The RBA cited their recovery in property prices in their recent statement, with a decision to hold the official cash rate at 1%. Economists were expecting interest rates to stay constant at current levels and were more interested in the board’s guidance for the future trajectory of interest rates.
The RBA has a triple mandate, that being maintaining currency stability, maintaining full employment and ensuring continued prosperity. In simple terms, this means trying to make sure the Aussie dollar doesn’t jump around too much, ensuring most people have a job and keeping economic growth up. The central bank will concentrate on different parts of the mandate at different times, as it sees fit.
Over the past few years, it is a focus on reducing unemployment that has caught the attention of the RBA. This is because the central bank believes that unemployment can go lower before inflation even approaches the top end of the RBA’s target band, helping explain why the central bank has kept interest rates at such low levels. The recent economic data, from both Australia and around the world, has however pushed them to be more concerned about addressing weaker economic growth. The RBA is biased towards further cuts and is unlikely to increase interest rates anytime soon.
Aussie interest rates over the past 20 years (Credit: RBA)
How the Aussie Economy is Tracking
The Australian economy is set to grow at the weakest pace since the financial crisis, with the prospect that quarterly growth could inch into negative territory. The main drivers of this move are weak dwelling investment on the back of a housing slowdown, in addition to poor retail sales and inventory numbers. Nevertheless, despite a slowing economy overseas, it is the stronger than expected trade surplus that might actually save the Australian economy from contracting.
Australia recorded a record trade surplus of $19.8bn for the March quarter, which was enough for the Aussie economy to declare it’s first current account surplus since 1975. This was far ahead of economist expectations of a $1.5bn trade surplus and was an impressive achievement in the face of falling iron ore prices towards the end of the quarter. The trade result will contribute 0.4 percentage points to Wednesday’s GDP numbers, without which the Australian economy would most likely be in contraction.
Australia’s tendency to borrow from overseas and offer attractive domestic investment opportunities has led to a persistent current account deficit for decades. While this does draw attention to a domestic savings problem, a current account deficit is not altogether a bad thing, since it highlights how attractive Aussie investment opportunities are to foreign investors.
What’s Happening in the Property Market
The RBA’s recent interest rate cuts have stimulated the Aussie property market, with home values rising 0.8% in August. The recovery is particularly pronounced in the Sydney and Melbourne property markets, where price gains exceeded 1.2%.
This comes off the back of some much weaker growth numbers shortly after the announcement. While such an outcome seems confusing at first, it is important to remember that monetary policy changes generally have a 12-18-month time lag, after which they will start having a more tangible impact on the economy. This is why central banks have to be forward looking in outlook, making decisions based on where they think the economy will be in a bit over a year’s time.
One other factor supporting property prices is the recent election result, since it means there will not be any changes to negative gearing or capital gains tax concessions. While there has been some tightening in lending, it is easier for a lot of borrowers to obtain a loan. Further government concessions to first home buyers as well as interest rate cuts, which will often make mortgage rates lower than renting a comparable property, have spurred recent action in the market.
If you want to invest in property, residential real estate is not the only game in town. Another investment opportunity is in high quality commercial properties, which you can get access to through real estate investment trusts (REITs) on the ASX. REITs consist of a portfolio of real estate assets, which you can invest in by buying REIT shares on the stock exchange. Let’s assume that a REIT had a $1bn office tower and divided it up into 10,000 shares that traded for $100,000 each on the stock market. By buying 10 shares, you own $1m worth of real estate in a property that would otherwise be reserved for very wealthy investors.
Examples of REITs on the ASX include Goodman Group (ASX: GMG), Scentre Group (ASX: SCG), Dexus (ASX: DXS), Mirvac Group (ASX MGR), GPT Group (ASX: GPT), Stockland (ASX: SGP), Lendlease (ASX: LLC) andVicinity Centres (ASX: VCX). Some investors who buy residential real estate are concerned by yield, but don’t realise that much higher yields are available in commercial real estate.
While most of our readers will not take issue with property price growth, since it feels good to see the value of your house go up, there are some economic side effects if prices get out of hand. If prices rise above the ability of people to pay for houses, it will increase Australia’s household debt levels. Australia has one of the highest levels of household debt in the developed world, well above where the US was in the GFC.
If people lose their jobs in a financial crisis, they are more likely to default if they have high levels of debt, pushing up mortgage arrears. As we saw in the GFC, a high level of defaults on home loans alongside high levels of negative equity can lead to bank collapses, throwing a systematically important part of the economy into chaos and causing a deep recession. Retirees would be particularly badly affected by house price declines and bank collapses, which is why it is better to prevent a bubble in house prices.
Australia’s household debt levels have been persistently rising (Credit: RBA)
A booming property market in Australia’s capitals stopped the RBA cutting rates to zero for a large part of this decade. Now that the threat of a property bubble has receded, the RBA cut interest rates by 150bps and has demonstrated a willingness to go further if necessary. Property price growth is constrained by tougher capital standards and a deteriorating economy.
Will we go into Recession?
2s10s inversion has been a timely recession indicator (Credit: St Louis Fed)
When investing in shares and property, it is important to have a view on the economic outlook since it impacts both asset classes. While we did not see sustained declines in the property market in the GFC, this is largely due to the RBA’s ability to cut interest rates 425 basis points (which would push us deeply into negative territory at -3.25% if it was replicated today. We also had an unprecedented stimulus package from China that pushed investment to 50% of the country’s GDP, the highest level on record for any major economy in peacetime.
It would be imprudent to base investment decisions on the hope that such extraordinary circumstances will repeat themselves. Property and equities are both cyclical asset classes that almost always move downwards in a recession. Nevertheless, given the long-term growth potential of both asset classes, it makes sense to still have some exposure and benefit from long term returns. Cash has always been a terrible long-term investment, so the main question is what percentage of your portfolio should be in growth assets.
One indicator that is used to see whether the economy will go into recession is the 2s10s spread. When investors worry about the economic cycle, they prefer to buy long term bonds since they go up more than short term bonds. To illustrate why, suppose you held a $1,000 bond paying a $50 a year in interest for the next 10 years. Imagine interest rates suddenly fell by 5%, and new bonds that sold for $1000 now paid a 0% interest rate. Investors will clearly pay a lot more for the first one since it makes more money, pushing the price of the initial bond up. This effect is more muted over shorter time horizons.
This is why investors like longer term bonds as much as shorter term ones when they think the economy will contract. Bond markets have, in the last four market cycles, predicted contractions far earlier than the stock market. The difficulty is that the stock market generally rallies 13% over a few quarters after the first yield curve inversion. If history is any guide, now is not the time to exit the markets completely, but it is the time to invest more defensively.
Global GDP growth is slowing, but not as fast as Aussie growth in the last quarter (Credit: RBA)
One of the main reasons why investors invest in property and shares is attractive dividend payments and rental yields. Nevertheless, as the US sub-prime housing collapse showed us, rents do not always go up. Even in Australia, cities exposed to the slump in mining activity a few years ago saw rapidly falling rents. People should still invest, but it is important to monitor the positions and not turn a blind eye to the fundamentals.
BHP’s dividend cut in 2016 also showed us that most of the income from attractive, fully franked dividends can be lost very quickly. Investors who are playing the mining cycle or believe in the fundamentals of the business would need to ask different questions, but investors who are after dividends may do better to look elsewhere.
This explains the importance of quality yield and highlights why we still recommend stocks paying a 4-5% dividend locally, despite being able to easily find stocks paying much more. We would rather a 4-5% dividend that could sustainably grow to over 10% of the initial investment over a few years, than a 10% dividend for a company in terminal decline.
Is There a More Set and Forget Way to Invest in Dividend Stocks?
Our international high dividend Vue, a selected list of international stocks with attracts no management or performance fees, pays an 8-9% dividend yield. For investors who also want to not tie all their assets to the health of the Aussie economy, an 8-9% dividend yield beats 1% in local banks. This is one of the many options that investors have, if they want to boost their income and get out of the trap of declining interest rates that has defined term deposits over the past few years.
One of the securities we hold in the Vue is Gaming and Leisure Properties Inc. This is a Real Estate Investment Trust (REIT) covering high quality properties in the United States. While gaming is a cyclical business, the beauty of the REIT is that it only controls the underlying real estate, not gaming businesses like casinos. Their properties are leased to experienced operators in triple net lease arrangements, which means that they will get a steady income stream for years. Their clients are large, safe and experienced gaming operators, which are very unlikely to go bankrupt. The attractive 7.11% yield significantly outpaces Aussie REITS, which typically yield 3-5% for properties of a similar quality.
We also hold a top 3 Global private equity firm, which manages over US$220 billion in AUM. PE firms run investment funds that buy out entire businesses, improve efficiency and profitability as they transform the operations of those companies, sell them at a profit. After this, the PE firm will close its fund an receive a large component of its performance fees.
This creates a volatile earnings stream, given the company is paid for their performance after a few years. For this reason, private equity as an industry tends to be poorly understood by investors. In a market obsessed with quarterly earnings, the great 20%p.a. long-term growth rate of a brilliant business with sustainable competitive advantages is completely ignored by the market. This creates a great opportunity for us to use our long-term investment mindset to our advantage, and lock in a 7.81% yield at 7.6x earnings.
America is a great place to invest for dividends. There are numerous US companies that have not missed a dividend payment in a hundred years, have sustainable payout ratios and quality management. Given this includes two world wars, the Great Depression and the GFC, it is quite an accomplishment.
Typical issues which Aussie investors have with investing offshore include a more limited knowledge of companies outside, sky high brokerage costs at the major brokers and not knowing where to start. We side-step these issues through developing a platform called Macrovue, where a top performing fund manager identifies attractive international investment opportunities for us to look at. We pay $15 a trade for brokerage and have a clear direction on which economic trends we are investing in. As one of the only platforms offering managed portfolios without performance fees, it’s worth looking at a couple of the themes we are looking at. The portfolios each have several stocks that investors can pick and choose if they wish:
Warren Buffett Top 10 (11.21% LTM): While the Oracle of Omaha needs no introduction, the $400k price tag of one of his class A shares prices many investors out of the company. To address this issue, we created a portfolio tracking his top 10 holdings, allowing you to instant access to the wisdom powering the 20% average returns for 60 years that Buffett delivered to his investors.
Luxury goods (+4.82% LTM): Luxury goods producers have high profit margins and sticky customer bases, making them excellent long-term investments. They are particularly well positioned to take advantage of growth in China, given the high levels of luxury goods expenditure amongst the nation’s booming middle and upper class. Many of the companies in this view have significant family ownership stakes, including Hermes and LVMH, protecting them from short term biases in decision making.
5G Wireless Technology (32.65% LTM): 5G technology is the driving force enabling most of the game changing technologies over the next decade, from autonomous cars to smart homes. With most of the US and Europe poised to roll out 5G technology over the next few years, companies exposed to this trend are expected to see massive revenue growth.
This article has been prepared by the Australian Stock Report Pty Ltd (AFSL: 301 682. ABN: 94 106 863 978)
(“ASR”). ASR is part of Amalgamated Australian Investment Group Limited (AAIG) (ABN: 81 140 208 288 Level 13, 130 Pitt Street, Sydney NSW 2000).
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