Cruising Along At The Top?

If you want to disagree with that sort of data you need a pretty good “this time is different” argument. This Bloomberg article puts forward six reasons why investors should ignore these elevated ratios. I do give some credit to the argument that very low interest rates and quantitative easing could be here for a long time yet. The Japanisation of the US and European economies was something that many laughed at in 2009 but have more recently come around to. There’s also the risk that excessive money printing creates hyperinflation and investors therefore need to be in assets that have the ability to float higher with that.

Whilst almost everyone is talking about asset prices being high, only a few are taking meaningful action to protect against a potential correction. The most common actions are to increase cash positions a little or switch to lower risk assets. However, the decision by Altair Asset Management to temporarily close its equity funds and give back capital to investors is an all in bet that Australian equities will go lower. Altair’s CIO cited highly leveraged property, Chinese debt issues, overvalued Australian equities and geopolitical risks as reasons to hand back cash to investors. It’s attracted a lot of publicity and if the timing is roughly right it could pay off many times over for Altair and its clients.

Contrast this with the prevailing attitude in US high yield debt, where managers acknowledge high prices but are more worried about being unable to reinvest capital in a seller’s market than the possibility of material capital losses. Australian credit remains something of an island, where good value still remains. With a view that asset prices could be much cheaper in the medium term, my portfolios are now full of credits that shadow rate to investment grade with credit duration of around two years. Despite these conservative risk metrics, I’m continuing to deliver a net yield above that of US high yield for clients.

The general opinion of the 2017/18 budget is that it is a politically savvy but economically boring budget. It’s easy to agree with this on a superficial level, but dig a little deeper and there’s a lot more colour to it.

Firstly, on the political side it has been called a Labor light budget in that it adopts some of the higher spending and higher taxing ways of the opposition Labor party. The ruling Liberal/National coalition has given up the fight for its core values of lower taxation, less waste and getting people to be less reliant upon government services. In shifting to the left to neutralise Labor, the coalition is leaving the right of politics wide open to the newly created Australian Conservatives, the Liberal Democrats and One Nation. If these parties can get their act together they will steal a stack of senate seats at the next election.

On the economic side the little noticed measures to stop healthy, working age people who can’t be bothered to work claiming welfare is great policy. It brings to mind the old Benjamin Franklin quote “I am for doing good for the poor, but I differ in opinion about the means. I think the best way of doing good to the poor is not making them easy in poverty, but leading or driving them out of it.”

When we are importing people to work in our fields, our tourist operations, our offices and food service outlets whilst over a million Australians are unemployed or underemployed there is clearly a willingness to work issue, not just a lack of jobs. The proposed measures draw from the successful New Zealand policies of the last decade, which are also finding favour with the Trump administration. I’m also strongly supportive of the efforts to crackdown on the black economy, which the taskforce head has estimated to be at least $35 billion per annum.

The biggest shortfall of the budget is that completely fails to take meaningful action to get back to a surplus. The plan for a balanced budget in four years (note this is well after another federal election and therefore a problem for another government) relies on ridiculous assumptions for inflation and employment growth. The old Keynesian principle of surpluses in the good times and deficits in the bad times has been discarded for deficits all the time. The major parties have given up on living within their means, unwilling to tell the population that we cannot have everything we want. At a federal level, we have given up on following the prudent examples of John Key (New Zealand) and Mike Baird (NSW), and have chosen the road to poverty that the US, Europe and Japan are taking.

The slow strangulation of higher taxes is ignored by many economists and politicians but it remains true. I’m not an advocate of Australia competing with Singapore and Ireland for the lowest corporate taxes in the world as that is a game we cannot win. However, Australia could compete in having lower tax rates for workers by shifting the tax burden to GST and land tax. Our migration should be focussed on very high skill workers and wealthy people, who will pay disproportionately high levels of taxation. By having a strong base of skilled workers, we can attract more of the new economy companies that will be driving future growth. The prize is not so much gaining corporate taxation from these companies, though targeted measures can capture more of their revenues. It is increasing the employment rates and income of Australians, thus increasing total taxes collected and lowering welfare spending.

The biggest news of the month for China was the downgrade by Moody’s of the country credit rating from Aa1 to A3. Whilst the first downgrade since 1989 came as a surprise to many, the massive growth in debt, lack of transparency in financial matters and the potential for bank bailouts means China should be rated much lower than A3. However, in saying this I’ve firmly of the view that almost all country ratings are inflated so I’m not singling out China on this. The aggressive Chinese response to the downgrade also isn’t unusual, countries and companies have long bad mouthed rating agencies after downgrades occurred. Rating agencies are transparent in their methodologies, typically outlining what needs to be done well in advance of downgrades. When borrowers fail to take corrective action they only have themselves to blame.

All of the above hasn’t stopped Bloomberg and Citigroup (NYSE:C) from taking steps to add Chinese bonds to their bond indices. I see four issues with this:

1. The quality of financial information is poor with fraud commonplace
2. Limited rating agency coverage, with the Chinese rating agencies notoriously optimistic in their assessments
3. Resolution of defaults is a very grey area. The legal system isn’t transparent or independent with corruption considered endemic, particularly against foreigners. Bailouts from local, state and the national governments are common when locals are the investors, but foreigners can be left with losses.
4. Trading rarely or never occurs on the majority of bonds, making valuations questionable and trading difficult.

These issues are common for emerging market countries, just part of the risk taken for the higher yield. Relative to other emerging markets though China’s debt offers very low returns. This is in large part due to the massive amount of capital trapped in the country by the exchange rate regime. As China’s bond market offers international investors relatively lower returns for high risk, there’s little reason for active investors to take the gamble. For passive investors, they look set to be stuck with poor value bonds being pushed into their portfolios. This is just another reason that passive investing for bonds is suboptimal.

After many false starts, reform of the financial system could be the real deal this time around as President Xi has given the orders. Credit growth in April was still strong, but wealth management products and entrusted loans saw a substantial drop in issuance. A life insurer banned from issuing new products has claimed there will be mass defaults and social unrest if it can’t start selling investment products again.

Regulators have cut off access to offshore bond markets for property developers and are insisting that collateral must exist and be saleable otherwise banks cannot lend. Research from the central bank called out moral hazard noting that no banks have collapsed even though some should have. The markets are pricing in this risk as interbank funding is now more expensive than corporate borrowing. This has occurred even with the huge expansion in central bank provided liquidity shown in the graph below.