Josh Phillips

Tyndall Asset Management (Tyndall AM), one of Australia’s largest and most experienced Australian equity investment teams, is pleased to announce the appointment of Josh Phillips who has joined as co-Portfolio Manager for the firm’s growing small companies franchise.

Josh joins Tyndall AM with 12 years’ investment industry experience. He was most recently at Aware Super, where he was co-PM of the small cap capability from its inception, with responsibility for development of the strategy’s philosophy and process, following five years in Aware’s Australian Domestic Equities team as an Associate PM and with responsibility for consumer sector coverage.

Prior to Aware Super, Josh’s prior roles include approximately eight years in Global Equities roles with Auscap Asset Management and Perpetual Investments.

Josh will work alongside co-PM James Nguyen to help drive the performance of Tyndall AM’s small companies portfolio. His focus will include uncovering high-potential opportunities in the small-cap sector, leveraging his strong analytical acumen and deep understanding of the Australian market.

Tim Johnston, Head of Australian Equities at Tyndall AM, commented: “We’re delighted to welcome Josh to Tyndall. His strong capabilities and passion for investing make him a perfect fit for our growing small companies franchise, which as at 31 December 2024 has delivered an impressive 15.41% p.a. before fees its inception, outperforming its benchmark by +5.52% p.a.

“Josh’s appointment underscores Tyndall AM’s ongoing commitment to enhancing its investment capabilities and delivering exceptional value for its clients. His expertise aligns with the Firm’s disciplined, research-driven approach to delivering long-term value across the Australian small-cap sector.”

Josh Phillips added: “I’m excited to have joined Tyndall, a Firm with a rich history of active investing and a client-first approach. I look forward to working alongside James and the broader team and contributing to the ongoing success of the small companies portfolio.”

Weather cycles (El Niño/La Niña and Indian Ocean Dipole) – Another consideration

While global warming has resulted in climate change, and is an increasing challenge for insurers, insurers can ultimately price for this underlying trend via higher insurance premiums over time.

Within this underlying trend of global warming, there are also overlaying weather cycles. Some of the key cycles that meteorologists watch out for include El Niño Southern Oscillation (ENSO), Indian Ocean Dipole (IOD), and to a lesser extent Southern Annular Mode (SAM).

Arguably, the main weather cycle to watch out for is El Niño Southern Oscillation (ENSO). ENSO events are caused by the interaction between the surface layers of the ocean and the overlying atmosphere in the tropical Pacific. The El Niño phase of ENSO are often accompanied by cooler than normal sea surface temperatures along the east coast of Australia.

Over much of Australia, but particularly eastern Australia, El Niño events are associated with an increased probability of drier conditions, i.e. less rainfall. During the La Niña phase of ENSO, the opposite occurs and is often associated with an increased probability of wetter conditions.

An area of focus in Australia recently has been the weather conditions over the last three years. 2020-2022 saw the Bureau of Meteorology (BoM) declare an ENSO alert for a La Niña three years in a row. This rare event saw extended periods of rainfall and flood risks skyrocket, with some notable catastrophic events such as the 2022 SEQ/NSW floods and Halloween Hailstorm of 2020.

The last three years had also seen a negative IOD which, in conjunction with La Niña, had significantly contributed to the prolonged and widespread wet weather.

What is the IOD and how does it Interact with ENSO?

The Indian Ocean Dipole (IOD) is defined by the difference in sea surface temperature between the western Indian Ocean and the Eastern Indian Ocean. The IOD affects the climate of countries that surround the Indian Ocean, including Australia. Like ENSO, the IOD is impacted by sea surface temperatures and the overlying atmosphere, but in the equatorial Indian Ocean. A positive IOD is associated with drier conditions over Southern Australia and the Top End. A negative IOD is associated with wetter conditions in those same regions.

It is thought that the IOD and ENSO are somehow linked, and that positive IOD are often associated with El Niño. Similarly, a negative IOD is often associated with La Niña, like we have experienced here in Australia over the last three years. When this occurs, the La Niña and El Niño events are often more intense and widespread across the country. When they are out of phase, the impacts of La Niña and El Niño events can be more moderate.

What is the outlook for ENSO and IOD 2023?

BoM’s ENSO outlook has recently shifted from “Watch” to “Alert” for an El Niño. This means that there is roughly a 70% chance of an El Niño forming in 2023.

While the IOD is currently neutral, various weather models are suggesting that a positive IOD could develop in winter. This may exacerbate the drier conditions that El Niño typically brings.

The outlook for rainfall over the three-month period from July to September (refer Figure 2) shows that most of the country is likely to receive around or below the median rainfall.

Near term outlook for Insurance companies

Wet weather tends to be more detrimental from an insurance perspective than bushfires since the latter is typically localised in certain areas. However, under an extreme El Niño scenario it is still possible for insurers to experience higher than normal claims, with out-of-control fires over large, populated areas like we experienced during the summer of 2019/2020. On balance, it looks like we are in for a more favourable year for insurers, especially compared to the last three years.

Global warming and its subsequent weather impacts are a point of volatility and concern that insurers monitor carefully. There is little doubt that the severity and frequency of catastrophic weather events has risen due to global warming. However, the most recent years of heightened insurance claims activity has been more about the weather cycle.

La Niña potentially coming to an end after three straight years would represent a rather positive development for the insurance sector. While there is an increased chance of El Nino, outside of an extreme El Nino event, the insurers are likely to experience more favourable conditions – and fewer claims – than they have experienced over recent years.

The combination of elevated premium rates in response to recent weather events, and significantly higher interest rates, has materially improved the outlook for insurers profitability. Normalisation in claims activity due to an El Nino event that reduces storms and rainfall will only add to the improved outlook.

Conclusion

Given this improved outlook for insurers, Tyndall has an overweight position in QBE Insurance, which has a global focus, as well as a domestically focussed insurer, Suncorp. We expect these companies to outperform in the medium to long term given this positive backdrop, which, in our view, the share market has not priced in properly.

Stefan Hansen

ESG forms an integral part of our process when looking at resource companies within our investment universe. Our in-depth analysis extends to ESG issues facing the global sector which can identify good investment opportunities at home.

Supply chain risk creates investment opportunities

The concentration of supply of critical minerals related to decarbonisation is an issue that has been highlighted by major Western economies as a risk to securing the materials needed to meet climate goals. The US Government acknowledged its concerns around this supply chain risk within the recently passed Inflation Reduction Act. Amongst other issues, this Act outlines potential tax credits for Electric Vehicle purchases if certain conditions have been met, including that no critical mineral used in the vehicle is sourced from a “foreign entity of concern”.

A key resource sector holding in both the Tyndall Australian Share Wholesale Fund and the Tyndall Australian Share Income Fund is Iluka Resources. This company is one of few miners globally whose products are all considered of high strategic importance. These products include zircon, titanium, and a growing position in rare earths. While rare earths are ubiquitous in our daily lives – they are critical inputs for electronic devices, glass, specialty steel alloys and emission control systems in internal combustion engines – it is the development of permanent magnets that enable lighter and more energy-efficient motors which place rare earths on a substantial growth trajectory to meet the world’s climate goals.

The supply dynamics of key materials needed for decarbonisation are already well understood given they are part of our most consumed metals, including copper and nickel. Others, which form an integral part of the road to electrification, are coming from an almost insignificant demand base relative to their outlook. This includes materials such as lithium, cobalt and rare earths. China’s control of these materials needed to transition away from fossil fuels is extraordinary, dwarfing even that of OPEC’s control of global oil markets. China controls 80% of battery raw material refining, 80% of solar panel manufacturing and 60% of wind turbine installations. Notably, while the level of market share is high for these manufactured products necessary in the energy transition, China does not dominate the supply of the raw materials needed to produce them. This provides global consumers with the opportunity to support new entrants to these markets to mitigate the risk around supply chains. However, rare earths are an exception.

China controls almost 90% of rare earth processing and over 60% of rare earth mining. This number could be considered closer to 75% when including Myanmar volumes which are generally trucked across the border, implying an element of control over these mines by the Chinese. The high level of market control exerted by China historically has allowed its government to manage rare earth prices to levels that have generally deterred international competition.

Environmental risks to supply chains

China’s growth and dominance in rare earth mining and processing were driven by lax environmental standards which resulted in some exploitation of the country’s abundant resources. The Chinese Government’s credible environmental efforts saw the introduction of regulations to reduce environmental harm, including through forced industry consolidation to improve monitoring and the introduction of an export quota system to limit over-production. While environmental standards have increased, China’s largest producers of rare earths still have low ESG scores. For example, China Northern rare earths is rated by Sustainalytics as “Severe Risk” and ranks the company second last out of the 14,647 stocks covered. Myanmar’s nascent rare earth industry is facing substantial claims of environmental and social damage, with an Associated Press exposé highlighting substantial ecological harm and major negative impacts to Myanmar from mining practices.

The growing expectation amongst Western consumers for sustainable and ethically sourced materials will see an ongoing focus on the poor operational and environmental practices of Chinese and Myanmar producers. This, plus the geopolitical pressure to ensure the security of supply, creates an opportunity for producers in other jurisdictions to bring new supply to the market.

The Land of Plenty

Australia can capitalise on this dynamic. It is already a key supplier of many critical minerals vital for decarbonisation, although current production is only a small fraction of the country’s demonstrated resource. This provides significant scope for growth.

Iluka has the fortunate position of having all its products classified as ‘critical’. It is a major producer in its established markets – including a 30% share of the global supply of Zircon and a 10% share of the supply of high-grade Titanium feedstocks. While this is well understood by the equity market, we believe it is Iluka’s opportunity in rare earths that the market is yet to fully appreciate.

Iluka’s Eneabba project, located some 300km north of Perth in Western Australia, will be Iluka’s relatively low-risk entry into rare earth production. It is slated to produce 2.7mtpa NdPr initially, scaling up to 5.5mtpa in later stages which equates to 7% of forecast demand (for reference, Lynas rare earths currently produces 6ktpa NdPr).

While we usually have a healthy amount of scepticism when miners attempt to move beyond core competencies, the Eneabba project has several attributes that make it relatively low risk. These include:

• The utilisation of a considerable stockpile of rare earth-bearing monazite ore in place at Eneabba gathered from decades of mineral sands mining. This provides a known quantity, grade and mineralogy of material for processing in the initial years. This stockpile alone underpins the economics of the project, with further upside from additional mined deposits.
• Given the use of stockpiles in the initial phase, the environmental impact from mining is minimal as it uses a previously classified waste stream.
• The monazite has been previously treated by a French processor in La Rochelle (now owned by Solvay) in the 1980’s, meaning we know it can be done.
• Iluka engaged global French rare earth processing experts Carester early in the development process who are incentivised to see the project commissioned on time. Carester has first-hand experience in treating Iluka’s monazite ore during their time at the La Rochelle plant, with these same experts also bringing experience from other ex-China processing plants which provides a wealth of knowledge from years of troubleshooting.
• Iluka has secured almost all the upfront capex from the Australian Government via a $1.25bn non-recourse loan at market competitive rates and with a long tenor. The finance includes risk-sharing mechanisms to support the project in the face of potential technical, operating and/or market-based challenges.

While no new development is ever a lay-down misère, it is rare to find a development in the resources space with relatively low technical and financial risk to the operator. We believe the project could ultimately be worth in excess of A$2bn and account for almost half of Iluka’s value, when factoring in contributions from other resources. It is also rare to find a business fully exposed to key critical minerals at material levels of market share including elements so strategically important for decarbonisation.

Conclusion

As Western economies pivot to ensure supply security along entire decarbonisation supply chains, we expect the market’s appreciation of Iluka’s rare earth exposure will grow and add significant value to our investment. The US Inflation Reduction Act’s rules around critical mineral sourcing away from “foreign entities of concern” creates a strong rationale for Australian rare earths to attract a valuation premium. We expect this will be priced into Iluka over time.

By Stefan Hansen, Senior Research Analyst

Lillie previously completed roles with Perpetual as an External Reporting Intern and at Macquarie Capital as a Financial Control Intern during 2021. She also completed the Investment Management Mentoring Circle and Female Business Series with Macquarie and the Institutional Banking Virtual Internship with CitiBank.

In this new position, Lillie will support Tyndall AM’s ambitious and entrepreneurial 11-person senior team to help further develop and expand the Firm’s investment reach across the Australian market. She will also assist the team in implementing, analysing and executing equity trades across the Australian equity portfolios.

Brad Potter, Head of Australian Equities, Tyndall AM, commented: “We are delighted to welcome Lillie to Tyndall. She was the standout candidate through our exhaustive graduate recruitment process, and her financial skills and experience to date ensures she will be an excellent fit for our team.

“We look forward to welcoming Lillie in January for what is shaping up for an exciting year ahead for our growing business.”

Lillie joins Tyndall having recently completed her Bachelor of Accounting degree at the University of Technology, Sydney.

Since the Tyndall Australian Share Income Fund’s inception in 2008, it has maintained a leading position against income-focused funds in the category, with the fund described by Morningstar as having “consistently excellent execution.” The Tyndall Australian Share Income Fund is characterised by Tyndall’s value focus but with a distinct income bias. The portfolio typically holds 40–70 stocks, which aids diversification. Turnover has been between 40% and 70% per year, supporting a tax-conscious strategy.

“We are incredibly proud of this recognition of the Fund’s success in continuing to deliver positive alpha relative to the category benchmark index. Our investment team is specialised and collaborative and our true to label products ensure there are no surprises for clients. It’s a strong validation of our team’s relative value approach to delivering an income stream for clients over the long term,” said Malcolm Whitten, Portfolio Manager for Tyndall AM.

The Fund’s straightforward bottom-up analysis seeks out stocks offering the best value on an internal rate of return (IRR) basis. In addition to scrutinising financial data, the Fund also conducts thorough industry and risk analysis, a holistic research approach favoured in market. The approach has been recognised as clear, robust and repeatable.

“Our strategy allows us to build portfolios with diversified sources of high dividend-paying stocks and helps to produce lower volatility returns versus the S&P/ASX200 Index over the life of the Fund,” commented Michael Maughan, Portfolio Manager and Senior Analyst for Tyndall AM.

The Fund is co-managed by Malcolm Whitten and Michael Maughan. Both Whitten and Maughan have more than 20 years of industry experience with complementary skill sets and run the portfolio collaboratively. The two are backed by an 11-person investment team, including Tyndall AM’s Head of Australian Equities, Brad Potter.

Brad Potter

Tyndall Asset Management (Tyndall AM), one of Australia’s largest and most experienced investment teams, has announced its official rebranding, returning the business to its original foundations.

For more than 30 years, the Tyndall name in Australia has been synonymous with value investing. Its long-standing approach, process and performance track record have been well rated by the research community, and it boasts a highly awarded Australian share fund.

Tyndall continues to be led by Brad Potter, who brings more than 30 years’ industry experience. Potter leads an experienced and aligned team of 11 investment professionals, the majority having worked together for 15 years, focused on building high-conviction, diversified portfolios consisting of stocks with high forecast returns.

“We believe the best results in the future come from identifying value in the market today. Our single-minded focus on our clients helps us aim to deliver repeatable, sustainable and consistent investment outcomes. The team remains squarely focused on the continued delivery of strong, long-term outperformance,” said Brad Potter, Head of Australian Equities, Tyndall AM.

Tyndall believes all stocks have an intrinsic value and that inefficiencies in the market create buying opportunities. The team continues to apply its fundamental approach, known as Comparative Value Analysis, to build high-conviction portfolios comprising stocks that the team believes represent compelling value.

“The rebrand restores the business to its former heritage, and we’re really excited to be bringing back a brand that has such an excellent and long-standing reputation in the Australian market for delivering for its clients,” added Potter.

On 12 April 2021, Yarra Capital Management (Yarra) confirmed that it had completed the acquisition of Nikko Asset Management’s Australian business. Under the terms of the agreement, Yarra has ownership of Nikko AM’s Australian subsidiary and its associated entities. Under the agreement, Tyndall AM remains separate to Yarra’s style-neutral Australian equities business, with no crossover in investment management activity and no change to its value investment philosophy or process.

The dividend drought has broken – green shoots emerging for dividends.

Dividends have recovered a third of what they were pre-COVID-19, but as the economy bounces-back, these should return to prior levels, making income generation from equity income funds look attractive compared to bonds.

Growth in dividends set to return

Earnings expectations have recovered half of the COVID-19 decline while dividend expectations have recovered only a third due to current conservative dividend payout ratios. Payouts should rise as the economy re-opens, confidence increases, and earnings recover. Combined with rising earnings, distributions in the hands of shareholders should increase, and as a result income generation from a diversified equity income fund looks attractive compared to bonds.

The journey last year was an adventure. It is worth reflecting on what happened to prices, earnings, payout ratios, and dividends.

The Australian market declined sharply from a February 20 high of 7160 to a low of 4536 and has since recovered to just shy of 7000 in early April 2021. The decline was driven by fears and the uncertainty of the extent of the medical crisis and the economic consequence of isolation and social distancing measures intended to slow the contagious new COVID-19 virus. The severity of the share price moves has largely been a function of the sensitivity to the shut-down. The recovery rally has been driven by responsive health policies, Reserve Bank monetary policy, Federal government fiscal policy, and community acknowledgement of risk. Together these succeeded in cushioning the Australian economy from the negative effects of COVID-19. Through a combination of good policy and good luck, Australia has weathered the crisis better than most nations.

Now to the potential longer-lasting economic and financial effects of policies intended to counter the detrimental effects of COVID-19. Top of the list is greater government indebtedness, input price rises (the costs that go into producing a good or service), and consequence of rising real rates (the interest rate that takes inflation into account).  Markets are now reflecting the potential longer-lasting economic and financial effects of these policies.

How sustainable is the recovery?

What then is the future durability of the cash flow, earnings, and dividend recovery? Across the market, cash preservation strategies in response to the shutdown went deep, well beyond dividend suspension and cuts.  Temporary reduction in advertising, brand promotion, and travel expense are less likely to face a spending catch-up.  Less discretionary and longer-term commitments that temporarily conserved cash included delayed capital expenditure (CapEx), maintenance CapEx, releasing cash through running down inventory are more likely to be re-activated and be a drag on available cash and consequently limit future dividend payments and payout ratios.

At face value, the broad recovery in dividend payments reflected improving operating conditions as the economy has re-opened. The dividend payout ratio observed at the February company reporting season remained low versus history and reflected a cautious stance.  Future durability of the cash flow and earnings rebound is a key question for investors as they shape the dividend yield expectations for the year ahead.  The recent company reporting season was notable for the high percentage of earnings beats vs misses and the rebound in dividend payouts. Australian market consensus earnings per share for the next 12 months declined 20% due to COVID-19 and held this depressed level of expectations through to September 2020 when the earnings recovery commenced.  Earnings expectations have risen and just eclipsed their pre-COVID-19 level. The recovery was due to emerging optimism regarding vaccine candidates, clarity regarding the US election result with victory to President Biden with a clear majority, and a growing recognition of the success in health and economic policy packages in containing the virus and economic effects of the shutdown.

Whilst the broad market aggregate earnings expectations have recovered the drop, the composition in terms of timing, depth of trough, and extent of rebound differed by market segment.

Similarly, for dividend expectations over the next 12 months, the extent of the dividend drought and subsequent recovery reflects industry-specific forces.

The summary tables below show the change in indexed earnings and dividends from February 2020 before the crisis, the trough, and subsequent recovery. Dividend payout ratios show their lowest point, most recent level as well as the prevailing payout ratio pre-COVID-19.

The earnings decline and recovery

Each of the major market segments suffered earnings expectation declines of 17-23% from February 2020 with growing recognition that COVID-19 would have global consequences.

The first segment to recover was Resources in August 2020 and is the only sub-segment to re-take pre-COVID earnings levels and exceed pre-COVID-19 levels. Earnings expectations for the year ahead are now 32% higher than before COVID-19.

The resources sector performance has been driven by a powerful rally in the iron ore price due to ongoing COVID-19 related supply disruption in Brazil, combined with ongoing strong demand from China as they entered and emerged from the pandemic crisis earlier. A re-opening rally in the broader commodities sector including aluminium, copper, nickel, and oil has also contributed to positive resource sector earnings.

The Bank earnings expectations had been weak leading into February 2020 and fell an additional 23% in April 2020 due to COVID-19. The Bank downgrades were in anticipation of compressed net interest margin (NIM), expectations of rising bad debts, remediation charges, and charges against earnings for anticipated forward provisioning of loan losses.

Bank earnings expectations remained depressed from lows in May through to October and have since retraced 8% of the downgrades. It is noteworthy that earnings expectations remain 15% below pre-COVID-19 levels with the least amount of recovery.

The dividend decline and recovery

The bluntest assessment of the impact of COVID-19 and the subsequent re-opening show consensus S&P/ASX 200 Index dividend per share expectations for the next 12 months bottomed in August 2020 having progressively declined 26% from a year earlier.

The estimated deeper dividend decline than that of the earnings decline of 20% reflected a cut to the dividend payout ratio for the same period. The subsequent recovery in earnings and dividends has not yet seen an equivalent recovery in payout ratio. The lag in payout ratio recovery is illustrated in Chart 1 where the dotted dividend index lines have not caught back up to the solid earnings index lines.  The varying degree of separation for each market segment is reflective of the change in payout ratio.

Each of the broad market segments except Resources shows the dotted dividend lines below their equivalent earnings indicative of lower payouts than before COVID-19.  The rising slope since August 2020 of most of the dividend series greater than earnings suggests that a recovery in payout ratios has commenced. The notable exception to this broad improvement in payouts is Real Estate Investment Trusts (REITs) where dividend expectations slid sequentially over 2020 and are now 39% below pre-COVID-19 levels.

Retail-based asset exposure within REITs face a period of downward rental reset risk. Combined with unsustainable payout ratios, and commitments to prioritize debt reduction, these factors have seen dividend expectations continue to fall, while the rest of the market earnings and dividends have begun to recover.

Office asset rent expectations have been reset lower with uncertainty regarding occupancy as CBD businesses re-configure for ongoing greater propensity to work from home. Office re-leasing spreads have opened, and incentives have been pushed out to cycle highs. The construction of new capacity has been delayed. Despite observed strength in direct market transactions, the listed market faces strong earnings headwinds.

The larger dividend payout picture is shown explicitly in Chart 2 which aggregates the rolling earnings and dividends over the last twelve months from pre-COVID to the conclusion of the February reporting season.  A feature of the most recent February 2021 reporting season was one of a greater increase in dividends than earnings. Share price response to the positive dividend surprise was greater than that to earnings with the market seeming to have already anticipated the earnings strength.

Boardroom confidence in the re-opening has been signalled through raising dividends. This has been well received and suggests higher dividend payouts in the future.  Forward-looking indicators of business confidence such as the NAB Business and Roy Morgan Business Confidence survey have shown rapid improvement to multi-year highs in business confidence which is also supportive of increased dividend payout ratios.

In July 2020 APRA restricted bank payouts to 50% of earnings to preserve capital due to the COVID-19 crisis. The effect of this is shown in Chart 2 with bank payouts falling the most from 85% to a low of 60%. This exceeded the limit due to the restriction being applied after CBA had already gone ex-dividend and being in force for only 5 months.  The bank dividend restriction was lifted in December 2020 with APRA pointing to evidence that suspended loan repayments under emergency relief waivers have rapidly recommenced repayments.

The APRA action was a precautionary and temporary reduction in the bank sector payout ratio. This payout ratio should rise in the future in an environment of rebounding economic growth, robust housing loan growth, and benign defaults.  The timing of a reversal in additional provisions taken in the face of COVID-19 is uncertain.  A reversal in the precautionary provisions will boost reported earnings for the Banks.

Dividends for Resources have eclipsed their pre-COVID-19 levels. The payout ratio is already at a historically high level and less likely to increase further. Future resource dividend resilience, therefore, depends on the prevailing high commodity prices and earnings being sustained. Transitory COVID-19 supply interruptions to production in Brazil ending and new iron ore mines sponsored by the Chinese could release some tension in that market, with the latter being many years out.

The 73% payout ratio of the Non-Bank Industrials has been remarkably stable in comparison to the other segments. This group is more numerous and diversified across the industry admittedly with winners and losers from the lock-down.  The meagre rise in expected earnings and dividends also reflects the many crosscurrents to the different industries within the Non-Bank-Industrials sector.  For example, the re-opening and stimulus upswing in detached housing-related companies is offset by a retreat in activity from stay-at-home winners, such as consumer staples and some discretionary retail.

Path of dividend yields and outlook

The historical path of expected dividend yields is shown for the market and major segments since March 2018 in Chart 3.

The longer-term downtrend in dividend yield has followed a greater reach for yield trade. Aside from the apparent blow-out during the worst of the March – April 2020 sell-off, combined with lagging updates to estimates and Resource earnings, the overall trend has also been for a narrowing in dividend yield. Differentiated portfolio positioning on yield alone is more challenging as yields converge.

The net effect of the potent share price rally since November 2020, and partial recovery in dividends has seen the expected dividend yields compress back to 3.7% at March 2021.

Investors should take note of the strong price gains which have far exceeded the recovery in earnings and caused compression in most dividend yields. The dividend yield of Resources currently leads the other market segments but is reliant on an iron ore price which is far above the industry cost curve and provides unprecedented incentive to add production capacity.

Portfolio positioning

A ‘goldilocks’ scenario of re-opening driven earnings growth, interest rate normalization without an inflation/wage-price spiral seem necessary conditions to support the current pricing regime.  The Nikko AM Australian Share Income Fund (Income Fund) has continued to be run with the aim  to generate of generating a yield above that of the market and consistent with our comparative value analysis (CVA).

A valuation distortion brought by fears of the economic impact, a flight to safety , and a ‘stay-at-home’ focus has unwound rapidly.  The outperformance of ‘Value’ over ‘Growth’ has seen the market recover much of the 2020 lost ground.

The market recovery has been predicated on the ‘Goldilocks’ recovery. If consensus is that Goldilocks continues, any contrary evidence would see cracks appear in the recovery which would likely be volatile. This could happen with increases in virus cases and reluctance of the population to vaccinate due to blood-clot concerns.

Possible challenges to the consensus may come from delays in vaccinations, outbreaks of new virus strains, and policy stimulus withdrawal impacting growth. Alternative risks from the economy running too hot are an inflation breakout and an interest rate driven reset in asset prices.

In recognition of the potential for higher volatility, risk in the portfolio has been reduced.

We believe that opportunities remain to reflect our valuation process and the income objective in our Income Fund. To this end and in the spirit of transparency, a summary of our portfolio actions follows.

Actions over the last quarter

Bank exposure has rotated out of the more expensive CBA into relatively cheaper Australia & New Zealand Banking Group (ASX:ANZ), National Australia Bank (ASX: NAB), and Westpac (ASX:WBC).  Position size in Virgin Money UK (ASX:VUK) has been reduced as the gap to our assessed valuation has narrowed.

Our patience in a baseline assumption of the oil market normalizing enabled us to ride out the worst of the oil price moves and we gladly supported calls during the crisis and with the subsequent rally, sold some of the position at higher levels. The subsequent rally in Energy names provided an opportunity to take profits.

Within the defensive Retail names, we have taken profits reducing Wesfarmers (ASX:WES) and Woolworths (ASX:WOW) and bought into Coles (ASX:COL) which has been seemingly oversold in the re-opening trade and offers both valuation and dividend yield appeal.

A rotation within our Insurance positions to better reflect our assessed valuation and spread risk over three names: Insurance Australia Group (ASX:IAG), QBE Insurance Group (ASX:QBE), and Suncorp Group (ASX:SUN), rather than just Suncorp.  Although the current yields are lower, the valuation gaps are greater. Each should benefit from higher investment returns on capital reserves.

Within the Utility/Infrastructure space, we have commenced recycling highly regulated returns with low growth into less regulated higher growth. Examples of this would be selling Spark Infrastructure (ASX:SKI) into less bond-sensitive APA Group (ASX:APA), and Transurban (ASX:TCL) with the ability to inflate toll charges.

The Income Funds’ exposure to Resources has been reduced taking profits in Deterra Royalties (ASX:DRR) and reducing BHP Group (ASX:BHP) ex-dividend to reduce downside risk to iron ore. Despite the spot iron ore price resilience, we do not expect the price to hold longer-term.

The Income Fund re-entered CSL (ASX:CSL) via a buy-write (a relatively low-risk options position owning the underlying security while writing options on it) which has growth attributes longer term. This has reduced portfolio risk-reducing underweight in Healthcare with income generated from the option premium.

Conclusion

Australia has been very fortunate to have acted promptly to isolate and support those companies and individuals most affected.  The dividend drought has broken. Resolve to ride out the COVID-19 episode and stick to process has carried the Income Fund well.

The composition of the market dividend yield stands at approximately 1/3 Resources. 1/3 Banks and 1/3 Non-bank Industrials. There is downside risk to Resources earnings and dividends, upside risk to Bank earnings and dividends, and a flat outlook for Non-Bank Industrials.

The outlook for equity market dividend income looks balanced and attractive at the current level of 3.7%.  The rapid and deep cuts to dividend payout in response to the crisis leave good scope for future dividend payout recovery. This sets a positive outlook for future equity portfolio income generation.

A diversified equity income portfolio can continue to provide a superior yield to 10-year government bonds which are currently yielding 1.8%.  Growth in an equity income portfolio vs bonds is desirable to mitigate longevity and inflation risks.

We remain confident in meeting the rolling 5-year income objective of a grossed-up dividend yield greater than the S&P/ASX 200 Yield with an additional positive contribution to long-term capital growth from our active investment process.

By Malcolm Whitten, Portfolio Manager and Senior Analyst

Al Clark

Australian and New Zealand investors’ sizable allocations to global assets is leading Nikko Asset Management to make a major global product push into these markets, the company announced yesterday.

The Tokyo-based asset manager is also aligning the current Tyndall brand names in both Australia and New Zealand with the firm’s global name, Nikko Asset Management.

The asset manager will use its expanded investment expertise and capabilities to provide new products to institutional and retail clients in both countries. In August, Nikko Asset Management formed a new global multi-asset team led by Al Clark. In the same month, it added a global active equity capability headed by William Low, and in October 2013, an Asia ex-Japan equity team led by Peter Sartori.

“We are one company and therefore should share one name globally as Asia’s premier global asset manager,” said Takumi Shibata, president and chief executive officer of Nikko Asset Management. “The investment teams, the sales and marketing teams and the back office teams are all working collaboratively for the benefit of our clients. One brand simply reflects what is already working for us.”

Nikko Asset Management plans to introduce several global strategies through its local subsidiaries in Australia and New Zealand in the coming months, while continuing to offer products investing in local securities. The move will allow the firm to leverage its significant global resources in meeting the varied needs of investors.

“We are very pleased to be expanding our global offering to Australian investors,” said Mike Davis, Managing Director of Nikko Asset Management, Australia. “The evolution of our business over the past three years as part of Asia’s premier global asset manager has added to our depth of investment capabilities to meet the sophisticated needs of our clients in this competitive environment. Approaching the market as Nikko Asset Management in Australia will allow us to differentiate the value we bring to our clients, borne out of our Asian insights.”

The firm’s Australian operation has A$24 billion (US$23 billion) in assets under management, representing approximately 14 percent of Nikko Asset Management’s total assets of US$168 billion as of June 2014.

“Nikko Asset Management is well known globally, and we are excited to bring more of the firm’s global expertise to our clients,” said Peter Lynn, Managing Director of Nikko Asset Management, New Zealand. “With this brand transition, there is no change to our investment teams, their investment philosophy, processes or portfolios. As one company, with one name, we will further distinguish our offering to clients in New Zealand.”

The company’s New Zealand operation, which is based in Auckland, is the only foreign asset management firm operating in the country. Its assets under management reached NZ$3.8 billion (US$3.3 billion) as of June 2014.

According to a June 2013 survey conducted by the Australian Prudential Regulation Authority[1], some 31 percent of superannuation fund assets were allocated to global investments, with 25 percent in equity and 6 percent in fixed income. Meanwhile, in New Zealand, a survey of leading balanced funds by Aon Hewitt[2] reveals that 48 percent of assets were allocated globally, with 32 percent in equity and 16 percent in fixed income.

Nikko Asset Management is conducting its inaugural Foreword client event this week in Melbourne, Sydney and Auckland. Speakers include the firm’s global head of investment Yu-Ming Wang, in addition to the portfolio managers in charge of its leading global and local investment strategies.

———–

[1]Annual Superannuation Bulletin June 2013 (revised February 5, 2014)

[2] The Aon Investment Update, Aon Hewitt Investment Consulting July 2014

Figure 3: Vale, Carajas iron ore pit (Source: Tyndall AM).

With the football World Cup recently held in Brazil, it is worth mentioning another large contributor to the Brazilian economy – iron ore.

Brazil remains the second largest seaborne supplier of iron ore to China (behind Australia) and is home to the world’s largest iron ore producer, Vale. Following a recent research trip, I believe Brazil remains crucial to the supply-demand balance in the seaborne iron ore market and will have significant ramifications for prices over the medium to long term.

Brazil is a large, high-quality iron ore supplier

Morgan Stanley estimates that Brazil will export 320 million tonnes (mt) of iron ore in 2014, of which Vale will export 265mt. What is often not mentioned when comparing Brazil to Australia, is the superior quality of Brazil’s iron ore. Average iron ore grades from Brazil are well above the benchmark 62% iron (Fe) content that is often quoted. Vale produces products with up to 66% iron content. This is in stark contrast to Australian iron producer, Fortescue Metals, which produces sub-60% iron content. The key saleable iron ore grade from Rio Tinto, who produces Australia’s highest quality iron ore, is 61% (for Pilbara Blend Fines).

A shift to a supply surplus has implications for pricing In recent years, a deficit in the supply of iron ore meant the grade differential between the various iron ore qualities did not result in any significant discounting. The adjustment to the lower iron content was made to the benchmark pricing plus an additional small penalty for the Chinese mills taking lower grade than they would otherwise like for their sinter feed (iron ore feed to the blast furnace). For the producers of low-grade products this was an excellent outcome but unsustainable.

Looking back over a longer time horizon, this has not been the case. When the market moves from a deficit of iron ore supply to a surplus, the steel mills are less willing to take a lower quality product. The lower-quality product produces more slag in steel making (and a less efficient blast furnace), requires steel mills to find higher-quality iron ore to blend and increases handling costs of iron ore as low-quality ore must be blended with a high-quality product. As a result, the small penalty that is separate from the grade adjustment has in fact been a significant penalty in the  past, as high as 30% in 2009 (as highlighted in figure 1).

Figure 1: A deficit in iron ore supply has kept the price discount low in recent years

We are now moving into a phase where the supply of iron ore has caught up with demand for iron ore. In 2014, new seaborne supply in the iron ore market will be approximately 110mt per annum. For the first time since 2008, Chinese domestic iron ore supply to steel mills will fall materially (by over 70mt). 2015 will see close to a further 100mt from both Brazil and Australia. The additional tonnes in 2014 are expected to be high-grade iron ore (60% to 66% Fe) from Rio Tinto (+50mt), Vale (+40mt) and other Brazilian producers(+20mt).Steel consumption will increase by approximately 3% in 2014from 2013 levels. Over the same period, seaborne iron ore supply will grow by 16%. The large increase in supply relative to the steel consumption increase will be balanced by the closure of high-cost production both domestically in China, but also from other non-traditional producers such as Africa and the Middle East. We believe this should provide a floor in the iron ore price of around USD 90 to 100 per tonne in 2014.

Quality not just quantity

The reason this will be a golden age for Brazilian iron ore is due to its quality. Vale produces high-quality iron ore, particularly in the northern system (region), with Vale’s Carajas project being among the best quality, large scale iron ore mines in the world. In addition, the new expansion project at Carajas, S11D,is expected to add 90mt per annum of supply by 2016. The cost of producing the S11D iron ore is a mere USD 11 per tonne (excluding freight costs), reflecting the size of the iron ore body, quality of the deposits and lower labour costs.

Compare this to Rio Tinto, which is in the mid-USD 30s per tonne (excluding freight costs) and the superior economics of the new Vale iron ore are easy to see. Adding another USD 20 per tonne for freight to China and Vale will deliver iron ore to Tianjin port for approximately USD 30 per tonne, while also receiving a premium to the 62% Fe index which will make the margin for the Vale product at almost USD 60 per tonne.

It is not just the Vale iron ore that has such great economics. A review of other iron ore producers in Brazil shows that the cost delivered to the port in Brazil for many producers is in the low USD 20s per tonne. The lack of infrastructure to load ships is preventing this production reaching the seaborne market.

Port owners are able to command over USD 20 per tonne to load a ship. Add another USD 20 per tonne for freight to China and these producers are delivering iron ore to Tianjin at USD 60 per tonne. This cost is still well below the likes of Fortescue Metals and well below some of the higher-cost mid-cap Australian producers – but above Rio Tinto and BHP.

What has held back Brazilian supply?

The question then becomes, if the economics are superior for these Brazilian projects, why have they failed to deliver net new tonnes to the seaborne market (as evidenced by figure 2)? The difficulty in delivering infrastructure solutions can never be underestimated. The junior Australian iron ore miners (those who produce less than 30 million tonnes of iron ore per year) who do not own rail or port facilities understand this challenge. This lack of infrastructure has hampered their ability to deliver tonnes to the market when prices were more favourable. Brazil suffers a similar fate. For the junior miners in Brazil, the biggest infrastructure problem they face is port access. Currently, two key companies control the major export ports for iron ore. They are Vale and Trafigura.

Figure 2: Brazil has lagged Australia in delivering supply

Vale has an incentive to keep iron ore prices supported and fill the market with their own tonnes of iron ore. They benefit from the port fees they are charging to load ships and also benefit from the slightly higher iron ore price. If they increase the port capacity, Vale will likely lower the loading fee of approximately USD 20 per tonne and will increase seaborne supply, helping to push the iron ore price lower.

Trafigura is a global trading house. By controlling supply, they can ultimately influence pricing which they rely on for their trading business. Therefore, there is not a great incentive for port expansion for non-Vale tonnes. It is this tonnage that is uncertain to come to the market by 2016 as forecast.

In addition to infrastructure challenges in Brazil, the other issue Vale has faced is environmental approvals. Carajas sits in the mountains of Northern Brazil (see figure 3). Deep in the jungle, the environmental challenges of developing mining operations has forced the government to consider the impact on the natural environment. Among the challenges are the potential destruction of caves and forest areas which affect flora and fauna. Until recently, this has been the biggest hurdle in the expansion of the S11D project.

The tide is turning for Brazil iron ore

It appears that the government is finally turning to a more favourable view on Vale expansion projects. In July 2013, the Brazilian government approved the construction of S11D, three years after the company originally expected to be granted approval. There remains one licensing hurdle to completion and the exporting of ore, and that can only be achieved once construction is complete. The recent approval shows the intent of the government to allow Vale to grow and suggests the years of frustration that have delayed production expansion (as evidenced in figure 4) may finally be over. With these tonnes, it will further reduce the need for low-quality iron ore, which suggests the low-grade iron ore produced by the Australian mid-tier miners (including Fortescue) could struggle to find a home.

Figure 4: Vale supply guidance has consistently disappointed

Increased focus on the low-grade iron ore discount

Vale has spoken of their desire to push the low-grade discount down further. They are opening a blending facility in Malaysia, with the purpose of blending their high-grade, low impurity

Carajas ore with their lower-quality, higher impurity southern system ore. The result is a product of around 64-65% iron content. The CFO of Vale recently confirmed to me during a meeting while on the research trip to Brazil, their goal is to address the company’s concern that they were not receiving a big enough premium for their high-quality iron ore (the flip side being that Fortescue was not receiving a big enough discount for their low-grade iron ore). Vale has not been happy with Chinese steel mills blending their product with lower-grade product – from Australia in particular.

It will be interesting to follow the grade discount rather than the headline price over the next six months. The big producers such as Rio Tinto, BHP Billiton and Vale have the ability to increase high-grade iron ore production and shift the mix to meet market demands and take advantage of premiums or avoid discounts. Fortescue on the other hand (and the junior iron ore miners) are more limited. It should be noted that the junior miners in a lot of cases have developed resources that BHP Billiton and Rio Tinto no longer wanted when the iron ore price was in the USD 30s per tonne. The junior minors have limited flexibility to improve grades without increasing production costs substantially.

The situation developing in Brazil will be making many Australian iron ore miners sit up and watch, and it won’t just be for the football. Brazil remains the key unknown to where prices and discounts in the iron ore market will sit. Delivery of net new tonnes will be the key for consensus pricing to sit around USD 85 per tonne. Failure for Brazil to deliver net new tonnes in 2016 will see the long-term price rise above the market consensus. This would be a positive for the lowergrade producers including Fortescue and Atlas.

In the short term however, the market will remain well supplied for the remainder of this year as Chinese steel consumption seasonally weakens in the third and fourth quarters. The cost curve has shifted down structurally. USD 100 per tonne will now be the new USD 120-130 per tonne.

Grade discounts are now the focus, rather than the headline benchmark price. The potential risk, particularly for low-grade iron ore producers, is how large these discounts can grow.

By James Eginton

———-

Disclaimer

This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (TIML). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. Reference to individual stocks in this material neither promise that the stocks will be incorporated into the Tyndall Australian equity portfolios nor constitute a recommendation to buy or sell. TIML and TAML are part of the Nikko AM Group.

]]>

Figure 3: Vale, Carajas iron ore pit (Source: Tyndall AM).

With the football World Cup recently held in Brazil, it is worth mentioning another large contributor to the Brazilian economy – iron ore.

Brazil remains the second largest seaborne supplier of iron ore to China (behind Australia) and is home to the world’s largest iron ore producer, Vale. Following a recent research trip, I believe Brazil remains crucial to the supply-demand balance in the seaborne iron ore market and will have significant ramifications for prices over the medium to long term.

Brazil is a large, high-quality iron ore supplier

Morgan Stanley estimates that Brazil will export 320 million tonnes (mt) of iron ore in 2014, of which Vale will export 265mt. What is often not mentioned when comparing Brazil to Australia, is the superior quality of Brazil’s iron ore. Average iron ore grades from Brazil are well above the benchmark 62% iron (Fe) content that is often quoted. Vale produces products with up to 66% iron content. This is in stark contrast to Australian iron producer, Fortescue Metals, which produces sub-60% iron content. The key saleable iron ore grade from Rio Tinto, who produces Australia’s highest quality iron ore, is 61% (for Pilbara Blend Fines).

A shift to a supply surplus has implications for pricing In recent years, a deficit in the supply of iron ore meant the grade differential between the various iron ore qualities did not result in any significant discounting. The adjustment to the lower iron content was made to the benchmark pricing plus an additional small penalty for the Chinese mills taking lower grade than they would otherwise like for their sinter feed (iron ore feed to the blast furnace). For the producers of low-grade products this was an excellent outcome but unsustainable.

Looking back over a longer time horizon, this has not been the case. When the market moves from a deficit of iron ore supply to a surplus, the steel mills are less willing to take a lower quality product. The lower-quality product produces more slag in steel making (and a less efficient blast furnace), requires steel mills to find higher-quality iron ore to blend and increases handling costs of iron ore as low-quality ore must be blended with a high-quality product. As a result, the small penalty that is separate from the grade adjustment has in fact been a significant penalty in the  past, as high as 30% in 2009 (as highlighted in figure 1).

Figure 1: A deficit in iron ore supply has kept the price discount low in recent years

We are now moving into a phase where the supply of iron ore has caught up with demand for iron ore. In 2014, new seaborne supply in the iron ore market will be approximately 110mt per annum. For the first time since 2008, Chinese domestic iron ore supply to steel mills will fall materially (by over 70mt). 2015 will see close to a further 100mt from both Brazil and Australia. The additional tonnes in 2014 are expected to be high-grade iron ore (60% to 66% Fe) from Rio Tinto (+50mt), Vale (+40mt) and other Brazilian producers(+20mt).Steel consumption will increase by approximately 3% in 2014from 2013 levels. Over the same period, seaborne iron ore supply will grow by 16%. The large increase in supply relative to the steel consumption increase will be balanced by the closure of high-cost production both domestically in China, but also from other non-traditional producers such as Africa and the Middle East. We believe this should provide a floor in the iron ore price of around USD 90 to 100 per tonne in 2014.

Quality not just quantity

The reason this will be a golden age for Brazilian iron ore is due to its quality. Vale produces high-quality iron ore, particularly in the northern system (region), with Vale’s Carajas project being among the best quality, large scale iron ore mines in the world. In addition, the new expansion project at Carajas, S11D,is expected to add 90mt per annum of supply by 2016. The cost of producing the S11D iron ore is a mere USD 11 per tonne (excluding freight costs), reflecting the size of the iron ore body, quality of the deposits and lower labour costs.

Compare this to Rio Tinto, which is in the mid-USD 30s per tonne (excluding freight costs) and the superior economics of the new Vale iron ore are easy to see. Adding another USD 20 per tonne for freight to China and Vale will deliver iron ore to Tianjin port for approximately USD 30 per tonne, while also receiving a premium to the 62% Fe index which will make the margin for the Vale product at almost USD 60 per tonne.

It is not just the Vale iron ore that has such great economics. A review of other iron ore producers in Brazil shows that the cost delivered to the port in Brazil for many producers is in the low USD 20s per tonne. The lack of infrastructure to load ships is preventing this production reaching the seaborne market.

Port owners are able to command over USD 20 per tonne to load a ship. Add another USD 20 per tonne for freight to China and these producers are delivering iron ore to Tianjin at USD 60 per tonne. This cost is still well below the likes of Fortescue Metals and well below some of the higher-cost mid-cap Australian producers – but above Rio Tinto and BHP.

What has held back Brazilian supply?

The question then becomes, if the economics are superior for these Brazilian projects, why have they failed to deliver net new tonnes to the seaborne market (as evidenced by figure 2)? The difficulty in delivering infrastructure solutions can never be underestimated. The junior Australian iron ore miners (those who produce less than 30 million tonnes of iron ore per year) who do not own rail or port facilities understand this challenge. This lack of infrastructure has hampered their ability to deliver tonnes to the market when prices were more favourable. Brazil suffers a similar fate. For the junior miners in Brazil, the biggest infrastructure problem they face is port access. Currently, two key companies control the major export ports for iron ore. They are Vale and Trafigura.

Figure 2: Brazil has lagged Australia in delivering supply

Vale has an incentive to keep iron ore prices supported and fill the market with their own tonnes of iron ore. They benefit from the port fees they are charging to load ships and also benefit from the slightly higher iron ore price. If they increase the port capacity, Vale will likely lower the loading fee of approximately USD 20 per tonne and will increase seaborne supply, helping to push the iron ore price lower.

Trafigura is a global trading house. By controlling supply, they can ultimately influence pricing which they rely on for their trading business. Therefore, there is not a great incentive for port expansion for non-Vale tonnes. It is this tonnage that is uncertain to come to the market by 2016 as forecast.

In addition to infrastructure challenges in Brazil, the other issue Vale has faced is environmental approvals. Carajas sits in the mountains of Northern Brazil (see figure 3). Deep in the jungle, the environmental challenges of developing mining operations has forced the government to consider the impact on the natural environment. Among the challenges are the potential destruction of caves and forest areas which affect flora and fauna. Until recently, this has been the biggest hurdle in the expansion of the S11D project.

The tide is turning for Brazil iron ore

It appears that the government is finally turning to a more favourable view on Vale expansion projects. In July 2013, the Brazilian government approved the construction of S11D, three years after the company originally expected to be granted approval. There remains one licensing hurdle to completion and the exporting of ore, and that can only be achieved once construction is complete. The recent approval shows the intent of the government to allow Vale to grow and suggests the years of frustration that have delayed production expansion (as evidenced in figure 4) may finally be over. With these tonnes, it will further reduce the need for low-quality iron ore, which suggests the low-grade iron ore produced by the Australian mid-tier miners (including Fortescue) could struggle to find a home.

Figure 4: Vale supply guidance has consistently disappointed

Increased focus on the low-grade iron ore discount

Vale has spoken of their desire to push the low-grade discount down further. They are opening a blending facility in Malaysia, with the purpose of blending their high-grade, low impurity

Carajas ore with their lower-quality, higher impurity southern system ore. The result is a product of around 64-65% iron content. The CFO of Vale recently confirmed to me during a meeting while on the research trip to Brazil, their goal is to address the company’s concern that they were not receiving a big enough premium for their high-quality iron ore (the flip side being that Fortescue was not receiving a big enough discount for their low-grade iron ore). Vale has not been happy with Chinese steel mills blending their product with lower-grade product – from Australia in particular.

It will be interesting to follow the grade discount rather than the headline price over the next six months. The big producers such as Rio Tinto, BHP Billiton and Vale have the ability to increase high-grade iron ore production and shift the mix to meet market demands and take advantage of premiums or avoid discounts. Fortescue on the other hand (and the junior iron ore miners) are more limited. It should be noted that the junior miners in a lot of cases have developed resources that BHP Billiton and Rio Tinto no longer wanted when the iron ore price was in the USD 30s per tonne. The junior minors have limited flexibility to improve grades without increasing production costs substantially.

The situation developing in Brazil will be making many Australian iron ore miners sit up and watch, and it won’t just be for the football. Brazil remains the key unknown to where prices and discounts in the iron ore market will sit. Delivery of net new tonnes will be the key for consensus pricing to sit around USD 85 per tonne. Failure for Brazil to deliver net new tonnes in 2016 will see the long-term price rise above the market consensus. This would be a positive for the lowergrade producers including Fortescue and Atlas.

In the short term however, the market will remain well supplied for the remainder of this year as Chinese steel consumption seasonally weakens in the third and fourth quarters. The cost curve has shifted down structurally. USD 100 per tonne will now be the new USD 120-130 per tonne.

Grade discounts are now the focus, rather than the headline benchmark price. The potential risk, particularly for low-grade iron ore producers, is how large these discounts can grow.

By James Eginton

———-

Disclaimer

This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (TIML). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. Reference to individual stocks in this material neither promise that the stocks will be incorporated into the Tyndall Australian equity portfolios nor constitute a recommendation to buy or sell. TIML and TAML are part of the Nikko AM Group.

The post A golden age for Brazilian iron ore? appeared first on AdviserVoice.

However, the returns on fixed income have actually been superior to the returns on term deposits over the past 10 years. Given the current economic environment both globally and domestically, cash rates are likely to remain lower for longer, which should keep bond prices higher and term deposit rates lower. As a result, Australian investors may want to reassess their low exposure to fixed income. 

Q: Is Australia unusual in its preference for cash vs fixed income?

A: The simple answer is yes. Historically, Australian investors have preferred cash rather than fixed income as the default position for the defensive asset holding in their investment portfolios. Although US investors have held around the same amount of equities as an Australian investor, instead of cash they held more of their portfolios in fixed income.

Pension Fund Asset Allocation in Selected OECD Countries, 2012

 Source: OECD Global Pension Statistics

The “Other” category includes loans, land and buildings, unallocated insurance contracts, hedge funds, private equity funds, structured products, other mutual funds (i.e. not invested in cash, bills and bonds, shares or land and buildings) and other investments.

For Australia, Source: Australian Bureau of Statistics. The high value for the “Other” category is driven mainly by net equity of pension life office reserves (14% of total investment).
For Canada, the high value for the “Other” category is driven mainly by other investments of mutual funds (15% of total investment).
For Japan, Source: Bank of Japan. The high value for the “Other” category is driven mainly by accounts payable and receivable (22% of total investment) and outward investments in securities (21% of total investment).

For Germany, the high value for the “Other” category is driven mainly by loans (18% of total investment) and other investments of mutual funds (17% of total investment).

 Q: What are the reasons for this disparity?

A: It is partly due to a lack of familiarity with fixed income in the Australian market and partly because historically Australian cash rates were high, leaving very little premium between the cash rate and the yield on the 10-year bond. By contrast, US investors historically have been paid to hold 10-year bonds and so have been incentivised to hold long duration assets.

Q: What was the effect on Australian investors of holding cash rather than fixed income?

A: Given the high yields available on Australian term deposits, the decision to hold them rather than bonds may be seen as rational and appropriate in a high inflation environment. However, such  investors missed out on the major benefit of holding high quality bonds – the negative correlation they provide to equities. This particularly came to light in the GFC when equity prices collapsed and many Australian investors had no fixed income exposure to offset the negative returns from equities. In fact, as cash rates fell to help stabilise the economy, cash holdings performed poorly compared with fixed income.

Q: What’s the difference in long-term returns between fixed income and term deposits?

A: The returns on fixed income have surpassed term deposits over the longer term despite the fact the Australian yield curve has been so flat over the past 10 years.  Although investors in cash believed they were investing in an asset class which was offering higher returns, actual returns were higher for true fixed income funds since cash and term deposit holdings missed out on the capital returns enjoyed by bonds. When choosing where to allocate funds, it seems that investors are more concerned about ex ante returns than the returns they would have got from an asset class they don’t own.

Bonds outperform term deposits over the long term

Source: Mercer Insight; RBA (data reference: FRDIRBTD10KAR)

Dividends and distributions are reinvested. Returns are gross (pre fees, pre tax) and assume reinvestment of distributions.
*Term deposit return is the average rate on $10,000 term deposits across all terms at the five largest banks, including their advertised ‘specials’ and regular rates (using the monthly effective rate)

Q: Will we see domestic investors looking more closely at fixed income for their liquid or defensive asset class holdings?

In our view, they should but the problem is that investors are still scared off by the fact that bond markets have had a 20-year rally and rates must return to their normal levels from the current historically low yields.

Bond markets have had a 20-year rally in Australia and this has been due to the fact the neutral rate for cash has fallen as inflation has fallen. The Reserve Bank of Australia (RBA) has an inflation target of 2-3%. The success of the RBA in achieving its target has resulted in the financial market viewing it as credible. Since longer-term bonds use this as a realistic inflation level, it has lowered the risk premium around future inflation levels helping to lower bond yields and raise prices.

Q: Bond yields are historically low: is this likely to continue?

A: Central banks globally have intervened to lower bond rates. They could not cut cash rates below zero and so embarked on unconventional policies, such as quantitative easing (QE) to help repair their economies. QE has depressed real rates and term premiums globally. Many of these programmes have stopped or are being tapered. In 2013, US rates rose by 100 bps on the back of the Federal Reserve’s tapering of QE. However, the Fed still holds a vast quantity of fixed income securities on its balance sheet. This is not just holding up bond prices (therefore keeping yields low) but also bolstering all risky assets, including equities.  While QE persists, bond yields will remain depressed.

As we have stated previously, Tyndall views the new neutral rate for cash as being around 4.0%, which would imply a normal rate for the 10-year bond yield of around 5.0% (100 bps above its current level of 4.0%).  With the cash rate at 2.5%, even the current low bond yields are still providing a better return than cash.

Q: What will be the impact on Australia of lower rates for longer?

Australia’s household debt to disposable income is at record highs at around 148%[1]. With the decline in the terms of trade, low wages and low returns, income growth will remain low. As a result, monetary policy will have a stronger impact on the economy and won’t require large increases in interest rates to have the desired effect on the economy as we have seen in previous cycles. With cash rates low and likely to remain low and term deposit rates falling, Australian investors may start considering increasing their exposure to fixed income.

The risk of being so underinvested is a major one that is often ignored and leaves investors exposed not only to a potential fall in the cash rate but also the current low interest rate environment.  Apart from bonds’ defensive qualities and negative correlation to equities, the longer term threat of low inflation and the inability of central banks to adequately deal with it also warrants an allocation to bonds, in our opinion.

[1] Source: Reserve Bank of Australia, table E2, http://www.rba.gov.au/statistics/tables/index.html.

By Roger Bridges, Head of Fixed Income Strategy, Tyndall AM

———–

Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“Tyndall AM”). Tyndall AM is part of the Nikko AM group. The information contained in this document is of a general nature only and does not constitute personal advice. Nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual.  The information in this document has been prepared from what is considered to be reliable information but the accuracy and integrity of the information is not guaranteed by the Company. Figures, charts and other data, including statistics, in these materials are current as of the date of publication unless stated otherwise. In addition, opinions expressed in these materials are as of the date of publication unless stated otherwise. The graphs, figures, etc., contained in these materials contain either past or backdated data, and make no promise of future investment returns etc. Past performance is not a reliable indicator of future performance.

The Tyndall Australian Bond Fund (ARSN 098 736 255) is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL 229664, a related entity of Tyndall AM.  Potential investors should obtain their own independent advice and consider the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest.