Goodbye cheap money

Australian equities have been more stable in the past week, but I still believe excess volatility will continue to be a feature of the market for the rest of the year.
Excess volatility does not mean we won't be able to make money; it actually means in the medium term we will be able to make more money. However, the keys to negotiating periods of excess volatility are discipline of price, and discipline of emotion.

The underlying catalyst for the continuing excess volatility is debate about interest rates. This debate won't go away; the question relates to where they will settle.

For the next three to six months, every single piece of data about inflation, wages, retail sales, and GDP growth will have an exponential effect on bond, currency, and equity markets in terms of trading activity. Yet, there's every chance that market participants are going to be more worried about all these individual pieces of data than central bankers, particularly if you read recent central banker transcripts.

I don't think inflation or bird flu will kill us all, and I personally think the central bank community is less concerned about inflation than the markets. Central banker transcripts point to the fact that while Chinese demand for raw materials is creating inflationary pressures, that conversely, Chinese exports of manufactured products are having a deflationary effect.

It's very easy for markets to focus on such factors as rising energy costs, but they seem to ignore the fact that the price of manufactured products such as electrical goods, cars, and clothing have come down dramatically in recent years due to China's labour cost advantage.

What we are really seeing at the moment is global central banks returning monetary policy to neutral, yet that will have effects on the price of asset classes and individual stocks that have relied on cheap debt funding to drive excess growth and expansion. The clear point is that the days of ridiculously cheap money are behind us, and those who rely on cheap money will struggle from now on.

We suspect the Federal Reserve will continue to raise rates, with the "neutral" target still 75 basis points away at the Federal Funds Rate level. The Fed showed after Hurricane Katrina that it would not deviate from its long march to a neutral setting.

Bond yields will continue to rise globally, and will become more attractive compared with equity yields than they have been for the best part of five years. I'm not saying unfranked bond yields are more attractive than equity yields; I'm saying they will become more attractive than they have been, and all those Australian industrial stocks that are purely priced off "yield multiples" will struggle to perform.

This is why I think the game is up for the infrastructure sector, and the “motherships” that rely on its performance fees. Not only is the cost of borrowing increasing for these highly geared companies, and the likelihood of asset revaluations falling; they also have to fight the new challenge of government bonds offering a similar "genuinely risk-free" yield.

I believe the Cross City Tunnel debacle in Sydney has turned public sentiment away from public-private partnerships; I also believe Macquarie Bank made a strategic error hiring former NSW Premier Bob Carr so soon after his departure from politics. Who am I to call anything Macquarie does an "error"? But I reckon that was an "error".

I believe any trading bounce in leading infrastructure names is a selling opportunity, and that any trading bounce in the "motherships" is a profit-taking opportunity. I also believe that if the major banks rally too hard after the reporting season that a profit-taking opportunity will arise in selected leading banks, once they are ex-dividend.

Historic performance is simply not a clear guide to the future, and I can't help but wonder if the investment community has become too complacent about low interest rates and low government bond yields.

I suspect the answer is yes, and on that basis our core equity strategy remains to hold a concentrated portfolio of lowly geared, highly cash-generative companies with clear final pricing power. I also want to own all these investment attributes for a price/earnings multiple lower than the market.

I really want 'balance sheet strength' in my portfolio, which basically companies generating cash. The vast bulk of medium-term "high cash generation" in the Australian equity market is to be found among companies in the resources sector, and the companies that service them.

However, these sectors are not without risks as we find out every quarter in production reports. Even the number-one resource stock, BHP Billiton, had a slightly disappointing quarter of iron ore production due to a train derailment, of all things. When a train with eight locomotives and 120 carriages leaves the tracks, it makes a hell of a mess.

But it seems most of the operation disappointments in the resource sector are in the mid and small cap space. I'm afraid you have to be a little ruthless in the space when disappointment occurs, and address your assumptions.