A summary of the week’s results


Week Ending 06.10.2017

Eco Blog

- China’s party meetings struggle to excite yet the changing industry and financial policies are expected to have long term repercussions.

- Australia’s retail spending took a hit in August with consumers concerned about the cost of living. What is considered dispensable also illustrates the rapid change in views on essentials versus discretionary.

China’s upcoming 19th party congress (commencing 18th Oct) is a carefully orchestrated affair. It is unlikely to be global headline news, yet China watchers will be keen to see the personnel changes and key position roles that may emerge. Premier Xi is expected to articulate a targeted growth level and major strategic initiatives. In 2012 the stated aim was to ‘double the GDP per capita by 2020’, requiring an annual GDP growth rate of 6.3%. This may be reinforced and accompanied by comments on pollution controls, social security and the necessity to manage the housing market. A centre plank is the goal of lifting China’s role in technology with a meaningful change in industry balance to come, as the example on steel versus semiconductors illustrates.

China’s steel and semiconductor output, 2001-2016

Source: Blackrock

As Premier Xi has consolidated power and filled positions with his preferred candidates, there is a view that this coming five-year period will see more economic reform than previously. Dealing with excess capacity and leverage early could see a better balance in the latter part of the term and potentially another five years for Xi. In this case growth may become more erratic into 2018 and 2019 before stabilising.

The current lift in global growth has been supported by the 2016 expansionary monetary policy in China. Modest tightening since March has had relatively little impact, given the economic strength across the rest of Asia, Japan and Europe. Consumer spending in China has held up well and consumer confidence is at multi year highs. Export growth has tracked higher in line with the global trends. Some of the data has been weaker, particularly property where the government has directly restrained activity.

It is rather the way in which China is managing its financial conditions that are of interest. This week the government reverted to an easing stance through a cut to the RRR (reserve requirement ratio, essentially a capital base) explicitly for banks that lend to small and rural businesses. 

In the past few years China has developed an arsenal of instruments to control credit.  The RRR has been a way to control credit without a price signal through interest rates. In the short term, the open market operations through reverse repurchase are frequently used. In practise, this involves banks placing bonds at the Peoples Bank of China as collateral for funds, commonly for 7-28 days. A variety of termed lending facilities allow for longer term liquidity management while specific programmes such as the ‘pledged supplementary lending facility’ is directed to government programmes including the shantytown redevelopment currently underway. 

While this may appear complex, in the past year the coordinated government authorities have been reasonable successful at controlling money supply and implicitly credit growth. The country’s high debt/GDP is often cited as one the major risks for financial markets. Financial deleveraging is specifically aimed at the so-called shadow banking sector (high yield lending outside financial institutions), property speculation and the restructuring of the state-owned enterprises (SOE).

The efforts to increase participation on new technologies should also not be under estimated. This is likely to result in displacing some global companies that operate within China as it builds its domestic operations. The days of investing in China through companies located in the developed world is rapidly fading.

As has been the case with demand for commodities, there is inevitable tendency for China to dominate an industry. This week the International Energy Agency released a report on global energy trends. Renewable energy represented two-thirds of additional net power capacity in 2016, with solar growing by 50%. Almost half of that came from China.

Global electricity capacity additions

Source: IEA

Just as the labour market in Australia is showing some resilience, along comes a very weak August retail sales figure of 2.1% YOY. The NAB consumer survey touched on the cause, namely concerns about cost of living, particularly essentials. Discretionary spending such as eating out, entertainment and purchases in formats such as department stores are particularly vulnerable. The changing dynamics of consumer lifestyles is reflected in the response to what spending was considered most essential.

“Lifestyle Spending” consumers fear losing most – by age

Source: NAB

Fixed Income Update

- As defaults in corporate loans stay low, market based lending gains traction.

- Delinquency rates on residential mortgage payments over 30 days rises nationally, while rates in Sydney and Melbourne fall. 

The corporate lending landscape has changed since the financial crisis. Regulatory changes calling for bank balance sheet restrictions and tighter business lending standards has strengthened the quality and reduced the number of business loans on Australian banks’ books. This has contributed to the fall in the level of non-performing business loans from ~3.7% following the crisis to 1% as at the Q1 2017.  This default rate sits below that of personal loans and only slightly above the housing sector.

Banks’ non-performing assets (domestic books)

Source: APRA, RBA

The fall in business lending by the banks has been absorbed by ‘market based’ or ‘peer to peer’ lending groups. Funds are raised through unit trust structures with investment into direct loans. While competition for new corporate loans by these groups has driven margins lower, given historic default rates in this sector, they appear to still offer value. The key is effective due diligence of selected businesses and diversifying across many loans to reduce the risk of negative performance.

The ‘fair value’ of these investments is a function of the lending rate, the default rate and recovery values in the event of default.  To demonstrate, we take a $1m portfolio that invests in loans paying current market pricing of BBSW+3.25% (~5%), and apply 10-year peak default rates of 3.7%. While the worst-case return is still very close to cash, when recovery rates are taken into account the result is a respectable 3.4%. With current default rates at only 1%, the returns on these strategies have been healthy and much higher than illustrated below. The market continues to grow with new, easily accessible, products such as listed investment trusts (LITS) that trade on the ASX.

Example of returns on market based lending

Source: Escala Partners

While the default rates in Australian housing remain low, recent data shows some cracks in the domestic Residential Mortgage Backed Securities (RMBS) market as delinquency rates for prime mortgages over 30 days has increased slightly. 

Unsurprisingly the mortgage delinquencies are concentrated in the mining states of WA, NT and SA with the WA having the highest rate at 2.96% due to the falling housing prices, weak economy and high underemployment levels. House prices in Perth have fallen for the last 2 years, and are down 2.1% in the last 12 months, while Darwin prices have fallen 6.4% in the last year.

In contrast, the delinquencies in Sydney and Melbourne have in fact fallen along with price rises of 12% and 16% respectively in the last year. The rising sale prices in these cities supports owners coming under financial stress with the capacity to sell their house at a price sufficient to repay loans.

Corporate Comments

- QBE Insurance has downgraded its guidance for 2017 following larger than expected losses from recent extreme weather events in North America.

- Queensland LNG producers (including Origin and Santos) will likely take an earnings hit from increasing their domestic gas supply.

QBE Insurance updated the market on the expected losses that it will incur from several extreme catastrophe events in North America, including Hurricanes Harvey, Irma, Maria and the Mexican earthquake. While the costs from these events are still to be finalised, the company has estimated that a $600m pre-tax impact inclusive of the estimated claims in the final quarter of 2017 resulting in a material downgrade on FY17 earnings guidance. As a result, QBE has now forecast a combined operating ratio of at least 100%, indicating an aggregate underwriting loss for the year.

Losses from these events were anticipated, although what surprised was the overall magnitude of the cost. Typically, large catastrophe events are covered by reinsurance policies that insurers have in place, although occasionally several large events in a single year can lead to a breach of these levels. For 2017, QBE now anticipates that these events over the last month are likely to translate into the costliest year in the history of the global insurance industry.

While QBE was initially sharply marked down following the announcement, the fact that the downgrade was triggered by this anomalous number and size of extreme weather events lead to the conclusion that this is by and large one-off in nature, and its share price recovered in the following days. Nonetheless, the short term impact is most likely to be a probable cut to its final dividend and its reduced capacity to continue with its on-market buyback program, although its balance sheet remains in a strong position.

The other expected outcome for the insurance industry is an increase in reinsurance costs in coming years, countered with a lift in their own premium rates. With regard to the former, QBE is in a good position, having already purchased much of their reinsurance cover for 2018.

QBE has a number of short term risks to its outlook, particularly given the issues it has faced with the poor results in its emerging markets business  and the potential for the incoming CEO (starting in January) to announce a more thorough deck clearing. The stock retains valuation support for more patient investors, on a low P/E and trading close to book value.

Additionally, its leverage to rising interest rate environment is in contrast to many other listed equities and is arguably the key driver of its share price, although has been overshadowed by company-specific issues in the last few months.

QBE and Bond Yields

Source: Bloomberg, Escala Partners

The Australian energy industry has been making news over the last month given the looming gas and electricity shortage. Domestic gas production has risen sharply over the last decade, however, this has predominantly been destined for international markets (where a supply gap was filled and pricing was much better) via the export of LNG. On the east coast of Australia, three large-scale projects at Gladstone in Queensland have been constructed and are yet to reach full production capacity.

In the last few weeks the Federal Government has intervened and negotiated an outcome with the larger exporters to ensure that the domestic market is fully supplied through next year. Even following a recent tightening of the domestic market and higher gas prices, it is still below that of what the exporters could achieve if they sold onto the spot market. Spot market sales have been used for excess capacity above that of the long term supply contracts to which the LNG exporters are tied (long term contracts generally represent around 80% of an LNG project’s capacity).

Adding to domestic supply, as opposed to spot sales, would have been an easier decision through most of this year - spot pricing has been weak given a well-supplied market. A recent surge in pricing (see following chart), however, has complicated the trade-off for producers who are looking to satisfy the objectives of the Federal Government and maximise their own profitability. The recent jump in pricing has in part been driven by a pickup in demand, although additionally the potential for Queensland supply restrictions has also aided the price.

The primary losers from these recent developments are the companies that have an interest in the various Queensland LNG projects – including Origin Energy and Santos – as they will now receive a lower price for increased domestic gas sales. Oil price movements, however, are more material in terms of overall profitability, given that this is the key variable in long term contract pricing.

On a shorter-term basis, if higher spot prices are sustained, other LNG producers should benefit. This would include Oil Search (OSH), which also sells into the Asian LNG spot market through its interest in PNG LNG.

Looking at the bigger picture, there has been pressure on the global LNG market given the number of large projects that have come into the production phase in the last few years and consequent oversupply. Lower price assumptions are therefore a probable key assumption that will be incorporated into any new project that is looking to be approved in coming years.

North Asian Spot LNG Prices ($US/mmBTU)

Source: Bloomberg, Escala Partners