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WEEKEND LADDER

A summary of the week’s results

01.04.2016

Week Ending 01.04.2016

Eco Blog

This week economists scrambled to put forward their case for the AUD exchange rate. Foreign exchange is perhaps the best definition of the ‘two handed economist’. On one hand, some are betting on a further rally in the AUD/USD. Rationale would be the RBA’s reluctance to cut rates, offset by a dovish Fed. Stronger commodity prices, improving local economic momentum, a rise in inflation and a fall in the current account deficit round out the case. These economists set their expectations at around 78-80c/USD by year end.

Taking the other side, a number have dug their heels in and are maintaining a view the currency will end the year close to 70c/USD. The poor traction in the economy outside exports and housing, persistence of low inflation due to falling income growth and potential easing of recent commodity prices support their argument.

Each forecast has a preferred secret sauce of inputs to confirm their estimate. Falling back on the long term, the generic view is that somewhere in the low 70c is the appropriate value (based on purchasing power parity), but the chart shows the big swings that are part and parcel of currencies.

Source: ANZ
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At roughly 70c/USD it feels intuitively in the right zone when one considers spending power in Australia versus the US (after allowing for issues such as GST etc). Conversely, the Euro and the Yen are gaining support, and that would appear justified using the same purchasing power parity.

Source: ANZ
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Source: ANZ
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The flip side of the weaker USD has been a much better backdrop for emerging economies. Recall that the run in the USD caused a flurry of concern on their foreign debt obligations, particularly hitting those with weak current accounts. The cycle has turned with a solid bounce, especially for South American currencies. The Brazilian Real had lost half its value against the USD over the two years to end 2015, but has rallied by 9% this year, notwithstanding its troubled political situation. In turn, the equity market (Bovespa) has stormed ahead registering a 30% increase in the first quarter of this year for US based investors.

Remaining with the emerging world, a rebound in the China PMI to 50.2 for March gave a glimmer of hope that economic growth would meet expectations of 6.5%.

China Official Manufacturing PMI

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In the US the data implies trends remain much as before. The critical employment reading due overnight will be closely watched. Notwithstanding some noise in short term labour markets, the overwhelming sense is that the job market is unfolding to plan. Based on client sampling, outplacement firms report 3:2 hire versus job cut in the private sector.

Domestically, the credit release for February took the annualised growth rate to 6.6%. Business credit has improved, though this may well be the last push in property as the business confidence shows no sign of budging.

The ABS Job vacancies survey suggests employment conditions are stable. NSW has been the strongest, but recently QLD is showing considerable resilience in the labour market. All points to the RBA sticking to its current setting.

Fixed Income Update

Dovish comments by Fed Chair Janet Yellen regarding the pathway for further rate hikes resulted in a decent performance in USD treasuries this week. The 2, 5 and 10 year Treasuries all rallied with yields falling 9bp across the board. The futures market has now completely taken out the possibility of an April rate hike, with mixed views on any further rate rises this year. The chart below shows the probability of any increase in the fed funds rate in the next 12 months as determined by market pricing.

Source: Escala Partners, Bloomberg
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As for our central bank, there are also diverse outlooks on whether the RBA will lower rates this year. The most common view is that the RBA is reluctant to cut rates further. However, if the AUD continues to strengthen they may do so. According to CBA, the Reserve Bank believes that: “unemployment will continue to fall; rate cuts don't help capital expenditure; and further rate cuts may damage consumer confidence.” They also suggest that the RBA will look to New Zealand, which despite recently cutting rates three times, the currency is yet to retest its 2015 lows. The Australian futures market is pricing in a 48% chance of a rate cut by July this year, down from an 86% probability one month ago.

The global high yield credit market has continued on its winning streak. Estimates are that US high yield funds have seen more than $13bn of capital inflow over the past five weeks, the largest since 2012. Investors have recently embraced debt offerings that they would have shirked a couple of months ago and many are saying that the recent credit sell off was overdone. In terms of performance, the Bank of America High Yield Index has risen 8.33% since the 10th of February this year. While credit has also performed well domestically, by comparison our Bloomberg Ausbond credit index (measuring investment grade credit spreads, not including government debt) is up only 0.47% over the same 6 week period. The absence of an equivalent high yield market here means those investors seeking such assets will need to look to offshore markets.

A recent phrase being touted in fixed income circles is that ‘credit is offering equity returns with half the volatility’ While this obviously refers to high yield credit as opposed to investment grade, it may well also be the case for our bank hybrid market. Over the last few months there has been a real dispersion in spreads between the longer dated bank hybrids and their short dated peers. Hybrids maturing within 2 years have rallied significantly (spreads tighter) whereas those maturing beyond 5 years have seen spreads drift wider. For the first time in the last couple of years there is a steepness to the spread curve which takes into account tenor risk (i.e being paid a higher premium for taking on a longer maturity).

On the back of this sell off on longer dated hybrid securities, three of the four major banks are now priced with yields to maturity in excess of 8% fully franked, with an expected call date less than 7 years. This is broadly in line with the expected dividend payout on the underlying equities with about half the volatility, a higher position in the capital structure and greater certainty in the income stream. The trade-off is any capital appreciation, but with that comes reduced risk of capital loss.

As a reminder, although coupons on the hybrids are ‘discretionary’ they do have a dividend stopper which means that the bank will have to cease paying any dividends on equity before the hybrid distributions are at risk. In addition, with banks coming under pressure this year, there is the possibility that the banks may cut dividend payout ratios for equity holder.

The chart below depicts the capital volatility this year of the ANZPE hybrid vs that of ANZ ordinary shares.

Volatility of ANZPE Hybrid vs ANZ Equity – 2016

Source: IRESS, Escala Partners
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Also in the domestic listed hybrid market, the new CBA Perls VIII made its trading debut on Thursday trading very close to par. The ticker for this security is CBAPE and it is a 5.5 year tier 1 security (bank hybrid) with an issue coupon of 5.2%.

Corporate comments

Comments on the banks run the risk of repetitive strain injury. Once again this week, the stocks bounced back and forth between the bear call on bad debts, potential dividend cuts, higher funding costs versus the high dividend yield, employment stability (therefore no looming housing collapse) and stable credit spreads.

Our view can be summarised as:

- Bad debts almost certainly bottomed in the past year. That said, there is no indication they are likely to spike. Instead selected sectors (resources, possibly some property developers) can be expected to hit the headlines with additional provisioning. Regional banks may see residential bad debts from properties in mining areas. Overall, however, it is much more likely to be incremental rather than a substantial jump.

- Dividend cuts are possible, but we believe unlikely at this stage. Instead underwritten DRP’s should limit the cash outflow for the banks.

- Higher funding costs are already in train which will restrict the net margin. In turn, profit growth will be slow to flat.

- Investment returns will therefore come from dividends, not capital appreciation. However, capital volatility can be expected to be higher than before as short term traders use the Australian banks to express a view. Lower volatility, but also lower yields from hybrids and sub deb,t are an alternative to equity.

There is no going back to past valuations and share prices as a matter of course. There are many reasons for this, not least much lower credit growth, more competition and regulatory imposts.

But in our view the most important is the fall in ROE, a function of the higher capital requirements. The chart below shows just one year’s move (admittedly with capital raisings from the banks) in ROE and how that translates into an adjustment on the price/book ratio, the favoured metric on a global basis.

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The outlook for the banks is unlikely to become friendly. Further regulation is anticipated in 2018 including earlier recognition of non-performing loans as bad debts and tightening the capacity to measure risk.

Far from discouraging investment in the banks, the comments are intended to call out the risks, the likelihood of low overall return and higher volatility than recent times. The major banks all have much the same risks – their lending books are similar and their cost of funding is largely the same. The specific risks that have come home to roost in NAB and now ANZ lie outside Australia. Globally banks are returning home, which makes them easier to understand, but also limits their growth options.

A raft of companies have been realising assets in deals often painted as win-win for the seller and buyer. AGL Energy (AGL) sold its interest in the Diamantina Power Station located in Mt Isa to its joint venture partner, APA Group for $151m. AGL will continue to supply gas to the plant, but as it is not connected to the national market, it was a discretionary asset.  Last year AGL had flagged that it intended to realise more than $1bn in assets to reinvest into solar and smart metering. The stock is held in our SMA portfolios.

APA on the other hand diversifies its assets from pipeline to upstream generation and deregulated assets. The structure of APA and its reliable cash flow from long term pipeline agreements allow it to fund acquisitions with high debt. A small upgrade to operating cash flow and confirmation of its distribution saw the stock price react favourably to the transaction.  RARE Infrastructure has a position in APA.

Over the past year Primary Health Group (PRY) has felt the consequences of government pressure to reign in health care costs. The group had been growing its network through acquisitions, resulting in goodwill representing 75% of balance sheet assets. As the valuation of this intangible came under question, PRY has sought to reduce debt through disposals. This week it has sold its Medical Directory division to private equity for $155m with the intent to pay down debt. EPS is estimated to take a circa 4% hit, but the alternative was likely to see Medical Directory profit fall without investment to upgrade its software in the face of growing competition.

This comes off the back of a China backed group, Jangho, taking an 11.2% stake in PRY. Jangho had previously acquired Vision Eye Institute, but has given no indication of its intent or rationale for its investments. The company is listed on the Shanghai exchange as an ‘Engineering and Construction Services’ group. Most fund managers continue to avoid PRY, though with corporate interest, there is likely to be a floor to the stock price.

Ardent Leisure (AAD), as a small cap company, has appeal with its mix of leisure and health club assets. However, post a run up off the strong growth of its US Main Event division, which is billed as ’bowling anchored entertainment’, the stock suffered a downgrade as costs grew faster than revenue. It has now indicated its intention to sell its Marina division and focus its attention on transforming its entertainment assets. Complicating matters is the stapled security structure which may prove tax inefficient to unwind. For some time AAD held the dual attraction of dividend yield due to its structure and the thematically favourable asset mix. However the high payout restricted its reinvestment into its asset base which require relatively frequent upgrades.  A possible breakup of the group, likely through a private equity organisation, has been mooted.

In anticipation of a recommendation from the Council for Financial Regulators allowing competition for cash equity clearing, the ASX is dropping its fees by 10%. This activity only accounts for some 7% of group revenue, but continues the slow easing of restrictions. From a revenue point of view, ASX has limited growth options as indicated in its half year result.

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Any incremental tightening of margin is therefore unhelpful. Cost reduction through technology is likely to be the key, with the government noting its support for potential ‘blockchain’ or distributed ledger technology. The regulator has relaxed the foreign ownership restrictions on ASX, through removing the requirement for parliamentary approval, with the 15% limit still to apply if the Treasurer deems it in the national interest.

Who wants to own an airline? Air New Zealand (AIR) has announced its intention to sell its 26% stake in Virgin Australia (VAH). Virgin had a number of larger shareholders with Etihad at 25%, Singapore Airlines at 16% and the Virgin Group with 10%. Virgin has progressively been working to cement itself as a comparable alternative to Qantas (QAN), but that requires considerable investment on a leveraged balance sheet.

Meanwhile Qantas reported respectable February passenger numbers, up 10.5% overall (with 3.6% due to the leap day). International travel has been more than sound, belaying the notion that the weaker AUD would limit the appetite of travellers. Lifted by additional capacity, Jetstar booked at 27% rise in passengers. We prefer to invest in air travel through Flight Centre, which is a much less volatile stock with low capital requirements and consequently the ability to manage distributions.

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