Author: Colin Twiggs

Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters. Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis. Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events. He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
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Theresa May: How to herd cats

Theresa May

Theresa May has a task of Herculean proportions: to negotiate a Brexit deal that will gain approval from a divided British parliament and an obstinate EU. Securing a deal would make herding cats look easy.

But Mohamed El Erian argues in Bloomberg that the British prime minister is close to a deal with which everyone is “equally unhappy”. And it is “possible that May has managed to corner both her internal position and the EU, opening a wider window for the government to secure support for her deal in the coming weeks. To understand this, consider how the bargaining positions are changing not just because of the pending March 28 deadline but also, and more importantly, because of the European elections scheduled for May 23-26.

More than the March 28 deadline, the European elections could well constitute a binding practical constraint on both the UK and EU, thereby significantly raising the probability of forcing the clarity and sufficient unity and cooperation needed for a workable proposal…..

With many European officials likely to oppose UK participation in the elections, the prospects of a disorderly hard Brexit essentially imposing itself will prove very threatening to British politicians on both sides of the argument. In other words, a May-proposed deal that includes some further EU concessions will certainly still not be optimal for them but will be better than being widely blamed for the alternative. And Brussels would go ahead, also fearing the alternative.

Here’s how this likely, though not yet overwhelmingly probable scenario would proceed: The May government would get agreement from parliament on a short-term extension to the March 28 deadline. This would be accepted by Brussels and allow for negotiations on some further concessions. Parliament would consider the revised deal and, after lots of noise and jockeying, agree to it before the European elections in which the UK would not participate.”

With an extension beyond April out of the question, parliament faces a clear choice: accept Theresa May’s deal or face a no-deal, hard Brexit. Securing approval of a negotiated deal would be a massive win for May, Britain and the EU.

Hat tip to Greg McKenna.

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Dollar retreats but Gold flat

The Dollar retreated from resistance at 97.50 and is likely to test support at 95.50.

Dollar Index

Spot Gold, however, continues to test short-term support at $1300/ounce. Breach is likely and would warn of another test of primary support at $1180.

Spot Gold in USD

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ASX 200 approaching resistance

A sign of increased risk aversion is the stellar performance of the A-REIT index. AREITs are trading at substantial premiums to net asset value as investors bid up stocks with stable cash flows.

ASX 200: Real Estate

Financials are retracing to test their new support level at 5900/6000. Calls from the RBNZ for the big four to increase their capital haven’t helped.

ASX 200 Financials

Materials are also retracing but continue their up-trend. Though the iron ore windfall is unlikely to last.

ASX 200 Materials

The ASX 200 is heading for a test of resistance at 6300/6350. Expect stubborn resistance, leading to a correction.

ASX 200

I remain cautious on Australian stocks and hold more than 40% in cash and fixed interest in the Australian Growth portfolio.

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S&P 500: Beware the buyback blackout

We are now entering the blackout period when US corporates normally refrain from buying back stock, in the four to six-week period prior to their next earnings release. There is no outright ban on buybacks during that period but discretionary repurchases are restricted.

Zerohedge illustrates the extent to which stock buybacks are currently driving the market:

S&P 500 buybacks

Buybacks dwarf the $18 billion year-to-date inflow from ETF investors into US equities. The blackout period is likely to cause weakness.

10-Year Treasury yields also breached support at 2.60%, warning of a further decline in long-term interest rates. A sign of increased risk aversion.

10-Year Treasury Yields

Volatility on the S&P 500 has declined close to 1% but an upsurge in the next few weeks would warn of elevated risk. Breach of 2600 would indicate another test of primary support at 2350/2400.

S&P 500 & Twiggs Volatility

We extend our sympathies to the victims of the shooting in Christchurch and their families. Our hope is that this atrocity will draw people together in support of each other rather than divide them.

It has often been said that power corrupts. But it is perhaps equally important to realize that weakness, too, corrupts. Power corrupts the few, while weakness corrupts the many. Hatred, malice, rudeness, intolerance, and suspicion are the faults of weakness. The resentment of the weak does not spring from any injustice done to them but from their sense of inadequacy and impotence….
~ Eric Hoffer

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China slowdown

Consumer durable sales are falling sharply:

And from Trivium China:

Premier Li Keqiang reiterated that big stimulus isn’t coming:

“An indiscriminate approach may work in the short run but may lead to future problems.”
“Thus, it’s not a viable option.”
“Our choice is to energize market players.”

….It’s a decidedly different tack than the credit-fueled stimulus of yesteryear, and the practical outcomes of this new policy response are two-fold:

  • Given that it’s a new strategy, the transmission channels from policy to actual economic growth support are not well understood.
  • The one thing we do know – this approach will take longer to impact the economy than the credit-driven responses of previous cycles.

The bottom line: It will take China’s deceleration longer to bottom out than markets and businesses currently expect.

China’s stated intention is to avoid big stimulus, so a policy reversal, if we see it, would signal that the slowdown is far worse than expected.

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Aussie banks get a wake up call from across the Tasman

I have long called for Australian banks to increase their equity capital in order to withstand a potential banking crisis in Australia. The Murray Commission found that banks, in a crisis, would act as “an accelerant rather than a shockabsorber”.

Now the RBNZ has announced plans to force the big four banks to hold more capital in their New Zealand banking operations. From Clancy Yeates at the Sydney Morning Herald:

The Reserve Bank of New Zealand has mounted a firm defence of its plan to force Australia’s major banks to hold $NZ12.5 billion ($A12.12 billion) more in capital in their banking operations across the Tasman, saying the “highly profitable” businesses would have to accept lower returns.

In an interview on Wednesday, RBNZ deputy governor Geoff Bascand also justified the plan to bolster bank balance sheets by emphasising the social costs of banking crises and arguing New Zealand could not rely on Australian parent companies for a bail-out in severe shock.

……The big four Australian banks made $4.4 billion in cash profits from their New Zealand operations in 2018 representing about 15 per cent of their total combined profit with ANZ tipped to experience the most significant hit.

Mr Bascand said the central bank had estimated the big four’s NZ return on equity, until recently 14 to 15 per cent, would decline by between and 1 and 3 percentage points as a result of the change.

Earlier, Bascand said:

“At one time, the owners of a bank had plenty of skin in the game; in fact, there was a time when banks got most, or all, of their money from their owners. However, over the last century, banks have started to use less of their own money and more of other people’s, and the balance has almost entirely reversed. While we are not attempting to turn back the clock …..We believe that more ‘skin in the game’ for banks will result in:

  • Banks being better able to absorb large, unexpected losses
  • Society being less at risk from banking crises
  • Reduced fiscal risk…..As the global financial crisis illustrated, when banks fail there can be a severe domino effect that puts pressure on governments to step in with financial support
  • Bank shareholders and management being less inclined to take excessive risks”

(Gareth Vaughan, Interest.co.nz)

The RBNZ proposal calls for systemically important banks to hold a minimum of 16% Tier 1 capital against risk-weighted assets, of which 6% would be a regulatory minimum and 10% would act as a counter-cyclical buffer to absorb losses without triggering “resolution or failure options”. Bear in mind that risk-weighting significantly understates total assets and that leverage ratios, reflecting un-weighted assets, are about 55% of the above (i.e. 8.8%).

The banks have protested, warning that increasing capital will raise interest rates to borrowers.

…..The RBNZ has acknowledged interest rates charged by banks will probably rise as a result of the change, but Mr Bascand said it estimated the impact would be about half a standard 0.25 percentage point move in official interest rates.

If banks’ borrowing rates did rise more sharply than expected, he said the RBNZ could offset this through monetary policy…..

What the banks failed to consider (or mention) is that investors are prepared to accept lower returns on equity if there is lower associated risk. Also banks with strong balance sheets have historically experienced stronger growth. Both lower risk and stronger growth would help mitigate the costs of additional capital.

Question is, why are RBNZ raising concerns about bank capital and not APRA? Another case of regulatory capture?

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S&P 500 optimism fades

10-Year Treasury yields are testing support at 2.60%. Breach of support would warn of a further decline in long-term interest rates. Declining yields reflect the outflow of funds from stocks and into safer fixed-interest investments.

10-Year Treasury Yields

Volatility on the S&P 500 has fallen close to 1% but a correction from here would be likely to form a trough above the 1% level, warning of elevated risk. Breach of 2600 would indicate another test of primary support at 2350/2400.

S&P 500 & Twiggs Volatility

Average hourly wages, total private, grew at 3.4% over the last 12 months, while production & non-supervisory wages grew at 3.48%. This keeps pressure on the Fed to raise interest rates as underlying inflationary pressures grow. The dampening effect of the trade dispute with China may have bought the Fed more time but a spike above 3.5% would be difficult to ignore.

Average Hourly Wages Growth

Impact of the trade dispute is more clearly visible on the chart below, with growth in total hours worked retreating below 1.5%. Slowing growth in hours worked warns that real GDP growth for Q1 2019 is likely to disappoint.

Real GDP and Hours Worked

China Trade Talks

US-China trade talks have made little in the way of real progress.

BEIJING—The U.S. and China have yet to set a date for a summit to resolve their trade dispute, the U.S. ambassador to China said Friday, as neither side feels an agreement is imminent. (Wall St Journal)

There is opposition to concessions on both sides:

China has a secret program to support the microchip and software industries. That’s according to Wang Jiangping, Vice Minister of Industry and Information Technology. Wang was speaking to CPPCC delegates at the Two sessions on Thursday, but the comments leaked to reporters (FX678):

“Last year, the Ministry of Industry and Information Technology planned the ‘Zhengxin Zhuhun’ project under the leadership of the Party Central Committee and the State Council.”
“The state will give strong policy and funding support, because industries such as microchips and software need to be iteratively developed.”

Wang said the ministry had kept the policy under wraps. That’s presumably because of the recent international backlash to the Made in China 2025 program…..Wang’s comments have already disappeared from the Chinese internet.

Get smart: Given Xi’s self-reliance push in key technologies, nobody really thought China would give up its industrial policies for these sectors. (Trivium China)

Whoever leaked Wang’s comments was not trying to make trade negotiations any easier. Impact of the trade dispute is starting to emerge in both economies but resolution and enforcement of a trade agreement is a long and tenuous path.

Hope is an expensive commodity. It makes better sense to be prepared.

~ Thucydides (460 – 400 B.C.)

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Dollar stirs, Gold weakens

The Dollar is testing resistance at 97.50 after poor progress in US-China trade talks. Breakout would signal an advance to 100 which would be bearish for gold.

Dollar Index

Spot Gold found short-term support at $1300/ounce. Expect a test of support at $1250 but a fresh Dollar advance would threaten primary support at $1180.

Spot Gold in USD

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ASX 200 gravestone

Australian housing prices are falling.

Australia: Housing Prices

Fueled by declining credit growth.

Australia: Housing Credit growth

With falling contribution to GDP growth from dwelling investment, and mining investment shrinking….

Australia: GDP Contribution

GDP growth is expected to weaken further.

Australia: GDP growth

The gravestone candlestick on the ASX 200 weekly chart warns of selling pressure. The primary trend is down and the index unlikely to break through resistance at 6300. Expect a correction to test support at 5650; breach would warn of another decline.

ASX 200

I remain cautious on Australian stocks and hold more than 40% in cash and fixed interest in the Australian Growth portfolio.

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Rural Funds Group (RFF)

Stock: Rural Funds Group
Exchange: ASX Symbol: RFF
Date: March 6, 2019 Latest price: $2.27
Market Cap: $757.4 m Fair Value Estimate: $1.49 (Gordon’s Growth model)
Forward P/E: 15.4 Net (adjusted) Asset Value: $1.75
Financial Y/E: June 30 Rating: Underperform (LT)
Sector: Real Estate
 Industry: REIT – Agriculture
Investment Theme: Dividends & Growth Structural Trends: Global population growth and rising middle class in Asia.

Company Profile

Rural Funds Group is a real estate investment trust (REIT) that specialises in agricultural properties which it leases to tenants on long leases.

Farming sectors include:

  • cattle
  • poultry
  • cotton
  • tree nuts (almonds and macadamias)
  • vineyards.

RFF also invests in water rights.

Sectors

Strengths & Weaknesses

Long-term global population growth is expected to increase pressure on food and water shortages, driving up agricultural prices. Rising living standards in Asia have also led to increased animal protein consumption:

We are likely to face increasing scarcity of food and water. Advances in technology have improved crop yields, but increased meat consumption in China and other Asian economies will reduce overall output. The area of land required to produce an equivalent amount of edible protein from livestock is 4 to 5 times higher compared to traditional grains and legumes, and up to 10 times higher for beef. Diversion of land use for ethanol production may also restrict food output. (The Patient Investor: Structural Trends)

There is a common misconception that “Farms don’t really deteriorate or need updating in the same way that shopping centres, warehouses or office buildings do (Motley Fool).” There is a symbiotic relationship between the farmer and the land. Only by investing time, effort and capital is the land likely to yield the best return. A tenant is likely to have a shorter-term outlook, without the same sense of stewardship towards the land.

It is also a misconception that triple-net leases mean that the tenant bears all the risk, while the landlord collects a steady return. Agricultural prices are notoriously volatile and the value of the land is determined by the return that can be achieved by the farmer. If prices fall for example, tenants may be unable to meet their rental payments and may seek rental relief until the market recovers. Weather events (drought, floods, hail, etc.), pests and disease can also impact on crops and livestock, affecting the financial viability of tenants.

Large scale tenants may be able to diversify risk but are still vulnerable to pricing and other widespread events.

Tenants

RFF has some strong tenants, although it appears that the fund is carrying operational risk through its lease to Cattle JV, a wholly-owned subsidiary. We also note that recent cattle properties acquired, totaling $58.5m, are leased to Stone Axe Pastoral Company whose board is dominated by private equity firm Roc Partners (also likely to have a shorter-term outlook).

Another misconception is that rural funds only hold investments in agricultural land that is at low risk of impairment. Here is a breakdown of RFF assets at fair value:

Sectors

Almost 20% of assets are trees and vines (bearer plants), while investment property includes “buildings and integral infrastructure including shedding, irrigation and trellising”. Intangible assets (12.7% plus 6.1%) consist of water rights, while finance leases (7.7%) include loans to tenants to fund establishment of feedlots and breeding herds.

Financial performance

Distributions

Distributions per unit have grown at a healthy 5% p.a. from FY15 to FY19 (forecast), with management targeting 4% future growth.

Distributions

Forward dividend yield, based on consensus estimates, is 4.66%.

Capital structure

The fund has $301.9 million of debt at 1H19 (pro forma), with a gearing level of 32.7% (based on adjusted asset prices). I consider this high for an agricultural fund, considering the variability of operating cash flows in underlying farming enterprises, and would prefer to see a lower limit of no more than 25%.

Valuation

Stated net asset value at 1H19 is $1.75 per unit, based on most recent valuations of underlying assets.

Using Gordon’s Growth Model and a required return of 11% p.a., with 4% growth, we arrive at a fair value of $1.49 per unit.

Technical Analysis

Long-term Momentum declined in 2018, after a strong up-trend, as RFF consolidated above support at $2.00. But yields on quality REITs have recently been falling as the prospect of interest rate rises (in Australia) fades.

Twiggs Momentum

Support at $2.00 has held firm and rising Trend Index troughs indicate buying pressure. Breakout above $2.30 would signal a fresh advance, with an immediate target of $2.60.

13-Week Trend Index

Conclusion

While RFF may present a short-term trading opportunity if it breaks above $2.30, we consider it too highly-priced for a long-term investment.

Disclosure

Staff of The Patient Investor may directly or indirectly own shares in the above company.

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