This week was rather eventful in the domestic space, both from an economic and policy perspective. And so we thought it might be worthwhile to firstly give credit where it's due and second understand the key lessons and takeaways through this crisis both from an investment and normative perspective.
Let me start with a disclaimer, we come from the school of thought (perhaps misguided) which fundamentally posits that good government is very little of it. But the events of the past few months have allowed us to see what we as a nation are capable of when faced with seemingly insurmountable circumstances.
Firstly, we are not judging the response from a health perspective. Compared to the rest of the world, we seem to have done very well to this point (though we will see how this continues to play out and what the dreaded "second wave" does). We are focused on the economic and financial side.
At the time of writing, the Treasurer is giving a speech outlining the state of the economy and what the Commonwealth has been up to lately. Namely, the idea is to take a reasonable approach while keeping in mind that any additional debt has to be paid by future generations. He didn’t by the way forget to keep the base happy with the notion of going back to fundamentals, namely the focus upon private sector to drive future economic growth, targeted productivity spending through reskilling/upskilling, cutting red tape further, spending on infrastructure and perhaps the more contentious topic of industrial reform (mayhaps he is alluding to what is in the pipeline). The ruling out of further tax increases also puts some of our fears at bay for now.
What has the government been up to?
Please note, this is not an exhaustive list of the policies implemented and actions taken by the state and federal governments. It is merely a selection of the more interesting and potentially impactful ones.
Perhaps the most important avenue the government has used to date is with regards to ensuring that structural unemployment does not come into the picture as the economy returns to some semblance of normality. The JobKeeper allowance enables employers who have been hardest hit through the crisis to access a subsidy to the tune of $1500 per fortnight per employee in order to keep them on the payroll. Whilst it might seem like a handout, this has been incredibly effective so far in ensuring that companies keep people employed and people keep spending money.
Think for a moment about the profile of people that might be impacted directly. The hardest hit sectors have been those on the frontline, retail, hospitality (those that employ a lot of part-time and casual staff) and tourism. The notion of keeping people in the workforce allows the participation rate to stay at reasonable levels whilst ensuring that those people that are directly impacted can return to the workforce in a timely manner (as opposed to seeking unemployment benefits for a longer time while they look for new jobs). Demographically, these workers tend to be the younger generation, hence have a disproportionate impact upon consumption and consumer demand. Giving them job security has further ramifications for ensuring that consumer demand stays at reasonable levels, and ensures that companies are also not disproportionately impacted.
It will be hard to say definitively that JobKeeper is doing its job until we are a little more removed from the crisis but, anecdotally, it does seem to be working. One university student, a part-time swim school instructor earning less than $1500 a fortnight, has seen their income jump instead of disappear entirely. And guess what? They’re spending that extra money on things that would otherwise sit outside their budget or they were saving for. To quote them as they sat on their laptop shopping online in isolation, “Thank you JobKeeper.” Another uni student, a part-time child-care worker, has also been doing the same; replacing sporting equipment, refreshing his wardrobe a little and buying a new gaming console to help kill the time in isolation. Under normal circumstances these purchases may have been spread out over months or, without JobKeeper, would not have happened at all. In his words: “JobKeeper is mad. I don’t feel like I’m hemorrhaging money anymore.” Regardless of whether you think spending like this is frivolous and thus not something you want your hard earned taxes subsidising, it is propping up consumption (see Consumption below). They simply aren’t supposed to be saving the entirety of the extra cash (our second student has put about 60% of that extra cash in savings), that would defeat the purpose.
The economy works in cycles, in this instance it is not the traditional business cycle that is at play, rather an exogenous event (as opposed to endogenous event). High unemployment and a bigger slowdown in consumer spending has further implications not just on those that are immediately affected but upon business spending as well. Businesses have to make Capex decisions and manufacturing supply chains are typically lagging indicators. When events such as these occur, there is no reasonable basis for making long-term decisions and, in a world where supply chains are already constrained, it can become a vicious cycle. Ensuring a baseline level of spending and employment can ensure that recovery is sped up.
Australia, as with most western developed nations (with the exception of perhaps Germany), are demand and consumption driven economies with consumption being the largest component of the overall national accounts. We can safely say, as mentioned above, that the JobKeeper is the first of the initiatives that ensures that this component of overall GDP stays at adequate levels. The other incentives, such as early access to superannuation, and financial policies to do with the direct buying of RMBS (Residential Mortgage Backed Securities) are another way of ensuring that credit growth which, at least on a short-term basis, has much to do with overall GDP growth.
We have no doubt that this has major adverse implications for both the pool of superannuation savings and credit quality on a long-term basis. But the short-term requirements of keeping consumption at a reasonable level allows us as an economy to both go through this crisis without deep unintended structural consequences and ensure that the pressure on fiscal spending is somewhat eased (with a fiscal spending package of close to 17% of GDP, we need all we can get). We would however have liked to see lines of credit extended by the RBA to the superannuation funds as well as the banks to ensure a smoother functioning of the overall system. Especially given that some of these funds have significant allocations towards illiquid assets (i.e. having forced sales cannot be good), but one would think the $10,000 AUD limit was for precisely that reason.
Here is where the fiscal side of the equation can make a marked difference, whether it be speeding up the existing pipeline or creating additional projects. Yes, this will add to the already concerning deficit (but let's face it, this is a lucky country) but it should have marked benefits over the long-run both in terms of getting wage growth back on track (which will hopefully increases the tax take) and the added advantage of the fiscal multiplier. The fiscal multiplier is the net effect of increases in fiscal spending to incremental GDP growth given by the equation 1/1-MPC (Marginal Propensity to Consume). A fiscal multiplier of 1.02, for example, implies that a dollar of additional spending by the Government increases overall GDP by 1.02.
Some policies like tax cuts might not have a long-term impact as much as say unemployment benefits. Because the MPC for tax cuts is much lower as citizens choose to take a certain component of the overall increase in income by way of savings (this is why the $750 Economic Support Payment was directed to those already receiving some form of welfare support, other than probably needing it more they’re simply more likely to spend it than save it). Investments like infrastructure can have a direct impact by showing up as government intervention and, when done right through PPP (Public Private Partnerships) rather than a wartime economy like the last time we had a similar (i.e. Pearl Harbour) type crisis (which crowds out private spending), we can have employment growth and wage increases.
Frydenberg has alluded to a growing focus upon infrastructure in the speech given today. Let us hope that the money is where their mouth is.
For once, the banks have come out as the knights in shining armour. After the events of the Royal Commission, the latest crisis has given them the opportunity to take the lead. With some help from the RBA and government of course. The first and most immediate avenue has been through regulations around capital adequacy, ensuring close coordination between the RBA, AOFM and APRA. Through an adjustment of CET1 regulations, it has allowed the financial institutions to not only have a little more breathing space but also to take risk on the balance sheet through something loosely resembling public private partnership seeing as the AOFM and the RBA have been buying RMBS, thus ensuring liquidity.
Sorry to all the people who have lost out on the juicy dividends, and it impacts upon the older generations and retirees disproportionately, especially at a time when much of their invested wealth has taken a hit. But having well-capitalised banks who are able to work through this crisis not only allows them to get rid of some of the reputational risk of the Royal Commission but also become better businesses over the long-term. Wouldn't you rather they be around in five years as opposed to giving us a dividend yield for a quick eighteen months?
Where to Next?
Suffice it to say, if the rest of the world is anything to go by, we are not through this by any stretch of the imagination. But our baseline expectation is that the administrative apparatus has prepared themselves for any further spikes.
The flexibility of the Commonwealth has also come into the limelight. Granted, the notion of states seemed a little bit redundant when one needs to get a different license when moving interstate but having the ability to tailor regional responses in a more nuanced manner has been exceptional through this entire scenario (thankfully Australia hasn’t been fractured in its response by partisan lines like in the US). One would hope a key takeaway might be the ability to give more flexibility at a local level as well, rather than a one-size fits all approach. We are here talking about councils, whereby they can take a tailored approach within the confines of the locality and the case counts.
The second thing we’ve noticed is how quickly things can move when push comes to shove. How long did it actually take to develop consensus and get things over the line? Whether we’re talking about JobKeeper or financial oversight? Even the superannuation drawdowns were done within five days? Perhaps take a page out of the now for the future? Partisan lines now often seem to get in the way of good sense (especially in the US).
Performance Rating: 8/10
So far, we think the government has done exceptionally well, especially when one compares them to their counterparts globally (we won’t say which, but one assumes that there is some awareness). Mr Morrison has also seemingly realised the crucial nature of optics. The gentleman has walked away from the Huawei fiasco (we’re quite sure he was on top of the situation back then as well given that we live in the age of Zoom, but the public can be ruthless) with the right attitude.
Say, 8/10 is reasonable. One would hope that the government can focus on retirees as well, especially since they are typically the property investors and the ones who rely on dividends.
It is important to point out here that the economy and financial markets are not one and the same thing (something President Trump often doesn’t seem to understand), though they do have a real impact upon each other (the direct influence is often unidirectional). The government’s focus has been on the real economy. While retirees hold a large chunk of investment assets they are exactly that, retirees, and have left the labour market. Investment assets might have long-term implications for cost of capital but in the short-run might not give the boost that the current situation warrents. The MPC/S for a student living paycheck to paycheck, for example, is significantly higher than a retiree living on dividend income/slowly drawing down on their super. Oversimplifying it (just a smidge), the government has been looking to maintain employment on a reasonable basis which also has the advantage of not exacerbating income inequality. The greatest disservice that can be done in events like these is to have long-term structural unemployment rear its head. Without getting too deep into the intricacies of it, a younger generation who have to involuntarily leave the active workforce for an extended period of time and for whatever reason (lacking recent or relevant experience, a skill set that is now outdated etc) will increasingly struggle to reenter the longer it drags out. These generations are also going to have to be the ones that takes on the tax burden of the additional debt has been created). However, that being said, there are certain segments of those in the typical retiree age demographic that have been able to access JobKeeper, as the father-in-law (in his 70s) of one of our directors, who has seen his ability to operate his driving instruction business disappear, pleasantly found out.
In all honesty, it has been a rather painful period. But, as the saying goes, you live and you learn.
One thing that we have taken away is that consistency beats all else. We will continue to be active in managing volatility and, going forward, will hedge appropriately but the recent government policies have implications from an investment perspective. Over the long run we see great potential for infrastructure investments across the spectrum, not a new thematic (the Western world is due for an upgrade) but stimulatory spending will accelerate the trend. But in the short-run here are few of the stocks we’ve been looking at and buying. We think that these have been amongst the first to bottom and looked reasonably attractive at the time of bidding:
Our Head of Australian Equities, Ron Shamgar, has written about Kogan (KGN) recently, so we will keep this summary brief. We will continue to see spending move online, isolating due to Covid-19 has accelerated this trend, while the government's insistence on keeping consumption at a reasonable level acts as a great catalyst for longer-term growth. In fact, here are just a few recent numbers for Kogan: active customers are up by 139,000 to 1,948,000, gross sales are up +100%, gross profit up +150%, and adjusted EBITDA is up +200% on a quarterly basis.
Additionally, Ron has also briefly highlighted a number of stocks in his monthly reports, Money3 and Tesserent are of interest:
Money3 (MNY) - provided an update in April and we have spoken to management several times through the crisis. We are now confident that the business is generating record cash collections and is seeing negligible bad debts. In fact, many of its customers are already on some form of welfare and are working in jobs that are in thriving industries like groceries or resilient government jobs. MNY is one of the few companies on the ASX to pay an interim dividend during this crisis.
Management is now seeing a rebound in loan originations and is already back to same levels of business as this time last year. We expect MNY to come out of this crisis in a stronger position. We have added to our position while others were selling. We value MNY at over $2.00.
Tesserent (TNT) provided a quarterly update on business performance in the cyber security sector. Q3 revenue exceeded budget at $8.3m and recent acquisitions have integrated well. TNT is on target to achieve their stated goal of $40m annualised revenue by June this year. The company exited the quarter with a healthy cash balance of $5.2m and a pipeline of acquisitions.
More importantly, organic growth continued with over 800 customers contracted, including fifteen government clients. The company also won a multi-year federal government contract of $3m. In total, they secured new wins of $5m in the quarter. The company did indicate that some future work for Virgin Airlines may be in question as the airline goes through the administration process. We expect TNT to turn profitable in Q4. We now value TNT at 9 cents.
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