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WEEKEND LADDER

A summary of the week’s results

01.02.2019

Week Ending 01.02.2019

Eco Blog

- The household sector looks to be the swing factor in economic growth into 2019. In most regions, consumers are in reasonable shape and will get government support. It implies careful stock selection to avoid those where margins will be curtailed by rising costs while focusing on the sectors that represent changing consumption patterns.

Financial markets got what they wished for, a Fed pullback on rate rises and balance sheet contraction. This may appease the long-held view that central banks will be the culprit to end the expansion, but it is also unlikely to be the cause of an improvement in economic momentum. That may well sit with the consumer.

Across many regions the household sector will be receiving a cash flow boost this year. The US tax year results in rebates payable from now through to April 2019. Due to the changes in the tax rate in 2018, this will be a larger number than in the past, though offset by changes to deductions that will result in a redistribution of the benefit to distinct cohorts. Alongside is the persistent 3% wage growth data, sufficiently ahead of inflation to provide real income growth. Job growth totaled 2.6m in 2018, up from 2.2m in 2017, which also adds those new entrants to the total income generating pool. The chart shows the sector additions for December and the past twelve months.

Employment in total nonfarm

Source: Bureau of Labour Statistics, Current Employment Statistics survey, January 2019
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To cap the positive trend is the moderation in Treasury linked mortgage rates and an easing in fuel prices.

The jobs report released tonight may be messy due to the shutdown, but the pattern is in place for a potential rise in household spending into 2019. The risks are in prices, with the impact of tariffs yet to be fully imbedded due to the flood of inventory prior to their implementation, and a weakening USD, which may also see further pressure on product costs. Food costs may also increase as labour is constrained from the Mexican border. Of the unauthorized immigrants, half work on farms and many in the industry report shortages as the labour market tightens.

China has skewed its easing towards the household sector through a fall in tax rate and increased deductions for health and education. Recently there have been other indications of further support for consumers and small businesses. While the details have been sketchy and tend to have a somewhat convoluted route through local government initiatives, the direction is clear.

China’s tax structure is, unsurprisingly, different to most developed economies. Personal taxes only account for around 10% of government revenue, whereas value added and social security taxes form the bulk of the source. Economists have often argued a value added tax is a more effective way to collect revenue, but it does limit the capacity of the government to directly impact the hip pocket (or in China’s case digital wallet). Small business is to benefit from the value added tax breaks by raising the threshold (from 10k yuan a month to 30k), in addition to a reduced corporate tax rate for those earning less than 3m yuan a year.

Europe is not far behind. The French government has already announced tax cuts, mostly for the middle class. Post the ‘yellow vest’ strikes, these have been brought forward and redistributed to lower income groups. Along with wage increases of circa 2%, French households will receive a 4% total increase in cash flow this year.

A cynical view on most correlations in financial markets is required, but the trend in the indices of Germany and China’s industrial production is uncannily similar. Unlike many other data sets, this one has some logic. These two countries depend heavily on export markets and the household sector is, by default, a smaller proportion of GDP. Typically developed countries have consumption at around 60% of GDP, with the consumer queen of the US at 68%.

Source: Global Economics data base
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Along with wage growth near 4% and a new welfare payment, German workers will gain an estimated 3.8% growth in net disposable income this year. The car industry issues we have referenced in previous articles has delayed purchase of vehicles and the household sector now sits on a healthy 10.3% savings rate. Coupled with the largest fiscal surplus ever, the German government is more than capable to adding another round of stimulus.

Australia is likely not far behind. 2018 was not a good year for the household sector, with wage growth particularly slow as well as the sticker shock of falling wealth from housing and equity markets. Now, with the budget in good shape, the forthcoming election is almost certain to see income flow to households, albeit with a strong political skew. At the very least, spending will support the job market and likely to see incremental wages gains. Housing wealth and debt will still be a drag, but at least mortgage rates are most likely to stabilise.

  • Simplistically investing in household-related equities is unlikely to be the best solution to capture this trend. Companies are finding it difficult to pass on price rises, and ironically with wage costs rising, are subject to margin contraction. The favoured sectors are likely to be in areas such as travel, entertainment and the select brands and services where premium or sticky pricing can be sustained.

Fixed Income Update

- We analyse the likelihood of an investment grade company defaulting, noting that the rating agencies don’t always get it right.

- Our views on how fixed income assets are likely to respond to the Fed’s dovish tone. 

Rating agencies (S&P, Moody’s, Fitch) assess the credit worthiness of a company and assign ratings accordingly and have long term data on defaults over the last 36 years. This is then interpreted as the probability of default in a given time frame for each rating. Unsurprisingly, high yield companies with weaker credit metrics are more likely to default than an investment grade issuer. On average S&P rated issuers at investment grade only have a 0.1% chance of defaulting within a 1-year period versus high yield at 3.75%. 

Global corporate average cumulative default rates by rating (1981-2017)

Source: S&P Global Research
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A default by a company refers to their inability to meet the interest payments on any financial obligations that are rated or unrated, other than when subject to a legitimate commercial dispute. An exception is when an interest payment is missed on the due date but is made within the contracted grace period. Preferred stock (including hybrids) are not considered a financial obligation as the issuer has the right, but not the obligation, to pay the interest.

In an upset to US bond markets this week, California’s largest electric utility filed for bankruptcy protection in anticipation of huge legal claims. PG&E have been under pressure since October 2017 after a series of bushfires in northern California. State investigators determined that PG&E’s equipment sparked or contributed to more than a dozen of those fires. The company’s crisis grew in November 2018 as another fire resulted in further damage and deaths, although it is yet to be determined if PG&E is at fault.

While the company is now rated ‘D’ following the default of a $21.6 million interest payment, it was rated investment grade at BBB- just a few weeks ago (early Jan). S&P have downgraded the company 3 times in January, first to ‘B’, then ‘C’ before the default. While it is extremely rare for an investment grade company to default within a matter of weeks (referring to the table, BBB- companies have a 0.25% probability of defaulting within a year), it does lean into the importance of fund managers undertaking their own credit research in addition to using the rating agencies and having a large number of securities in the portfolio.

  • When evaluating a fixed income fund, we look to the processes and credit work that is undertaken for security selection. Large global firms obviously have many credit analysts on hand, but we also expect our boutique firms to have a decent and intensive framework for assessment, and to not just be reliant on rating agencies.

As anticipated, the US Fed at their monthly meeting promised to be “patient” on further interest rate hikes as well as ‘flexible’ on the pace and extent of its balance sheet reduction. The dovish tone was well received and treasury markets rallied in response pushing yields lower across the curve.

What does this mean for fixed income assets? We expect that yields will now hold in a tight trading range with the central bank’s interest rate setting no longer dominating direction. Instead, the market will be driven by other issues, such as the trade agreements, the Brexit deal, economic data and supply/demand dynamics as the US deficit is funded. The statement indicates the balance sheet unwind is also under review, so we may see some changes in the coming months if the Fed is seeking a way to further alleviate tighter monetary conditions.

A slowdown in rate rises is viewed as positive for risk assets. For corporates (particularly those that are heavily indebted), it can reduce the cost of funding if stable interest coverage ratios imply stable credit spreads. Both investment grade and high yields spreads moved widened in December, but we have already seen investor demand returning to these sectors. (US IG credit spreads fell from 0.97% to 0.78% in January). US mortgages (RMBS) should also perform well in this environment. A fall in mortgage rates improves housing affordability and lowers defaults. Finally, emerging market debt will likely gain favour as the USD strength is expected to wane, supporting local currencies.

Corporate Comments

- TPG’s decision to halt its mobile network build has been viewed as a positive for industry returns, although competition has remained high.

- A mining disaster in Brazil will tighten the iron ore market further in 2019. Shareholders of the domestic producers stand to benefit from higher pricing.

TPG Telecom’s (TPM) announcement that it was abandoning its plans to roll out a mobile network across Australia gave the listed telco sector a bump, particularly Telstra, which is seen as the biggest beneficiary. The decision was driven by the Australian Government’s ban on the use of Chinese company Huawei’s equipment in the rollout of 5G networks, which TPM had been using.

TPG’s future in mobiles now rests on the approval of its proposed merger with Vodafone (a decision is expected by mid-April), though the ACCC has already expressed reservations given the reduction in competition. If it is unsuccessful in this bid, its future profitability will be dependent upon generating satisfactory returns from broadband, which is under pressure from high nbn access costs, competition and the substitution threat from 5G.

For Telstra, the threat of higher competition levels in mobiles has somewhat abated, particularly given that TPG was likely to undertake a price-leader strategy to acquire subscribers. Nonetheless, the mobile sector has already been highly competitive with the existing three-player structure, as evident by the decline in average revenue per user (or ARPUs) over the last few years, despite the surge in data usage. We remain skeptical of the industry’s ability to monetise the further spike in usage from the adoption of 5G, which is a core tenet of the current investment thesis.

  • Telcos have performed well over the last six months given the sector’s defensive attributes and optimism surrounding the rollout of 5G. In the short term, however, earnings are expected to contract as the nbn rollout continues.

Telstra Mobiles: Average Revenue Per User (ex-MRO)

Source: Telstra company reports, Escala Partners
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Iron ore miners were among the biggest movers this week following the tragic news tailings dam failure at one of Vale’s mines in Brazil. Vale has since announced the suspension of production at several similar mines, potentially withdrawing up to 40mt of capacity from the global seaborne market.

While Vale does have some spare capacity at other mines that may limit the overall loss of supply to the market, the most likely outcome is for a tight iron ore market and higher prices for 2019. Upgrades have already started to filter through, which suggest that prices may be up to US$10/t higher over the year than previously thought. For the domestic miners, the earnings upgrade could be quite significant, potentially adding 15% or more to their earnings base for the year.

  • We have held an overweight position in the domestic miners in our model portfolio based on supportive commodity prices, high free cash flow, capital discipline, improved shareholder returns and reasonable valuations. Among all commodities, iron ore had held up quite well through 2018, providing a solid earnings core for 2018/19. This week’s developments likely add to the higher capital returns thesis in the medium term.

Our half year reporting season kicks off next week at a slow pace, with Commonwealth Bank the most notable among large caps. Greater attention is likely to be generated by the release of the final report from the financial services royal commission. Notably, many of these stocks have been weak in the lead up, despite the actions already in train by market participants in anticipation of the recommendations. We will summarise the report in next week’s ladder.

Reporting season schedule for next week:

Tuesday: James Hardie, Shopping Centres Australasia, CIMIC, Navitas, Janus Henderson

Wednesday: Commonwealth Bank, IAG, Dexus

Thursday: Downer, IDP Education, Mirvac, AGL Energy, News Corp

Friday: REA Group

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