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Fire on all four
By Alan Kohler
August 17, 2009
PORTFOLIO POINT: Investors need to consider four big issues that affect their portfolios.
There are four issues dominating investment and economic life in Australia at the moment. By that I mean they are subjects where apathy is not an option, and not to decide is to decide.
They are: interest rates, climate change, China and the national broadband network.
Your portfolio is touched by each of them, and your wealth can either be damaged by them or enhanced. Today’s column is devoted to an examination of these four topics and what they mean to you.
Interest rates
This is really about the economic cycle and whether it has turned. Last week we were given the unequivocal message from Reserve Bank governor Glenn Stevens that it has turned, and that interest rates will soon go up.
Despite the fears of many (including me), the Australian recession has proved to be not very deep and not very long, and it’s now over. It wasn’t even a recession, technically, although using the sort of broader definition that the United States uses, it undoubtedly was.
Stevens made it clear last week that interest rates are this low for emergency reasons, and that the emergency is now over.
Usually rising interest rates are bad for share prices, and eventually that will probably be the case again – but not for a long time.
The increase in rates will not be rapid, more like the succession of a dozen 0.25% hikes between May 2002 and September 2008 than the sudden 2.75% in three hikes in 1994, as the economy roared out of 1991 recession.
On the other hand, the strength of recoveries is often underestimated, which is why Treasury took a stab at 4.5% growth in 2011 and 2012 in this year’s budget, and was ridiculed for it at the time. Now that forecast just looks optimistic rather than political and silly.
There are two implications of all this for your portfolio: don’t be put off by the prospect of rising interest rates because it won’t curtail any bull market; the duration of your fixed interest securities needs to be kept short, and your debt should now be fixed.
Long-term bonds will underperform, a situation that will be exacerbated by heavy debt issuing programs for all governments as they tackle their ballooning deficits, which will increase the supply of bonds and therefore tend to deflate their prices.
The bottom of the interest rate cycle, which is what this is, is also a time to start increasing portfolio risk in fixed interest (and in everything else for that matter). In Australia the fixed interest market is all about hybrids, which are floating rate securities, and while some of these have already produced huge gains over the past couple of months, many are still offering very juicy yields.
For example, Australand’s ASSET securities are currently yielding 10.5%, according to the CommSec daily hybrids bulletin (to read more on Australand hybrids, see Good news for hybrids). This company is unrated, but looks very unlikely to go broke (famous last words, I know). The highest yielding hybrid is Transpacific at 18.16%, but that may be a bit too risky.
The bank hybrids are currently yielding 5–6%, and most of the BBB-rated corporates are going for yields of 6–7%. There are a few standouts: AMP, 7.3%; Tabcorp, 7%; Multiplex 8.4%.
On a global scale, debate about interest rates and monetary policy is now focused on how and when central banks will “exit” the unprecedented measures designed to prevent a depression.
Gerard Minack has a good explanation of the “ins and outs of exiting” today, which is well worth reading. (see Central banks’ tricky encore). The message is that while rising interest rates are normally bad for “risk assets” (property and shares), bull markets only end when monetary policy actually becomes restrictive.
That won’t happen anytime soon. Remember that interest rates were going up for the entire duration of the 2003–07 bull market; in fact, they started going up in 2002 and didn’t stop until 2008, nearly a year after the market peaked.
Climate change
As I wrote last week, there is no excuse for missing the opportunities involved in carbon abatement: it is in your face every day.
I won’t repeat in detail what I wrote last week, but to summarise there are three key elements to watch: gas (not nuclear) will replace coal as the energy source for base-load power; mandatory renewable energy targets will result in a $30 billion renewables boom; and electricity prices will rise by 20–30%.
The second of those is especially relevant now that the government has agreed to separate the Renewable Energy Target bills (RET) from the Emissions Trading Scheme bill (ETS). The RET will now probably pass the Senate, but the ETS will not.
That means the two companies that have geared their corporate strategy around RET legislation – Origin Energy and AGL Energy – will be winners.
Most of the action in this business is wind power, and Origin and AGL are both positioning themselves to play big roles in wind power, along with the super fund-owned company, IFS.
As for the ETS, the release of the Frontier Economics report last week, which had been commissioned by the Liberal Party and Senator Nick Xenophon, only served to muddy waters some more although it did clearly highlight one thing: it’s all about electricity generation.
In my conversations with the author of that report, Danny Price of Frontier, as well as other experts in the field, it was brought home to me that the political debate about climate change in Australia is all about how quickly, and how brutally, we transition from coal-fired power generation.
There has been a lot of talk about carbon capture and storage, which might make coal viable, but that’s unproven and a long way off. It’s all about gas (to read more on this see my column from last week, Opportunities in the carbon age).
National broadband network
I’ve been trying to think of a way Telstra can use this as an opportunity to reverse the decline in its profit margin, but I’m struggling.
There has been a lot of research and commentary lately that describes the $43 billion national broadband network (NBN) as unviable because it will cost too much and the customers won’t pay enough and therefore pooh-poohing the whole thing. Don’t be sucked in: that’s a distraction.
The network will be built, it will cost a lot less than $43 billion and consumers will pay what is needed to make it viable.
It will be built because the government has said it will be and the Minister, Stephen Conroy, is determined that it will be his legacy. He has appointed a high-quality management and board to run it, and I think it would be foolish to base your Telstra investment strategy on the proposition that it won’t happen.
The figure of $43 billion was plucked out of the air. The real estimates range from half that to $30 billion, depending on a huge number of variables, such as whether the cable is underground or on poles, whether existing fibre networks are included or not, whether the HFC cables of Optus and/or Telstra are included and how long it takes.
The current cost of broadband internet starts at $29.95 a month. I pay $80.95 a month for cable internet. Some people pay $100, but not many. Analysts say the price of access to the NBN would need to be well over $100 a month, wholesale, to make it work and that this is impossible. No one will pay it, especially if there is copper-based ADSL broadband still available for $29.95.
Sounds true, except the NBN will also carry phone calls. My phone bill plus the internet would easily make the NBN viable (probably on its own, but then I’ve got 20-something kids still at home).
If Foxtel also runs through the NBN instead of the HFC cable, then it’s game over: the triple bundle of internet, voice and video would add up to about $300 a month and make the NBN perfectly viable.
So it will happen, and it will work. What does that mean for Telstra? Lower margins.
I suspect Telstra shareholders will have reason to curse former chief executive Sol Trujillo for decades over his failure to put a foot on Australia’s fibre future, because he pulled back from building the new network as part of a regulatory war with the government and the ACCC.
His successor’s job will be to manage the consequences of that: the restructuring that will be needed including, possibly, a demerger, and the steady squeezing of profit margins.
It may be a difficult few years for Telstra.
On Friday, Charlie Aitken wrote that Telstra is CHEAP, saying it’s a yield plus growth story with a potential 24% total return over the next 12 months. He said it is priced as a growthless junk bond with regulatory risk, but that its discount to the rest of the market will be removed as the market realises that the regulatory risk is not there. That’s because, Charlie says, the NBN will be pushed back and everyone will realise that there’s no network without Telstra’s co-operation and participation.
I can’t disagree that Telstra is cheap, but I think the regulatory risk is a real and present danger. Most of it may be in the price, but in my view it deserves to be.
China
In many ways this is the least clear of my four topics today. Three years ago we were talking about a commodity super-cycle thanks to the inexorable industrialisation of China; now the China miracle is beginning to fray around the edges, both economically and politically.
China does not seem to possess the constitutional and bureaucratic foundations for a modern society of a billion and a half people.
The absurd arrests of four Rio Tinto employees, the problems with the Uyghurs in the western provinces and the difficulty in controlling corruption are sign of a nation that is having trouble coping.
It is drowning in trash, there are too many factories, the infrastructure is inadequate, unemployment is endemic and rising, statistics are a joke. These things can all be fixed, but the risks are high.
Exacerbating the risks is the fact that a debt-funded bubble in shares and property values has developed, and a lot of wealth may well be destroyed when it crashes.
But China’s economy has proved remarkably resilient this year despite a big fall in exports at the end of last year and is likely to achieve the growth target of 7.5–8% that was set by the government (or at least the government’s statistics office will report that it has).
So while the risks in China look high, you would not sell BHP Billiton shares because of that. Apart from anything else, Europe’s recession is ending and America’s recovery is close. There’s nothing like resurgent demand to cover up problems among producers.
It seems to me that the risks around China confirm the benefits of a big company with a balanced global sales organisation – like BHP and Rio Tinto. Those that are tied too closely to sales to China should be approached carefully.
To sum up:
1. Interest rates are going up but that won’t cut short the new bull market.
2. Climate change means out with coal and in with gas and wind power.
3. The national broadband network is nothing but bad news for Telstra.
4. China is fraying, but don’t sell BHP.
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