Consumption drives investment not the other way around

-- | 09/11/2018

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Glenn Freeman: I'm joined today by Peter Warnes, and we're following up on his presentation at the Morningstar Individual Investor Conference. Peter, you covered a lot of ground there ranging from the broader macro-thematic things through to some of the more micro-Australian-centric topics. Now, can we just start on some of the big picture items that you're covering off there?

Peter Warnes: Yeah. Glenn, the big picture is that Economics 101's demand and supply affects all markets, and it will play itself out, and even the White House should understand that. So, from the equity market side, demand has exceeded supply for many, many years now, driven by improving fundamentals and now those fundamentals basically peaking high GDP growth, high earnings – corporate earnings growth and may look like they're starting to peak. That has been a very, very fundamental demand driver for equities.

Overlaying that, you've had a very, very significant increase in buybacks and dividends, but more buybacks, $800 billion through the year ended August, and by the end of the year, estimated to be nearly $1 trillion.

Freeman: We've been seeing more just lately that I think just this week we've seen BHP with another $100 million buyback announced?

Warnes: Yeah. Well, the management have understood to get a better bang for your buck, you got – run for short-term, give the money back to shareholders that attracts them to the market. And so, demand – another slice of demand force, if you like, overlaying the improving fundamentals. So, that's been the enabler and sounds sustainable.

U.S. corporate in the year, again, to August and September, they had paid out over 100% of operating earnings in buybacks and dividends, unsustainable. And then you've also had a very, very major switch from active to passive managers. That flow of funds whilst not necessarily a driver of demand, but don’t forget when you have passive managers, they've got to be 100% invested, so they replicate the benchmark and so that cash that might have been held by an active manager as an asset allocation has gone into the market as well. So, those three demand drivers have pushed the markets to record levels. Two of them are unsustainable, the last two, the passive management and buybacks, and the fundamental drivers are starting to weaken.

Freeman: So, you're saying potentially that if, say, dividend yields for equities markets are going to decline looking forward, more than likely, does that – are bonds – these fixed income potentially going to become more attractive if yields there are going up?

Warnes: Well, potentially, yes, Glenn, because GFC, post-GFC, investors were getting basically nothing for cash, very little for bonds because some of the interest rates were so low. And you push further and further out the risk curve to get yield. Now what will happen is that – but be careful, because don't forget, if you buy a bond, you won't take a capital loss unless you hold it to maturity. So, don't go and buy a 30-year bond because you won't be holding that to maturity. Stay short, very short; in other words, two, maybe five years, but I've been waiting a little because these bond yields are going to push up and then probably six or nine months down the track look to position yourself in a bond. But you could go in there now and nimble.

Again, in the hybrid space, the CBA (pulls), those type of things and there will be more supply of that coming, look at those situations, particularly the ones that aren't so much equity related, more debt related and higher up in the capital structure. So, there's a couple of opportunities coming, and investors are going to get a bit more return for their money. But make sure that you have a look at the risk-adjusted rates of return, not the headline ahead of return.

Freeman: Sure. And also, just turning to the local household level, you spoke about that and how the rising costs for Australian households in tandem with the time when we are seeing flatlining wage growth, what were you saying there?

Warnes: Well, again, it's all about GDP growth. And the biggest contributor to GDP growth in Western developed economies is household consumption. Household consumption is 24x7. That's what you've got to stimulate and if you stimulate that and sustain it, then that will be a very, very major foundation stone for your GDP growth.

At the moment, and I ask the question of the audience, how many people think the household expenses are going up at the inflation rate of 2%, and there's not one person to put a hand up. And that's the reason why this is a serious situation, because I'll say, the household consumption is so significant. So, what the government should be doing is stimulating household consumption by a meaningful cut in personal tax. It probably won't happen, but that's what should happen. Don't worry about cutting corporate tax rates and what have you. Consumption drives investment; investment has never driven consumption.

This report appeared on 2021 Morningstar Australasia Pty Limited

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