- 2014 was not an easy year for Australian-based investors and 2015 will be somewhat similar.
- The equity yield trade is far from over.
- The key lesson is to cut your losers but to let winners, like Telstra, run.
No doubt the rally in safe havens and protection is a sign we can expect further equity market volatility. The fact we are seeing the US dollar, US long bonds, global long bonds, gold and volatility (VIX) all rally at once is a sign of investors becoming increasingly defensive. On the other side of the equation, the sell off in the commodity complex can accurately be described as a rout.
The investing world appears to be positioning for an extended period of low GDP growth, low inflation and ultra-low interest rates. That is all you can conclude from the pricing of long bonds and commodities. That view, outside of the USA, is most likely correct in my opinion and clearly has stock, sector and asset allocation ramifications for Australian investors.
Let’s start top down then conclude with a bottom up stock idea.
Commodity rout
The Oil price crash has MAJOR inflationary implications, which you can see the bond market is all over and pricing in. In fact, both input prices in terms of commodity prices have fallen across the board and wage inflation also remains anaemic. The bond markets could well be right in pricing in an extended period of low inflation/deflation and low GDP growth. The World Bank lowered its global growth forecast for 2015 from 3.4% to 3% yesterday.
Let’s just remind ourselves of some of these stunningly low, long bond yields globally. These yields are for 10 years.
[1]
US dollar power
If anything, they are right about the only developed economy in the world having UPSIDE interest rate (cash rate) risk being the United States. Every other developed economy, from the UK, through Eurozone, Japan and even Australia has a flat to lower interest rate trajectory ahead. This is why I continue to believe in the currency world all roads lead to the US dollar and we are in the infancy, yes infancy, of a major US dollar revival, which has major cross asset class and volatility ramifications.
[2]I continue to recommend shorting the Japanese Yen, Euro and Australian dollar. My target on the US dollar Index (DXY) is 100 in the near-term, while I have to admit that I also forecast the NZ dollar will go above parity to the Australian dollar due to the differentiated growth and interest rate directions of the respective trans-Tasman economies.
The key point is that for Australian-based investors there remains a clear case for increasing US dollar exposure either directly or indirectly. I am targeting 75 US cents as my Aussie/US dollar target. It’s only 6.5 US cents away and we have all seen how quickly currencies can move.
Australian-based investors also need to strongly consider what the global and domestic bond yield curves are trying to tell you. The Australian 10yr bond yield is now only 6 basis points above the current RBA cash rate setting of 2.50%. The entire Australian bond yield curve, with the exception of the 10yr yield, is now below the current cash rate. The 3yr bond yield is 42 basis points BELOW the current cash rate. That discount to the cash rate has widened since I last wrote on the topic in December and it’s fair to say the RBA is getting further and further behind the curve.
Rate cut expectations
My core strategy is the RBA will cut rates by 50 basis points in the first half of 2015 as GDP surprises on the downside and unemployment on the upside. That clearly has currency, asset allocation, stock and sector recommendation ramifications for Australian-based investors. Clearly, for one, the equity “yield trade” would be far from “dead” in that scenario.
Telstra
I am going to start the year by banging the drum on a core high conviction stock pick and portfolio overweight, Telstra (TLS). This is a classic example of letting a winner run.
[3]Telstra could well be the top 10 stock to own. It has dividend growth, positive earnings revision, regulatory certainty, pricing power, excess capital and massive grossed up yield advantage to any duration of Australian government bond.
Telstra is an equity growth bond. In FY15 I forecast Telstra to pay 32c of fully franked dividends. The interim dividend is a little over a month away. At the current share price ($6.17), Telstra has a prospective dividend yield of 5.18% or 7.40% grossed up, based off that 32 cent fully franked annual dividend forecast.
With the huge move down we have seen in bond yields and yield curves, I am upgrading my 12-month forward Telstra price target to $7.00 from $6.40. There is simply no way that Telstra will continue to yield “grossed up” more than 3.5 times the equivalent 3yr government bond rate (2.08%), or potentially more than 3 times the future RBA cash rate. Telstra yield will be bid down and, inversely, capital growth will be solid, as money flows from fixed interest to equity yield. At 3.5 times the current 3yr bond yield, you are being compensated for taking equity risk.
TLS vs. 3yr AGB yield
[4]That’s my first piece of stock and portfolio advice this year: make sure you own enough Telstra (TLS).
2014 was not an easy year for Australian-based investors and I expect 2015 will be somewhat similar. However, there will be capital gains and income to be generated, we just need to remain extremely focused on where that will come from. The key lesson from 2014 remains – be a ruthless cutter of losers and let winners run. I suspect that will be even more valid in 2015 as the Fed starts the interest rate normalisation cycle, while the rest of the world is heading in the other direction.
I hope I can again help you negotiate through what will continue to be volatile markets. In volatility there is opportunity.
Go Australia, Charlie
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