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WEEKEND LADDER

A summary of the week’s results

11.09.2015

Week Ending 11.09.2015

Eco Blog

The longest wait in recent financial times comes to a possible conclusion next week with the Federal Open Market Committee (FOMC) meeting. Market pundits are full of advice and opinion. The data suggests it’s a likely outcome; the instability in financial assets has some calling for time out.

Besides the option of a 25 basis points cash rate move in September, there is the possibility the FOMC will test the water with a 10-15 basis points rise. Otherwise, it will have to revisit this in December when the liquidity in bond is typically lower. The rationale for the quarterly timeframe is that press conferences are usually conducted after these months and therefore there will be a capacity to explain their view.  Some believe October could be used as an exception this time.

From an economic perspective, the hurdles to a rate hike would lie with low inflation and generally subdued re-leveraging. The strength of the USD may also weigh on their decision, though this is likely to be a semi- permanent feature given the easing bias elsewhere.

This week, US consumer credit rose above income growth. The softer rate of personal consumption suggests spending is taking place outside of traditional areas, likely to be services.

US Consumer Credit

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Small business confidence ticked up, with hiring intentions particularly strong, only inhibited by the 48% stating that they are unable to find enough qualified applicants.

The UK paints a similar picture, with an apparent slowdown in labour market growth. However, the survey from the recruitment sector shows that it is a lack of qualified candidates that is reducing job placements and, in turn, putting pressure on wages.

The chart below illustrates this acceleration in wage growth, particularly for permanent positions.

UK Wage Cost Index

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A range of surveys gave colour to the Australian economy. The NAB Business Survey opened the possibility that the business sector was on the mend, with a decent improvement in perceived conditions. Trading is reported as reasonable and profitability is improving. The combined impact of the lower AUD and low interest rates is likely to be the major reasons. Services continue to lead the pack and the retail sector is also feeling better, in line with respectable trading in some sectors such as homewares and speciality apparel. The downside is that business confidence fell back, implying capital spending is likely to remain weak, further reinforced by very soft demand for credit.

In turn, the labour market release suggested that jobs growth is sufficient to keep the unemployment rate largely stable. While there have been some suggestions of a rise in the unemployment rate (possibly due to the new test for unemployment), the services sector is likely to be absorbing the slack.  As we have noted, however, this invariably means aggregate wages growth will be low and, implicitly, household spending.

NAB has also been running a ‘consumer anxiety survey’. Overall, we are apparently a little less perturbed by our situation now than in the last quarter. Queensland, however, is worrying about most things, while Tasmania is relatively content with their lot. Below are some of the rather curious assessments.

•    NSW/ACT: Spending behaviours have shifted in favour of travel, home improvements and major household items.

•    VIC: Spending behaviours have shifted most towards utilities, eating out and children.

•    QLD: Consumer spending behaviours rose across the board (especially utilities).

•    WA: A big shift away from spending on children.

•    SA/NT: Cuts across the board, especially savings, super and investments, home improvements, travel and use of credit.

•    TAS: Volatile, with a big shift towards travel, charity and personal goods.

Notwithstanding low inflation, consumers still cite the cost of living as their major concern, particularly the perceived, or real, pressure on utilities, health and children. Conversely, the preferred non-essential spending is in home improvement and travel.

Brazil has suffered the ignominy of being downgraded to junk. After moving into investment grade in 2008, S&P has now slapped a BB+ rating on its sovereign debt, down one notch. The rationale was the incapacity of the government to pass budgetary measures in line with its intended path.

Latin America has faced trying economic conditions in the past year, not all of their own making. The two major influences are commodity prices and the US, particularly the USD. Most of the currencies in the region have fallen sharply, not entirely dissimilar to the AUD. Inflation remains a persistent problem in the region, bar Mexico, and the fall in their currency can bring about pricing pressure, given the inflexibility in most of the economies.

The CPI in Brazil is still at around 9.5% p.a. About 25% of prices are administered, or set by authorities, with these rising at 16% p.a. In turn, these feed back into market inflation, as wage demands rise to accommodate the set price levels.

By contrast, China’s CPI release at 2% was slightly higher than expected due to food prices (essentially pork meat, which is up 16% year on year). Conversely, producer prices fell by 5.9%, continuing the negative trend of this year. The higher food CPI may make it a touch more difficult for China to engineer the consumer spending pattern they would hope for. Falling producer prices point to competitive export markets and presumably lower profit margins. There is no easy path for China and it may take some time before a clear trend emerges.

Fixed Income Update

Credit markets continued their rollercoaster this last week. Investment grade credit spreads remained wide for most of the week, stabilising on low volumes aided by the US holiday on Monday, and tightened on the days when equities were up. The performance of credit is historically positively correlated with the equity market, and this week that held true. Any rallies in equities was positive for credit and the reverse was true. The movement in the Australian Itraxx (proxy for 5 year AUD credit spreads) over the last week is illustrated below.

Source: Bloomberg, Escala Partners
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Like investment grade credit, the hybrid market traded at its lows early in the week before finding support as equities rebounded. The majority of the gains were seen in the major banks with solid volume returning to this market. The recent new issue by Westpac opened for trading on Wednesday and was quickly sold down in line with its peers. This 5.5 year tier 1 security with a coupon of +400 is now trading at 97.40 with a spread of +450.

This week also saw the pricing of a new Telstra A$500m 7 year fixed rate deal with a coupon of 4%. The order book was said to be in excess of $650m, which is a good result in this fragile market and shows the appetite for good corporate issuers. China Construction Bank (A S&P, A1 Moody’s) has also launched a new 3 year floating rate note in AUD at 120 basis points over the bank bill swap rate, with the book build underway. 

The RBNZ cut their cash rate to 2.75% on Thursday. They indicated a lower NZD and that another rate cut was appropriate. Markets expect a further cut in December.

The Australian futures market continues to price in the chance of further easing by the RBA in the coming months. Price action is showing that more than 50% of market participants expect a 25bp rate cut by the end of this year.  

Corporate Comments

Early this week Oil Search (OSH) confirmed market rumours that larger peer Woodside Petroleum (WPL) was interested in acquiring the company when it announced that WPL had made a non-binding indicative takeover proposal. WPL’s proposal is one WPL share for every four OSH shares held and is subject to several conditions, including satisfactory due diligence and support from key stakeholders and shareholders, including the PNG Government.

Based on Monday night’s closing share prices (before the proposal was announced on Tuesday morning), the implied premium of WPL’s offer was just 13.6%. The implied value fell further on Tuesday following the decline in WPL’s share price after the announcement. At first glance, it would appear that the premium on offer to OSH shareholders is a little light on, although WPL may argue that this has been higher on average over the last six months, with OSH outperforming more recently, somewhat fuelled by this takeover speculation. Takeover premiums in the energy sector are typically 25%+. Illustrating what can be agreed to at the high end of the scale, Shell’s takeover of BG Group five months ago was completed at a 50% premium.

Woodside 1:4 Oil Search Premium

Source: Iress, Escala Partners
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The deal would appear to make some sense for WPL given one of the key criticisms of the company is that it has a lack of viable (from an economic sense) growth options in its portfolio, particularly in a lower oil price environment. OSH, on the other hand, still has attractive opportunities to explore, including a brownfield expansion of the initial two-train PNG LNG facility, as well as the potential to develop the Papua LNG project (it currently holds an interest in these gas fields along with Total and InterOil).

Aside from an agreed price (which would adequately reflect these growth options), there currently appears to be two hurdles for the transaction. One is in the PNG Government’s 10% stake in OSH; a position it bought into when the company raised equity to fund the purchase of the gas fields associated with Papua LNG. With the PNG Government paying $8.20 share 18 months ago, it is thought that they may be reluctant to realise a loss on this investment, even despite the oil price decline since then.

Secondly, on most analyst estimates, the deal will be EPS dilutive to WPL, even in its current form, indicating few operating synergies by combing the two companies. This would also seem to go against the disciplined investment and acquisition mindset that the current WPL management team has been keen to portray.

A bidder may also emerge from one of the large international oil companies. Given that both are currently operating in PNG, Exxon Mobil and France’s Total would screen as the most likely candidates. The recent fall in the $A would have made Australian companies more attractive to international acquirers, something which will certainly play into the thoughts of Exxon Mobil, Total and other large international energy companies.

OSH’s strong asset base and aforementioned growth pipeline has been the key reason in the stock being our preferred exposure to the energy industry. With the company yet to formally respond to WPL’s offer and the stock trading above the implied offer price, however, we advise against entering into new positions in the stock.

Westpac (WBC) conducted a strategy day this week, with the bank putting forward several targets that, while highlighting the challenges of the industry, for the most part, were viewed as relatively conservative. These included limiting expense growth to 2-3% p.a. and reducing the group’s cost to income ratio to below 40% over the next three years. With WBC targeting an additional 1m new customers over this time frame, it would imply that a mid-single digit revenue growth outcome (per annum) will be driven by market share growth. Like most of the other major banks, WBC has found it difficult to report positive ‘jaws’ (that is, revenue growth ahead of cost growth, resulting in higher margins or a lower cost to income ratio) over the last few years, so achieving this outcome would go against this more recent trend.

One area in which WBC has perhaps a greater opportunity to reduce its operating costs is by further reducing its branch network, which is the largest of the major banks. What will limit the number of potential closures for WBC is the fact that it continues to operate several smaller brands, along with the flagship Westpac brand. Some people would be surprised to learn that St George, Bank of Melbourne and Bank SA all fall under this category, with these banks all having been acquired by Westpac at some point in time.

A step up in investment spend is also designed to deliver WBC efficiency gains, although it is debatable whether or not the banks are net beneficiaries from increased spend and advancements in technology. The trend across the sector has been for a greater level of expenditure in this area, although in many cases the banks are more likely just protecting their market share against smaller, more nimble disruptors (OzForex (OFX) is one example) who are not burdened with older legacy systems and stringent capital requirements.

WBC is also targeting (like all the banks) an increased number of products per customer; however, we would note from the chart on the following page (from Commonwealth Bank) that the entire industry has struggled on this measure in the last few years.

Major Banks: Number of Products Per Customer

Source: Commonwealth Bank
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Valuations have improved in the banking sector considerably over the last few months, with investors digesting higher capital requirements and slowing profit growth. Westpac is the only one of the major banks not to have undertaken a large capital raising since May, and while this will remain a risk for shareholders in the near term, it is thought that the additional capital could be satisfied via underwritten dividend reinvestment plans over the next few periods. We have reduced the underweight position in our recommended portfolios this month.

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