Investment grade credit continues to outclass equities

TL;DR

Money goes to where it’s treated best. So, it should come as no surprise that when allocating capital in Australia today, professional investors have many more reasons to allocate to corporate credit over equities. And if there is another rate hike on the RBA’s pad, we will see more investment flowing in the same direction.

Australian equities should regain their lustre once interest rates are cut, more liquidity enters consumer economies, and dollar availability (USD) improves to turbocharge demand in Asia Pac and emerging markets.

Inspired by a chat I had with industry colleagues last week, here are some buy-side perspectives on investment grade credit versus equities.

Relative yields

Professional investors are increasingly favouring investment-grade credit over Aussie equities. Investment-grade credit floating rate notes and fixed coupon corporate bond yields range from 5% to 7% (some low/no risk corporate paper issuing now at 6.4%), significantly above the 3.8% dividend yield in the Aussie equities market (All Ordinaries).

Market returns

Meanwhile, our favourite investable equities index, the ASX200, has seen a 12-month return of 9.6%. And the problem with this is that it pales in comparison to international markets like the U.S., Japan, India, Pakistan, Korea, Malaysia and others. These have generated returns of over 20%, with the Nasdaq100 printing ~30% over the same period - 4x the ASX200.

Corporate earnings and economic growth

The growth and inflation profile of Australia is also not helping equities. GDP growth is down at a pedestrian 1.1%, while core inflation remains high with core printing 4.4% in May. We are in fact moving further away from the RBA’s target of 2% to 3%.

Putting Official Rates policy aside for the minute, what this means is that corporate margins in interest rate/cost-side sensitive sectors are getting squeezed. Margin go down, profit go down - unless expenses below the GP line are slashed. For those businesses that have avoided cost right-sizing, better late than never. But if there is another rate hike on the RBA’s pad, the calculus will be more adverse.

These commercial factors along with a higher for longer cost of capital make equities look less attractive than credit, at the minute.

China performance has not been helping

China’s economic slowdown has not been helping equities. GDP growth has cratered to 5.3% and inflation sits at, well, 0%. This mirrors the disinflationary and stagnant economic conditions of Japan's past. With no significant broad-based China stimulus in sight, we cannot expect much demand-side help from China at present, another factor making equities less attractive. Plus, we are still waiting for our demand drivers to transition to India. It will happen, just not yet.

Challenges in project and commercial debt

Arranging project and commercial debt facilities in Australia has become increasingly difficult. Rising land, labour, and capital costs, coupled with a higher cost of capital have led to depressed internal rates of return (IRRs). This makes funding large projects challenging and less attractive to investors. It also means that only the most attractive projects will get banked/funded, while banks channel reserves into lower risk/higher return areas.

Macro favours investment grade credit

Given the macroeconomic environment, professional investors can’t help but notice the attractiveness of investment-grade corporate credit - whether that be floating rate notes, bonds, hybrids or high yield.

This asset class offers higher and more stable yields for no/low risk in the current macro climate. Sure, you may want to consider timing with bonds given the capital gain/loss aspect, but that’s more a question of duration and each investors’ time horizon.

And for all of the above and other reasons it’s no wonder non-government bond issuance has been rising steadily in Australia, and we will no doubt see higher candles once the chart below is updated for Q4.

Future Outlook

Once we see a macro regime change, marked by more liquidity being injected into consumer economies, lower interest rates here and in our region, and a weaker USD - Aussie small and mid-cap equities, as a category, should regain their lustre.

In the meantime, investment-grade corporate credit remains a compelling option for professional investors seeking low risk and reliable returns, down under.

And as corporate treasurers know, the buy-side leads the sell-side.

See you in the market.

Mike

Michael GanonJuly 2, 2024#money, #management, #markets, #investing, #technology, #india, #future, #finance, #executivesandmanagement, #businessintelligence, #fundraising. #strategy, #managementconsulting, #business, #wealthmanagement, #sustainability, #venturecapital, #investmentbanking, #entrepreneurship, #economy, #gold, #silver, #bitcoin, #corporatedev #corporatedevelopment #miningandconstruction, #strategy, #commodities, #corporatefinance, #equities, #stocks, #bonds, #economics, #macroeconomics, #ethereum, #inflation, #qeinfinity, #interestrates, #trade, #transformation, #ceos, #directors, #founders, #cfos, #currencies, #construction, #mining, #renewables, #leadership, #china, #australia, #education, #research, #businessowners, #brexit, #community, #covid, #populism, #crypto, #successionplanning, #familyoffices, #uranium, #copper, #nickel, #Fed, #federalreserve, #monetarypolicy, #centralbanks, #marketoutlook, #financialmarkets, #stockmarket, #valuation, #SP500, #realestate, #foreignexchange, #humanresources, #productivity, #continuingeducation, #financialanalysis, #CPA, #CFP, #CFA