Market update: Inflation
The Australian and US interest rate markets are reducing their long term interest rate pricing, which is a strong indication that expectation of long term high inflation is easing (see charts below). Australian 10 year government bonds have eased from over 4% to 3.45%, a significant reduction. US 10 year government bonds have eased to below 3%. This shows that the markets think inflation won’t be sustained for the long term. See charts below for the trends.
US 10 Year Bond Yield rate history Source: Eikon
Australian 10 Year Bond Yield rate history Source: Eikon
These long term interest rates are the base rate for risk return calculations in asset markets, including the share market. They are seen as the minimum rate of return. All other asset classes should have higher returns than this rate based on the risk of the asset.
We have seen this play out over the last few years with very low 10 year government bond yields and thus the returns expected on shorter term fixed interest type investments being low. Eg. Term deposits at record lows.
The spread between the 10 yr bond yield and the share market return is the risk premium. Share markets are demanded to pay a higher premium than term deposits and bonds. In the short term, this often does not happen, but over time, the market is rational and prices in the appropriate return.
We have seen the short term irrationality of the market over the last couple of months. Companies with strong free cash flow have taken a bath along with companies without these attributes. The market is quite irrational in the short term and is driven by fear and greed. Short term and long term market behaviours are very different.
Over the longer term, the market prices a share by calculating the expected cash flow it will generate. Solid businesses with wide moats, free cash flow and capital independency are valued higher than those businesses that have higher risks due to lacking these attributes. Our portfolio focuses on these solid businesses. Our forecast portfolio free cash flow yield is above 7% and we expect it to grow at around 12% per annum. We comfortably expect our future returns to be above the US 10 year government bond rate of 2.91% by a significant margin.
There are many market participants predicting significantly higher structural inflation over the next few years and hence, leading to materially higher interest rates. We are not convinced that this will eventuate based on evidence confirming our suspicions, we expect economies will slow down when rates are in the 1-3% range instead of the 3-4% range. We think that the economy will not need a big hammer to adjust but a few small taps.
Alphabet and Constellation Software highlight this short term / long term concept beautifully. Movements in their share prices during significant macroeconomic downdrafts from over a decade ago are almost imperceivable over the longer term:
Constellation Software long term share price trend Source: Eikon
Alphabet Long term share price trend Source: Eikon
We have deliberately positioned our portfolios for a heads we win, tails we win position by concentrating the portfolio in companies with net cash and buying back shares. If rates rise and share prices temporarily fall, the company's cash balance becomes a higher percentage of the market capitalisation, and the buybacks are more accretive leading to higher long-term returns. We can’t control the ups and downs of markets. We can control whether the downs are permanent or temporary.
Businesses who are not capital independent and cash rich like our companies, are companies that need to find future capital to keep the lights on.
Citibank GFC carnage:
Several investors have bought into companies that are enormously capital dependent at the top of the cycle. When Warren Buffett is quoted as saying “you only know who has been swimming naked when the tide goes out” this is what he is referring to. Citigroup is a perfect example of a capital dependent business that has seen their capital permanently destroyed when the tide went out. Its share price fell from $550 to the current price today of $46. This massive correction occurred due to a 35% fall in US property prices from 2005 to 2012. Banks are far riskier investments than the share prices of our four major Australian banks suggest.
Australia recently hit $10.2 trillion in total residential property. This is 4.8 times the size of our economy. The only other economy to reach these stratospheric heights was Japan in 1989. They then proceeded to have 32 years of economic malaise due to their excesses. To put this in perspective, the US “bubble” in 2005 was only 1.9 times the size of their economy. Our economy is far more dependent on selling second hand houses to each other than any other economy in history. We are very happy to be avoiding this area as much as possible.