By Raymond Chan

Our chief economist Michael Knox, in his quarterly presentation, updated his macro economic outlook. Knox noted that the US economic growth is below historical trend according to CFNAI (Chicago Fed National Activity Index, Chart 1).

While the “below trend economic growth” suggests no immediate inflationary pressure, the US employment growth remains very strong – this brought the unemployment rate down to 4.9% (as shown in Chart 2) - a level below which the inflation will likely be a problem soon (why? Lower Unemployment Rate  Higher Wage Growth  Higher Consumption  Higher Inflation).

For now, the slow economic growth and higher employment growth are sending conflicting signals to the Federal Reserve. Latte with Ray is of the view that the Fed will continue to hike rate at a very modest pace and yes we’re still expecting rate hike in 2nd half of 2016. 

 

Chart 1: Chicago Fed National Activity Index (CFNAI, L.H.S.)

Source: Morgans, Michael Knox, Federal Reserve, Bloomberg

Chart 2: US Unemployment Rate (R.H.S.)

Source: Morgans, Michael Knox, Federal Reserve, Bloomberg

To make matters worse, we started to see some stress with BAA Credit Spread reaching multi-year high, as shown in Chart 3.

Chart 3: BAA Credit Spread near post GFC high

Source: Latte with Ray, IRESS, Bloomberg

While our strategy team has decided to stick with model valuation of 5,496 points, Latte with Ray “feels” a more conservative fair value of 5,200 points should be adopted given the high and elevating level of short selling positions in our ASX 300 stocks, as reported by our Strategist Andrew Tang

Tang commented “short sellers … have stuck to their conviction maintaining an elevated exposure to the market with $30.7bn held short or 95% higher than the corresponding period in 2014 and 2013, 47% higher than 2015 despite the S&P/ASX 200 index being lower in 2016 … High PE stocks have had a difficult time living up to elevated expectations this reporting season, given the low levels of conviction elsewhere in the market leading up to February.

Investors have clustered around the high-growth names such as Baby Bunting, IPH, Bellamy’s, A2 Milk, Capilano, Carsales, Next DC, Costa Group, Domino’s Pizza, and REA Group, many of which have found it difficult to impress the market despite posting strong results. Short sellers have recently increased selling in Blackmores, Vocus, Corporate Travel and REA Group … Short sellers again focused their attention on the big 4 banks. The threat of further and more onerous capital requirements and deteriorating asset quality in a challenging growth environment raises earnings and dividend risk. A further A$1.5bn of stock has been sold short across the four banks suggesting the recent updates have not fully alleviated concerns.

All four majors registered increased short selling with CBA and NAB seeing the bulk of the selling.”

While it’s quite unsettling to see (1) high level of ASX 300 shortings and (2) AFR articles “Uncovering The Australian Big Short” being one of the most read articles, Latte with Ray thinks the Australian Lending Practices are having far higher standards than some of those US financial institutions before the GFC (as described in Warren Buffett’s letter to shareholders, released last week). Buffett wrote, “Mortgage-origination practices are of great importance to both the borrower and to society. There is no question that reckless practices in home lending played a major role in bringing on the financial panic of 2008, which in turn led to the Great Recession.

In the years preceding the meltdown, a destructive and often corrupt pattern of mortgage creation flourished whereby (1) an originator in, say, California would make loans and (2) promptly sell them to an investment or commercial bank in, say, New York, which would package many mortgages to serve as collateral for a dizzyingly complicated array of mortgage-backed securities to be (3) sold to unwitting institutions around the world.”

In conclusion, Latte with Ray thinks Australian Banks look attractive at current level. As a rule of thumb, if we hold a stock with dividend yield of 7% p.a., our cost of entry will be fully reimbursed by dividend payments in 10 years. Yes there’s risk of dividend cuts but in this instance the reward is likely to outweigh the risk for patient investors.