AUSTRALIAN EQUITY, THE DESTINATION IN YOUR GLOBAL SEARCH FOR YIELD

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1 30 Reece Birtles, Martin Currie Australia Reece Birtles is chief investment officer and portfolio manager for Australian equity income, value, dynamic value and multi sector funds. He joined Martin Currie Australia (formerly Legg Mason Australian Equities) in January In 2003 he moved to London as global equity portfolio manager and head of financials research, before being promoted to head of European equities. Reece returned to Australia in 2006 as CIO of the firm. He spearheaded the launch of retirement income solutions in In his time as CIO the firm s trust range has doubled and tailored strategies have been developed for both domestic and overseas clients. AUSTRALIAN EQUITY, THE DESTINATION IN YOUR GLOBAL SEARCH FOR YIELD The search for stable, predictable returns in the post-global financial crisis world has led many investors to re-evaluate how and where they find income. In this global quest for yield, there are very few investment markets today that can provide a sound economic foundation for high and stable income. We believe that Australia is uniquely positioned, with interest rates and dividend yields that are among the highest in the developed world, but with a relatively low risk environment. Offshore investors in particular are beginning to realise the benefits of Australian equities, given that for many, their own interest rates are very low. For both domestic and overseas investors, Australian equities may represent an income solution with unique benefits unmatched by existing choices. In this white paper, we highlight the key benefits of Australia for equity income, in terms of its economics, currency, and yield. We also explore how the Martin Currie Australia Equity Income strategy is positioned to further capture the income opportunity for investors. Executive Summary Australia remains a compelling place for high-quality income and yield diversification in a global world of low interest rates and economic uncertainty. Australian interest rates are higher in real terms when compared to our trading partners, enabling the RBA to have the capability to further lower rates should global growth slow and risk premiums rise. Australian GDP remains high at over 3% pa, in some cases well above comparable developed countries, and over 60% of GDP is from domestic consumption, underlined by population growth. The Australian dollar is likely to be less volatile going forward given Australia s low debt to GDP ratio, and strong population and employment growth. The recent Brexit decision will certainly cause more volatility with external economies, but the Australian domestic economy is likely to be well insulated with a lower currency and a well-diversified service based economy. Martin Currie Australia s tailored range of income solutions aim to deliver consistent income growth with attractive yields when compared to other global and regional asset classes.

2 31 The Martin Currie Australia Equity Income strategy is leveraged to the Australian domestic economy. The strategy focusses on highquality stocks with strong franchises, and those benefiting from an improved domestic cycle, and offer a unique source of high and growing dividend income for investors. The Martin Currie Australia Equity Income strategy, at 5.6% (unfranked) and 7.4% (franked), has a higher forecast yield than all the comparable global and regional asset class indices, including the Australian share market. Australia s economic strengths High interest rates but low credit risk environment Despite the slowdown in the mining economy, Australia is still in a unique and enviable economic position for a developed market. With its AAA credit rating, Australia is one of the few OECD countries to have successfully weathered the Global Financial Crisis (GFC) or Great Recession. Australia is one of just nine countries to have the top credit rating (with a stable outlook) awarded from all three of the world's major credit ratings agencies. Credit ratings agency Moody's and Fitch reaffirmed Australia's top credit rating following the May 2016 budget. Solid economic prospects, underpinned by robust population growth Australia s solid economic position is highlighted by its current annual GDP growth rate of 3.1%, low inflation rate of 1.3%p.a. and low unemployment rate of 5.7%. These strong fundamentals are reflected in the high interest rates compared with many other developed economies. The following graph shows that Australian real GDP growth has remained very resilient, even in times of financial instability such as the Lehman Crisis when Australian GDP remained positive, even when the European Union and the USA recorded negative GDP. In a post-gfc world, global markets continue to face headwinds from weak aggregate demand and excessive government debt levels that will keep interest rates low, Australia continues to provide leading GDP growth versus its peers. Economic growth underpinned by robust population growth Supporting the solid economic outlook is the strong population growth expected for Australia. Based on UN projections, Australia is expected to reach a population of almost 50 million by Importantly, Australia s robust population growth is due to both an increase in the natural rate of population and also net overseas migration. With population growth of around 1.3% p.a., high interest rates relative to the developed world, a sound fiscal position with low debt and low political and legal risk, Australia s economy is very well-placed to offer investors access to a wide range of dynamic companies. Passing the baton from resources to the domestic economy The challenge for Australia has been to transition from mining to non-mining sectors of the economy. We have been describing for a number of years how we expected domestic cyclical stocks would benefit from the end of the mining boom. Australia s 3.1% yoy GDP growth was head and shoulders above many developed world counterparts, and comes despite the pull back in mining. Other vulnerability measures are lower Australia s government system is stable and it has well-developed national institutions, with a strong regulatory environment that is business friendly. This is reflected in Australia having a very favourable MSCI ESG Governance, and Political & Economic Risk rating within the Asian region.

3 32 Overseas investors often see Australia as an economy based solely on mining, and that the end of the mining boom presents Australia with a crisis. However, the reality is that more than 90% of the Australian economy is driven by non-mining influences, and mining consists of less than 2% of Australian employment. The recent slowdown in mining is not all bad news. In fact, the end of the boom is credited with reducing the cost of unskilled labour, lowering the exchange rate, and thus helping domestic businesses in industries such as agriculture, tourism, education, and manufacturing which were hurt by rising costs during the boom. We expect that the unemployment rate will continue to fall, consistent with the lead indicators such as ANZ Job Ads index, which continue to suggest steady jobs growth as part of the transition to non-mining sectors of the economy. Sound fiscal position One of the big concerns stemming from the GFC is that governments in the northern hemisphere have taken too much debt on to their balance sheets. This has clear implications for their fiscal positions, in terms of funding that debt. Thankfully, Australia is in a much stronger position compared with other economies. What s more, unlike the other developed countries in recent years (such as US, Japan and the Eurozone), Australia has not engaged in quantitative easing (QE) policies. In the long term we believe this will lead to a more stable currency than countries which have in effect printed money to purchase low-grade credit. When assessing the likelihood of long-term economic growth predictions for a country it is useful to compare the level of government debt to GDP. According to a paper by the International Development Association and International Monetary Fund, a country can be said to achieve external debt sustainability if it can meet its current and future external debt service obligations in full, without recourse to debt rescheduling or the accumulation of arrears and without compromising growth. Importantly, while this ratio of Australian government debt to GDP has now risen to 26%, it has been higher in the past having reached a two-decade peak of 32% in December 1994, and is currently at a sustainable level. The sound fiscal position Australia faces today is a reflection of prudent economic management through the 2000 s. To date, the success of this shift can also be evidenced by the continuation of non-mining GDP growth in the non-resource states such as New South Wales and Victoria since the commodity peak in August 2011.

4 33 Australia s Currency Advantages The Australian dollar (AUD) has depreciated by 15% on a tradeweighted basis since June 2013 to the end of May 2016, and has fallen by 22% against the US dollar, and 6.5% against the Euro over the same time period. This reflects a marked fall in commodity prices, especially iron ore, coal and LNG and a slowdown in the Chinese economy. The AUD has several different drivers, with lower world growth impacting commodity prices, but we note this will also depend on any policy stimulus response, especially from China. Higher risk premiums generally see the AUD fall, but given Australia s very strong economic fundamentals in terms of low debt, rising population growth and employment growth, this is a standout globally in the current level of uncertainty. The AUD is likely to show less volatility than in prior periods of uncertainty. Given Australia s very low government debt to GDP ratio, and high relative interest rates in Australia compared with the rest of the developed world, it would appear the AUD has now fully reflected the risk of a slower global growth environment and the fall in the price of key export commodities such as iron ore, coal and LNG. Australian dollar is not under the pressures of printing money Against a backdrop of loose monetary policies undertaken by many central banks since the GFC, the fundamentals of the AUD now look healthier than many other countries. Australia has been immune to the pressures of printing money, with the Reserve Bank of Australia s (RBA) assets maintained at a low percentage of GDP (when compared with countries such as Japan and the US with growing levels). Australia also has a low current account deficit and low debt-to- GDP ratio. The sustainable debt level as defined by the IMF Eurozone conversion criteria is 60% Debt to GDP, and if exceeded, economic growth is no longer sustainable and growth is compromised. Australia is therefore one of only a few developed countries with high income yields and low economic risk. Weak Australian dollar supporting tourism and domestic economy Over the past 18 months, we have also seen a notable pull back in the AUD. This is a theme we have been following with interest for some time. The weaker AUD has had an impact in the form of reduced leakage of offshore tourism spend. The strong trend of increasing outbound travel over the last five years, reversed course during 2015 as Australians holidayed locally to avoid higher costs overseas. This downward trend in the AUD also supported an increase of inbound visitors, particularly from the traditional tourism sectors such as the US and Japan, and also the growth markets of China, India, Philippines and Korea. Since the GFC, the fundamentals for the AUD have been strong versus its major trading partners, with high relative cash and bond rates compared with other developed nations. The interest spread also provides demand for the AUD. High dividend yields Attractive dividend yields that are well supported In the current world of low interest rates, the Australian equity market offers an attractive yield in comparison with other global equity markets and against cash rates.

5 34 Importantly, while Australia s credit risk assessment is low, its economic fundamentals remain robust and this is reflected in its relatively high interest rates. The high cash rate and 10-year bond rate and high forecast dividend yield for Australian equities are an increasing match for investors requiring long-term income growth and high yields relative to other more traditional income assets such as fixed interest. The following six charts highlight that Australian equity yields also remains attractive compared with pre- GFC levels. US treasuries, bonds and REITs have seen very correlated compression in yield since the GFC, and remain well below pre- GFC levels. This is in contrast to Australian forward equity yields, which still remain attractive when compared with their pre-gfc levels. Additionally, the Australia share market s dividend yield of 4.4% looks remarkably attractive versus record-low cash and bonds yields, with the positive spread to equity yields compared to bond yields (grey bars) similar to GFC levels in Even if the US Federal Reserve embark on a continued trajectory of rate hikes in the coming years, we believe that it s very unlikely that yields will go back to the long-term levels that existed prior to the GFC. Cash rates around the world have been significantly reduced, and there is no way you can achieve a 56% yield out of any cash-type instruments today, and this is also unlikely to rebound to that level in the future. According to IMF Euro convergence criteria discussed above, it is clear that a number of countries have now exceeded their sustainable level of debt and also have very low expected dividend yields. The typical higher-risk, higher-return relationship has broken down in the low interest rate world. Australia is the only AAA rated country to exhibit a high expected dividend yield and have very low debt to GDP. Powerful companies and industry concentration Looking beyond Australia s macroeconomic level, the story is also compelling. The country has a broad spread of powerful companies with industry concentration that is very favourable when compared to the US. The large banks, owners of supermarkets, shopping centres and insurance companies have high economic returns, high barriers to entry and large sunk capital which has led to strong cashflow, profit and dividend generation over many years.

6 35 Oligopolistic industry structures The smaller nature of the Australian economy produces industry structures that are relatively consolidated, with less competition and high barriers to entry a feature. This is of significant benefit to incumbent players. In particular, such oligopolistic features are observed in those industries where scale advantages make it difficult for new competitors to gain market share (for example, in banking and supermarkets). This means those industries produce a higher return of equity (ROE) than their US peers and therefore higher sustainable dividends over the longer term. Australian tax structures favours dividends Australian companies have maintained consistently high payout ratios, with the taxation system encouraging the payment of dividends and ensuring no double taxation of dividend payments. This means returns in the form of equity dividends have a natural bias to remain high. Payout ratios in the last 15 years have averaged over 60%, well above other developed countries. Today, balance sheets are well placed and these low levels of corporate debt support the sustainability of the relatively attractive dividend yield on offer in Australia. A compelling investment solution for income For income investors, the Australian Equity market is compelling for high-quality income and yield diversification in a global world of low interest rates and economic uncertainty. Australian shares can be a volatile place to invest when seeking capital growth. However, for investors focusing on dividend income, the same asset class may offer comparatively low volatility with attractive yield attributes. That s because company dividends are generally more stable than share prices, and it is the dividend that matters most to an income investor. Corporate Debt levels are at decade lows The advent of the GFC in 2008 saw a sizeable reduction in leverage across Australian corporate balance sheets. In particular, significant de-risking of balance sheets has occurred at the larger end of corporate lending. Whereby, the outstanding dollar value of loans larger than A$2 million declined in absolute terms over the two and a half-year period leading up to March Following this deleveraging phase, aggregate loan value in this bracket has increased by 16% through to December 2015, reflecting growth from a robust base.

7 36 Australia continues to be a favourable source of income; with higher interest rates, a low-risk environment and a tax system that favours dividends. Australia is in a unique position economically, with solid economic prospects, robust population growth (assisted by net migration), a sound fiscal position and low political, legal and corruption risk. The country is also home to many strong companies and a solid banking system, and corporate debt levels are at decade lows. Australian companies tend to have a high dividend payout ratio, which is favourable for investors seeking income. Furthermore, for domestic 0% tax-rate investors such as retirees, Australia equities offer unique advantages through the franking credits payable on dividends, as these are fully passed through to those investors. Ignoring this franking pass-through forgoes significant return opportunities. Martin Currie Australia has developed a range of tailored income solutions for clients both domestically and internationally, that aim to capture these benefits. Furthermore, we believe that the Australian equity market s naturally high starting point for dividend yield can be further bolstered by building a portfolio of higher-quality companies, without reference to an index or market-cap weighted benchmark. Martin Currie Australia Equity Income The Martin Currie Australia Equity Income strategy was designed with retiree s income needs in mind, and was launched in The strategy aims to deliver attractive and sustainable income by actively investing in Australian companies that we believe have highquality business models and a solid prospect of paying and growing dividends through the business cycle. The overarching belief for all of our income-focused strategies is that companies that have solid earnings can sustain dividend payouts and are likely to be less volatile than other stocks. Even in times of market volatility, the selected companies are expected to continue paying dividends and provide regular income. The Martin Currie Australia Equity Income strategy is designed to provide investors with: a high, growing and well-diversified income stream long-term inflation protection by investing in assets that grow with the Australian economy lower volatility than the S&P/ASX 200 Index through active stock selection low stock and sector concentration to avoid income shocks the opportunity for domestic investors to maximise after tax income through extracting the full benefit of franking credits High-quality stock selection is integral Experience has shown us that higher-quality companies offer a far greater probability of their earnings returning to normal following shocks, and thus will exhibit lower volatility than the broader market. We choose powerful companies with high-quality and low-risk characteristics based on a deep understanding of each asset s valuation, quality, direction and sustainable dividend, from both a fundamental and quantitative perspective. We believe that the combination of these four different investment factors can lead to stronger income and capital returns over the long term than a focus on any one factor can deliver on its own. Leveraged to the domestic economy The Martin Currie Australia Equity Income strategy portfolio generally consists of three key sectors: consumer, financials and real assets. The portfolio is thus leveraged to the Australian domestic economy which has 60% of GDP from consumption. It has very little resource exposure and the invested sectors are not directly influenced by external factors. The portfolio objective is therefore to capture the high returns from the Australian economy by focusing on companies which have very high barriers to entry, sustainable dividends, high-quality balance sheets and a sunk capital base which enables free cash flow to be distributed back to shareholders. This ensures the strategy delivers consistent income growth with attractive yields when compared to other global and regional asset classes. Highest forecast yield The Martin Currie Australia Equity Income strategy, at 5.6% (unfranked), has a higher forecast yield than all the comparable indices, including the Australian share market (represented by the S&P/ASX 200 Accumulation Index). This, in part, reflects the characteristics of the investable universe for our equity income strategy over 68% of the Australian stock market have companies with dividend yields greater than 4%. More importantly though, it also demonstrates the high-quality, sustainable income focus of our company stock selection and the emphasis we place on high, free cashflow from companies with very strong sustainable returns on invested capital. Furthermore, we explicitly value franking benefits to domestic 0% tax rate payers from regular dividends in our valuation models, in order to improve the after-tax outcomes for our clients. For the Equity Income strategy, the franked forecast yield for domestic 0% tax rate payers is 7.2%, versus 6.2% for the S&P/ASX 200, a difference of 1.0%. A focus on quality nullifies recent challenges to high yield The focus on companies with leverage to domestic GDP is continuing to generate positive income growth for the portfolio, whereas the overall market is now seeing a decline in expected income with the resource companies now cutting dividends and guidance has already seen a test for high-yield strategies as the market experienced the first aggregate downgrade to dividends per

8 37 share (DPS) in the last five years. This was driven by Rio Tinto and BHP Billiton s dividend cuts and highlights the importance of focusing on company quality when assessing sustainably of dividend payments. Consequently, the Martin Currie Australia Equity Income strategy does not invest in resourced-focused stocks such as BHP Billiton and Rio Tinto. As such, the expected income for our portfolios has been unaffected by the fall-off, as can be seen in the chart below. CPD Questions 1. Australia s current annual GDP growth rate is: a) 3.0% b) 3.1% c) 3.5% d) 3.7% 2. Australia is expected to reach a population of almost 50 million by: a) 2020 b) 2050 c) 2080 d) Mining consist of what portion of Australian employment? a) 2% b) 5% c) 12% d) 13% 4. Australian government debt to GDP has now risen to: a) 26% b) 28% c) 35% d) 38% Looking forward In a post-gfc world, global markets continue to face headwinds from weak aggregate demand and excessive government debt levels that we believe will keep interest rates low. We believe that Australia is uniquely positioned with strong population growth and options to flex monetary and fiscal policy to support the ongoing transition from mining to domestic driven growth. In aggregate, the recent economic highlights have been quite positive, despite various market concerns. Real GDP is now 3.1%, and discretionary retail sales and housing starts are now at a level consistent with population growth. We believe that high-quality stocks with strong franchises, and those benefiting from an improved domestic cycle, offer a unique source of high and growing dividend income for investors. Given attractive market valuations, we believe that unhedged equity income from high-quality stocks offers an attractive risk versus reward payoff. Furthermore, when compared with record low bond yields and term deposit rates, dividend income and franking credits, Australian equities continue to look remarkably attractive. fs 5. Australia also has a low current account deficit and low debt-to-gdp ratio. a) True b) False The Financial Standard Continuing Professional Development (CPD) program is complimentary to paid subscribers only. To enquire about the program and receive CPD points accredited by the Financial Planning Association, please contact subscription@financialstandard.com.au or