Asset Class: International Equities

Will there even be an exit?

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The soap-opera continues. The twists and turns outdo any political fiction and the punchline is yet to be written.

We had hoped to be penning this edition of Pyrspectives post Britain’s EU exit but that is not the case. Will there even be an exit? Who will be Prime Minister in a month’s time (or tomorrow)? Will the UK be part of the Customs Union and subject to EU rules forever? We cannot answer any of these questions.

On a brighter note we can report that all the warnings of the UK’s imminent economic collapse by the Bank of England (and many others) that sprouted like mushrooms following the referendum result three years ago have proved to be dramatically overblown. Not only does the UK have full employment but its economic performance has matched that of Germany (real GDP growth averaging 1.5% p.a. since July 2016) while shaming the growth rate in Italy. Real wages have risen by a modest 1.5% over the three years but in a climate of tiny or zero real wage growth in much of the developed world that is not too bad. Retail sales have continued to notch up annual volume growth averaging around 3%.

The vested interests on both sides of the Channel have provided a masterclass in expectation exaggeration — Brexit will either be a total disaster or the best economic initiative in living memory depending on which side of the fence you sit. Now, we have never been pessimistic about Britain’s prospects outside the cloying embrace of the EU but we recognize that nothing that involves the economy and sovereignty (and politicians) is either all good or all bad. But we don’t like half-way houses. If Britain does finally get out let it be a genuine exit and not a bit of this and a bit of that — as the Prime Minister has repeatedly proposed.

If there is an exit with no deal at all the sky will not fall. Pragmatic and practical minds will quickly orchestrate the way forward with the sort of detail that should have been figured out long ago. Is it really to be expected that France will cease exporting vast quantities of wine to the UK or reject the flood of British holiday-makers who happily splash about in the French sunshine each summer? Let’s move on.

Recession?

Most recessions creep stealthily upon you. Often you have found that it commenced some months ago while you and others were still eulogizing over the strength of the economy. There is no sure-fire way of knowing when a recession will strike — just ask the IMF how difficult it is — but one measure that does provide a fairly good indicator of looming trouble is the gap between short and long-term interest rates.

The theory runs that long-term rates should be higher than short-term because of the greater risk involved for the investor. No argument there. So what is going on when the curve inverts? That is, when short rates exceed long. It suggests that investors are piling in at the long end of the curve (pushing yields down and prices up) because of an expectation of lower economic growth and an overall softening in interest rates. And that, in a nutshell, is what is happening now.

The chart below examines the “gap” between 3-month treasuries in the U.S. and 10-year bond yields since 1990. The gap turned negative in July 2000 (the recession started in March 2001), negative in August 2006 (recession commenced at the end of 2007) and is now sitting precisely at zero. As recently as last November the 10-year yield was over 3%. If past form is any guide it suggests that 2020 could be a pretty dodgy year.
 
Will there even be an exit - US yield spread - Difference between 10 year bonds and 3 month Treasuries
 
It is also pertinent that the Federal Reserve has publicly abandoned any suggestion of an official interest rate increase in 2019 — a total about-face from its stated position at the end of 2018. It is also likely to cease quantitative tightening — the non-replacement of bonds on its balance sheet as they mature. This remains a far cry from quantitative easing but nevertheless represents a significant change in demeanor.

The “Fed” has also reaffirmed its view that trend U.S. real GDP growth will be in the range of 1.75%-1.8%. This is marginally more pessimistic than our trend forecast of 2%. Either way it leaves the U.S. stock market at a precariously high value relative to potential growth. The Dow Jones index first hit 26,000 in January 2018 and is below that level today. It has therefore spent more than a year going nowhere. Perhaps we are witnessing another portent of dodgy times ahead.

Yields on 10-year bonds have fallen in all major developed economies over the past six months. It is remarkable how swiftly the investment and economic climate can alter.
 
Will there even be an exit - 10 year bonds
 

Housing affordability

Each year at this time we like to give air-time to analysis prepared by the Demographia group in relation to housing affordability in a number of countries around the world. The analysis contains far more detail than we can repeat here but the table below is a summary that covers major housing areas in several countries and ranks them on the basis of the median multiple — median house price divided by median household gross income. The data is at the 3rd quarter of 2018.
 
Will there even be an exit - Major housing markets ranked by affordability
 
Demographia rate any multiple above 5.1 as “severely unaffordable.” All of the 20 markets in the above table fit into that category with the outlier, as always, being Hong Kong. This is a market where property prices are simply extraordinary thanks to government curtailment of land availability and the influx of mainland Chinese money into the market. Will it end? Probably, and it won’t be pretty when it does. For those with long memories they will recall the time when Hong Kong real estate was a classic boom and bust tale. Lately it has only been of the boom variety but history has a way of repeating itself.

Australia always features prominently in the Demographia analysis with all five of the major markets rated as “severely unaffordable.” However, times are a changin’. In 2018 property prices fell in each quarter with an accelerating trend as the year progressed.
 

 
Sydney has been the epicenter of the housing bubble and is now the epicenter of the fall. Prices topped out in the June quarter of 2017 and are now down around 15%. In 2018, according to the Australian Bureau of Statistics, prices fell by 7.8% with a sizable 3.7% in the final quarter. We cannot find another quarter with such a significant price drop in Sydney — even during the Global Financial Crisis. A new acronym has started popping up in the Australian press — FONGO (fear of not getting out), as opposed to FOMO (fear of missing out).

Analysis by Demographia suggests that: “Available data shows that house costs have generally risen at a rate similar to that of household incomes until comparatively recently. This is consistent with cost trends among other basic necessities, such as personal transport, food and clothing…Historically, the Median Multiple has been remarkably similar among six surveyed nations, with median house prices from 2.0 to 3.0 times median household incomes (Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States). Housing affordability remained generally within this range until the late 1980s or late 1990s in each of these nations.”

So what has changed? In a nutshell, availability of credit and urban containment policies — the latter placing an artificial cap on available land. The credit phenomenon, particularly in Canada and Australia is apparent from the chart below. In both countries it has now reached an extreme whereas in the U.S. and UK it has significantly moderated.
 
Will there even be an exit - Household debt to disposable income
 
In Australia the rise in house prices has been aided by a surge in housing purchased for investment purposes – either in a superannuation (pension) fund or as a regular investment which capitalizes on Australia’s unique negative gearing practice. This allows losses from property investment to be written off against normal income. Many “small” investors own a string of properties designed to produce a net income deficiency after borrowing and other charges have been taken into account. They usually end up paying no tax at all.

This game appears to be changing for several reasons — bank and non-bank lenders have tightened credit criteria; supply has increased; foreign demand has eased; the opposition Labor party has declared it will modify the negative gearing rules if it gains power in this year’s general election (a strong possibility) and the tumble in prices over the last year has set nerves on edge. One thing that is bound to upset a heavily geared property portfolio is negative equity.

The fall in finance for investment properties is pronounced. It peaked in April 2015 and is now down some 37%.
 
Will there even be an exit - Australia investment housing finance all lenders
 
Property prices ultimately relate to affordability although they can get out of hand for significant periods as we have seen over the last 20 or so years. Nevertheless there are many markets around the world that have median multiples of 4.0 or less according to Demographia. Our guess is that several more will join them over the next few years.

Eurozone

The European Central Bank has dramatically lowered the growth forecast for the eurozone. A year ago it forecast growth in 2019 of 2.4%; 3 months ago it forecast 1.7% and now is forecasting just 1.1%. Some drop! Mr. Draghi, the ECB President, naturally blamed everyone else for the weakness in the eurozone: the trade war between the US and China, slowing growth in Japan and China, Brexit and the change in US Federal Reserve interest rate policy. He employed a phrase which no doubt will be repeated many times: “Continued weakness and pervasive uncertainty.”

In addition to the drop in the growth forecast he lowered the inflation forecast for 2019 from 1.6% to 1.2%.

Mr. Draghi has stated that there will now be no increase in benchmark interest rates before 2020 (Mr. Draghi leaves office this October) as well as announcing plans for a series of cheap two-year loans for eurozone banks — an effective easing of policy.

Among the various data series we track we note that productivity growth (real GDP per employed person) fell below zero in the December quarter while industrial production has exhibited negative year-on-year growth since November. The composite leading indicator has been steadily falling for a year. Mr. Draghi has said that the likelihood of a recession is “very low.” We’re not sure that we agree with the descriptive “very.”

The eurozone has now notched up 20 years of operation – having commenced with just 11 members in January 1999. There are now 19 members. Has it worked? It would be a long stretch to assess it as a successful economic experiment. Real GDP growth over the 20 years has averaged a shade less than 1.5%. The UK (see graph) has done much better. Labor productivity growth has averaged just 0.7%. With an ageing population and static to negative growth in the workforce it will be a struggle to achieve even 1% GDP growth going forward.
 
Will there even be an exit - Selected Eurozone countries and UK
 
Jamming 19 sovereign entities into one exchange rate and one common short-term interest rate structure combined with limited fiscal flexibility has never made much sense to us. We remain of the view that a break-up, in some form, is far from a remote possibility.

Superyachts

Every so often we like to visit the world of superyachts as revealed in the pages of the monthly superyacht “bible”: Boat International. Why? It tells us whether the ultra-super-rich are still spending freely or battening down the hatches. The Global Financial Crisis sent a cruel wind through the leisure boating market and it took many years to regain its vigour. Long lead-times for “new-build” mean that economic conditions encountered when an order is approaching completion can be very different from those prevailing when the order is placed.

During the GFC many “new-builds” were mothballed as financing collapsed. Potential owners simply walked away foregoing substantial deposits. Many boat-builders went to the wall – including some long-established and respected names.

So what’s the current status? In 2018 the brokerage market chalked up sales of 434 superyachts with a total asking price of 4.26 billion euros. To save you working it out that equates to an average asking price of 9.8 million euros. In the previous 12 months the average asking price was 8.8 million euros and 438 yachts changed hands (total of 3.86 billion euros). In 2016 the total was “just” 3.37 billion euros.

In 2018 twelve yachts measuring more than 70 meters (231 feet) were sold, up from eight in the previous year.

Conclusion — this market is in rude health which immediately causes a rapid increase in our patented palpitation index. When the super-rich are spending at this rate on totally indulgent luxury items it smacks of the tail end of a boom. Superyachts are a classic lagging indicator. This market descends into the mire sometime after the rest of the world has figured out times are not what they were.

The super-rich tend to be compulsive market “players.” In other words, they have lots going on and using age-old financial wisdom generally do so using someone else’s money. When the economic cycle turns sharply down some of the balls in the air thud painfully to earth. What to do? – well, you sell your third or fifth house and (reluctantly) put your floating pride and joy on the market.

How long before balls start thudding to earth? Perhaps another year or two. Perhaps not. If you really fancy yourself reclining in luxury on your own 100 meter slice of indulgence we suggest that there may be a few cut-price bargains around in the next few years. That is, if you can call something a bargain that takes half a million dollars or more to fill with fuel before you leave the dock. Then again, you could just charter one for a week and write the astronomical charter cost off as a deposit on a dream.

The final word

Over long periods of measurement (20 years or more) equities in the major developed markets have tended to provide fairly consistent returns — usually between 5 and 7% compound per annum – including income.

Over the last 20 years, however, returns haven’t matched the past. Were you aware, for example, that in the first decade of this century most developed markets provided a negative nominal return — including income? One of the better performers was the U.S. market but even it generated a negative number. The S&P 500 index, including income, fell by 9.1% over the 10 years to December 2009 (annualized fall of 0.95%). Of course, the current decade, which we are 92.5% of the way through, has seen a marked recovery, generating a total return on the S&P 500 to March 31 of 208% or 12.9% p.a. (all data from Thomson Reuters Datastream). Rolling the two decades together we find that the total return has been 180% or 5.5% p.a. If we deduct inflation which has averaged around 2.2% it suggests the real return over 20 years has averaged little more than 3% p.a. – quite a bit lower than in the past.

So what has changed? It seems to us that the main difference is a lower income component in the total return. Since the mid-1990s the dividend yield on the S&P 500 has averaged at least a full percentage point less than the average dividend yield of the past. This deficiency has not been made up by faster profit growth which could be expected to lead to more rapid market appreciation.

Of course interest rates are much lower than in the past but so is economic growth (and trending lower). We are, in a nutshell, in a low growth, low return world. And, importantly, a heavily indebted world. Some would go so far as to suggest that a classic debt deflation is ahead – negative inflation, non-existent interest rates, economic stagnation. Others would suggest that central banks will blow up an inflation bubble (or try to) in an effort to shrink indebtedness in real terms.

Anything is possible as we haven’t previously lived through economic times similar to the current but we’d prefer to simply stick to the low growth, low return outlook. We’d like to see higher dividend yields to compensate for lower stock market returns. This would suggest a one-off market reset (lower share prices). But the vested interests will fight that tooth and nail.

So be prepared for dull market returns. Should this trend continue you could expect to earn next-to-nothing after inflation on fixed interest (or less than nothing) while equities are priced for “normal” economic conditions. And we don’t have anything close to “normal.” What fun the next decade could be.

 

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