Your Quarterly E-Zine
Edition 11 • December 2019

This website contains the latest edition of Forsyth Barr Focus, a quarterly on-line magazine written by senior members of Forsyth Barr's investment team.

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MIND THE GAAP

In a recent report, we coined a new term for viewing the New Zealand sharemarket, “GAAP” or “growth at any price”. This new take on “growth at reasonable prices” (or “GARP”) comes at a time when everything seems expensive.

Does this mean there is no value in the New Zealand sharemarket? Probably not, but investors need to understand what they own and what is expected to drive returns.

Share prices have benefited from higher earnings and lower interest rates
Two main drivers of share prices are earnings and the required return on investment

Our analysts spend a lot of time on the former trying to assess what earnings can be delivered, but also whether these could surprise positively or negatively.

We can then back-out earnings growth from this analysis, which allows us to look at how important “required returns” or “PE expansion/contraction” has been for the market.

Using the New Zealand sharemarket as an example, following the re-set in the market post the financial crisis, share prices tracked earnings closely up until March 2012. The first part of PE expansion then occurred. This reflected the sharemarket risk premium reverting to a more normal level.

Since then the sharemarket has benefited from falling interest rates with PE expansion closely following changes in interest rates.


Figure 1. NZ Equity market PE expansion vs earnings


Figure 2. PE expansion highly correlated to interest mid 2013

We are now in the position where global growth is recovering. This is positive for the outlook for earnings growth, but has led to concerns that interest rates could again rise. This would impact required rates of return and therefore cause a degree of PE contraction.

Crying Wolf
Calling for interest rates to be higher has become a bit like “crying wolf”, given every time we thought we had reached the turning point at which interest rates would rise, they declined further. Nevertheless, let’s set out both sides of the argument:

1. With global growth higher and becoming more synchronised and with long-term interest rates theoretically reflecting both growth and inflation, we believe we have already seen the lows in interest rates.

2. Central Banks are beginning to normalise monetary policy and the process of reducing asset purchases, although monetary and fiscal policies are likely to stimulate for some time yet.

Growth higher
One reason why interest rates have kept falling longer than we had expected, is that global growth, until more recently, has disappointed and revisions have been continually lower. However, we are now past the point when revisions have turned positive. In fact, the low in interest rates coincided with the bottoming of this revision cycle.

This supports the proposition that we are past the low in the interest rate cycle, but do we need to worry about how high interest rates now go?


Figure 3. Global growth revisions positive since start of 2017

Monetary policy issues
The “bears” point to the fact that there has been an extremely strong relationship between the level of the S&P500 index and the size of Central Bank balance sheets.

They then point to the unwinding of the US Federal Reserve’s asset purchases and the fact it is no longer reinvesting monies from maturing securities.

We are a bit more balanced.

We agree that quantitative easing measures are beginning to be reversed, but if we combine European Central Bank and Bank of Japan activities, the collective Central Bank ownership of securities is continuing to grow and in fact isn’t expected to peak until late 2019.


Figure 4. Central Bank balance sheets have supported equity prices


Figure 5. but balance sheet growth unlikely to peak until 2019

Central Bank balance sheets should therefore continue to be supportive of asset prices in the near-term. We also consider that, in conjunction with balance sheet activity, official cash rate settings will be progressively increased. We see this as a positive.

Fiscal stimulus should help offset any monetary policy tightening and by raising official cash rates, inflationary concerns should be able to be held in check.

Importantly this should help limit increases in interest rate term premiums. We are therefore in the camp of again saying interest rates should be higher going forward. However, the levels should be manageable and improving growth should offset any concerns in PE contraction.

This still leaves us preferring investment in companies able to deliver earnings growth.

Brian Stewart
Senior Analyst, Strategy

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