Are bonds or equities right about the future?

The stress in the global capital markets has some strange consequences. In an environment in which most developed economies have, in effect, have little or no cost of capital, many of the usual inter-relationships do not behave normally. The centre  may not hold, as it were. Dividend yields are above bond yields in all major developed economy markets. Macquarie is pointing out that in Australia the dividend yield to long bond rate spread seen is unprecedented and unsustainable in the medium term. The question is how does it resolve?

The current >300bpt positive spread of the equity market’s forward dividend yield the Australian 10 year bond rate is unprecedented in the last 60 years, and a resolution of this spread must occur at some time; the critical question is through which of the three mechanisms (bond rates, dividends or equity prices)?

It can be rectified by raising the bond yield, by a drop in dividend payouts or an appreciation of share prices, Macquarie argues. In terms of the latter, there is an argument that the bearish sentiment is extreme and perhaps over done.

Our analysis suggests that unlike GFC 1, in the last month to six weeks investors have moved pre-emptively to the view that this event is indeed likely. This is clearly highlighted in the extreme risk aversion priced into the Australian equity market as based on the implied ER). Similarly, equity prices also appear to be reflecting a view that the impact on earnings growth, dividends, cashflows and balances sheets will also be similar to that seen in GFC1.

Thus unlike GFC 1, when equity markets stubbornly refused to price the implications of a global credit crunch even as the event was unfolding, the market today appears to have immediately priced in a significant amount of the risk that a GFC2 would present. It is notable to revisit some of these key metrics as they stood as GFC1 was unfolding. As at June 2008 – The market’s FY09 EPSg forecast was 27.9% while the 1 yr fwd PER was 11.2x; Gearing and interest cover ratios were at cyclical peaks and well above long-term averages; Payout ratios were high and for many stocks in key so-called “defensive” sectors such as LPTs and infrastructure, there was insufficient cash profit generation to pay dividends, with the shortfall being made good through borrowings.

The question is whether this is GFC 2. Macquarie thinks the dividends are sustainable:

DPS for most stocks and sectors in the Australian market are now more strongly supported by the Free to Invest* cashflow (FTICF), particularly those sectors that had offered high yield (LPTs, Utilities & Infrastructure) in the period leading to GFC1 where much of this yield was “manufactured” through constant re-gearing of assets (refer FTICF discussion later in this note.

Thus, given the significant repair to balance sheets, the broad increase in FTICF and counterintuitively the sustained pressure that earnings have been under for much of the market over the last three years, we see the dividends at their current levels as more sustainable generally than dividends that were paid in the period leading to GFC1.

So what to pick? Deutsche offers this list of dividend plays:

With the global environment not conducive to a market rally in the immediate future, yield plays look worthwhile. We update our dividend yield screen, which takes into account not only the 12m forward yield, but also future DPS growth, valuations, EPS momentum and stock beta. Stocks screening well that DB analysts rate a ‘buy’ include Challenger, Primary, AMP, Lend Lease and Crown. Other stocks rating well include Onesteel, IAG, Bendigo, QBE and Fairfax.

The misalignment between fixed interest and equities does seem to represent an opportunity. The question, however, is how much damage is being done to the capital markets? These unusual metrics are a sign that the system remains under extreme stress. If the system starts to crack, that is likely to result in an even more bearish sentiment in the stock market, even when that bearishness is probably already priced in.

Macquarie (10)


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  1. Good question to ask after what has been a great year for FI (17% spread between aussie shares (-6) and aussie FI (+11) for the industry fund i use!)

    “Peter believes that record low bond yields also point to the risk that privatesector de-leveraging could overwhelm policymakers’ ability to keep growth near the potential rate. As a result, he believes widespread policy easing could occurin the next month or two. This is likely to drive a mini-beta surge in equities, but he warns that easing alone will not solve the underlying issues”

    This is what i’m starting to wonder – can the monetary policy even keep pace with the rate of de-leveraging. The level of leverage was so high that a monetary response may not be sufficient to respond to its unwind, and as such this will be an even shorter lived response in equity markets.

    The risks feel much higher than what the equity analysts are talking about. There are still some very ugly things on corporate balance sheets that were acquired in the boom and haven’t been marked to market. The analysts tend not to bother with such bagatelles.

  2. JacksonMEMBER

    OneSteel and Fairfax? Crikey, just because the denominator is shite it’s worth a crack? glad they are not in charge of my dollars.

  3. Your article is superb. I have a question that how investor assess the fund’s strategy for paying dividends.