Checking the couch for every coin

The Financial Stability Report (FSR) has done nothing to dampen expectations of a May rate cut; in fact, it has actually caused the probability to increase.

Source: Bloomberg

Expectations of a 25 basis-point rate cut in May reached 104.2% at the close of business last night. April is now pricing in a 57.5% chance of a cut.

Interestingly, the market is now pricing in a 57% chance that the cash rate will be at 1.75% come May (a 50bp cut) – will this provide further support for the equity market?

That is an interesting situation the market is pricing in - the FSR argued that it is becoming increasingly concerned speculative property purchases are rising. It singled out the commercial sector as a particular worry considering the risk attached to tenancies in a slowing economy. The fact tenancy yields may not warrant the current investment could lead to increased selling if rates of returns are not met.

The report also stated that it was monitoring bank lending and had seen an ‘increase in loan competition’ of late. Although standards hadn’t declined, it believed further monitoring is needed as the new APRA rules released in November needed further time to filter through.

There are mixed messages from the FSR, however. Nothing in the report suggested the ‘concerns’ were becoming ‘overheated’. This explains why the interbank market moved higher as monetary policy is still needed to support the non-mining sector.

And, despite the concerns around mass expansion in the banking, telecommunication and healthcare spaces, we continue to see bidding on any dips as the cash rate is heading lower.

Timing the exit

The changing landscape of the yield trade is presenting a real challenge as yield compression continues almost unabated, even with the US Federal Reserve signalling that the rate hike cycle is edging closer. However, the dovish outlook from the Fed illustrates the difficulty in exiting the unconventional yield trade.

The other issue the yield trade has created is altered board behaviour as they scramble to give the market what it wants. The biggest losers of the yield trade have been the cyclical and growth plays of old - plays that benefited from commodity moves or innovation in niche areas.

The issue for these firms is the market is no longer willing to risk capital for longer-term growth opportunities. This has forced firms to pay out cash to attract investment.

This statistic clearly illustrates the effect the yield trade has had on non-financial plays:

From FY10 to the end of FY14, ASX 200 non-financial firms generated A$128 billion in free cash flow. Over the same period, the non-financial space has given back A$177 billion.

That means that for every dollar returned to shareholders over the past four years, companies have had to generate 1.4 time in cash. Going deeper into the sectors – materials have paid out 1.6 times free cash flow, industrials have being paying out 1.2 times free cash. Over 50% of firms have returned more cash than they have generated. And this was during a time when these plays have been undergoing huge cost cutting and capex reduction programs.

This model is unsustainable. The probability of meeting forecasted dividends as EPS growth falls will not be sufficient to meet these targets in the current conditions as cost cutting measures now look fully implemented.

I am not advocating a rush to the exit or even an exit in the immediate future. I am, however, looking at a very slow drip out of this trade – I think navigating the overvalued yield trade will be a disorderly affair when it unwinds. 

Ahead of the Australian open

We saw a fairly volatile night in the US, where the S&P and DOW both lost over 1% and the NASDAQ had its worst night in five months falling 2.4%. The futures market is looking a little bleak.

We are calling the market down 31 points to 5942. It is likely to be the banks that will feel the sell-off, considering RIO in London has had a fairly positive night. There is no major Asian macro news today, meaning the market is likely to react to the US futures and whether Wall street is pointing to another weaker night.

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