10 big investment ideas for 2016
It’s time to fire up the interneuronal connections and carve out 10 big ideas for 2016.
My first offering is that Australia will likely become an Asian nation in its ethnic orientation. Apologies to the xenophobes, but it’s happening under your nose. An incredible 28 per cent of Australia’s population (or 6.6 million people) were born overseas – the highest in 120 years. During the last census a remarkable 12 per cent of Australians said they had Asian ancestry.
In Sydney and Melbourne, 19 per cent and 18 per cent, respectively, of residents are Asian. In Sydney regions like Parramatta and Ryde, the Asian share of the population is as high as 34 per cent and 33 per cent, respectively. China and India have overtaken the UK as Australia’s biggest source of new migrants, collectively accounting for 35 per cent of the intake in 2013-14.
The idea of Australia stealthily yet ineluctably becoming an Asian nation is a big deal: it will reinforce our unique antipodal trading position and powerful role as a politically stable economic conduit between east and west; it will help improve our cultural commonalities with major regional actors like China, India and Indonesia (mitigating geopolitical hazards); and it should serve as a source of innovation, productivity and growth, just as the influx of ambitious European migrants did after World War II.
Bank returns on equity will fall
Idea number two is that the major banks’ returns on equity (RoEs) are inevitably going to fall from around 15 per cent towards their 11 per cent cost of equity as result of the banking system becoming a highly competitive and level playing field. While this process may take five years or more, it should mean that rather than trading at an unusually high two times book value, the majors will price at circa one times. If I’m right, there is much downside to current valuations, which is a proposition reinforced by analysts’ crazy forecasts that bad and doubtful debt charges will stay around 30-year lows.
In five years the majors will have ceded the competitive advantages that fuelled their world-beating RoEs. Rather than carrying 25 per cent more leverage than rivals, they will end up having less leverage and more equity capital in the funding mix. Combined with the fact that smaller banks tend not to source as much funding in the dearer wholesale bond markets – underwriting assets with cheaper deposits that are now a government-guaranteed (and more stable) funding source – I believe the majors will wind up having more expensive funding costs. In short, we will migrate to a system where the majors are much safer banks with reduced risks of failure, with the trade-off of lower returns on equity than competitors that have loftier leverage and lower funding costs. There should, therefore, be an economic role reversal between the big four and their rivals.
Another Macquarie Bank?
If the majors are going to become slow-moving, yet bullet-proof, utilities, a third idea is investors should look for superior returns from more fleet-footed alternatives that are not saddled with the financial baggage of being too-big-to-fail. One day we will eventually see another Nicholas Moore who creates a new Macquarie Bank with a much skinnier 50 per cent dividend payout ratio (compared to the majors’ 80 per cent pay-out policies) that retains earnings to support investments in innovative and entrepreneurial opportunities. Macquarie has done a fabulous job of continuously reinventing itself to maintain growth and studiously avoided allocating too much capital to competing in the majors’ commodity markets.
On this note, the majors will likely lose significant market share in home loans to regional banks that for the first time will be able to compete effectively with them on price without crushing their returns. Rather than being price setters, the majors will become price takers and have to give back the recent rate hikes they have foisted on borrowers to compensate for expanding equity funding costs or suffer market share losses. This will compel them back into the less contested business lending space, which will lubricate credit to companies. Indeed, I think the majors’ balance-sheet splits between residential and business loans will revert back to the 40:60 levels before the 1991 recession.
Our forecasts for double-digit house price growth in 2013 and 2014, and high single-digit growth in 2015, were spot on. My fourth idea is that there will be no imminent housing collapse, and the price of our bricks and mortar will again climb in 2016, albeit at a much slower pace of around 1 to 2 times income growth. I maintain the view that the market is very expensive (15 to 25 per cent above fair value) and recently sold my own home. The interest rate hikes that will be the catalyst for a sustained Aussie housing correction appear to have been shunted into the distant future.
A fifth idea is that as the US and UK jobless rates (5 and 5.3 per cent respectively) fall towards 3 per cent in 2016 and 2017, wage and consumer price inflation will gradually reanimate. While the Fed will hike in December, central banks will get behind the curve because of their desire to “look through” this reflation.
Fixed-rate bond prices to plummet
This prompts another idea, which is that fixed-rate bond prices will melt as long-term yields rise on the back of financial markets resisting the Fed’s dovish view of the world and acknowledging stubbornly strong inflation data. The existential moment for global central banks will arrive when the break-even inflation rates priced by the bond market begin breaching official inflation targets in a sign that investors no longer think that monetary policy (and so-called nominal growth targeting) is compatible with price stability. Asset allocators need to be short interest rate duration or, if you have to be exposed to this risk, hire a smart duration manager – they can be hard to find. Few people can consistently call rate changes right.
If this base case plays out, my seventh thought is that global equities will face tremendous headwinds as long-term risk-free rates (that is, government bond yields) mean-revert back to some semblance of normality, which means yields 50 per cent to 100 per cent higher than current marks. Recall that the 10-year government bond yield is an essential input as the underpinning for the discount rates in the valuation models for all listed and unlisted equity and real estate markets.
Sell ‘beta’ buy ‘alpha’
This insight furnishes an eighth idea, which is sell equity “beta” and buy “alpha”, as I advocated last year. Aussie shares (beta) have declined over the year to date while market-neutral and long-short hedge funds (alpha) have delivered terrific returns (at least the guys that I invest with have). This dynamic is unlikely to change.
In the more immediate term (over the next, say, one to two years), I like “spread” assets as the search for yield will remain a critical influence over investor behaviour as long as deposits do not offer any material “real” returns above inflation and equities continues to get hammered. One example is major bank subordinated bonds, which currently trade very cheaply on a global basis despite the majors being among the best capitalised banks globally, care of $33 billion of equity origination over the last 12 months. The credit ratings on major banks’ subordinated debt are on par with the senior bonds issued by Goldman Sachs, Morgan Stanley or Citigroup, and I think there is a decent chance they will get upgraded to the “A” band next year if Standard & Poor’s lifts the majors’ stand-alone credit profiles from “a” to “a+”, as it has signalled it may do.
A final thought is that if the world is once again forced to choose between elevated interest rates and high and volatile inflation, there is a possibility that the value of paper money will atrophy as a credible medium of exchange. This could precipitate a flight to safety in the form of a resurgence in the demand for gold as a hedge against the debasement of money by governments using the printing press to finance their own deficits.