RIO - abrdn Australia Equity Fund: A Real Risk Of An Australian Recession

2023-03-10 13:04:21 ET

Summary

• Australian stocks appear fair valued at best on various quantitative valuation metrics. The banking sector has seen performance holding up okay since the beginning of 2022, which surprises me.
• This is at odds with the macro trends emerging. The central bank has aggressively hiked rates, inflation is yet to come down in response, and consumer confidence is low.
• Homeowners are witnessing an unusual fall in the value of their most valuable asset. Renters at the same time are experiencing a “rental crisis” of surging rents.
• Thus far, in 2023, the Australian stock market is still up. IAF’s discount to NAV tightened from 10% to circa 5% in recent weeks, making it time to consider selling.

Introduction

The abrdn Australia Equity Fund (IAF) is a closed end fund ("CEF") that invests in Australian companies listed on the Australian Stock Exchange ("ASX"). Its primary aim is to achieve long term capital appreciation. Secondary to that is the objective deliver regular income. This is expected to be derived primarily from the underlying dividends received on the portfolio of stocks it holds.

Regarding dividends, the ASX is a relatively high yielding market, and this does assist this product making a 10% plus annual distribution (delivered on a quarterly basis). I would exercise caution in this regard however, as sustainability is questionable. As I shall elaborate on further down, the longer-term annual returns have been less. The fund also currently has net assets of only around a modest $120 million. This indicates some pressure regarding keeping fixed costs low as a percentage and maintaining healthy liquidity in the stock.

According to the IAF website, the fund has an expense ratio of circa 1.5%. This seems like a reasonably challenging headwind to overcome to outperform on the ASX. That is particularly for a fund where its portfolio looks fairly similar to the index.

abrdn Australia Equity Fund performance

When assessing the performance of IAF, I would note the product's historical modest use of leverage. For example, recently leverage has been reported at 7%, which is not uncommon with its history. This should in theory have helped a CEF structure like this to beat their benchmark over the last decade. During this time, we have experienced an era of rising equity markets and generally low interest rates.

As we can see from the performance table below, we don't have any indication that they are adding alpha.

This may not be too important necessarily if we note a recent sub advisor change announcement for this product that was made in December last year. Even if this announced intention is fulfilled, I don't see a potential catalyst that the mentioned advisor in SG Hiscock could necessarily add alpha if given the opportunity. Around 5 years ago SG Hiscock experienced significant change , and lately I see the 5-year performance numbers on their ASX high conviction fund lagging the index.

Given this performance backdrop, and the expense ratio of around 1.5% as previously mentioned, it's not surprising the fund trades at a discount to NAV. My starting point expectations would be to expect this to trade at around a 10% discount like many other CEFs do, yet lately the discount has been circa 5%.

Are Australian stocks cheap, are bank shares worth it for the dividends?

On a 12 month forward P/E ratio basis, in the context of the history over the last two decades, it would be fair to describe Australian stocks as around fair value.

The Reserve Bank of Australia pointed to this last month, and the market has not moved materially enough since to alter such a long term viewpoint. Below are the charts illustrating this breaking it down to key sectors. Potential investors should be wary that the benchmark is heavily slanted to the Financials and Resources sectors which easily make up more than half the index.

The "other" category on the chart has looked expensive for many years now and that remains the case today. Over the last decade the larger companies in Australia have matured and become more "ex-growth", the banks might be seen as an example of this. As a result, the few companies that Australian fund managers identify as high-quality growth companies are often very popular, commanding very expensive P/E ratios.

In my opinion some areas of the market are far less appealing than others and the above charts hint at this. I am surprised that the financials were sitting slightly more expensive than their historical range. As I shall explain further down, earnings forecast risks appear to be to the downside.

The major bank stocks in Australia are a big driver of the overall relatively high dividend yield of the market. This plays a key role in supporting the high distribution IAF likes to pay out. There are major headwinds for Australian consumer confidence for the rest of this year. This can in turn impact the bank's asset quality of their loan books. Relative to global banks they are more heavily exposed to residential housing. Australian house prices have already fallen about 10% from around 12 months ago.

Is Australia having a housing crisis?

Yes, and Australia's housing crisis is different this time, homeowners and renters are down on confidence.

Even if personally you are relatively better off, the daily barrage of negative news articles is still likely to dampen your confidence of the wider domestic economy.

Such articles usually focus on three key areas related to the housing market.

1. Australia's "fixed rate cliff" of home lending rates

This "fixed rate cliff" refers to the following. A couple of years ago fixed rate home loan rates fell to lows of around 2%. This sparked a huge climb in the number of people that favored borrowing on fixed terms, often only fixed for a couple of years.

Now we are hitting the stage where throughout this year a lot of such fixed terms will expire, and the loan rates will increase materially towards 6% instead. The below chart helps display the magnitude of such impact.

2. Surging rent inflation

Most commentary suggests rents are surging much faster than the already high overall reported CPI figure of 7.8% for the last 12 months in Australia.

The problematic issue is we are seeing asking prices for rents currently already surging, and there is usually a lagged effect before this feeds into the official CPI figures.

Such stories of Australia's rental crisis are occurring now, even before the country hopes to ramp up immigration this year. One area for example is with Chinese students returning as China relaxes its previous stringent rules to deal with the pandemic.

3. Reduced borrowing power for future home buyers

This is somewhat related to point 1 discussed above as it has also been brought about by the recent sharp interest rate rises.

Lack of housing affordability, and the bank's strict lending criteria, will severely impact the ability of potential home buyers to be able to qualify for loans in the future.

Now under the higher interest rate structure, banks are not able to lend as much. A key factor in this is the Australian Prudential Regulation Authority (APRA), ensuring that banks still must continue to add a 3% "buffer" on top of current interest rate levels, when assessing loan applications.

This lack of borrowing power is likely to be the biggest factor in forecasting where Australian house prices are headed, and it is clearly a negative one.

It is negative Australian housing articles like this, that are becoming a daily read across a range of news sources that are constantly pointing out the above 3 dynamics.

Is Australia headed for recession in 2023?

Only a few weeks ago for what it is worth, National Australia Bank's chief economist was at least expecting Australia to flirt with recession this year.

Whilst admittedly I wouldn't want to rely on economists' forecasts to determine a stock market stance, I think this is worth noting to some extent. That is in the context I touched on earlier that Australian stock valuations look far from "cheap".

Is this the likely backdrop where the ASX200 manages to experience less than a 10% drawdown from the highs? Will it likely bottom and commence a new bull market now when we cannot be sure if inflation and the rate hiking cycle has peaked?

At a minimum I suspect we should be quite cautious still if considering broad ASX200 exposure, and that there is a good chance of better entry levels later this year.

The positives - resources sector looks more appealing, unemployment at least still low

Without wanting to appear overly negative though, I would acknowledge some areas that could provide relief for the Australian economy this year. China's reopening in 2023 looks to offer hope that was difficult to see some 6 months or so ago.

In the context of the ASX long term sector valuation metrics that I pointed out earlier above, a bit more relative value might exist in the resources sector.

Despite the worrying future prospects of the Australian housing market, it is also so far encouraging we are not witnessing any overly concerning jump in the unemployment rate at this stage. This may help avoid the situation where we see distressed selling of properties due to job losses. Perhaps the pain in the economy might be more felt in the consumer discretionary area from consumers tightening their belts.

I also have some sympathy for those with the view that a lot of the economic concerns I have raised are widely known and should be somewhat factored into markets. By the same token though, I do worry many market participants have not been through a period like this. i.e., higher interest rates, higher inflation, and perhaps a protracted bear market in equities?

abrdn Australia Equity Fund holdings

Below is a recent snapshot of their portfolio breakdown. Note the large exposures to major banks such as Commonwealth Bank of Australia (CBAUF), National Australia Bank (NABZY) and ANZ Group Holdings (ANZGY).

Also like their benchmark, they have prominent positions in resources heavyweights such as BHP Group Limited ( BHP ), Rio Tinto Group ( RIO ) and Woodside Energy Group ( WDS ).

The P/E Ratio of the fund doesn't appear overly enticing given the macro backdrop.

Are CEFs in Australia or as they are known (LICs) better than ETFs?

The CEF sector in Australia is generally known as Listed Investment Companies (LICs). Sentiment towards ASX LICs has not been so good in the last few years.

Given that I am somewhat bearish on the overall ASX200 still this year, I next wanted to consider if there might be a compelling reason why IAF may overcome this. Could an active CEF that focuses on the ASX200, that is priced at a discount to NAV, still be attractive?

From my experience if one was bullish on the Australian stock market, you are better off just sticking to low cost index ETFs. In fact I would also argue this in most cases of getting exposure to larger capitalized stocks in other developed markets in the word.

Australian investors are increasingly coming to a similar view and ETFs are expanding rapidly whereas the CEF sector is struggling with new issuance.

This is hardly surprising to me, when I notice the performance of Australian CEFs versus ETFs . Barring the odd exceptions, ETFs have generally clearly been the way to go the last 5 years or so.

I therefore do not see a compelling reason why IAF should be priced at a discount to NAV of less than 10%.

Conclusion

It fair to say most of my points in this article are about key risks to the Australian economy and stock market for the remainder of this year.

In my view there is not a compelling reason to use IAF as a vehicle for exposure to Australian stocks. Like many of its peers that incur fee drags of well over 1% annually, I would expect it to struggle to beat low-cost index ETFs.

If a discount to NAV existed of over 15% perhaps you could make a case that could provide a tailwind if you got some mean reversion with the discount, however this is not applicable at the present time.

I had planned to rate IAF a sell a few days ago when I got a bit more in depth in examining this stock. At the time of this article submission, I have noticed the Australian market has already lost a few percent and with banks under pressure since then. Whilst markets are volatile and I would not be shocked to see a short-term bounce, I'll still label IAF as a sell. I expect any sort of rallies are worth selling into. If one wants Australian stock market exposure later down the track, index ETFs should be a better alternative and may well trade cheaper later this year.

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