When Safe Havens Become Bubbles In Disguise

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The search for yield in an increasingly yield-less world has become the biggest financial sport in town. The logic is understandable. Thanks to our beloved central bankers, traditional investment portfolios heavily reliant on government bonds and cash are earning little, or worse when inflation is taken into account. Because of this, money is making its way into areas such as corporate bonds, junk bonds, real estate and high dividend yielding stocks. The problem is that many investors are now buying yield with little regard to the price that they’re paying. That’s the stuff that bubbles are made of and why some perceived safe havens may prove anything but.

Today, Asia Confidential is going to explore the causes of the growing “yield bubble” in more detail and the ways that it may all come unstuck. We’ll also look at how some of the current hot asset classes are almost guaranteed to earn poor returns on a long-term timeframe. Lastly, we’re going to suggest how investment portfolios may be structured to minimise exposure to the more bubbly assets and still earn respectable (not high), low risk returns.

The Great Manipulation

For the most part, we don’t live in a free market world anymore. Since the financial crisis, there’s been unprecedented intervention by central banks in the developed world via quantitative easing (QE) and their zero interest rate policy (ZIRP).

QE involves central banks printing money to buy bonds, largely from banks. The aim is that banks will lend this money out and that the money will make its way into economies through consumption, investment and so on. The problem is that this hasn’t happened. Banks have held onto the printed money due to new regulations requiring they hold more capital and their customers have been unwilling to take on more debt as they’ve been too busy paying off existing debt.

The commercial banks are ok with this because the money that they’ve been kindly given by central banks is helping them to improve their balance sheets after their enormous risk-taking blew up in 2008. Central bankers aren’t as impressed because the printed money isn’t flowing through to economies. That’s why you’re hearing suggestions in the U.S. that banks should be forced to start lending more money.

The other important aim of QE though is for bond yields to remain artificially low. The central banks are saying to people: “We’re going to print money to reduce the value of your cash and we’re going to make sure you earn little on your bank deposits. We want you to depart with your cash to take on more risk.”

The theory behind this is the so-called wealth effect: if people move cash into the likes of stocks and real estate and these assets increase in value, they’ll feel wealthier and increase their consumption of goods. A win-win for everybody, it would seem. However, there’s no proof that the wealth effect actually works, even though central bankers remain convinced that it does.

Putting this aside, it’s clear that cash previously held as bank deposits is starting to make its way into various assets. People are searching for yield. There’s been a lot of recent hoopla about a great rotation out of bonds into stocks, but the truth is rather different. It’s bank deposits that are making their way into stocks. And money is also pulled from commodities and parked in stocks. 

But it’s certain types of stocks, namely those with high dividends, that are catching the best bids. High dividend yielding companies in sectors such as utilities and consumer staples have been outperformers and now trade at extensive premiums in most markets. In Asia ex-Japan for instance, utilities trade at 15x 2013 earnings, a 25% premium to the region. That’s despite them generally having poor returns on capital and significant regulatory risk. 

It’s not only high dividend yielding stocks that are attracting money, however. Investors are converging on corporate and junk bonds in their search for better yields over government bonds. Real estate is the other area which is continuing to attract investors who are seeking both yield and security. This is particularly the case in Asia versus other parts of the world, as inflation rather the deflation remains the key problem here.

Possible Endgames

If we acknowledge that some of these high-yielding asset classes now appear elevated or even bubbly, then the next question is: what are the potential triggers for these bubbles to eventually pop? Rising inflation is the obvious one. This would lead to hikes in interest rates, or a tightening cycle in economic parlance.

Under this scenario, most bonds, particularly government bonds, would get crushed. So would real estate, where over-leveraged speculators in over-priced areas such as Beijing, Singapore and Hong Kong would suffer most. Rising inflation would actually be positive for stock markets to a certain point. In the developed world for example, history suggests that inflation doesn’t start to hurt stocks until it reaches around the 6% level.

The other possible trigger for the current yield bubble to burst is deflation. Under this scenario, investors would scurry back to government bonds and cash. Stocks and real estate would get hammered. 

Regular readers will know that I think serious inflation or deflation are the most likely endgames, with the latter being the most probably outcome. But we could muddle through for a while, possibly a long while, before either of these endgames eventuates.

That means the extraordinarily low interest rates currently on offer may be around for some time yet. And the yield bubble could well get bigger before deflating.

The Math Doesn’t Add Up

But do the potential rewards for chasing some of the higher yielding asset classes outweigh future risks? To determine this, let’s crunch some numbers. We’ll first take a look at the popular asset of Hong Kong real estate.

Hong Kong residential property is the world’s most expensive per square foot. According to The Economist, it’s also the second most expensive, behind Canada, in terms of price to rent compared with long-run averages.

Right now, you’ll get close to a 3% rental yield on residential property in Hong Kong. Mortgage rates at the largest lender there, HSBC, increased from 2.6-2.9% to 3.15% in March.

For those that rent out properties they’ve purchased, the positive carry (rent exceeding mortgage rate) prior to March has now disappeared. But that’s not the half of it. The Hong Kong government has increased stamp duty by 2x to 8.5%. There are also other taxes and maintenance spend that need to be factored in too.

Without capital gains, you’re very likely to earn little or no returns on Hong Kong property. But inflation also needs to be taken into account. Current inflation in Hong Kong is 4.4% compared with a 20 year average of 4.6%. Consequently, without significant capital gains, there’s also a high probability of negative real returns (returns after inflation).

Given the paltry potential returns on real estate in many parts of Asia, investors are turning to high dividend yielding stocks for alternatives source of income. After all, if you can get a 4% yield on a stock in Hong Kong for instance, it sure beats the 3% yield from real estate there and the close to 0% on offer from bonds and cash.

While yield is nice, paying up for it can be a dangerous game though. Take Hong Kong’s largest power utility, CLP, as an example. It has about an 80% share of the electricity market. The company has expanded overseas into markets such as Australia and India due to stagnating electricity usage at home.

Currently, you’ll pay 19.7x 2012 earnings for this well-managed stock, compared to 11x for the overall Hong Kong market. CLP also sports an attractive 3.9% dividend yield. And the company has managed to grow earnings per share at a 3.4% compound rate over the past decade.

Let’s assume that you’re looking to hold this stock for the next five years. If the company manages to grow earnings at historic rates and the dividend payout ratio stays the same, you’ll get about a 7.3% annual pre-tax return, assuming the current price-to-earnings ratio (PER) stays the same. That return may not beat the overall market, but it would easily beat the current 4.4% inflation rate, assuming there’s no major spike on this front.

However, if the stock’s price-to-earnings ratio (PER) declines to its historical average of 16.6x, then any potential capital gains would be wiped out, leaving a pre-tax return close to the current dividend yield of 3.9%. That return would likely trail inflation during the period.

And that’s also ignoring any risks around earnings. Profits have actually fallen the past two years due to poor overseas returns, so a 3.4% annual growth assumption on this front may also be optimistic.

Do the potential rewards outweigh the risks for this high yielding stock? I doubt it. But plenty of investors disagree at present due to their willingness to pay up for yield, no matter the price. 

Alternative Ways to Seek Low Risk Returns

This leads to a question that I’ve been getting a lot of late: in a world where many safe havens are not so safe, where can I invest my money to earn respectable, relatively low risk returns? It will obviously depend a lot on your personal circumstances, location, risk tolerance and so on. But here are a few tips:

  • If you have to own government bonds, stick to short duration ie. less than two years. Short duration bonds are less sensitive to interest rate rises than long-term bonds.
  • Treasury inflation protected securities (TIPS) are also worth investigating. As the name suggests, these bonds protect you from rising inflation. Make sure that you don’t pay up for them though.
  • Stocks, particularly ex-high dividend payers, are reasonably priced in many markets, particularly in Asia. Despite long-term risks, they’ve probably got more to run with low interest rates here to stay. Therefore, they’re worth having in your portfolio. To what extent depends on your risk tolerance.
  • Gold is worth owning, even if it’s only a small part of your portfolio. It’s a hedge against extreme events and is a great diversifier in an asset portfolio, being totally uncorrelated to stocks and bonds.
  • REITs are worth including, albeit only those in less bubbly countries/segments. Research shows that the performance of REITs is also uncorrelated to that of stocks and bonds.
  • Keeping cash on hand makes sense. Despite current meagre returns, cash gives you flexibility and the capacity to move when some of the current elevated asset prices pull back.

One last thing to stress is that it’s important to keep a diversified portfolio. The current actions of central banks are unprecedented and no-one can be sure of the end result. A diversified portfolio can help protect your hard-earned money and possibly grow it in a relatively low risk manner.

And that’s all for this week. I’ve got a sick child to attend to and a mother who’s coming into town this evening. It’s going to make for a busy weekend.

Source: Asia Conf.

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About James Gruber