Don’t fight the Fed

Chief Investment Officer and founder of Aitken Investment Management
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The Fed is reducing support for the yield trade (QE ends October) and will start raising cash rates in 2015. Your portfolio needs to be positioned ahead of that event. Markets move in anticipation and you can’t wait for the “fact” here.

This is a major trend change event and, in my view, the beginning of the end of the outperformance of the yield trade. You only have to look at the Australian dollar for guidance to this starting.

You don’t need more banks

On the 29th of April this year, I downgraded the Australian bank sector to “hold” (neutral) on the basis that our long-held FY14 5.00%FF yield-based share price targets had been hit or exceeded. That day proved to be the top for ANZ ($35.07), NAB ($36.00) and WBC ($35.99) for the year to date. CBA did trade slightly higher into its FY14 result/div, but is now lower and has cracked the multi-year technical uptrend (chart below).

Since then I have further downgraded the bank sector to “underweight” on the basis of rising unemployment, rising long bond yields, regulatory capital risk (Murray report), macro-prudential risk (RBA), weak credit growth, competitive pressure, a view on bad and doubtful debts (BDD) increasing from here (WA led), weakening technicals (momentum fade) and basic over-ownership by Australians.

Yesterday, the ASX200 Banks index broke down through the 200-day moving average, a clear sign of a major momentum change.

Click here for a larger image

Central banks have forced anyone who relies on investment income to move up the risk curve, to the point where I believe people who were buying “yield at any price” are clearly forgetting equities and corporate debt are not fixed interest, least of all a term deposit.

QE and zero interest rate policy (ZIRP) have created the greatest yield bubble in modern history. We rode it on the way up, made great capital gains inverse to yield compression, but now it’s only a question of whether the yield bubble deflates slowly, or simply pops. Either way, the absolute and relative price paid for yield has peaked. Simultaneously, volatility in yield equities has bottomed.

My concern has been that these individual investors, who were somewhat late to the “yield compression party”, haven’t been tested by volatility and capital losses. I also suspect there is more personal carry trade money in risk yield instruments than we all suspect, again negatively gearing into fully franked yield equities is rewarded by the ATO to Australian taxpayers, but no foreign investor sees it that way. Again, this is outright dangerous when the tide turns.

Quite frankly, Australians are paying a massive premium to the rest of the world for exactly the same earnings/dividend stream. That had worked up until April this year, but the world is changing. What you need to consider is who is going to be the marginal buyer of Australian yield equities (and debt for that matter) as global long bond yields and cash rates normalise?

I can’t answer that and I suspect we won’t find any foreign buyers of Australian anything until the Australian dollar is down near 85 US cents. In fact, as we have seen in recent weeks, the Aussie dollar falling brings out foreign selling of Australian yield equities, most likely from Japanese insurance companies getting killed on currency carry.

Dividends will still be paid

Funnily enough, I don’t have concerns about the physical ability for Australian banks to pay consensus dividends and hybrid payments. If I had those concerns, I would be limit short, not just underweight.

Don’t get me wrong. Raw Australian bank annual dividends will continue to rise, albeit very slowly from here, as they are forced to hold more regulatory capital. My concern is what will the world pay for those dividend streams in a more normalised long bond yield and interest rate environment?

If you are only interested in fully franked income streams, then at this stage you should have no concerns about those income streams. Your concerns should be about capital. You will get your income, but the value of your investment will fall in capital terms.

In an attempt to quantify the capital downside in the Australian banks, I am going to do the inverse exercise of the last few years (which made us so much money). I am going to set potential share price targets from prospective dividend yield-based targets, albeit this time around the share price targets are all below the current share prices.

All Australian banks weren’t created equal. On that basis, I am going to risk assess each bank and allocate what I think is an appropriate risk-adjusted dividend yield target for FY15. I believe this is a more appropriate approach moving forward than the “one size fits all” yield approach we had on the way up. Bull markets are indiscriminate. Bear markets are more discerning.

I am assuming Australian government bonds 10YR yields move to 4.20% in the period and have applied what I believe would be an appropriate equity yield risk premium to that “risk free rate”. These are the FY15 dividend yield targets I have applied.

CBA 5.75%

WBC 6.00%

ANZ 6.25%

SUN 6.25%

NAB 6.50%

BOQ 6.50%

BEN 6.50%

Suncorp best pick

While not a perfect science and only an exercise in forecasting, the table above reminds you why Suncorp is our no.1 pick and the only “bank” in our high conviction buy list. This also reminds me why we are strategically overweight insurers and underweight banks. It also reminds you, which is 100% right, that the biggest downside capital risk in this scenario is in the regional banks. I can’t see any risk adjusted reason to own the two regional banks. The chances of regional banks being allowed to hold less capital are zero in my view. What will happen is big banks will have to hold more capital and that’s where the playing field will be marginally leveled. No bank regulator is allowing any bank to hold less capital at this point of the cycle. The switch from Bank of Queensland to Suncorp remains extremely valid in my view.

My advice remains that you need less exposure to Australian Banks. Whether it’s physically selling one of them, or simply recycling dividends into other stocks/cash, my point is you don’t need MORE exposure at this stage of the interest rate and asset price cycle.

Let me just finish with a couple of charts that confirm Australian banks are well and truly part of the global yield bubble, a bubble that is deflating.

ASX Banks Index vs. Federal Reserve Total Assets (green line)

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ASX Banks Index vs. ASX200

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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