As an independently-owned family office, Wattle Partners regularly has the opportunity to meet with and understand the views of some of the most experienced and intelligent investors in the world. In an effort to share these insights with our clients and readers we recently started hosting regular round table lunch events with some of the more insightful people we have met.
Last week a small group of clients and friends gathered in Melbourne to hear the views of Christopher Joye, the Portfolio Manager of the Smarter Money Group of funds. Chris’ entire career has been focused on modelling the risk of and investing into bonds issued by Australian companies. As a result he as an intimate knowledge of the inner workings of both the Australian financial system and the major banks. Chris has also been called upon to advise the likes of Scott Morrison, Malcolm Turnbull and the Treasurer of the Commonwealth Bank of Australia. Chris accurately predicted both a correction in Australian house prices and the number of Fed rate hikes that would occur in 2017-18, which no other economist had forecast. As a result, we were interested to learn his views of the year ahead. To say that Chris insights were interesting, would be an understatement. Nothing was off limits.
Throughout the 10 years since the GFC the majority of experts and investors have been concerned about disinflation or deflation, not inflation. Chris suggests we should be worried about the opposite, a large spike in inflation. He suggests that an inflation crisis may be on the cards in the next 3 to 10 years as the profligate policy of the last decade comes to a head.
His outlook for the global economy was generally positive, suggesting the US economy will continue to surprise to the upside on growth, inflation and employment. He believes Trump is a pragmatic politician, that knows how to say the right things and get results that are palatable for American’s, and that the trade war with China will end before it really begins. During his presentation he noted that if it wasn’t for a substantial spike in Australia’s participation rate, or those now willing to work, the unemployment rate would actually be just 3.1%. The strength in the economy has attracted more people into the work force.
In terms of investment markets, he shared the same view as us, in that the biggest influence on sharemarket returns and company valuations will be the change in the discount rate, or 30-year bond rate. It is this input that all investors and companies use to value the future earnings from businesses or investment, and with bond rates increasing around the world has been the main contributor to the recent bout of volatility. In Chris’ view the days of holding a long-only portfolio of blue-chip stocks are over, particularly in the period when interest rates begin to normalise. He suggested that long-short, market neutral and traditional hedge fund strategies represent one of the only ways that investors will have any hope of generating positive returns and protecting their capital in an increasingly difficult environment. This is a view shared by the Investment Committee and reflected in the increasing allocation to the Targeted Return Bucket.
Chris’ presentation then turned to what he knows best, the Australian banking sector and the balance sheets that support them. He was outspoken in his concerns regarding the exponential growth in bank balance sheets in 2013, which he addressed via his column in the Australian Financial Review. Whilst it took some time, the macro-prudential measures implemented by APRA have rectified this situation and required the major banks to reduce their leverage from some 90 times back to 30 times. He congratulated APRA for successfully creating a property correction during a boom, rather than allowing a crisis to drive performance; the major question is whether it can remain an orderly correction. The major concern is the implications of the Royal Commission in terms of lending and risk taking and whether this comes at an incredibly bad time given the slowdown has already commenced; only time will tell.
Interestingly, it appears the Royal Commission is the only one in the world to come before a banking crisis, however it has been far too specific in highlighting individual cases of unethical behaviour or human intervention rather than systematic issues. He believes that bank equity or shares will be impacted in the short-term, as they pull back on lending, are required to hold additional capital and their return on equity falls as a result. Longer-term Chris suggests the banks become one of the most attractive investments due to their ability to cut costs and invest in innovation. The banks are likely to become simple transactional institutions, taking deposits and lending to people and businesses, however, they have so much data that they can leverage this to their advantage. He expects a similar course of action to Telstra, insofar as they will seek to close branches, cut staff numbers and further automate their manual processes. They also have the largest IT and R&D budgets in Australia which bodes well for the future.
One of the major threats to the economy is an overshooting of the slowdown in lending caused by the Royal Commission. The real threat is the ‘wealth effect’ and the confidence issues that occur when house prices fall leading to further weakness in retail and consumer spending. This could be exacerbated by the introduction of responsible lending legislation, which is effectively making lenders responsible for the repayment of the loans they make, rather than the borrower. Interestingly, he noted that the majority of loan applications include understated expense figures and that the lambasted ‘benchmark’ expenses where higher and more conservative, suggesting it has been a storm in a teacup. In the short-term, Chris believed that bank debt and hybrids represent a better investment opportunity than ordinary shares, and that they would be supported by a likely upgrade in Australia’s credit rating which would introduce more investors.
He noted that the proposed franking credit policy has already been priced in and that it is unlikely to raise any additional money for the Labor Government. He noted that there is substantial negative polling on each of the franking, CGT and negative gearing policies as proposed, and as a result Scott Morrison may still have a chance.