Mark Draper

Mark Draper

Wednesday, 17 July 2019 08:34

What lower rates mean for investors

Hamish Douglass - Magellan

Tuesday, 16 July 2019 19:04

30 mins with Platinum Asset Management

With permission from our friends at Intelligent Investor, we are pleased to bring you a 30 minute interview with one of Platinum Asset Managements' senior investment management, Clay Smolinski.  Below is both the transcript of the interview and the audio podcast.

This week's fund manager interview is with Clay Smolinski, Portfolio Manager at Platinum Asset Management. Nathan Bell speaks to Clay about the big gap between growth and value stocks and which sectors Platinum has been focussing on of late.

Magellan has been the funds management company that everyone's been talking about for the past few years and people have gone a little bit cold on Platinum Asset Management, who are widely regarded as probably the best international investors in Australia. 

Today, I've got Clay Smolinski on the phone. He's a Portfolio Manager and has been at the company for a very long time. 

I thought we'd look at a few broader issues such as the big gap between growth and value stocks, which is now the biggest gap since the tech boom in 1999, and also take a look at the number of opportunities that Platinum's recently been buying. 

First of all, Clay, thanks very much for giving us your time. I heard Kerr Neilson once say part of the reason he hired you was because you were very mature at what I'm guessing, was a young age. Why was that and what were you doing before joining Platinum?

It's kind of him to say. Look, in terms of what I was doing before I joined Platinum, it was nothing particularly special. I grew up in Perth and I got interested in investing at a fairly young age, but what was apparent in Perth was there probably weren't too many roles in that vocation. Certainly, most of my friends were engineers or going off to get jobs on the mines.

Prior to joining Platinum, I was just in Perth, really just looking for roles that could somewhat get a foot in the door, so I started off as an accountant working in audit. I then moved on to work for the Home Building Society, which was a small little Perth based bank, before I got very lucky that Kerr and Platinum gave me a chance.

Look, I think one of the factors was I was just extremely lucky when I joined Platinum, both that Kerr gave me a lot of his time, and I got to benefit from spending a lot of time with him and getting his tutelage, but also I think my first years at Platinum, I spent a lot of time with the founders, so Toby Harrop, who's one of the founders of the business as well, who was running the European fund. I really worked underneath Toby for the first three years and that just taught me a lot, and so kind of saying the people you spend a lot of time with, some of their attributes maybe just rub off on you a little bit.

But certainly one thing I remember just from the early days of Kerr just coming back and doing analysis, Kerr always had this saying of he'd like you to look around corners when you're making an investment, which is really just another way of saying you don't take information at face value and you try and test your assumptions and look, I always had a pretty healthy insecurity about whether I actually had the facts straight and whether the market was wrong on any particular stock. I think Kerr probably saw that as a positive.

I think most young people that come into a value investing house are very worried about making mistakes, which tends to slow down their turnaround on stocks, which quickens up a lot once they get more experienced.

Yeah. Look, that would describe my early years to a T.

I was going to say, I certainly remember my research director telling me the same thing. A couple of years ago, Andrew Clifford started writing a macroeconomic piece at the introduce of Platinum's quarterlies. Why was that?

Yeah, no that's quite an astute observation. The answer's probably simpler than you think. Look, Platinum, one of our key duty as any fund manager, is to really communicate to your clients at all times exactly how you're managing their money and what you're doing. We always put a lot of time into writing our quarterly letters. Every fund manager wrote their own one and every fund manager had to write one.

But what we were finding that over the years, as each PM would sit down to write their letter, you would have three or four of them wanting to make some reference to the macro environment in that letter, and hence we were repeating ourselves across all of the letters. We just figured, "Look, for the benefit of investors' time and probably to make things clearer, it would just make more sense for us to do. All right, we'll do one. If we want to discuss the macro, we'll do one macro summary up the front" and that's probably better for everyone. That was the genesis of that move.

Do you think you're actually thinking more about the macro environment, just because of the changes in the Frankenstein monetary policies, if you like, that have changed the world?

I don't know if we're thinking more or less about it. I think our approach to macro at Platinum is, you've always just got to understand where you are and what's happening in the world, and I call it the Howard Marks approach. You're going to look at all of the economic data, and you look at investment sentiment, just to give you that picture of, "All right, where am I in the cycle today and what does the data and the sentiment maybe imply where we're going to in the future?"

You pay attention to macro in that way. Then really, the second aspect is we say whenever you're buying a stock, you really need to understand the perspective and the reasons of the people who are selling that stock to you, or other investors. Why are they not buying this business? What are they worried about? In today's world, often that worry is economic or macro in nature, so you really need to have a good understanding of, "All right, what's happening in the data? How are they responding to the data? What forecasts are they reacting to?"

That's how you're always bringing macro into the process. I think the difficulty with macro is it's just, it's noisy data. The world is a very, very complex system and it's difficult to predict the macro, so I think while you want to understand the macro situation and where we are, you want to be very careful that it doesn't then start driving your whole investment process, and you want to make sure it's not preventing you from buying into value and stocks when you see it.

On the flip side, have you found at all that just the markets or particularly, in regard to a specific stock, where macro concerns have actually created opportunities in the business?

Oh look, many, many times over the years. We've got concerns today, so you think about look, we've got roughly 10 per cent of our fund in the semiconductor stocks. Certainly, something that's hitting those businesses are the worries around the trade war. Semiconductors has traditionally been an economically sensitive business, and for sure, part of the reason of why those businesses are trading at book value or on single-digit P/Es are concerns around the next macro move and what happens with the trade war and what happens in China.

We can see why the short-term macro fears are keeping people away from these businesses. We say, all right, well we understand that. We can't really bring a lot of edge to that, but what we can do is say, all right, well, what do these businesses actually look like on the longer-term front? And then you're sitting back and saying, all right, well I don't know what's happening with macro, but in the longer-term, I'm pretty sure consumers will buy 5G phones, companies are going to keep moving their software to the cloud, and companies are still going to invest in artificial intelligence.

Essentially, if those three things continue to happen, it's highly likely these semiconductor businesses will be bigger in the future. That's how we pair it.

Would you put the Italian banks in that bucket as well?

Yeah. Look, the Italian banks are interesting. You can go back to macro, and I think this is a good example of why macro's so hard. Look, I managed the European fund for many years and over that period we had, during the sovereign crisis, you had people believing it was a sure thing that the Eurozone was going to break up. We had interest rates on Greek debt in the high teens. Italy had an 8 per cent interest rate.

We then, fast forward today, the yield on Greek debt is what? 2.8 per cent. The yield on Italian debt is below 2 per cent. How much do things change, right? These were unthinkable situations back in the sovereign crisis. Also, you go back 18 months ago and people were, we had rising rates in the US and people were dead certain that rates were going to be rising in Europe and in other places.

And now we've completely reversed the picture, so no one believes that we'll get rate rises ever again, and we're talking about Europe being in a Japan-style scenario, where we're going to have negative rates forever. Then, you bring it back and say, all right, well let's look at the Italian banks. The banks have de-risked, they've written off a tremendous portion of their loan book. A bank like Intesa still has a large asset management business that is generating very good earnings and growing.

The Italian banks, again, something like an Intesa is still benefiting from their credit costs falling, new NPL inflows have collapsed and you're getting a 10 per cent dividend yield while you wait, and then really the discussion is just around the sustainability of that dividend yield. But that's an example where the sentiment has gone 100 per cent negative, right? No one's thinking that the future can get any better, and we look at that and think, well, actually when you look at a lot of the data, it's not that bad.

Again, not saying interest rates are going to be high in Europe, but could they at least be zero, rather than negative 50 in some point in the future? It doesn't seem that hard. That's an example of where, if you're getting paid a large dividend yield to wait, you can have a portion of the portfolio in that kind of idea I would say.

Just switching gears for a moment, I don't believe shorting stocks is well understood by most people, particularly Australian retail investors. Can you explain Platinum's shorting strategies, the types of situations you short, and position sizing?

Yeah, absolutely. What we look for in shorting is really just the inverse of what we look for in a stock that we want to buy. When you're buying a stock, you want investors to have low expectations for the business in the future, you want to have a low price and you want to ideally be able to identify a reason why the future's going to look much better in a certain time frame. In shorting, you just want the opposite.

So we want companies where investors, they're in love, the company is surrounded by hype, so very high expectations. You want a high price that leaves no room for error, and you want to have a clear reason why the future may look worse than today. Where we can find those situations, we will go off and short, and we've found some of those situations recently in the tech space, and some of the software stocks.

For us, how is shorting different though, to essentially owning a stock? When you buy a stock, even if you are completely wrong, like it's a complete disaster, the most you can lose is 100 per cent, and even that is a pretty rare occurrence. But if you're shorting a stock, and you're wrong, you can lose a lot more than 100 per cent of your initial position. As the stock goes up, your position size continues to get bigger, so it becomes a larger part of your portfolio. Certainly, when we short, we're typically taking smaller positions than when we would go long, or own a stock. And you tend to be a bit more focused on the timing aspect, and being very clear around that catalyst of when you're going to start to see change.

Just in terms of the small sizing position, are you talking like 50 basis points, or might it be a per cent, or..?

Yeah. If you think about it, you're saying a large, one of our full-sized positions in the fund might be a 3 per cent position, and with a short, you can be thinking, again, it comes back to depending on how confident you are with that catalyst. If you're less confident around just the timing, it might be a 50 basis point position, but we have had positions in shorts where we were very confident around the timing and we had ticked all three of those factors that we want to see, and we might have a 2 per cent position. But there, the 2 per cent positions are more of the rarer breed.

Platinum actively manages currencies. How much of Platinum's historical returns would come from currency management?

Yeah, look, I can give you the figures over the last 10 years. If we look over the last 10 years, it works out the currency has added 2 per cent per annum to the return, but that's spreading it out. The returns tend to actually come in lumps, and if we think about that 10 year period, a lot of the money was made via shorting the Japanese Yen, when it had become very expensive. Generally, how we tend to approach the currency positions, we tend to approach it in two ways.

We want a very strong reason to essentially hedge out or go, to take a large position on currency. We just see our natural position on currency is where the stocks lie. If we own Japanese stocks, we will own Japanese Yen, as it were. But if we do it in a situation where we feel strongly, so a good example would be the Yen. A good bell ringer in currencies, so you know a currency is maybe unsustainably strong is when your exporters in that country can't make money at that level of the exchange rate.

When the Yen was down 80, you saw Toyota, these bastions of Japanese industrialisation struggling to make money. It was the same situation when the Aussie dollar was at 1.10 to the USD in this country, and basically all of the car manufacturers left. When we can see examples like that, we typically move in size. Other areas where we might use currency shorting is where it provides very cheap tail risk hedging.

Past examples, certainly something I did in the European fund days, was during the sovereign crisis, you could hedge out some of the Euro at a very cheap rate, and it was very cheap tail risk insurance of a breakup. In China today, we've chosen to hedge some of our exposure to the Renminbi, just with an understanding that look, that is a tool, so the Chinese government may wish to devalue the Renminbi in the event that the trade war continues to essentially accelerate or intensify.

Next one's a very topical question at the moment. The valuation spread between so-called value and growth stocks in the US has recently eclipsed the gap since during the tech bubble. Do you think the gap will close as it has done historically with the next downturn, or do you think the gap might be a bit more stubborn this time around given technology's ability to render businesses obsolete so quickly?

Yeah. It’s that interesting discussion around the disruption and whether this time is different. My own personal view is that it will close, and I don't think it's particularly different this time. First of all, there's a lot of talk about disruption and the pace of disruption today. I actually just don't think this is that new. Technology has been forever rendering businesses obsolete, so an example that everyone will know, we'll talk about how eCommerce is killing retail today.

The new formats in retail have always been killing the old formats of retail over the last 50 years. Whether that be the supermarkets killing the local grocery store, or the department stores getting killed by the specialty retail. So, I think the disruption is very much fitting the words to the music and is being used as an excuse to try and justify some of the valuations.

The other thing I'd point out, just in terms of what is actually driving that valuation gap and difference, look, most of the cheap stocks are actually not being disrupted at all. It's more that these stocks have some cyclicality to their businesses, and investors today are absolutely petrified of the macro environment, and are petrified of having any businesses with a bit of cyclicality. We see this just in the wild prices that are being paid for defensive businesses these days.

You've got what are fairly slow growth businesses trading upwards on 30 times earnings, and then if we look at the valuation spread, the difference between what's the value of the high P/E stocks versus... We look at it by dividing the market into five groups and it's divided by valuation. So you look at, all right, what's the average value of the top group versus the average value of the bottom group?

If you look at this over a very long time period, that valuation difference tends to stay in a band, and that actually makes sense, because investing is somewhat of a relative game. If I can go and buy a whole business on 10 times earnings, I'm getting a 10 per cent return on my purchase price. If, Nathan, you're going off and buying one of 40 times earnings, you're getting two and a half per cent on your purchase price, and your business needs to grow incredibly fast over the next years to catch up to the return I'm getting.

Eventually investors wake up to this and capital rationally moves to the higher returning opportunities. So, this has happened in the past. The simple answer was look, during the tech bubble, the internet was there to disrupt all businesses. You actually look over the ensuing 20 years, and a lot of what it was meant to do actually happened, right? It did disrupt many businesses, but that didn't stop the valuation gap closing, and people who were investing in those wildly priced companies having a pretty rough time of it. I think it will close.

Okay. Nothing new in finance?

No, no, no. We just painfully learn the old lessons again.

This is a bit more of a personal question, but can you provide some insight into how you come across some of the more obscure opportunities in China where you have to do a lot more on the ground research compared to, I guess, some other Western countries? Do you have a team on the ground, for example, or relationships with local analysts and investors?

No, no. It's interesting. We actually keep everyone in Sydney, and we do that very purposefully. We find that just having the team in one place, it really helps with communication. It's much easier to talk and engage with the different ideas the team is working on, and it's much easier to just communicate and saying, all right, well we're seeing this happen in China or, we're seeing this happen in the tech space in the US. How may that apply to other geographies and what's happening in your countries?

We've experimented with the US office and we just think it doesn't work, at least for us, on the communication front. In terms of generating ideas, look I don’t think the idea generation process is that different in China. Maybe the difference is look, the rate of change in that economy is probably greater than others in the West. Whether that be the healthcare system reforming, or the cutthroat competition you see in the internet space, and of course change creates a lot of opportunities, so you're following those.

But I think what helps is Platinum's been investing in China for over 20 years now. Over that time, you build a lot of relationships, you build a lot of relationships with the corporates, and I think that helps. There's several meetings where you'll go in and you'll meet management, and you go, "Ah yes, I remember. We remember you from this company." Because people still move around. That helps, because the companies know that look, you're serious investors and you're here for the long term.

And then how do we bridge that gap of not having the office and not having someone on the ground, is simply that we just travel there extensively. We've got a six-man Asia team, they're focusing purely on Asia, and really if you think about China, we've probably got someone from the investment team on the ground travelling and meeting companies every three months.

Yeah, I think you've owned the large Chinese insurer, Ping An, for a number of years. What makes this company special other than just its huge potential as insurance coverage increases across China?

Yeah. Look, I think the interesting point about Ping An was this was a company that was always run as a private entrepreneurial business, they were primarily competing with the state-owned enterprises. You see that pattern so often, is when you pit the private, fast-moving competitor, versus the state-owned enterprises, it's generally the private company that tends to win over time.

That’s certainly always appealed to us about Ping An. But then you go a layer deeper and you think about, all right, where is the company special, or why is it succeeding? You just look for those signs of excellence, where the company's just operating a lot more efficiently than its competitors. You can look at examples of that for Ping An, so in terms of life insurance, Ping An, the old saying is that life insurance isn't bought. It is sold, right? You need to have someone to come to you, they need to explain it. It's not something you just wake up and go, “Yeah, I'll buy some life insurance today."

Your agent force is very important, and Ping An always placed a very large emphasis on training their agents. Workshops, teaching them what insurance products make sense for customers at different life stages, really teaching them how to sell, and importantly, they very much always focused on how do we sell the more profitable, longer-term, what I would call true life insurance policies? Whereas a lot of the SOE competition would get carried away selling shorter-term savings products that were much easier to sell, but would look good from basically a FUM basis, but were pretty weak profitability.

And because Ping An invested and really concentrated on the agent force, you saw the positives. Their agent force would have far less turnover, their agents would make roughly two times more income than similar agents at competitors. What that meant is just over time, one, you kept the better-quality agents, and two, you just attracted high-quality staff overtime, and that makes a big difference.

Other examples is just one of the impressive things about Ping An is the money they've spent in FinTech. This all really started with Ping An basically saying, "Look, we want to develop software and technology internally to run our insurance businesses better." You've got to remember these are insurance businesses at incredible scale, so Ping An at different stages have had over half a million agents working for them. So after building those systems they then said, "Okay, well, can we actually take this further? Can we open up our systems in terms of software business and actually sell that technology to other businesses in China?"

So, we've got a unique way to approach that and that's led them to kind of develop some pretty impressive software and technology businesses servicing the financial community in China. So it was those factors that always appealed to us, and so look, this is, again, it's a serious company who should win in the long-term.

You recently added online travel agent, Booking.com to the portfolio. This was once a market darling and probably one of the best-performing stocks I can think of since the GFC.

Yeah.

But fears about Google entering the space and hotels offering discounts to book directly have knocked valuations down across the sector. What's the case for Booking.com?

Look, I think Booking's an interesting case and we can cover those two issues directly. But, look, when I look at Booking, I don't see a big problem that's scaring the street, and also there's no amazing angle that I don't think the market particularly doesn't understand for Booking.

I think, overall, this investment is... Look, this is a very high-quality business, it meets a great need for both the hotelier who always has unsold inventory, so they want to sell those rooms, and users. You know, because hotel pricing's dynamic, it's always changing, there's a lot of value to jumping onto Booking and searching for different hotels because more often than not there'll be a hotel owner on there looking to discount rooms to fill and you'll get a good deal.

It's a high-quality business, it's serving a real need, and then I think there's enough growth tailwind. The business is growing at about 10 per cent per annum, and they've got enough growth tailwinds to really sustain this type of mid to high single growth going forward, and those growth drivers are simply in the West we're seeing, I guess there’s a trend of people wanting to spend more on experiences to go travelling, do things, rather than maybe spending their money on more material possessions or more stuff.

The second big driver is just that outbound wave of tourism coming from China. If you think, today, roughly 15 per cent of Chinese nationals have a passport, that compares to maybe 50-70 per cent in most other countries of the world, and really that will only grow, and I think the Chinese outbound wave will continue to grow from here.

On the concerns around Google, in terms of what Google's doing, I don't think's that different. Google for a long time has been a huge partner of Booking.com selling them travel-related keywords, and what Google's trying to do is really become a bit more of a metasearch proposition where you can go and type in your dates and it will present hotel options to you, much like you see on KAYAK or Trivago or even TripAdvisor today. But their business model is still getting that lead and then passing that lead onto the OTAs, because it's the OTAs paying for that lead.

So I don't think it's a vastly different change to the competitive landscape, and certainly the chain hotels have been doing their best to try and attract people directly to their websites to book direct. The simple reality is yes, if you're going to London and you know you want to stay at the Intercontinental London, then booking direct on that website will probably get you the best price or get you a free breakfast.

But the other side to that is, well, if you're not set on the Intercontinental, again, you can go onto Booking.com and there'll be many hoteliers who may be wishing to discount to fill a room, and hence you may get a better room at a cheaper rate by going off and searching. I think that’s one of the real reasons why the whole book direct wave has not really had a lot of impact on these businesses and I think shouldn’t have too much of a pronounced impact going forward.

Okay, last one, Clay. The oil space has been a bit of a graveyard for investors over the past few years. What’s your general view of the sector and what’s a current opportunity?

Yeah. No, look, understand that. We've taken some hits in this sector, but we're still reasonably positive. So you think about our investments in oil, so we've got to hark back that it feels a long time ago, but the oil price collapsed in October of 2014, so we're now five years on from that oil price collapse and it's been a period where industry capex has been down 50 per cent, and so we've had five years of the industry being in a fairly large recession.

In terms of how we've invested in this sector, our first wave was to buy the oil producers with just a belief that, look, oil markets will tighten over time, the price should rise and the producers will be the first to benefit from the higher oil prices. And largely that was a profitable investment. The second wave of our activity was going onto then buy some of the companies that provide the capex side of the equation, so when the oil companies start spending again. Now, this has been the painful area of investment and these haven't performed well and we’ve taken some losses here.

But why are we still positive on the capex producers? And I guess the case for oil is this. So, again, we've had industry capex in recession for five years now. The oil industry has always been about replacing a depleting resource, so if you think about the world consumes roughly a hundred million barrels of oil a day, on average, demand for oil grows at one million barrels per day, per year, and really this has been driven by China, India and Southeast Asia.

But we need to find that one million, but on top of that we also need to replace the natural decline rate of the fields, and globally the fields deplete at 3.5 to 4 per cent a year. So, just to keep round numbers, in any year we probably need to find four to five million barrels of oil to meet growing demand and to replace that decline. Now, what we can observe is that, look, oil has been getting harder to find over the years. The oil industry was not drilling shale and going and developing offshore kind of oil reserves for fun. These were the hardest and most expensive sources. They were doing this simply because the nice, cheaper conventional oil resources onshore or in shallow water, they just weren't there. We were running out of it.

So looking forward, why would oil capex pick up from here? Obviously, the story in this industry has been the effect of shale. Now, we can look at can shale meet the needs of future demand but also replace that decline rate over time? So despite the hundreds of billions of dollars thrown at the shale oil industry, the maximum amount of oil production shale has ever brought on in one year is 1.3 million barrels.

I think you can kind of say, look, shale can't do it on its own back alone. I think the other interesting factor is over the past five years, you've had offshore and conventional oil projects that were sanctioned in 2010 to 2014. These are generally projects that have a long lead time, and they were coming on from '15, '16, '17 and '18 and providing some supply to the oil markets while prices were still low as those projects were being finished.

Really, the bulk of those projects now is done, so the cupboard is starting to look bare, so if shale is going to struggle to do a lot more than 1.5 million barrels a year, we've got to ask where are the other 3.5 million going to come from, and we think that needs to come from new oil capex and will need to come from offshore development to some degree.

That's what we're starting to see the first green shoots of activity around, so you're now starting to see investment decisions around offshore resource development starting to pick up. You look at a business like FMC Technip, over the last seven months they've...new project decisions to the tune of $5-6 billion, and that's why we're still confident that you will see inactivity pick up in this space and we can still make money from here.

Brilliant. Okay, Clay, we'll let you go and let you go and find some more stock opportunities, but we really want to thank you for your time.

More than welcome. Thanks for your time, Nathan.

Thanks, Clay.

Bye bye.

That was Clay Smolinski, Portfolio Manager at Platinum.

 

For investors simply seeking growth tail winds, India has a far clearer economic growth story than China according to Douglas Isles, Investment Specialist at Platinum Asset Management, although he acknowledges that in practice investing is more nuanced.  

Already the world’s 5thlargest economy, with forecast growth of 6-8%pa over the next decade, India is likely to become one of the three largest economies alongside the US and China by 2030.

It is unlikely to be another China though, as India’s Government can’t simply mandate growth in the same manner as China. India is currently where China was around 15 years ago according to Mr Isles based on GDP per capita figures.  Each home to populations of around 1.4bn people, India and China are to become economic heavy weights in the coming decades.

 

 

 

 

India’s scale is extraordinary.  By 2025, one fifth of the world’s working age population will be Indian.  By 2030 there will be over 850 million internet users in India (currently around 500m) Source: Australia’s Dept of Foreign Affairs and Trade.

The Modi Government was re-elected in a landslide victory in May.  His first term was punctuated with many reforms including the introduction of GST, bankruptcy and insolvency changes, digitisation of subsidies which has resulted in large numbers of Indians now having bank accounts, and a steep rise in infrastructure spending on building roads, rail and electrification to power the nation.

India’s road and rail networks are critical to increasing its population’s standard of living and economic prosperity as they connect farmers to markets, children to education and goods to consumers.  During Modi’s first term, India built almost 200,000 km of rural roads. (that is building the road from Adelaide to Melbourne 275 times).  The number of rural villages connected by roads grew to 91%, up from 56% in 2014.  

Modi’s new Government has pledged 100 trillion rupees (US $1.44 trillion) over the next 5 years for infrastructure investment. This is huge considering the expenditure on roads and railways was only about 1.2 trillion rupees for the 12 months to March 2019.

Jack Lowenstein, Morphic Asset Management, believes that the infrastructure sector is one of the greatest opportunities in India and the sector presently looks cheap.  He adds “financials offer the best returns in India, but having seen so many false bottoms to what is now a nearly decade long bad credit cycle, we are going to sit on the sidelines until we see momentum in the recovery story.”

Douglas Isles, empathises and says “India’s banking system has gone through a process of repair, which sets it up for the prospects of an investment boom, perhaps akin to what we have already seen in China. 

This should be good for banks, and companies benefiting from investment in infrastructure. While it benefits the consumer, stocks in that area are well-liked, and the overall market, like the US, trades at all-time highs. This is a stark difference from China, but note that India is at an earlier stage of its economic evolution, and as a democracy, remains more chaotic than its northern neighbour.  The paradox of markets is that a simple growth story does not make such a simple investment case.”

Investing in India through global ETF’s or actively managed funds is the obvious way of gaining exposure to the India thematic.  But it is not just Indian companies that stand to prosper from India’s infrastructure boom.  

Australian businesses who provide finance, maintenance / construction expertise, or other products and services could also be beneficiaries.  

Some of the questions that Australian investors need to ask themselves are:

  1. What Australian goods are likely to be sold to Indian consumers (think A2 milk to Chinese consumers)
  2. What Australian expertise could be exported to India? (perhaps education, infrastructure maintenance)
  3. What Australian companies may be able to assist in the financing of Indian infrastructure? (Macquarie Group is the business automatically linked to infrastructure investing)
  4. Will the increase in infrastructure spending create the environment for another resources boom?

As legend investor Kerr Neilson (Platinum Asset Management) says “Investors have to invest on the basis of what the world is likely to be, rather than as it is now”.  Therefore investors would be wise to think about ways they may be able to gain from the rise of India over the coming decades.

 

This article was written by Mark Draper and published in the Australian Financial Review in June 2019.

For investors simply seeking growth tail winds, India has a far clearer economic growth story than China according to Douglas Isles, Investment Specialist at Platinum Asset Management, although he acknowledges that in practice investing is more nuanced.  

Already the world’s 5thlargest economy, with forecast growth of 6-8%pa over the next decade, India is likely to become one of the three largest economies alongside the US and China by 2030.

It is unlikely to be another China though, as India’s Government can’t simply mandate growth in the same manner as China. India is currently where China was around 15 years ago according to Mr Isles based on GDP per capita figures.  Each home to populations of around 1.4bn people, India and China are to become economic heavy weights in the coming decades.

 

 

 

 

India’s scale is extraordinary.  By 2025, one fifth of the world’s working age population will be Indian.  By 2030 there will be over 850 million internet users in India (currently around 500m) Source: Australia’s Dept of Foreign Affairs and Trade.

The Modi Government was re-elected in a landslide victory in May.  His first term was punctuated with many reforms including the introduction of GST, bankruptcy and insolvency changes, digitisation of subsidies which has resulted in large numbers of Indians now having bank accounts, and a steep rise in infrastructure spending on building roads, rail and electrification to power the nation.

India’s road and rail networks are critical to increasing its population’s standard of living and economic prosperity as they connect farmers to markets, children to education and goods to consumers.  During Modi’s first term, India built almost 200,000 km of rural roads. (that is building the road from Adelaide to Melbourne 275 times).  The number of rural villages connected by roads grew to 91%, up from 56% in 2014.  

Modi’s new Government has pledged 100 trillion rupees (US $1.44 trillion) over the next 5 years for infrastructure investment. This is huge considering the expenditure on roads and railways was only about 1.2 trillion rupees for the 12 months to March 2019.

Jack Lowenstein, Morphic Asset Management, believes that the infrastructure sector is one of the greatest opportunities in India and the sector presently looks cheap.  He adds “financials offer the best returns in India, but having seen so many false bottoms to what is now a nearly decade long bad credit cycle, we are going to sit on the sidelines until we see momentum in the recovery story.”

Douglas Isles, empathises and says “India’s banking system has gone through a process of repair, which sets it up for the prospects of an investment boom, perhaps akin to what we have already seen in China. 

This should be good for banks, and companies benefiting from investment in infrastructure. While it benefits the consumer, stocks in that area are well-liked, and the overall market, like the US, trades at all-time highs. This is a stark difference from China, but note that India is at an earlier stage of its economic evolution, and as a democracy, remains more chaotic than its northern neighbour.  The paradox of markets is that a simple growth story does not make such a simple investment case.”

Investing in India through global ETF’s or actively managed funds is the obvious way of gaining exposure to the India thematic.  But it is not just Indian companies that stand to prosper from India’s infrastructure boom.  

Australian businesses who provide finance, maintenance / construction expertise, or other products and services could also be beneficiaries.  

Some of the questions that Australian investors need to ask themselves are:

  1. What Australian goods are likely to be sold to Indian consumers (think A2 milk to Chinese consumers)
  2. What Australian expertise could be exported to India? (perhaps education, infrastructure maintenance)
  3. What Australian companies may be able to assist in the financing of Indian infrastructure? (Macquarie Group is the business automatically linked to infrastructure investing)
  4. Will the increase in infrastructure spending create the environment for another resources boom?

As legend investor Kerr Neilson (Platinum Asset Management) says “Investors have to invest on the basis of what the world is likely to be, rather than as it is now”.  Therefore investors would be wise to think about ways they may be able to gain from the rise of India over the coming decades.

 

This article was written by Mark Draper and published in the Australian Financial Review in June 2019.

Friday, 17 May 2019 16:15

Why Airports make great investments

Monopoly infrastructure businesses such as airports are usually considered low growth, but investors may be surprised to learn that since GFC the number of air travel passengers has almost doubled.  With the growing number of airports around the world being privatised, investors can seek to profit from this growth.

Airports are now very much an essential component of infrastructure to most modern economies as they cater collectively to around 4 billion passengers annually, with future increases driven by a growth in middle class put together with a decline in the cost of air travel.

How an airport generates income is typically split into 3 core components.

  1. Aeronautical charges – fees paid by passengers for use of the airport
  2. Retail – rent received from shopping within the airport and also car parking
  3. Office / Industrial property – this can be from spare land owned by the airport that can be leased to companies wishing to be located near an airport, such as freight companies, hotels and airline businesses.

Usually airports generate around half of their revenue from aeronautical charges, which are linked to passenger numbers.

Passenger growth historically has been at the rate of approximately twice that of GDP. While risks such as terrorism and health scares such as SARS have put a short term dent in passenger numbers, over time these risks have been short term blips in a long term uptrend.  This can be seen in the chart below which provides annual total airline passenger numbers over the past 50 years.

Investors should have a high degree of confidence that passenger growth is likely to continue into the future due to structural demographic changes.  One only has to look at China which currently has 230 operating airports but by 2030 is forecast to be operating 430 airports.  This structural change is being caused by the large growth in the Chinese middle class who are forecast to double from around 300 million to 600 million in the next 5 years.  This, plus the fact that only around 8% of Chinese citizens have a current passport, sees a long runway for growth in passenger numbers.

Sydney Airport in its strategic planning for the next 20 years is forecasting a 51% increase in passenger numbers to 65.6m over the planning period.  International passengers will be the main driver of this growth and are forecast to represent 48% of total passengers by 2039 (source Sydney Airport Annual Report 2018).  This is important as it is generally considered that International passengers are worth around 5 times more to an airport than domestic passengers due to higher landing charges and higher retail spend from passengers.

Investors in Australia can gain exposure to airports through owning securities in Sydney Airports and Auckland International Airport which are both listed on the ASX.  Exposure can also be achieved through specialist infrastructure funds including but not limited to those offered by Magellan Financial Group and Lazard.

While the business case for airports is sound, investors should be mindful of the impact of long term interest rates on airport valuations.  Increases in long term interest rates are generally considered to be negative for airport valuations.

Other key risks investors should consider are those of regulatory nature.  There are generally two types of regulatory frameworks for airports around the world. One regulatory  model is where the entire airport is fully regulated, resulting in returns from the airport being in line with a fully regulated utility. This is known as single till.  The other model, which is commonly referred to as ‘dual till’ is where the aeronautical revenue is regulated, but the rest of the business (retail, car parking and property) is not.  The dual till model offers investors the prospect of higher returns, but at the same time investors are accepting higher risk. Most institutional investors prefer the dual till approach.

Growth in passenger numbers and consistency of revenue are two attributes that can generally be found in airport investments, which earns their right to have a place in a well structured investment portfolio.

 

This article was published in the Australian Financial Review during May 2019 and was written by Mark Draper.  Our thanks to Gerald Stack, Head of Infrastructure at Magellan Financial Group for his assistance in putting this article together.

Sunday, 05 May 2019 08:46

Property - Is this the tipping point?

This article is reproduced with permission from Investsmart.

 

In this week's Property Point podcast with CoreLogic's Tim Lawless, home dwelling prices are patched into a deeper narrative, where everyday investors require expert guidance.

Welcome to Property Point, a podcast exploring all things related to property investment in Australia.

This week I’m speaking to Tim Lawless, Head of Research at CoreLogic Asia Pacific.

The CoreLogic home value index lost 0.5% in April. That’s after we saw a 0.7% fall in March, and a 0.9% fall in February.

Could this easing represent a turnaround to come?

House price declines seem to have moderated in Sydney and Melbourne. However, there are signs of further price slippage elsewhere, outside of our two capitals.

Sydney has come off 10.9% for the year and Melbourne has come off 10%. Prices are back to mid-2016 levels in both cities, and about 20-25% off their levels seen five years ago in 2014.

From the September 2017 peak, national house prices are now down nearly 10%. 

Sydney and Melbourne read as much worse, down 14.5% and 10.9% from their peaks respectively. Melbourne’s price declines have now surpassed the 1989 downturn – in addition to 2004, 2008, 2010 and 2015's downturns.

The current price adjustment has now extended for 19 months.

 


Tim, this spot of data, being CoreLogic home values, finds itself in a very patchy narrative.  Home sales volumes are at 23-year low, which was another set of data that came out this week, even though auction clearance rates have been holding steadier, in some pockets ticking up over the last little while.  The big question, of course, in light of all of this, are you expecting further declines through the rest 2019 or have we seen the bottom?

Well, of course the market is very different from region to region.  But broadly, yes, we are expecting values to continue falling across most areas of Australia.  That's certainly been a most recent trend, although we aren't seeing values falling quite as quickly as what they were late last year or a bit earlier in 2019, it's quite clear that markets like Sydney and Melbourne are still seeing a fairly rapid rate of decline.  In fact, our April figures showed Sydney values were down by 0.7 of a percent over the month, and Melbourne's down 0.6%.  Not quite as bad as the nearly 2% month on month declines that we were seeing late last year, but still quite a material decline and we are also seeing the geographic scope of weakening conditions has expanded to include other capital cities, where values were generally rising previously.

And taking a broader view from that, so what are we seeing in terms of data standouts outside of Sydney and Melbourne?  Is the troubled Perth turning around, or is Hobart continuing its upswing?

Well, touching on Perth, no, unfortunately, we're still seeing values falling in Perth.  In fact, about a year and a half ago, we were seeing some signs that Perth was close to levelling out and values were holding relatively firm, but there has been a bit of a freshening of the downwards trend, which I think probably coincides with the tighter credit regime we're in at the moment as well as the fact that local economic conditions across WA still remain relatively soft.  I could say the same things about NT and Darwin, as well.

Interestingly enough, in Hobart, that really has been the standout market.  It's the market where values having been trending higher quite quickly, but our April figures have shown had a bit of a crack in that façade, with values falling by nearly 1% over the month in Hobart, which I guess doesn't really come as much of a surprise considering that the growth rates were highly unsustainable in that marketplace.  A bit more than a year ago values were rising at nearly at nearly 13% per annum, and now the annual rate of growth is just below 4% across Hobart and, of course, affordability constraints in that market have really deteriorated quite quickly.


Source: CoreLogic

Last year, I think most of the warnings were around apartments, particularly Melbourne and Brisbane.  But now it seems like, to me, that everyone might have been worried about the wrong thing, where houses have actually shown a bigger price correction over the last year and the cycle to date.  But is that just a function of the price run-up we saw in houses, as opposed to apartments?  Or is there something more to it?

I think there's a few things happening here, and just to explain the numbers, looking at some of the largest cities.  For example, we could write a pretty good case study, so Sydney house values over the past 12 months are down 11.8% and Sydney unit values are down by just over 9%, 9.1%.  With a really similar story in Melbourne.  So absolutely, unit values are falling, but not quite as much as what we've seen in the unit sector.  So, I think what's driving that trend is a couple of things; one would be that we are seeing the market becoming very price sensitive, and of course apartments do offer up a much lower price point than detached housing.  And the reason I think we are seeing this price sensitivity comes back to affordability issues in the most expensive markets.  But probably more importantly is, I suppose, the change in the credit environment, where we are seeing lenders generally becoming much more cautious around high debt to income ratios and debt to loan ratios, which seems to be funnelling credit demand and credit availability toward that middle to low end of the market.

I think also with the surge first home buyer activity, particularly across Sydney and Melbourne, of course that segment of the marketplace is very price sensitive and I think that there is an anecdotal trend at least, where we're seeing more and more of first home buyers are willing to sacrifice their backyard and Hill’s hoist, and look for areas or housing stock that may be medium to high density, but located closer to where they're working, or where their family is, or closer to major transport nodes and so forth.

I'd like to just touch on clearance rates as well, which do remain at historically low levels.  Several are making predictions, like JPMorgan, that clearance rates will remain below 50% for most of 2019.  And elsewhere it’s been claimed that anything below 50% is a very weak result, and that it's evidence the market is still falling.  But I've noticed that markets like Brisbane are actually consistently below 50% for clearance rates.  So, what do you think about this?  Is 50% nationally actually a tipping point?  Or does it mean anything?

I think you can read a little bit too much into the national clearance rates.  And, generally speaking, clearance rates are very, I suppose, important, very indicative of market conditions.  In markets where auctions are still a very popular way of selling, and that's generally restricted to Melbourne, Sydney, and Canberra.  Most other markets see a very small proportion of properties being taken to auction and auction clearance rates are much less indicative of broader market conditions, probably more indicative of what's happening in the premium sector where you generally find unique properties or distressed properties are taken to auction. 

I think that when we look at auction clearance rates in say Sydney and Melbourne, to a lesser extent in Canberra, we're generally seeing the auction clearance rate holding around the mid to low 50% mark, which as you say is still very low.  It does suggest that there is ongoing weakness in the market, but they are much better than what we were seeing at the end of last year, where auction clearance rates were down around the low 40% mark, even at one stage dipping below 40% in Sydney.  I think that does coincide with this subtle improvement in the rate of decline that we've been seeing across Sydney and Melbourne over recent months.  The market's still falling, but not as quite as severe as what it was.  Auction clearance rates are still low, but not as quite as severe as what they were late last year.

Tim, looming large over property, of course, is the RBA, which is meeting next week.  The RBA has raised the issue of negative equity.  I'd like to ask you about this.  I don't know whether too much attention is paid to negative equity, like you've said with clearance rates, given the context where as long as a household with a mortgage has an income and a job, the RBA has said they don't seem to think it'll be a problem.  What's your view on the negative equity conundrum, where if house prices fall 25% nationally, I've read, it would put 850,000 home buyers in negative equity?

Yeah, that makes sense to me.  It's actually quite an elusive statistic to obtain in Australia.  Simply because there isn't a lot transparency or visibility on the debt side of individual home ownership.  Quite clearly, in our data we can see how much values have fallen, how much values have changed, but we don't know how much deposit, for example, was held against individual properties.  What we can see though that gives us a pretty firm hint around equity levels would be the areas around Australia where values have fallen by say more than 15 and more than 20%.  So if I look around the subregion of the capital cities, there's only one region across the country based on statistical area 4s, SA4 regions, where values have fallen by more than 20%, and that's the Sydney area of Ryde, where values are down by 22.7%.  You've also got areas like the inner south-west of Sydney, Sutherland Shire, the Hills District, the inner west and North Sydney, where values have fallen by more than 15%, and you could throw Parramatta in there as well.

In Melbourne, it would be the areas like the inner-east and the inner-south, which tend to be more exclusive markets, where values have fallen by more than 15%.  When you have value declines of that magnitude, it's pretty clear that if you're a recent buyer to the marketplace, and so you did have a 15% to 20% deposit, then there will be some evidence of negative equity creeping into those markets.


Source: CoreLogic

How likely, Tim, do you think a rate cut is next week by the RBA?  The market's pricing a 40% probability.

It's my view that we probably will see the RBA starting to position for a rate cut later this year, but probably not cut in the May meeting.  Simply because I think cutting before the federal election may be a thing a difficult thing to do politically, not that the RBA has political ties.  But also, the fact that I think the RBA probably will start changing their commentary to start setting up an expectation for a rate cut over coming months.  Of course, we did see the very low inflation numbers, in fact, you know, the donut after the March quarter, but we're still reasonably strong labour market indicators, mostly emanating out of New South Wales and Victoria, of course.  But I think that as we start to see labour markets potentially softening, as the residential construction sector in both those states starts to settle down, then maybe we might start to see more evidence of the labour market indicators, which is another key element of what the RBA is looking for before they cut, could start to soften out a little bit.

And another big question: Will rate cuts fire up housing again?  Do you think that will be the catalyst?

I'm not too sure about that.  Absolutely, if we do see rates coming down, and I think we probably will see rates move lower and then most of that being passed onto mortgage rates as well, but we still have a fairly substantial serviceability assessment as a barrier for a lot of borrowers.  I don't think, even if we do see mortgage rates moving lower, it won't have the same stimulatory effect as what we've seen over previous periods when rates have come down.  No doubt it's going to be a net positive for the marketplace, a lower cost of debt is always going to be positive, but I think there will be some prospective buyers out there who simply will still find that obtaining finance and getting through that credit assessment is going to be a barrier for a substantial or a mature enough lift in buying activity.

Do you expect that changes to negative gearing, should Labor get in at the federal level later this month, are they already factored into these changes in home prices?  Or do you think an even bigger slide could happen if Labor does get in?

Well it's certainly an uncertainty, and I think the truth is that nobody really knows what the effect of these policy changes might be if we do see a change in government and they do get through to the senate.  I think, generally speaking, if you remove an incentive from the marketplace, generally that's an overall net negative, and we'd expect there to be some dampening effect on investment activity in the market.  To what extent that impacts on prices is really the great unknown.  My expectation is if you take away some demand for the marketplace, it's likely to have some further downwards pressure on prices.  Maybe that could be compensated by some upwards pressure from lower mortgage rates, improved affordability, and so forth as well.  So overall, not too sure how that outcome's going to play out, but I think if we do see less investment of the marketplace, we potentially would see rental rates gradually starting to rise higher and I guess, encouraging that already evident trend where rental yields are moving higher, probably would result in higher rental yields longer term, alleviating the need for negative gearing in the first place.

I think the biggest question here is the adjustment period, if we do see these policies implemented, what's that adjustment period going to look like, and how much does it impact negatively on housing prices.

I might leave it at there for today with the great unknown.  Thank you so much Tim, for the chat.

Thanks, it’s been a good chat, great interview.  Thanks very much.

That was Tim Lawless, head of research at CoreLogic Asia Pacific.

Sunday, 05 May 2019 08:42

Property - Is this the tipping point?

This article is reproduced with permission from Investsmart.

 

In this week's Property Point podcast with CoreLogic's Tim Lawless, home dwelling prices are patched into a deeper narrative, where everyday investors require expert guidance.

Welcome to Property Point, a podcast exploring all things related to property investment in Australia.

This week I’m speaking to Tim Lawless, Head of Research at CoreLogic Asia Pacific.

The CoreLogic home value index lost 0.5% in April. That’s after we saw a 0.7% fall in March, and a 0.9% fall in February.

Could this easing represent a turnaround to come?

House price declines seem to have moderated in Sydney and Melbourne. However, there are signs of further price slippage elsewhere, outside of our two capitals.

Sydney has come off 10.9% for the year and Melbourne has come off 10%. Prices are back to mid-2016 levels in both cities, and about 20-25% off their levels seen five years ago in 2014.

From the September 2017 peak, national house prices are now down nearly 10%. 

Sydney and Melbourne read as much worse, down 14.5% and 10.9% from their peaks respectively. Melbourne’s price declines have now surpassed the 1989 downturn – in addition to 2004, 2008, 2010 and 2015's downturns.

The current price adjustment has now extended for 19 months.

 


Tim, this spot of data, being CoreLogic home values, finds itself in a very patchy narrative.  Home sales volumes are at 23-year low, which was another set of data that came out this week, even though auction clearance rates have been holding steadier, in some pockets ticking up over the last little while.  The big question, of course, in light of all of this, are you expecting further declines through the rest 2019 or have we seen the bottom?

Well, of course the market is very different from region to region.  But broadly, yes, we are expecting values to continue falling across most areas of Australia.  That's certainly been a most recent trend, although we aren't seeing values falling quite as quickly as what they were late last year or a bit earlier in 2019, it's quite clear that markets like Sydney and Melbourne are still seeing a fairly rapid rate of decline.  In fact, our April figures showed Sydney values were down by 0.7 of a percent over the month, and Melbourne's down 0.6%.  Not quite as bad as the nearly 2% month on month declines that we were seeing late last year, but still quite a material decline and we are also seeing the geographic scope of weakening conditions has expanded to include other capital cities, where values were generally rising previously.

And taking a broader view from that, so what are we seeing in terms of data standouts outside of Sydney and Melbourne?  Is the troubled Perth turning around, or is Hobart continuing its upswing?

Well, touching on Perth, no, unfortunately, we're still seeing values falling in Perth.  In fact, about a year and a half ago, we were seeing some signs that Perth was close to levelling out and values were holding relatively firm, but there has been a bit of a freshening of the downwards trend, which I think probably coincides with the tighter credit regime we're in at the moment as well as the fact that local economic conditions across WA still remain relatively soft.  I could say the same things about NT and Darwin, as well.

Interestingly enough, in Hobart, that really has been the standout market.  It's the market where values having been trending higher quite quickly, but our April figures have shown had a bit of a crack in that façade, with values falling by nearly 1% over the month in Hobart, which I guess doesn't really come as much of a surprise considering that the growth rates were highly unsustainable in that marketplace.  A bit more than a year ago values were rising at nearly at nearly 13% per annum, and now the annual rate of growth is just below 4% across Hobart and, of course, affordability constraints in that market have really deteriorated quite quickly.


Source: CoreLogic

Last year, I think most of the warnings were around apartments, particularly Melbourne and Brisbane.  But now it seems like, to me, that everyone might have been worried about the wrong thing, where houses have actually shown a bigger price correction over the last year and the cycle to date.  But is that just a function of the price run-up we saw in houses, as opposed to apartments?  Or is there something more to it?

I think there's a few things happening here, and just to explain the numbers, looking at some of the largest cities.  For example, we could write a pretty good case study, so Sydney house values over the past 12 months are down 11.8% and Sydney unit values are down by just over 9%, 9.1%.  With a really similar story in Melbourne.  So absolutely, unit values are falling, but not quite as much as what we've seen in the unit sector.  So, I think what's driving that trend is a couple of things; one would be that we are seeing the market becoming very price sensitive, and of course apartments do offer up a much lower price point than detached housing.  And the reason I think we are seeing this price sensitivity comes back to affordability issues in the most expensive markets.  But probably more importantly is, I suppose, the change in the credit environment, where we are seeing lenders generally becoming much more cautious around high debt to income ratios and debt to loan ratios, which seems to be funnelling credit demand and credit availability toward that middle to low end of the market.

I think also with the surge first home buyer activity, particularly across Sydney and Melbourne, of course that segment of the marketplace is very price sensitive and I think that there is an anecdotal trend at least, where we're seeing more and more of first home buyers are willing to sacrifice their backyard and Hill’s hoist, and look for areas or housing stock that may be medium to high density, but located closer to where they're working, or where their family is, or closer to major transport nodes and so forth.

I'd like to just touch on clearance rates as well, which do remain at historically low levels.  Several are making predictions, like JPMorgan, that clearance rates will remain below 50% for most of 2019.  And elsewhere it’s been claimed that anything below 50% is a very weak result, and that it's evidence the market is still falling.  But I've noticed that markets like Brisbane are actually consistently below 50% for clearance rates.  So, what do you think about this?  Is 50% nationally actually a tipping point?  Or does it mean anything?

I think you can read a little bit too much into the national clearance rates.  And, generally speaking, clearance rates are very, I suppose, important, very indicative of market conditions.  In markets where auctions are still a very popular way of selling, and that's generally restricted to Melbourne, Sydney, and Canberra.  Most other markets see a very small proportion of properties being taken to auction and auction clearance rates are much less indicative of broader market conditions, probably more indicative of what's happening in the premium sector where you generally find unique properties or distressed properties are taken to auction. 

I think that when we look at auction clearance rates in say Sydney and Melbourne, to a lesser extent in Canberra, we're generally seeing the auction clearance rate holding around the mid to low 50% mark, which as you say is still very low.  It does suggest that there is ongoing weakness in the market, but they are much better than what we were seeing at the end of last year, where auction clearance rates were down around the low 40% mark, even at one stage dipping below 40% in Sydney.  I think that does coincide with this subtle improvement in the rate of decline that we've been seeing across Sydney and Melbourne over recent months.  The market's still falling, but not as quite as severe as what it was.  Auction clearance rates are still low, but not as quite as severe as what they were late last year.

Tim, looming large over property, of course, is the RBA, which is meeting next week.  The RBA has raised the issue of negative equity.  I'd like to ask you about this.  I don't know whether too much attention is paid to negative equity, like you've said with clearance rates, given the context where as long as a household with a mortgage has an income and a job, the RBA has said they don't seem to think it'll be a problem.  What's your view on the negative equity conundrum, where if house prices fall 25% nationally, I've read, it would put 850,000 home buyers in negative equity?

Yeah, that makes sense to me.  It's actually quite an elusive statistic to obtain in Australia.  Simply because there isn't a lot transparency or visibility on the debt side of individual home ownership.  Quite clearly, in our data we can see how much values have fallen, how much values have changed, but we don't know how much deposit, for example, was held against individual properties.  What we can see though that gives us a pretty firm hint around equity levels would be the areas around Australia where values have fallen by say more than 15 and more than 20%.  So if I look around the subregion of the capital cities, there's only one region across the country based on statistical area 4s, SA4 regions, where values have fallen by more than 20%, and that's the Sydney area of Ryde, where values are down by 22.7%.  You've also got areas like the inner south-west of Sydney, Sutherland Shire, the Hills District, the inner west and North Sydney, where values have fallen by more than 15%, and you could throw Parramatta in there as well.

In Melbourne, it would be the areas like the inner-east and the inner-south, which tend to be more exclusive markets, where values have fallen by more than 15%.  When you have value declines of that magnitude, it's pretty clear that if you're a recent buyer to the marketplace, and so you did have a 15% to 20% deposit, then there will be some evidence of negative equity creeping into those markets.


Source: CoreLogic

How likely, Tim, do you think a rate cut is next week by the RBA?  The market's pricing a 40% probability.

It's my view that we probably will see the RBA starting to position for a rate cut later this year, but probably not cut in the May meeting.  Simply because I think cutting before the federal election may be a thing a difficult thing to do politically, not that the RBA has political ties.  But also, the fact that I think the RBA probably will start changing their commentary to start setting up an expectation for a rate cut over coming months.  Of course, we did see the very low inflation numbers, in fact, you know, the donut after the March quarter, but we're still reasonably strong labour market indicators, mostly emanating out of New South Wales and Victoria, of course.  But I think that as we start to see labour markets potentially softening, as the residential construction sector in both those states starts to settle down, then maybe we might start to see more evidence of the labour market indicators, which is another key element of what the RBA is looking for before they cut, could start to soften out a little bit.

And another big question: Will rate cuts fire up housing again?  Do you think that will be the catalyst?

I'm not too sure about that.  Absolutely, if we do see rates coming down, and I think we probably will see rates move lower and then most of that being passed onto mortgage rates as well, but we still have a fairly substantial serviceability assessment as a barrier for a lot of borrowers.  I don't think, even if we do see mortgage rates moving lower, it won't have the same stimulatory effect as what we've seen over previous periods when rates have come down.  No doubt it's going to be a net positive for the marketplace, a lower cost of debt is always going to be positive, but I think there will be some prospective buyers out there who simply will still find that obtaining finance and getting through that credit assessment is going to be a barrier for a substantial or a mature enough lift in buying activity.

Do you expect that changes to negative gearing, should Labor get in at the federal level later this month, are they already factored into these changes in home prices?  Or do you think an even bigger slide could happen if Labor does get in?

Well it's certainly an uncertainty, and I think the truth is that nobody really knows what the effect of these policy changes might be if we do see a change in government and they do get through to the senate.  I think, generally speaking, if you remove an incentive from the marketplace, generally that's an overall net negative, and we'd expect there to be some dampening effect on investment activity in the market.  To what extent that impacts on prices is really the great unknown.  My expectation is if you take away some demand for the marketplace, it's likely to have some further downwards pressure on prices.  Maybe that could be compensated by some upwards pressure from lower mortgage rates, improved affordability, and so forth as well.  So overall, not too sure how that outcome's going to play out, but I think if we do see less investment of the marketplace, we potentially would see rental rates gradually starting to rise higher and I guess, encouraging that already evident trend where rental yields are moving higher, probably would result in higher rental yields longer term, alleviating the need for negative gearing in the first place.

I think the biggest question here is the adjustment period, if we do see these policies implemented, what's that adjustment period going to look like, and how much does it impact negatively on housing prices.

I might leave it at there for today with the great unknown.  Thank you so much Tim, for the chat.

Thanks, it’s been a good chat, great interview.  Thanks very much.

That was Tim Lawless, head of research at CoreLogic Asia Pacific.

Thursday, 18 April 2019 14:28

Roadsigns to Recession

Mark Draper (GEM Capital) wrote this article for the Australian Financial Review and was published during the month of April 2019.

 

With the graphs of leading Australian economic indicators taking on the shape of a waterfall, investors would be wise to dust off the play book about how to invest in a recession.  While not in recession yet, we are likely to know in the next few months whether Australia will enter recession, and it depends on whether some indicators, that we examine here, can change direction.

Many investors have not seen an Australian recession during their investing life, with the last one taking place in 1990/1991.  During that recession the economy shrank by almost 2%, employment reduced by just over 3% and the unemployment rate moved into double digits.  Business failure rates increased along with bank bad debts, and two of Australia’s major banks were in financial stress with share price falls of at least 30%.

At the epicentre of the current downturn is the residential property market.  Property values have been heading south, rapidly, particularly in the eastern states.  The further and faster property prices fall, the greater the probability of recession.  The IMF believes the downturn is worse than previously thought.  This is one of the few times that property prices have fallen without the RBA raising rates or from rising unemployment.

The second key indicator is housing credit growth.  Housing credit growth is currently below the level seen during GFC and below the level witnessed during the 1991 recession.  Credit approvals are falling, particularly in the second half of 2018.  This reflects tightening of lending standards by banks, but also that Australian consumers may have reached their capacity to take on new debt.  Investors need to ask what will alter this environment.  Previous episodes of weak demand for credit have been met with cuts to official interest rates, but with rates currently at 1.5%, the RBA does not have much ammunition to fire.

Building approvals are collapsing.  While there is currently enough work from buildings currently in progress to keep tradesman busy, building approvals point to a more troubling future.

Falling property values can create a wealth effect where consumers feel less wealthy and as a result defer purchasing decisions.  This can be seen in new car sales figures and 2018 saw its worst annual result since 2014.  This is against a backdrop of strong population growth during that time.

The weakening economic outlook is unfolding during an election campaign that the ALP are favoured to win.  The ALP is proposing to significantly increase the overall tax levied, (ie franking credit changes, CGT and negative gearing changes) which is likely to suck further money out of the economy and act as an additional handbrake.

If Australia were to enter recession, there are several investment sectors where investors should tread carefully.

Given that 60% of the Australian economy revolves around consumer spending, discretionary retailers are most at risk to a consumer under pressure.  Caution should also be taken with the price paid for food retailers who may also come under pressure as consumers seek to lower their expenses during a downturn.  The recent Woolworths profit result shows the food retailers are already operating in a very difficult retail environment.

Travel is another sector at risk as consumers in a downturn could turn their focus away from discretionary leisure spending.  Businesses too could replace interstate travel with more teleconferences in tighter economic times.

Banks are obvious investments to suffer in an economic downturn as demand for credit weakens and bad debts rise.

Property investments with a focus on property development profits should also be scrutinised.

The currency could be one of the few safe havens as the Australian dollar most likely depreciates during recession.  Beneficiaries of a weaker currency are those Australian companies who earn income from overseas or unhedged International investments.  Australian exporters who have not hedged currency can also benefit from a lower Australian dollar.

Investors should pay attention to the next few months of leading economic indicators to determine whether Australia is likely to break the 27 year recession drought, and position their investments accordingly.  

Montgomery Investments have recently produced their 'Best of the Best Report' for April 2019.

 

In this edition, they cover:

1. The recent company reporting season - opportunities for investors

2. Sydney Airport - is the runway for growth likely to continue?

3. Their view on Challenger

 

To download the report - please click on the image below.

 

April 2019 Best of Best image

Thursday, 18 April 2019 14:15

Major Parties' Tax and Super policies

thinking aboutThe federal election has been called for May 18 and both major parties have outlined their superannuation and tax policies. With the federal election only weeks away many of our clients have been asking what the major political parties’ policies are that may impact their SMSF, individual taxation circumstances or personal investments. 

 
LIBERAL-NATIONAL COALITION

Superannuation

  • Australians aged 65 and 66 will be able to make voluntary superannuation contributions without needing to work a minimum amount. Previously, this was only available to individuals below 65.

  • Extending access to the bring-forward arrangements (the ability to make three years of post-tax contributions in a single year) to individuals aged 65 and 66.

  • Increasing the age limit for individuals to receive spouse contributions from 69 to 74.

  • Reducing red-tape for how SMSFs claim tax deductions for earnings on assets supporting superannuation pensions.

  • Delaying the implementation of SuperStream (electronic rollovers for SMSFs and superannuation funds) until March 2021 to allow for greater usability.

Taxation

  • From 2018-19 taxpayers earning between $48,000 and $90,000 will receive $1,080 as a low and middle income tax offset. Individuals earning below $37,000 will receive a base amount of $255 with the offset increasing at a rate of 7.5 cents per dollar for those earning $37,000-$48,000 to a maximum offset of $1,080.

  • Stage 1 tax cuts: From July 1 2018, increasing the top threshold of the 32.5% tax bracket from $87,000 to $90,000.

  • Stage 2 tax cuts: From 1 July 2022, increasing the top threshold of the 19% personal income tax bracket from $41,000, to $45,000.

  • Stage 3 tax cuts: From 1 July 2024, reducing the 32.5% marginal tax rate to 30% which applies from $120,000 to $200,000. The 37% tax bracket will be abolished.

AUSTRALIAN LABOR PARTY

Superannuation

  • Disallowing refunds of excess franking credits from 1 July 2019 – this would mean SMSF members in pension phase no longer receive refunds for the franking credits they receive for their Australian share investments.

  • Banning new limited recourse borrowing arrangements.

  • Reducing the post-tax contributions cap to $75,000 per year down from $100,000.

  • Ending the ability to make catch-up concessional contributions for unused cap amounts in the previous five years.

  • Ending the ability for individuals to make personal superannuation tax deductible contributions unless less than 10% of their income is from salaries.

  • Lowering the higher income 30% super contribution tax threshold from $250,000 to $200,000.

Taxation

  • Labor supports the stage 1 tax cuts and will match the $1,080 low and middle income tax offset. From 1 July 2018, individuals earning below $37,000, will get a $350 a year tax offset, with this amount increasing for those earning between $37,000- $48,000 to the maximum $1,080 offset.

  • Introduce a 30% tax rate for discretionary trust distributions to people over the age of 18.

  • Will limit negative gearing to newly built housing from January 1 2020. (Existing investments are grandfathered under the current law).

  • Reduce the capital gains tax discount for assets that are held longer than 12 months from the current 50% to 25%. (Existing investments are grandfathered under the current law).

  • Limit the deductions for the cost of managing tax affairs to $3,000.

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