The Australian Dollar: Drivers and Overlooked Implications

The Australian dollar has depreciated against the greenback over 30% from July 2011 where it peaked at $US1.10 to this month’s US$0.73. Its depreciation is slightly exaggerated against the US dollar as the US dollar also experienced appreciation over the past year, and the fall is lesser when expressed against a basket of currencies. According to the RBA’s announcement regarding the hold on the 2% cash rate, further depreciation is both likely and necessary given significant declines in key commodity prices.

Global markets

NAB revised its forecast this week for the Australian dollar to be at US$0.72 at the end of this year, down from US$0.74. This has been partly from the financial crisis of Greece, the deflating equity bubble in China and investor concerns over a slowdown in global growth. Once there is panic in the markets regarding potential crisis in the global market, low risk financial instruments whose values are historically unaffected become in demand, one of which includes US government bonds.  The Kiwi and Canadian dollar also fell this week as the US dollar and Japanese Yen appreciated from having attracted investors seeking safe haven assets.

Commodities

Commodity exporters including Australia, Canada and New Zealand are at risk from depreciation due to commodity prices. The majority of commodities are priced in US dollars, and when the US dollar appreciates, commodity prices and the currency adjust accordingly. Therefore there is high correlation between the value of a metric tonne of iron ore and the Australian dollar. For instance, iron ore was $US55.26 per tonne last Friday and the Australian dollar was at $US75.23. On Tuesday iron ore was $US49.60 per tonne and therefore the Australian dollar adjusted to $US74.51.

China

As China’s growth is slowing, and given their position as Australia’s largest trading partner from their demand for our resources, the mining industry in Australia may attempt to gain revenue against the falling commodity prices by increasing production to export more, despite this driving prices even lower. Furthermore this could mean high cost producers lose market share, which can facilitate demand and supply returning to equilibrium at a lower price. I do not believe the recent volatility in the Sharemarket has directly influenced this fall in commodity prices as it does not indicate weakness in the real economy. Nonetheless China should play a role in the downwards pressure on the Australian dollar in this way.

Interest Rates

The current and expected difference between Australian and US interest rates is another driver of the Australian dollar depreciation. As the US interest rates are expected to experience a series of increases, 10 year US bonds should attract investors as purchasing them essentially indicates that they are buying an annual return that reflects where the real interest rate will be in 10 years. This has been the case since October 2014 where the US Federal Reserve formally stopped its bond buying/quantitative easing. Meanwhile the RBA has been cutting interest rates and this trend should continue given the domestic slowdown effects from lower commodity prices. Substitution of the long term Australian bond for the US bond is therefore on the rise, and less demand for both physical and financial Australian assets leads to a lower Australian dollar.

Implications

The RBA’s calculations demonstrate a 10% fall in the real exchange rate increases GDP growth by 0.5-1% and the annual inflation rate by 0.25-0.5% over two years. As Treasurer Joe Hockey described, “A lower Australian dollar is inevitably going to help the South Australian economy, the Victorian economy, it’s going to be of great benefit for tourism and education, exports. So the diversity of the Australian economy is working in our favour.” It is not just the tourism and mining industry that benefits. Shares that also benefitted from this fall include AMC (a global packaging company), BXB (a supply chain logistics group), CSL (global biotech), JHX (an Irish cement company).

Notice that these shares are affected from the exchange rate movements due to exposure either because of overseas operations, or from export relationships. The first would have its revenue and costs denominated in foreign currencies, translating to higher $A profit if the value of the Australian dollar relative to their currency falls. The exporter, typically wine producers and the resources sector, would have its costs denominated in a different currency from its revenues which leads to a strong correlation between exchange rate movements and profit margins. This can be positive or negative depending on where they source revenue and where the costs are mainly incurred and the exchange rate should be relatively more significant to the business than the overseas operator.

In theory, Australian wine producers should experience wider gross margins from the greater value of the revenue from its export markets, typically the US and UK, while costs remain stable. Sensitivity analysis is a means by which investors could forecast the impact of a change in the Australian dollar on earnings. For instance Treasury Wine Estates published in 2014 that a change in the Australian dollar by 10% against the US dollar has the potential to impact their EBIT by more than 20%.

Therefore, wine industry experts are expecting foreign investment in South Australian vineyards to increase despite growers exit the industry from prolonged unfavourable weather and poor prices in recent years. Although China’s austerity measures weaken foreign investment, the number of foreign investors seeking to purchase agricultural land has risen with interest in aquaculture ventures. China’s currency devaluation leads to a reduced competitive advantage for Australia however, but not when attracting US investors, who comprise of the majority.

However for exporters like TWE where product pricing is in the currency of the destination market, there are other factors that should be taken into account, such as retailer bargaining power and the competitive environment that a currency depreciation does not improve. Wine competitors in other nations such as Argentina, Chile and South Africa benefit further from depreciating currencies as these have depreciated 21%, 12% and 9% against the US dollar respectively in the 12 months to June 2015 while the change in the Australian dollar was on par with South Africa. This suggests Australia did not gain a unit profit advantage relative to many of its competitors. Retailers are also in a stronger position to negotiate for reduced local prices as they can directly calculate the additional revenue the falling Australian dollar offers to the producer, and with such a large competitor base fuelling their leverage, the potential gains in earnings are offset by squeezed margins. For instance, Australian Vintage reported that the margin profit from the lower $A against the pound was offset by the UK competitive environment.

Forecasts

Overall prices of iron ore and interest rates are consistent with the Australian dollar further depreciating against the US dollar for the foreseeable future. Capital Economics Australian economist Paul Dales notes that if iron ore prices were to fall from $US52/tonne now to US$40/tonne by the end of this year, the Aussie should be around US70 cents. Furthermore if the RBA cuts rates to 1.5 percent while the US Federal Reserve raises theirs, an Australian dollar rate of US65 cents is possible. 

References

RBA, ABC News, CBA, Sydney Morning Herald, Australian Financial Review, The Australian

Pacific Brands DCF Model Template (ASX: PBG) Target Price 0.47, Current Price 0.4

Quantopian Algorithmic Trading Strategy: Statistical Arbitrage (Pairs Trading)

What is Statistical Arbitrage?

Statistical arbitrage refers to where there is mispricing between securities which traders aim to profit from. It is based on mean reversion, as the divergence between the two stocks should be constant and any deviation away from such a constant spread is a trading opportunity since the spread is undergoing mean reversion. This means the two stocks we choose to focus on must be in the same sector as this takes away market influences and we can exploit the fundamental reason for believing the spread is mean reverting or constant. Mathematically, cointegration tests for whether stocks work well in a pairs trade as the error term in regression modelling is stationary. This is also why cointegration is important in time series analysis. A stationary relationship means the hedge ratio remains constant.


import numpy as np
import statsmodels.api as sm
import pandas as pd
from zipline.utils import tradingcalendar
import pytz


def initialize(context):
    set_slippage(slippage.VolumeShareSlippage(volume_limit=0.025, price_impact=0.1))
    set_commission(commission.PerShare(cost=0.0075, min_trade_cost=0.0))
    context.y = symbol('ANF')  #Abercombie & Fitch
    context.x = symbol('AEO')  #American Eagle Outfitters

Defining whether to use a hedge ratio calculated 2 days ago as we are trading off mean reversion- where a hedge ratio excludes 2 days of recency such as when there are large divergences which the algorithm hopes to exploit to be greater aligned to the economic historical relationship of the stock pair. A hedge ratio is defined as a ratio comparing the value of a position protected via a hedge with the size of the entire position itself. e.g. an investor with $1000 in foreign shares is exposed to currency risk though if $500 of the shares is hedged with a currency position, hedging ratio is 0.5- 50% of their equity position is protected from currency risk.

    context.use_hedge_ratio_lag = True
    context.hedge_ratio_lag = 2


    context.lookback = 20     # used for regression
    context.z_window = 20     # used for zscore calculation, must be <= lookback
    context.entry_z = 1.0      # trade entry triggered when spread is + or - entryZ
    context.exit_z = 0.0       # trade exit triggered when spread is + or - entryZ

    context.spread = np.array([])
    context.hedge_ratio_history = np.array([])
    context.in_long = False
    context.in_short = False

    if not context.use_hedge_ratio_lag:
        # a lag of 1 means to include the most recent price in the hedge_ratio calculation
        # specificlly, this is used for np.array[-1] indexing
        context.hedge_ratio_lag = 1
   
For every trade event...

def handle_data(context, data):
    if get_open_orders():
        return

    now = get_datetime()
    exchange_time = now.astimezone(pytz.timezone('US/Eastern'))

    # Only trade 30-minutes before market close
    if not (exchange_time.hour == 15 and exchange_time.minute == 30):
        return

    prices = history(35, '1d', 'price').iloc[-context.lookback::]

    y = prices[context.y]
    x = prices[context.x]

    try:
        hedge = hedge_ratio(y, x, add_const=True)  
    except ValueError as e:
        log.debug(e)
        return

    context.hedge_ratio_history = np.append(context.hedge_ratio_history, hedge)
    # Calculate the current day's spread and add it to the running tally
    if context.hedge_ratio_history.size < context.hedge_ratio_lag:
        return
    # Grab the previous day's hedgeRatio
    hedge = context.hedge_ratio_history[-context.hedge_ratio_lag]
    context.spread = np.append(context.spread, y[-1] - hedge * x[-1])

    if context.spread.size > context.z_window:
        # Keep only the z-score lookback period
        spreads = context.spread[-context.z_window:]
   
        zscore = (spreads[-1] - spreads.mean()) / spreads.std()
     
        if context.in_short and zscore < context.exit_z:
            order_target(context.y, 0)
            order_target(context.x, 0)
            context.in_short = False
            context.in_long = False
            record(stock_Y_pct=0, stock_X_pct=0)
            return
   
        if context.in_long and zscore > context.exit_z:
            order_target(context.y, 0)
            order_target(context.x, 0)
            context.in_short = False
            context.in_long = False
            record(stock_Y_pct=0, stock_X_pct=0)
            return
       
        if zscore < -context.entry_z and (not context.in_long):
            # Only trade if NOT already in a trade
            y_target_shares = 1
            x_target_shares = -hedge
            context.in_long = True
            context.in_short = False
       
            (y_target_pct, x_target_pct) = compute_holdings_pct(y_target_shares,
                                                                x_target_shares,
                                                                y[-1], x[-1] )
            order_target_percent(context.y, y_target_pct)
            order_target_percent(context.x, x_target_pct)
            record(stock_Y_pct=y_target_pct, stock_X_pct=x_target_pct)
            return

        if zscore > context.entry_z and (not context.in_short):
            # Only trade if NOT already in a trade
            y_target_shares = -1
            x_target_shares = hedge
            context.in_short = True
            context.in_long = False
       
            (y_target_pct, x_target_pct) = compute_holdings_pct(y_target_shares,
                                                                x_target_shares,
                                                                y[-1], x[-1] )
            order_target_percent(context.y, y_target_pct)
            order_target_percent(context.x, x_target_pct)
            record(stock_Y_pct=y_target_pct, stock_X_pct=x_target_pct)


def is_market_close(dt):
    ref = tradingcalendar.canonicalize_datetime(dt)
    return dt == tradingcalendar.open_and_closes.T[ref]['market_close']

def hedge_ratio(y, x, add_const=True):
    if add_const:
        x = sm.add_constant(x)
        model = sm.OLS(y, x).fit()
        return model.params[1]
    model = sm.OLS(y, x).fit()
    return model.params.values

def compute_holdings_pct(y_shares, x_shares, y_price, x_price):
    y_dollars = y_shares * y_price
    x_dollars = x_shares * x_price
    notional_dollars =  abs(y_dollars) + abs(x_dollars)
    y_target_pct = y_dollars / notional_dollars
    x_target_pct = x_dollars / notional_dollars
    return (y_target_pct, x_target_pct)

Specifying to only trade 5 (rather than 30) minutes before the market closes gives higher returns

Changing hedge ratio lag to 1 day generates returns of almost 50% over the year starting 2014, compared to the benchmark of 15%. 

Lookback period with hedge ratio lag of 1 day:

15 days - 38.7%
20 days - 49.5%
25 days - 18.2%

JP Morgan & Bank of America Pair Trading Strategy: 

Avon and Estee Lauder Pair Trading Strategy: 

Australia's Largest Insurers: IAG and QBE

IAG vs QBE

The insurance sector is usually characterised as a defensive sector with large margins and low claims, preferred by investors for its stable dividends. Currently it faces increased pressure to reduce premium pricing given increased money supply.

QBE Insurance Group (QBE), a global insurance provider, has been a target of aggressive overseas acquisitions during the 2008 GFC, many of which have performed below expectations. However its Australian and New Zealand operations, which comprise of 28% of the business, are demonstrating consistent strong performance with the depreciating dollar boosting North American and European operations.

Insurance Australia Group (IAG), because it is a domestic insurance firm, has had relatively larger exposure to the natural disasters Australia experienced this year such as tropical cyclones and NSW and Brisbane hailstorms. It does boast catalysts for positive growth nonetheless with its recent acquisition of Wesfarmer’s WFI and Lumley insurance underwriting in 2014, and a strategic relationship with Warren Buffett’s Berkshire Hathaway. These two insurance giants have quite different company profiles and financial health, management style and outlooks which make them worthy of comparison.

Financial risk

Both QBE and IAG are exposed to financial risk, though due to the strong presence of APRA over the insurance sector, such risk should be manageable. IAG had a regulatory capital position of 1.6 times the prescribed capital amount (PCA) at the start of this year, which is weaker than last year. Nevertheless after its strategic relationship with Berkshire Hathaway, this is forecast to improve to 2 times. 

QBE at the start of this year had a regulatory capital position of 1.7 times the PCA, and this has been consistent with historical figures. QBE also has a short duration, fixed interest portfolio that can benefit from the Fed rate hike. Financial health therefore is strong for both companies with excess capital for regulatory requirements.

Management

Increased natural disaster costs and subdued equity markets during the half year ending December 2014 caused IAG’s margins to reduce to 6.6 percent. Their rise in gross written premium (the premium before reinsurance costs) was largely driven by the addition of the Wesfarmers underwriting business, rather than organic growth, and therefore their performance was flat compared to previous years yet results were solid after taking into consideration the difficult domestic conditions. Over 2015 and 2016 combined pretax synergies are expected to cumulate to an annual $230 million. 

QBE’s gross written premium on the other hand fell 9 percent as a result of poorer North American business performance. Nonetheless recent results have demonstrated a stronger group insurance margin due to favourable currency movements. The depreciation of the Australian dollar offset the weak earnings from North America and Europe for QBE while IAG faced challenges with Australia’s increased natural disaster claims over this period.

Outlook

IAG’s growth in gross written premium is expected to be driven by the expected contributions from Wesfarmers underwriting integration and in line with their half year result, at 19.5% revenue growth and 20.84% ROE. Under IAG and Berkshire's 10 year quota share arrangement, IAG reduces its capital requirements by $700 million, and gains $500 million from Berkshire Hathaway to use for further expansion. This strategic relationship can also provide greater capital flexibility, acting as a catalyst for IAG to expand overseas particularly to pursue growth opportunities in Asia and strengthen its domestic presence in the medium to long term. 

Conversely QBE is expecting a 3-5 percent decline in gross written premium, though offset by improvements in its insurance margins to 9 percent. These improvements stem from the transformation of its senior management team, improvements in the US market and further weakening of the Australian dollar amongst investor sentiment for a US Fed Rate hike. European conditions remain weak though its challenges faced by the North American operations should be resolved by its early June actions – the sale of its Mortgage and Lender Services business, which is expected to free up in excess of $100 million capital that will be reinvested elsewhere. This does reduce its gross written premiums by $400 million though should improve their North American operations budgeted 2016 combined operating ratio by 1.5 percent and return on allocated capital by 1.8 percent. The $120 million after tax net loss for the fiscal year 2015 given recent underperformance in this overseas region can be argued to be due to one off, non cash costs and write offs from the divestment, and the transaction should be viewed as a positive for the future.

Share Value

IAG and QBE trade at 14.4 and 16.4 price earnings ratios respectively, with the industry average at 15.7. For IAG, earnings per share should fall for fiscal 2015 due to the Wesfarmers acquisition and Berkshire Hathaway relationship. Nonetheless for investors interested in dividend potential, IAG should be their preference as over the past two years IAG has paid a fully franked dividend yield of 6.5 percent. This is a dividend payout ratio of 50-70 percent of cash revenue.

IAG’s share price history could suggest its short term underperformance is attributed to temporary issues.

1 year   -2.23%

3 year   +65.7%

5 year   +64.74%

Meanwhile QBE provides a fully franked dividend yield of 2-3.5 percent, with a target dividend payout ratio of 50 percent of cash earnings. Their earnings should also improve from the weaker Australian dollar, though their dividend yields are still below the market’s gross dividend yield of 4 percent. Management's recent decision to review QBE’s dividend policy in response to its strong capital position indicates potentially higher dividends.

QBE’s share price history could suggest it is improving from its previous issues – though this could be due to external factors such as a favourable exchange rate.

1 year   +24.13%

3 year   +6.65%

5 year   -27.03%

References:

Australian Financial Review, Business Insider, Sydney Morning Herald, Morningstar

US Fed Rate Hike

Investor Expectations

Dennis Lockhart, president of the Fed Reserve Bank of Atlanta, mentioned economic data would have to greatly deteriorate to avoid a rate hike. His statements contrast investor sentiment who have predicted rate rises much later in the year.  The implied futures contract rates points to a rise of 1% by next year, which contrasts the latest median projection of 1.6% from the Reserve Board.  Valuations are inflated, the bull market has reached its seventh year with investors being optimistic and EPS growth is slowing- all factors which have previously seen large losses. This is especially because margins are driven by a small cluster of stocks.

Historically, it takes three rate hikes to ultimately eliminate bubbles.

September Rate Hike

However, labour and retail spending figures support a rate hike- claims for state welfare have remained below 300,000 mark for over 5 months, which suggests strengthening job market. The four week moving average of claims which eliminates weekly volatility is at its lowest since 2000. Associated increase in retail spending particularly in automobiles implies a solid third quarter growth. With factors supporting wage growth, US stocks must keep rising against rate hikes and reduction in profit margins. 

Effects on Bonds & Reasons

Analysts at QIC report that a US rate hike will result in losses on long bonds if major central banks raise rates faster than what investors expected for the past few months. The premium that investors required for taking on interest rate risk will revert back to normal as the drivers that previously lead to low yields are reversed. Foreign ownership in bond markets has reached a 25-year peak, and central banks have begun to liquidate their foreign currency reserve holdings. The excess supply results in higher yields. Such accumulation has been due to a number of factors. Firstly, the 90s Asian currency crisis increased investment in foreign currencies to act as a future buffer. Secondly, oil-producing economies are drawing on such holdings to maintain their expenditure levels given the decline in oil prices. Most of the accumulation is accredited to China’s growing export economy, which means China has invested foreign currencies from their export market into US treasury bonds to limit Chinese currency appreciation. Clearly this has helped Chinese export competitiveness. However, economic data demonstrates China has been easing capital controls- their foreign currency reserves peaked at $US 4 trillion last year in June but this number has steadily declined to $US 3.7 trillion in June 2015. This could imply China has been using its reserves to short US treasury bonds. If China is developing a floating currency governed by demand and supply, there will be positive and negative effects on Australia. Previously low bond yields correlated with quantitative easing in the US meant investors flocked to other economies such as Australia for higher yielding currencies, increasing the supply in the Australian bond market. As a result, our currency appreciated and was limited in its stabilization role during declines in terms of trade. The increase in the premium and yields in US will assist in the RBA’s current focus on $A depreciation, allowing it to focus on calming the property price bubble.

Other economies

The price yield curve means bond prices fall with increased yields. Britain’s ten-year bond yield increased six basis points to 1.93%, Germany’s increased four basis points to 0.68%, Australia’s increased seven basis points to 2.8%. Treasuries ten-year note yields increased nine basis points to 2.24%. Sliding oil prices were responsible for the increase in Germand ten year bunds as it supported speculation that slow inflation will remain.

However RBI Governor Raghuram Rajan is not worried about the effects on the Indian economy, arguing the impact of the action has already been factored in by global markets as one of the “most awaited things in history in recent times”. To offset potential volatility post Fed hike, the RBI has been increasing its forex currency reserves since the beginning of 2014 by $105.8 billion to $354 billion.

Delay? China’s Devaluation

Further delay could even be expected with China’s recent move. China’s central bank devaluing its previously tightly controlled currency drive speculation that such action could delay the interest rate hike as it added volatility to global forex markets. China’s growth had previously been weak from capacity excess, larger than expected drop in exports in July and over valuation of the yuan. The yuan devalued by 1.9%, which was stressed as a one-off that allowed its currency to be appreciated by market factors. However, some economists believe that if the Chinese economy joined other economies who have a large propensity to save (e.g. Japan) in the global currency war could trigger another crisis.  If other central banks follow and devalue their own currencies to boost their export markets, which is likely given deflationary pressures from low commodity prices, this would further damage US companies who are already struggling due to the strong US dollar buying from talks of a rate hike. Albert Edwards at Societe Generale stated the devaluation will change investor perceptions over the US economy’s resilience, and the currency war will eventually mean the US starts to import deflation.

However, others argue this action will not substantially impact the Fed’s decision making given the fact that China’s Real exchange rate has increased by approximately 14% in the past year and a decrease of 2% is too little to spark major change. Moreover, the Fed has no obligation to any economies outside the US and hence the importance of emerging markets is being overstated- unless the move creates economic mayhem, it is unlikely such a move will influence the Fed. In fact there are speculation over the reasoning of this devaluation was du to anticipation of the Fed’s close rate hike as it would hinder China’s goal of getting ahead of the curve.  

With boosted export competitiveness from China, demand and prices for iron ore and commodities should increase. With how stocks in the mining sector have acted previously to interest rate hikes, there is little need for concern for adverse effects from US monetary tightening.  July experienced the lowest commodity prices in four years. Performance correlation with US interest rate movements has historically been positive. However, the other side of the story is that the rate hike will obviously cause appreciation which has always been a negative sign for commodity exports. Investors must look at the relative side of things- appreciation will only happen if the rate hike is greater than the appreciation in other currencies from their respective rate hikes.  

Commodity safe haven Gold reached almost a five and a half year record low following comments from the Board regarding next month’s interest rate hikes. Bullion has remained below the $1100 threshold after overreaching its support level in July this year which pulled gold down to its weakest since Feb 2010. 

Banks: Domestic, Overseas and Dividends

Banks and the ASX

The ASX has never been equally diversified, as it is always skewed towards the industries in which we specialise in, particularly mining and oligopolies that dominate many sectors. However the domination of the banks is unprecedented. They comprise of 42% of the ASX 200 index, and, when one considers most of their business is mortgage lending, this means the stock market is heavily exposed to the housing boom. In the US, financial stocks represent only 16% of the S & P 500 index.

This is not the first time the market has seen skewness. Technology, media and telecommunications made up 37% of the index in 2000 – News Corp alone accounted for 20%. Mining then took over in 2008 and accounted for 39% of the index with the market cap of TMTs reduced to 10%.

However what makes the banks noteworthy is that they are providing high dividend yield and tax advantages of imputation (dividends are tax free to the extent that the company tax has already been paid). In the TMT boom, many stocks had no earnings at all, and mining companies tend to reinvest earnings rather than pay dividends. In an environment of low interest rates across the developed world, which has created unfavourable investment conditions, those dividend yields are one area that investors expect good returns to be at. However amid growing signs that the banks are under pressure (including Australian ones, where rising interest rates signal potentially higher risk from the housing bubble for creditors) the Sharemarket faces a higher degree of vulnerability.

Global Banks

Financials are both globally and domestically oriented in the sense that it can depend on the valuation in that country, or it is mostly affected by the global regulatory environment and interest rates. Global banks have proven to diversify Australian equity portfolios focussed on dividend distributions, with the overseas banking sectors provide higher returns over the past 12 months than Australian ones, and trading with consistent upside in earnings and improving return on equity. This is the result of a change in regulations, particularly across Europe, which have required these institutions to increase capital and sell assets.

The traditional P/E is not typically used to value overseas banks as they represent more than operating earnings, rather return on equity or price to book ratios would better represent how they operate - essentially as an asset pool. Furthermore their dividend yields do not account for most of the valuation, and some banks do not pay out dividends at all to satisfy their capital requirements. This nonetheless is on a declining trend. Therefore currently the difference between global banks and Australian banks is their dividend payout ratio. Global banks usually pay out 30-40% of their earnings in dividends, with many including buybacks in addition. These buybacks can represent a further 20-40% of the payout.

Global banks therefore diversify an Australian investor’s portfolio. They not only tend to outperform our banks, but also diversify risks related to lending growth, capital structure and the interest rate. As a result of this they compensate the lack of dividends with capital growth. Furthermore our banks have similar profiles that are quite weighted in mortgage lending. Overseas banks will reduce the risk from overexposure to the housing bubble. However because of the changing regulatory and digital environment, share price movements tend to influence weighting and selections of the global banks’ equities more than the Australian counterparts.

Dividends and Capital Gain

Australia’s ‘dividend market’ has been driven mostly from the growth in self-funded retirees, and also government bond yields trending lower over the last five years from both lower domestic and global interest rates from the quantitative easing in Europe, Japan and the US. High yielding stocks are therefore sought after as substitutes for fixed income investments. The 10 largest cap ASX companies have seen dividend yields converge over the past 5 years. However simply going long in these seemingly blue chip stocks assumes identical risk and return profiles, which is not the case.

Expected return also takes into account capital gain and loss. BHP, CBA, RIO and TLS are examples of the ASX 10 companies that have forecasted negative future values for year 1 and BHP and RIO continue this downward trend for year 2, down 7.3% and 2.5% respectively. Meanwhile forecast dividend yield for these stocks remain attractive at 4.20%-4.97%. MYR has a dividend yield of over 8%, yet its share price fell over 40% during 2014. On the other hand CSL out of the ASX 10 has the lowest dividend yield at 1.42% although they have high value growth from reinvesting earnings at relatively higher rates of return.  Therefore investors should be aware of the risk of capital loss, or the probability of capital gain, at the expense of dividend income.

Australia’s market, known for its stable banking industry and their appeal to retail investors, is now becoming an interesting mix with global equities if future prospects and value is taken into account. Financials are reporting record high dividend payouts (the proportion of earnings paid as dividends) at 71%. This could however be also attributed to weaker corporate profits. Furthermore this is not necessarily positive for shareholders in the long term, with pressure to maintain this high dividend payout ratio (numerous factors contribute to this pressure to either pay at or more than historical rates - see previous posts) subtracting capital for the firm to use for investment purposes. Investing for growth paths the way for sustainable rises in earnings, and only then are increases in the share price and dividends enabled. 

References

Australian Financial Review, Reuters, CBA