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WEEKEND LADDER

A summary of the week’s results

01.03.2019

Week Ending 01.03.2019_old

Eco Blog

- We are entering a low-level transition with much of the current data reflecting the sharp slowdown of Q4. Forward indicators support the contention that the economic cycle is not yet over.

There is little good economic news. That may sound extreme, but it is hard to find a major data release that is showing positive signs. The most recent US GDP release, delayed by the shutdown, is of relatively little relevance given the time lag and backward-looking aspects entrenched in GDP. For example, investment decisions likely made earlier in the year would start to appear as activity around the end of the year, but don’t give much indication of what will happen in the coming year. On that criteria, business confidence and surveys on spending intentions are far from promising.

Of the recent releases, December US housing starts took a sharper than expected nosedive; China energy consumption, retail sales and domestic travel all eased; Japanese industrial production fell in January and German business conditions have shown little sign of improvement. Yet, that belies other indicators.

Measures on expected outcomes suggest that the forthcoming data will be less bearish. For example, US pending home sales (akin to settlement periods) have kicked up for January compared to the previous months, indicating that the lower mortgage rate and household income growth has created a positive impetus. Applications for fixed loan mortgages rebounded 5.8% in January after the effective 15-year mortgage rate of 4.1% declined to its lowest level in a year.

China’s Purchasing Manufacturer Index (PMI) remains, on aggregate, on a downward trend, but one key aspect, forward orders, has turned. This may be an early response to the easing of the 2018 credit tightening that likely accounted for at least as much as the tariff uncertainty.

China credit impulse (12 month % change)

Source: Bloomberg, TS Lombard
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It would be logical to assume that the inventory movement prior to the imposition of the first round of tariffs has largely worked its way through the system and that, with an uneasy hiatus, US companies would again import from China in advance of any other trade restrictions that could come from the administration. This could give a handy boost to manufacturing into mid year.

It is harder to find a positive tone for Europe. Nonetheless, the region will avoid a recession due to the resilience of the services sector. The most recent PMI for services shows a steady growth rate for February and underpins the view that the consumer was not only unaffected by the manufacturing issues of Q4 but rather benefited from a wage rise of circa 3%. Notably, it is central Europe’s manufacturing base that is weak, while growth has held up in the north and southwest.

Amidst the persistent headlines on Australian house prices, corporate capital spending intentions have improved. Aggregate capital spending has, for some time, been a function of the mining sector. Now it is other forms of investment that have gained ground and the negative trend in mining also appears to be at an end.

Capital Expenditure (real, quarterly, by sector)

Source: CBA, ABS
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The benefits of the gigantic mining boom should not be ignored as the legacy is a long tailwind of exports and income flow to the domestic economy. Recent data show the 2018 growth in export revenues. Gas is only now reaching its potential.

Australia top exports ($bn) 2018

Source: ABS, Escala Partners
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The one proviso is that within the US/China trade negotiations China appears to have committed to buying more gas from the US, which may deprive Australia of a key growth market.

  • Global GDP growth is now forecast to ease towards 3% this year. The jury is still out as to how long this cycle will extend and exactly what will cause its undoing. We have raised our equity weight in anticipation of a mild recovery trend, but caution against taking excess risk across a whole investment portfolio while expecting periodic retracements, with the end result likely to be returns in the mid-single digits.

Fixed Income

- We focus on the direction of bond yields in the European market post the end to the European Central Banks’s (ECB) Quantitative Easing program.

December 2018 marked the end (at least for now) to the ECB’s €2.5 trillion quantitative easing program. The ECB started purchasing Eurozone government bonds four years ago at a rate of €60bn a month in a bid to support liquidity in financial markets and reduce the cost of borrowing for lenders as a stimulatory measure. From April 2016, it stepped up to €80bn a month, before pulling back to €60bn before being cut to €30bn in December 2017. It remained at this level until September 2018, before falling to €15bn a month. Over the course, the types of bonds that the central bank would purchase shifted from just Eurozone government debt to include corporate bonds and asset backed securities. 

APP monthly net purchases, by program

Source: ECB
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The impact of the program was that bond yields dropped to record lows, and the spread between core eurozone countries (e.g. Germany) and the riskier periphery (e.g. Italy, Spain, Portugal) compressed. With the completion last year (while noting that proceeds from bond maturities are still being reinvested but there are no new purchases each month), it is understandable to assume that the reverse would happen and bond yields would rise. So far in 2019, this has not been the case.

The recent dovish commentary from global central banks, including the US Federal Reverse and ECB, have increased demand for global bonds and held yields down. The European futures market is not pricing any meaningful rate hikes until mid-2020, with only a 25% probability of a rate rise expected by the end of this year. This is a full year beyond what the market was anticipating last year. With little threat of rates rising in the short term, investors are more comfortable holding these securities, resulting in capital inflows.

The fall in European bond yields this year has occurred even as many of the region’s governments have brought new supply to market. investors have been buying for the long term, as demonstrated by the high demand levels for a 30-year bond from France which had €31bn of orders for a €7bn bond paying a coupon of 1.5%. Other European countries have also taken advantage of the favourable conditions, with widespread issuance accompanied by record investor demand in debt sales.

Was the end of QE therefore ‘much ado about nothing’? In isolation, it is logical that reduced demand for bonds (as the biggest buyer being the ECB retreats), and unchanged supply would push up bond yields. However, the end of QE has not been in isolation, and instead has coincided with a slowdown in growth, no sign of inflation (although we note a pickup in last month’s wage growth data) and subsequently dovish rhetoric from the US Federal Reserve.

European growth expectations for 2019 have been revised down from a forecast 2% in early 2018 to 1.4%, steering investors towards safe-haven investments. This provides further support for domestic bonds is a slowdown in capital flows from Europe to the US. A negative basis swap currently exists between the EUR and USD and it is therefore not economical for European investors to invest in the US and hedge back the currency.

  • We have previously pointed to the end of QE to trigger a rise in yields. However, the deterioration in economic conditions and dovish stance of global central banks is likely to keep rates down at these levels. In time, we may see a return of QE spending or other targeted policies if the ECB needs to implement more stimulatory measures. None of the fund managers we invest with see value in this market, but some will still take on a relative trade, or look to opportunistically trade the range.    

Corporate Comments

- Boral’s (BLD) result was preannounced and the stock’s derating has been sharp despite a mix of positive and negative trends.

- Expectations for Adelaide Brighton (ABC) continue to edge down as the housing market cools.

- Revenue growth is the key metric for Seek (SEK) as the company invests and diversifies away from its core Australian operations.

- Capital management and high dividends from Rio Tinto (RIO) are backed by strong free cash flow and supportive commodity prices.

- Caltex (CTX) delivered on investor hopes for a special dividend. Low refining margins are having a detrimental effect on profits.

- Seasonality of produce should be more of a factor to consider for Costa Group (CGC).

Boral’s (BLD) half year profit was preannounced earlier in February, and there were few surprises when it released its full accounts. While earnings were softer in the half, a slight increase in the dividend spoke to the company’s confidence of an improvement in the second half. The key issues that have led to a large de-rating of the stock over the last 12 months include adverse weather conditions in the US, weakness in the domestic housing market, input cost inflation (with these not fully recovered through price rises), housing affordability in the US on the back of interest rate rises and finally, some delay in large domestic infrastructure projects.

Of these, most could be considered as transient in nature. Weather patterns should normalise; domestic housing activity has peaked (although the downturn has arguably been sharper than anticipated) but should stabilize through the year; recently announced price rises will help to restore margins and rates have again subsided in the US, alleviating affordability fears. Meanwhile, the synergies from BLD’s large Headwaters acquisition in the US have been upgraded. The stock is trading on a FY20 P/E of approximately 11X, as low as it has been in several years and through the cycle, hence it is arguably priced for a worst-case scenario. To close the discount to fair value a more consistent pattern of earnings delivery is required.

Boral: Forward P/E

Source: Bloomberg, Escala Partners
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While Boral has earnings support from synergies and a larger exposure to the US market, the outlook for construction materials group Adelaide Brighton (ABC) has been weakening due to its entirely domestic focus. ABC describes the demand environment as ‘stable’ with the positive flow through of infrastructure projects offset by a declining residential activity. Until recently, the strength of the former was expected to more than compensate for the latter, although expectations continue to be recast. Relative to BLD, ABC trades at a healthy premium and is typically favoured by those with an income focus given its consistent dividend history, including regular payments of special dividends.

Seek (SEK) got the tick of approval from investors for its first half result, despite a modest revision to its full year profit guidance. A focus on the group’s revenue line was behind this reaction, with total growth of 21% for the half. As has been the case in recent periods, EBITDA and profit growth lagged the top line due to higher levels of reinvestment across all business lines and associated depreciation expense.

Seek: Capex Profile

Source: Seek
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While the core domestic online jobs business continues to post solid numbers (13% profit growth), shareholders are banking on a myriad of international (such as China’s Zhaopin) and more speculative early stage investments to drive the bottom line over the longer term. The evidence has so far pointed towards a good return on this spend, although for many investors the time frame of earnings realisation would require atypical levels of patience. A key short-term risk remains the health of the Australian jobs market and SEK highlighted that there had been a “slowdown in macro conditions in a number of our key markets” over the last few months. We note that the stock is a core holding in our Selector SMA.

Rio Tinto’s (RIO) full year was largely as expected, with net profit relatively flat on mixed key commodity performance. As with BHP, shareholder returns were in focus, with an unchanged final dividend (although 10% higher in AUD terms) enhanced by a special dividend of US$2.43 per share. The special dividend was anticipated by investors as it had represented asset sales made through 2018 (primarily coal), with RIO having committed to returning the proceeds to shareholders.

While RIO only has very modest forecast production growth (2% p.a. out to 2023), the company’s capital discipline (replicated across the sector) continues to be well supported. Highlighting the strength of RIO’s balance sheet was the debt-free position as at 31 December and hence shareholders will again be well placed to benefit from the recent spike in iron ore prices through early 2019. With commodity price forecasts yet to be fully reflected in consensus numbers, the stock is again in an upgrade cycle and is on a reasonable valuation at 5x forward EV/EBITDA.

Rio Tinto: Key Commodity Prices in 2018

Source: Rio Tinto
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Caltex (CTX) reported a slight beat to its own guidance, although the sugar hit was provided by the announcement of an off-market $260m share buyback which will release some of the company’s large franking credit balance (we had previously identified the stock has a buyback candidate).

The primary driver of the lower earnings result was softer profits from its refining business, with margins at cyclical lows. Additionally, there remains some skepticism over the company’s ability to achieve its convenience retail targets. The investment thesis is predicated on some form of mean reversion in refining and/or growth in convenience, while success on either front could lead to a multiple re-rate from its current level of around 13x. The 2019 outlook is clouded by the likely re-emergence and market share gains of Coles Express, which should be more competitive on pricing after signing a new supply agreement with Viva. CTX remains a favoured stock among value managers and is a holding in the Investors Mutual core portfolio.

Caltex Refiner Margin (US$/bbl)

Source: Caltex
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Costa Group (CGC) has sold itself as an agricultural company that is less exposed to market cycles than other listed peers, although its first half result was a reminder that these risks cannot be fully discounted. Oranges, in particular, can produce heavy yields one season followed by a light yield the next. The weak yield from CGC’s oranges division was key in the soft result for the December half, leading to a 15% decline in revenue. While the biennial nature of oranges should lead to an easier comp in calendar year, the other hurdle to growth could come from demand. CGC had noted in its trading update last month that demand had been subdued across several other categories, including tomatoes, berries and avocadoes, although the company’s updated outlook commentary struck a more positive tone. The stock’s recent derating from a high 20s PE to ~20x more closely aligns the growth potential of the business with the cyclical risks.

Costa Group: Produce Revenue Growth

Source: Costa Group, Escala Partners
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