moving, and not to the benefit of savers.

New Zealand Refining raised $75 million in December last year at 5.10%. Today, people buy those same bonds at 3.30%. Most senior bonds trading on the market are now yielding well below 3%. Some are below 2%.

Globally, we are seeing changes designed to affect behaviour, largely to stoke inflation both generally and in the housing market.

Investors who have maintained long-term, liquid portfolios will be largely inoculated against these impacts, but should remain vigilant as bonds approach maturity to ensure their investments are still fit for purpose.

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The Napier Port offer has closed, and will list on the stock exchange next Tuesday (20August). Demand for stock will likely be strong.

As expected, allocations were extremely modest, with levels of scaling that were described as ‘extreme’. Residents of Hawke’s Bay have largely reported that allotments were filled, with scaling only being applied to larger investors.

Coupled with a higher-than-normal minimum for the broker offer (2,500 shares, or $6,500 worth) most investors outside Hawke’s Bay will be disappointed with the crumbs left behind, perhaps contemplating the secondary market to acquire a reasonable holding.  Investors would be wise to closely monitor the listing price on Tuesday, as the market will likely be excited and, possibly, irrational, in respect to an asset that is largely an unexciting and rational one.

Barring any chaos in financial markets, it will likely enjoy a reasonable bump upon listing, perhaps more a reflection of supply and demand, rather than any particular increase in the value of the assets themselves.

Scaling of this magnitude inevitably leads to questions around the pricing of the issue.

Considering the duration of the listing process, the pricing of the shares should delight Hawke’s Bay Regional Council.  Similarly, the lead managers will be pleased to see this outcome, with the result being a bumper return for their client (the Regional Council) and still maintaining enough public interest to induce strong demand.  Staff will own an asset likely to be worth well in excess of what they paid.  Ratepayers will be able to choose whether they want to continue ownership of the port, or to de-risk by selling.

The process was a political one, favouring locals and staff, a courtesy deemed necessary for the listing to achieve public approval.

The listing will be the conclusion to a process years in the making, and the NZX’s first major listing in years. One hopes that its success will help illustrate the key role capital markets can play in bringing together businesses in need of capital, and investors willing to invest.

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One sector that has seen phenomenal performance this calendar year has been the Listed Property Trusts (LPTs).

LPTs are often used as the first step fixed-interest investors take when migrating away from fixed-interest portfolios towards direct ownership through the purchase of shares.  LPTs tend to pay stable dividends, reflecting the predictable nature of their revenues, being long-term leases.  LPTs often carry the advantage of being a Portfolio Investment Entity, reducing the tax due on distributions for some investors.

Another characteristic of property trusts is that they often perform best when interest rates are falling, similar to bonds.  LPTs deliver leverage to this through lower cost of debt and a higher relative reward.

The LPT sector is comprised of four major players, being Goodman Property Trust (GMT), Precinct Properties (PCT), Kiwi Property Group (KPG), and Argosy Property (ARG).  All pay quarterly dividends, except KPG, which pays semi-annually.

All four have seen record share price performance this year, benefitting from both the long-term nature of their leases and falling interest rates.  The best performer, GMT, has seen terrific returns for investors this year.

All four companies invest in different sectors and markets, giving investors a range of different investments to choose from.

Goodman’s focus remains on Auckland industrial sites, both developing new land and leasing existing space.  Goodman previously had exposure to the Christchurch market, but has since divested itself of this.  Goodman has very low debt levels, modest dividends and a development pipeline expected to drive improving returns over time.

Precinct is mostly invested in Auckland office space (about 70%) with the remainder of its assets in Wellington.  Most of its leases are for very long terms, with a weighted average lease term of more than eight years.  This gives it certainty of revenue, which in turn can give greater certainty to unit holder distributions.  Precinct also has an investment in the co-working (‘shared office’) sector, a growing movement among mostly young entrepreneurs, where permanent office space is unnecessary.  Like Goodman, PCT has very low debt levels, but does expect to take on more low-cost debt as it expands its development portfolio.

Kiwi Property Group specialises in the retail sector, with a third of its $3 billion property portfolio value tied to the Sylvia Park development in Auckland.  Leases tend to be shorter, reflecting perhaps the volatility of the retail sector. However, KPG continues to enjoy very high occupancy rates as it consolidates its portfolio towards the higher returning assets and builds towards a ‘mixed use’ model, where commercial, retail and entertainment facilities exist in the same space.

Lastly, Argosy maintains a diverse portfolio of retail, commercial and industrial properties, with most of its assets focussed in Auckland and Wellington.  Argosy has also been gradually reducing the size of its large portfolio, as it focuses on higher value tenancies.  With 60 properties currently in its portfolio, Argosy’s diversity gives investors a broad spectrum of assets under ownership, both in terms of geographic spread and the sector the property is exposed to.

Outside of these four, Property for Industry (PFI), Vital Healthcare (VHP), Stride Property (SPG) and Investore Property (IPL) make up the balance of the listed property sector.

Listed Property Trusts form a key part of income portfolios, combining regular, predictable dividends with high liquidity, while investing in physical assets with an easily understood business model.  Property will always feature in an investor’s portfolio allocation, and the LPTs are an easy option to review and consider.

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Travel

Kevin will be in Christchurch on 5 September.

Edward will be in Auckland on 4 September, in Wellington on 12 September, in Napier on 16 September and in Blenheim on 18 September.

Anyone who wishes to make an appointment is welcome to contact us.