11 May 2023
Overvalued share markets and recession risk from USA
Why Australian banks are far safer than American banks
An Australian economic slowdown is coming. Consider:
1. Shares are expensive relative to interest rates. See below.
2. An estimated 15 percent of Australian residential mortgage holders are expected to be unable to cover their mortgage payments as the last of the low interest starting mortgages of the past two years roll over to substantially higher interest rates. We do not believe that house prices have stabilized. Many of the vast wave of borrowers being forced to switch from temporarily fixed cheap 2 percent home loans to variable rates of around 5.5 to 6 percent will find that they have insufficient home equity to ride out the storm.
3. The US Federal Reserve have advised that the world’s largest economy will probably experience a recession. Usually this leads to global slow down. Warren Buffet also sees a US recession as likely. Refer to his recent remarks at Berkshire Hathaway’s annual general meeting, available online.
4. Reportedly 15 percent of all listed companies could not service the interest payments on their debt even before the RBA announced the latest interest rate increase, let alone make principal repayments on their borrowings.
5. Waves of defaults and bankruptcies are emerging. This may prove to be a repeat of the vast number of insolvencies Australia experienced in the early 1990’s as the Reserve Bank squeezed high inflation from the Australian economy. Then Treasurer Keating described it as the ‘Recession Australia had to have’.
6. Bankruptcies already include a number of building companies.
7. Government guaranteed and hence risk-free bank deposits are paying 4 to 5 percent which means that to contemplate investment on higher risk assets there is a need to expect an income and capital appreciation return of 3 to 5 percent above the available risk-free returns. This is proving to be a challenge. Hope springs eternal but very few shares or other investments are likely to meet this hurdle in the coming year or two.
8. Australian banks only fix mortgage interest rates for home loans for short periods after which borrowers must transfer to variable rate mortgages or negotiate new terms for a further limited period. This means that the interest receivable on Australian bank assets is well synchronized with the interest cost to the banks on their liabilities i.e., bank deposits and loan facilities. Hence our four major banks are among the safest banks in the world. They are sound financially but likely to be less profitable as some house loans in default and business failures require provisioning for write offs to rise. The US banks which have failed/been bailed out lent very long term at fixed rates. Rising interest rates on deposits and declining realizable value of their government securities created loss-making outcomes. The US bank home lenders, mainly regional banks, did not match the interest rate conditions of their home loans with their funding. As this became known, depositors rushed to make withdrawals creating bank collapses. There are thousands of small banks in the USA regulated by state authorities which are simply not up to the task as distinct from some huge institutions such as J P Morgan Chase regulated by federal authorities. The fundamental weakness in the US banking system has been the habit of a myriad of smaller banks lending very long term on fixed rates of interest while dependent on short term deposit funding. Banks prefer that home borrowers who get into trouble sell their houses rather than face a bank mortgagee in possession outcome.
9. Warren Buffett warned the 40,000 shareholders present at Berkshire Hathaway’s annual general meeting, held recently in a sports stadium, that the US economy faces a slowdown this year, naming the commercial property sector, the US banking system and US tensions with China as the big three risks. US commercial property REITs (real estate investment trusts) which borrowed heavily short-term face substantial devaluations or insolvency as the FED increases interest rates and makes finance for large properties harder to get. Depositors in the US banks which got into trouble have been rescued by the authorities but bank shareholders have had their equity destroyed. History shows that Buffett has consistently gotten the big calls right. Berkshire Hathaway is sitting on $US 130.6 billion in cash! This is a reflection of Buffett’s view of market value.
A Big Worry: Inflation Kills Jobs
Despite their noise central banks have not yet killed the inflation bogy. Persistent high inflation kills jobs. This is why the Reserve Bank of Australia followed other central banks in lifting interest rates and has recently announced a further increase. Nor despite Treasurer Chalmers rhetoric is the budget deflationary. We may not yet have seen the last of the RBA’s interest rate increases in the current cycle.
Share Market Valuations
By most historic measures our market is still priced on the high side despite the ASX 200 index being significantly lower over the past 6 months. See below.
Our family superannuation fund has about 57 percent of its assets held in bank hybrid securities and cash but does not hold the ordinary shares of our four large banks which will face pressures from emerging troubled loans. Despite being safe we view them having to undergo some pain. We believe that it is the wrong time in the economic cycle to hold the ordinary shares of the big four Australian banks in our superannuation fund. They may be considerably lower over the coming year. The shares still held in the fund are carrying substantial long term capital gains, meaning that there is a substantial cost in selling them.
Shares in our non-superannuation investment portfolio which may have a substantially higher embedded capital gains tax impost if sold are treated separately on the Warren Buffet principle that we continue to achieve earnings on the unrealized capital gains tax impost by being long term holders.
The US share market sets the pace for the rest of the world. When Wall Street crashes it sets off a global chain reaction. There is a cyclically adjusted measure of the overall value of the US share market known as the cyclically adjusted price to earnings rate (CAPE). Since 1880 the average CAPE has been 16 to 17 times earnings but recently has been 29.5 times. The CAPE soared to 39 times earnings in 2021 but since the Fed launched a series of interest rate increases aimed at defeating inflation the US equities CAPE has started to normalize falling from an astronomical 39 to 29 times. There is still huge downside risk. The Australian share market has not reached the same heights but by historic measures remains significantly overvalued.
Core inflation in Australia remains substantially above the RBA’s target.
Beware of dead cat bounces!
What it Means in Australia?
A significant number of insolvencies will see closer scrutiny applied to company earnings. While I am loathe to desert the share market entirely, this is not a time to become involved with companies with poor earnings or heavy debt or with property REITs loaded with office space or businesses without strong earnings/customer bases. We continue to like ARB because of its net zero debt and reliable business and CSL because of its leading position in the pharmaceutical field. Both have achieved enormous long-term gain and lead the currently small number of stocks in our fund. Our next three best superannuation investments measured by unrealized capital gain are Cochlear, Woodside Petroleum and Woolworths.
Economic Madness
The Housing Australia Future Fund (HAFF) bill is stuck in the Senate. It involves authorizing the government to borrow $10 billion (yes, ten billion dollars). This will then be handed to the Future Fund to invest with the net proceeds to fund housing! This raises the question, “what if the funds return falls below the interest cost on the borrowings?”.
This scheme is akin to the disreputable Queensland based Storm Financial, which persuaded gullible investors to mortgage their houses to take geared investments in funds recommended by Storm Financial. Large numbers of investors lost their homes.
If it was wrong for Storm Financial to persuade people to borrow heavily against their home equity, how can it be sensible for the government to borrow ten billion dollars to invest on the risky assumption that it can produce significant net profit to invest in houses? What happens if its return is below borrowing cost? Is it not more sensible simply to borrow a smaller amount to build some houses?
Shock Budget Surplus!
Governments habitually bag their predecessors but the recently discovered surplus has been hiding in plain sight as tax collections have been buoyed by record employment and commodity sales of gas, coal and iron ore have been at prices much greater than Treasury forecast.
It suits Treasury to dampen political pressure to spend by unrealistically low forecasts of revenue. Some fat is likely well hidden in the budget, but regrettably worse times are to follow.
Strategy for the Times
Like Warren Buffett we see a recession as being possible in the near future. For those in retirement conservative investment strategies are appropriate. For those working, paying down debt, funding superannuation and holding cash buffers are appropriate.
Given recent government announced changes to superannuation it is sound, indeed vital, strategy for couples to build parallel superannuation balances to utilize each’s $1,900,000 pension account limit applying from 1 July for those who are still in accumulation stage of superannuation funding.
Financial Success for Dentists
Financial Success for Dentists: Rules for How to Approach Your Dental Career sets out the key strategies which make dentists successful. It is specifically written for those dentists and dental specialists owning their own practices and for those aspiring to own practices. Among the topics included:
· Understand key practice valuation criteria.
· Learn how some dentists inadvertently reduce the value of their practice by $500,000
· Avoid long term errors when purchasing your practice.
There are many accountants, financial advisers, marketing consultants, web site designers and practice advisers who give advice from their particular disciplinary experience, but very few have the wider breadth of experience to define for their clients the key rules to follow to optimize their practice and their long-term financial outcomes. An otherwise competent financial adviser may have little understanding of what makes one practice much more successful than another. Many accountants have detailed knowledge of the taxation rules but cannot identify if a dental client has broached invisible barriers to practice growth or a threat to practice goodwill value.
I spent 33 years examining dental practice financial outcomes and reviewing the key strategies and decisions which separated successful Australian dental practices and practice owners from the less successful and this led to relevant conclusions and advice to dental practice owners.
A complete and comprehensive career guide for mature and aspiring dentists.
Based on real life situations and a lifetime of dealing with dental practice ownership outcomes this book is worthy of Text Book status for every dental teaching school.
—Merv Saultry, Founder Dental Innovations Network
To Obtain a Copy:
· Go to the Delany Foundation website at http://www.delanyfoundation.org.au
· Click on the Donations tab and make a donation of minimum $60. This is easiest by Mastercard or Visa.
· Email graham.george.middleton@gmail.com confirming that your donation has been made, as well as your name and mail address
· A copy of the book will be mailed directly to you
All production costs and mail costs are met by me personally, so all money donated goes to the Delany Foundation which contributes toward the running of schools in Ghana, Kenya and Papua New Guinea. Naturally donations above $60 are welcome.
The donation to obtain this publication will be the most cost-effective practice advice most dentists will ever receive.
Please Pass On
If you like these newsletters, please pass them on to colleagues. Past newsletters and articles in Australasian Dental magazine on business issues are at grahammiddleton.com. I can be contacted directly at graham.george.middleton@gmail.com
Independence And Disclosure
I am not a representative of any accounting practice, financial planning firm, business or marketing consultancy. I spent 33 years as a business and financial adviser to mainly dental, medical and veterinary specialist and general practitioners. Since I retired as a director of a financial services group, of which I had been a founder, on 30 June 2020, I am no longer licensed as an investment adviser. Readers should treat the above as general advice and take professional advice as required.
General Advice
The above is ‘general advice’ and individuals are urged to undertake considerable personal research of companies in which they are investing as well as demanding of their advisers that they tailor advice toward their best outcome after demonstrating an understanding of their position in detail. Be cautious about accepting advice unless you are certain that your adviser has a thorough knowledge of your situation. If in doubt the best decision is often to make no investment changes.
I sold my interest in a financial services and accounting group on 30 June 2020 and have no intention of starting another financial services business. I own, via my family superannuation fund and investment portfolio, some of the stocks mentioned in this newsletter. My website is now available at grahammiddleton.com.
Those who find my newsletters of value to them are asked to consider making a donation to the Delany Foundation, a registered charity which assists schools in Papua New Guinea, Ghana and Kenya. Delany Foundation c/- Holy Cross College, 517 Victoria Road Ryde NSW 2112.
Best wishes to all readers
Graham Middleton
