Weekly Reports | Jul 14 2023
Weekly Broker Wrap: potential trap in being underweight Aussie banks; impacts of higher-for-longer interest rates; outlook for construction & the attraction of corporate bonds.
-A critique on underweight positions for Australian Banks
-What if inflation and interest rates remain higher for longer?
-Robust non-residential work, longer-term residential upside
-Janus Henderson notes corporate bonds are becoming attractive
By Mark Woodruff
A critique on underweight positions for Australian Banks
The Australian economy is not adhering to the usual script for economic downturns by showing great resilience to date, thereby endangering some investment strategies.
Citi suggests many investors are significantly underweight Australian banks, in the expectation of bad debt and net interest margin (NIM) pressures, and may be incorrectly equating current economic conditions to prior slumps.
A more resilient labour market and lower corporate leverage will result in a more benign asset quality cycle for banks compared to the downturns brought on by covid and the GFC, explain the analysts.
Because of these twin positives, the current downturn bears more resemblance to conditions experienced by the bank sector in 2002-03, points out the broker.
Over the 12-month period to March 2003, the ASX200 fell by around -23%, however, employment remained strong, and the GDP measure didn’t contract as in 2008-09 or 2020.
During those downturns, the Banks and Property sectors underperformed while Healthcare and Insurance outperformed, which the analysts note is just the opposite of sector performances over the 2002-03 period.
While mortgage stress and loan loss risks for the banks are rising, Ord Minnett expects losses will remain small relative to the size of bank loan books.
This broker suggests population growth and low unemployment (even if rising) will be supportive of house prices and the ability of borrowers to service debt.
If upcoming results season shows NIM pressures are moderating and that credit stress will be broadly manageable, Jarden predicts investor expectations will swing towards the broker’s more constructive/neutral stance on the banking sector, given the support from attractive dividend yields and further buybacks.
What if inflation and interest rates remain higher for longer?
Jarden poses the question: what if we are only at the start of the next long-term rising interest rate cycle?
Historically, interest rate cycles have endured over prolonged periods, with the latest downcycle in the US and Australia extending from 1981-2021 and 1990-2021, respectively.
Prior to this, the most recent up-cycle was over the period 1960-1980 (US 1958-80; Australia 1963-89).
To be clear, Jarden (and the broad market) believes the peak of the current rate hiking cycle is at hand and interest rates will be lower in the medium term.
Nonetheless, there remains an elevated risk inflation and rates remain higher for longer. This outcome would potentially undermine successful strategies of recent decades, notes the broker, such as buying long-duration growth and debt-funded real assets like infrastructure and property.
The worry is Jarden can see parallels in the current environment to the previous long-term rising rate cycle in which fiscal expansion continued even in the face of rapid inflation. For example, US government outlays are currently expected to remain around record levels, with ongoing deficits of more than 5% of GDP.
One saving grace, in the broker’s view, may be current debt levels, which are significantly higher than in the previous cycle. As a result, the economy is much more sensitive to interest rates and the sustainability of higher rates is considered questionable.
If we are at the start of a new long-term rising interest rate cycle, Jarden suggests the current period of elevated macro uncertainty and volatility will continue for some time.
Moreover, in these circumstances the broker points out risk premiums across both equities and bonds should be higher.
Presently, equity risk premiums (how much a stock might outperform risk-free investments over the long term) in the US and Australia are around the lowest in more than 10 years, points out Jarden.
Regarding near-term interest rate movements, Citi points out markets tend to emphasise CPI inflation in the US, but the Federal Reserve follows PCE inflation data, where used car prices attract a smaller weighting.
The PCE metric is likely to print a stronger reading (a 0.4% month-on-month core PCE forecast by the broker) that might quickly dissipate market optimism that inflation can easily be returned to target.
The analysts highlight wage inflation in the US is more consistent with 4% inflation than 2% inflation.
While recently weaker recent trends for producer prices is a positive sign of further easing in inflationary pressures, many of the weak prices in PPI data are not those faced directly by consumers, explains Citi.
Robust non-residential work, longer-term residential upside
As indicated by leading indicators and the record rate of construction company insolvencies, there is near-term downside risk to residential construction activity, though Jarden remains bullish over the longer term and continues to believe the next housing construction boom will take off from FY25.
Over time, this boom is set to benefit various sectors on the ASX, suggest the analysts, including Building Materials, Residential REITs and Household Goods.
March quarter construction data released this week showed the first decline since September 2020 for the residential work pipeline. However, Jarden points out this backlog remains near a record high at $76bn, which should provide around 10 months of work for the sector.
The construction data showed a solid 14% quarter-on-quarter rise to an annualised pace of 186,000 for residential starts though was largely driven by the volatile multi-residential category. Private houses fell by -6% month-on-month, broadly in line with the long-term average of 106,000.
Outside of residential construction, Jarden considers the outlook is more positive with a significant pipeline of public and private work underpinning activity.
For those construction firms and suppliers able to pivot from residential into other sectors, a record high $46bn worth of non-residential building and $118bn worth of engineering work is yet to be done.
Recent approvals for non-residential building suggest to the broker a bright outlook. Strength was largely due to big year-on-year increases in approvals for industrial warehouses, transportation and offices of 30%, 16% and 30%, respectively.
Moreover, business capex intentions point towards solid investment growth of 8% year-on-year continuing into FY24, explain the analysts.
Regarding public work, Jarden highlights the significant pipeline of road and rail projects underpinning more than $60bn of public engineering work.
The broker believes this pipeline will remain robust as government budgets are anticipating annual public investment of greater than $120bn per annum over the next three years.
Janus Henderson notes corporate bonds are becoming attractive
Janus Henderson observes corporate bonds (in particular) are becoming more attractive for Australians willing to lock in a fixed yield ahead of a peak in the Reserve Bank’s rate-hike cycle.
Moreover, there is the bonus of prospective capital gains, as bond prices rise when market interest rates fall.
In separate commentary, Janus Henderson highlights the ASX is largely comprised of cyclical sectors such as mining, where companies generally don’t borrow to the same extent as international peers.
Accordingly, in Australia there is a much lower overall net debt/equity ratio, which fell to a relatively low 29% at the end of 2022.
Certainly, this lower borrowing tendency holds true in the (latest) 2023 Janus Henderson Corporate Debt Index, which reveals Australian corporate debt has fallen by one sixth, while global debt has risen by US$456bn to almost US$8trn in 2022-23.
Higher global profits over this period boosted equity capital, which meant the global debt/equity level held steady at 49% year-on-year, despite increased borrowing.
Interestingly, Janus Henderson points out 90% of the US$433bn constant-currency increase in global profits was delivered by the world’s oil producers, while telecoms, media and mining experienced lower profits year-on-year.
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