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WEEKEND LADDER

A summary of the week’s results

01.06.2018

Week Ending 01.06.2018

Eco Blog

- The relatively good economic landscape is being battered by political and other features that could undermine business confidence.

- India’s economic growth is tracking well, albeit influenced by government spending. Finding an attractive direct link to equity markets for this growth is more problematic.

- The minimum wage rate rise in Australia raises a host of issues from competitive advantage and could lead to upside risk for inflation and domestic consumption.

Politics and policy are having a greater impact on financial markets than fundamentals. If the ebb and flux of these events continues, it is likely to overflow into the broader economy as uncertainly erodes the current high levels of confidence. This week alone has seen oil prices kick down, with Saudi Arabia and Russia suggesting they would increase production, which was followed by the Italian imbroglio and finally, tariffs reappeared again. In equity markets, these were reflected in a tarnished energy sector after a few stellar months, while financials across the globe gave up ground as the bond market retraced, diminishing the marginal benefit from a steeper yield curve and the potential for higher funding costs (akin to the Greek impact in 2013). The industrial and materials sector also underperformed, a function of potentially higher costs or trade limitations and risk-off in commodities.

  • These conditions, expressed in a short time frame, make it difficult for any equity manager to consistently hold gains. Only the information technology sector still has a life of its own, but the valuations are often cited as a hurdle.
  • US wage growth is now a near requirement to perpetuate the growth cycle.
  • India has been on the backburner but is exhibiting good economic momentum. As an equity investment, it requires specialist knowledge.

Forthcoming economic data will have to work hard to overcome the noise. The US looks most likely to print good growth. State-based central banks have a long standing informal survey of business conditions, the Beige Book, and in this week’s release the widespread nature of Q2 growth is noted. Manufacturing and basic industrial businesses are highlighted as they sense a change in pace, while the commentary on consumer spending is more subdued. Consistent with other surveys, the lack of skilled employment in manufacturing and trades is now a persistent theme. Early indications suggest that some price rises are trickling through to compensate for higher labour costs. This evening, the employment release will cast some light onto wage growth, with further gains in the employment rate restricted by the low level of job seekers.

A requirement for the household sector to step up further will be wages growth. Confidence is at year-long highs and consumption spending is growing at a 4.8% annualised pace. Yet, this has been brought about by a sharp reduction in savings rather than income growth. The saving rate has fallen to 2.8% from 6% in 2015, with personal income growth at 3.8%, below the rate of outlays. 

Source: CB, BEA/Haver
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Other caution appears to be evident in housing, with existing home sales down 2.1% year-on-year. New home sales are stronger, but prices are now levelling off and mortgage applications are softening as rates rise.

  • A wage rise is required and is arguably healthy, yet would set in train rate hikes that may eventually spell the end of this growth cycle.

India featured heavily in financial commentary as the Modi government made substantial changes to the financial system, including a demonetisation program to prevent leakage of tax and introducing a GST. The implementation was disruptive, but the judgement is that the economic potential had improved, not least due to a credible central bank. Nonetheless, the country still struggles with a current account and fiscal deficit.

This week, the Q1 GDP release was above expectations at 7.7%, though the contribution bias was skewed towards government consumption and infrastructure spending. Unlike elsewhere in Asia, India has not harnessed its labour force and relatively good education to developing an export market. Instead, the country runs a trade deficit and private investment is muted. Agriculture (and therefore weather) predominates as a swing factor, coupled with minimum support prices for key commodities.

India trade balance

Source: Haver Analytics
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Investing in India appeals given its potential growth and differentiation from China and closely linked countries. Yet the equity market there requires careful judgement. GDP growth is not a good indicator, as many companies are uncorrelated to the structural determinants. Instead, selected financial sectors have been viewed as attractive given the low level of formal banking and insurance. Conversely, IT has had patchy returns, as the companies tended to work on contracts that have been superseded by new entrants and changing requirements. The large generic pharma sector has also suffered from significant pricing pressure.

  • While it is tempting to consider country-specific funds in growth countries such as India, the risk of misjudging the underlying circumstances, impact of volatile investment flows and valuations suggest an active manager with the option of moving elsewhere in Asia is likely to be a better outcome.

The 3.5% rise in the Australian minimum wage to $18.93 will create debate on the impact for smaller employees, whether price can be raised to compensate, the benefit from spending and the competitive circumstances that Australia faces. Most commentators agree that US minimum wages are not the benchmark and therefore Europe and New Zealand are most comparable. The European data is shown below.

Source: Eurostat
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New Zealand raised their minimum wage to NZ16.50/hour, up 75c, on 1 April 2018 and the current government has committed to achieving $20/hour by 2020.

In practise the comparisons are tricky. Purchasing power varies considerably, cost of healthcare, education and travel have different levels of support for the less well off. Australian low-income employees are likely to struggle most with rental costs. Then one can argue about different levels of productivity.  Add to that the unquestionable divide between emerging and developed economy labour costs, technological changes and skills to complicate the issue.

  • The extent of flow through to inflation depends on whether employers adjust labour use or already pay over the minimum. On balance it will confirm that the low wage growth period is probably over given public sector wage rates have already moved up. A modest lift in consumption spending is another potential repercussion, but the rise is barely above inflation with essential cost increases likely to absorb most of the incremental dollar.

Investment Market Comment

- Australia's biggest takeover was completed this week as Westfield was acquired by European giant Unibail-Rodamco.

After multiple corporate restructuring Westfield ceased trading on the ASX this week after the $32 billion takeover by French retail property company, Unibail-Rodamco. Investors receive $US2.67 per share in cash and the rest in scrip, whereby investors will have the choice of taking the ASX-listed Unibail-Rodamco CDIs (CHESS depositary Interest which allows international companies to trade on the local market) or its shares offshore.

Unibail-Rodamco is the largest listed property company in Europe. As at December 2017, it had a portfolio of €43billion with interests in shopping centres (82% of total), offices and exhibition centres. The newly created company creates the world's largest chain of shopping malls comprising 103 assets across 13 countries including those of Westfield such as the World Trade Center in New York and high-end malls in Los Angeles, London and Milan. The Australian and New Zealand Westfield-branded shopping centres are owned and operated by Scentre Group, therefore, are not part of the takeover.

It gives Unibail-Rodamco an entrance into the US with the 35 shopping centres that Westfield has in the US. By comparison, the largest operator in the US is Simon Property Group which manages 233 properties including 107 malls valued at US$31bn.

Those investors who elected to receive shares in the ASX-listed securities  (CDIs) will not be entitled to the tax advantages that Westfield has received, and dividends will be subject to foreign withholding taxes.

The cash element of the takeover equates to around $7billion and investors will have to decide if they want to shift their capital towards other A-REITs to maintain their A-REITs exposure. In that case the second decision is whether retain a retail exposure and therefore consider companies such as Scentre Group and Vicinity. However, in doing so they will lose the offshore earnings exposure came from Westfield. Offshore earners as Goodman Group and Lendlease, technically not a A-REIT, could be viable alternatives.

The A-REIT sector has a reasonable representation of stock selection, but many have a small market capitalisation. There has therefore been a persistent trickle of takeovers and consolidations. The apparent simplicity of largely passive property holdings disguises a host of issues such as demand for such assets, regional differentiation, structural changes to industries that lease the space, gearing, debt maturity and valuation rates.

A-REIT Sector Allocations and 1-Year Performance

Source: IRESS, Escala Partners
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Before the takeover, Westfield represented 15% of the A-REIT sector weight. Depending on how many investors decide to take up the CDIs the newly listed Unibail-Rodamco could be between 5% and 10% of the index. These decisions could lead to a significant changes changes in the landscape of the A-REIT ASX indexes and consequently the ETFs that passively follow their structure. Such events illustrate the unintended consequences of passive investment where corporate activity or an index restructure results in a different economic exposure.

  • We do not recommend passive exposure to A-REITs, nor a dedicated allocation to this segment of the market. While this is still a traditional approach for some financial advisors, the sector may not be attractive all the time, nor the reality that A-REIT is retail heavy. Further similar investments that are based on real assets and structured to pay out distributions derived from the use of those assets are much broader with Transurban, Sydney Airport or APA as examples.

Fixed Income Update

- Italian bonds react sharply to the potential collapse of the Italian collation sending the sovereign’s bonds to new historic lows.

· The US yield curve flattens to a 10 year low this week, only months after Federal Reserve research shows that an inverted curve is still the best indicator of a recession.

- Changes to the methodology in calculating the Australian BBSW rate comes into effect this week.

The collapse of the Italian government and the likelihood of fresh elections dominated bond markets.  There have been extraordinary price falls in Italian bonds, particularly earlier this week, which had widespread implications for other fixed income assets. 

The Italian government two-year bond yield, which has been the most reactionary to the political upset, was trading at a yield of -0.297% at the beginning of May. By Wednesday it reached 2.76%, the highest level since 1992. The yield on this bond jumped 1.86% in one trading session, said to be the largest overnight move on record. The 10year Italian bond yield started the month at 1.77% and reached 3.09% at its peak, a 0.45% move in a day. Both have recovered somewhat in recent trading sessions.

Yield on 2-year Italian Government Bonds

Source: Bloomberg, Escala Partners
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Moody’s have placed Italy’s Baa2 credit rating on review for a downgrade. The agency stated that the “sovereign rating would likely be downgraded if we were to conclude that whoever emerges as the next government will pursue fiscal policies that will be insufficient to place the public debt ratio on a sustainable, downward trajectory in the coming years”. The other main rating agency, Standard and Poor’s has Italy’s debt at “BBB” with a stable outlook, following an upgrade from “BBB-“in October last year. S&P did affirm Italy at “BBB” on April 27 yet warned that the rating would come under pressure if a new government strayed from the path of budgetary improvement or unwound past reforms.

The spread on Italy’s five-year credit default swap (CDS), which is an instrument that provides investors a payment upon a debt default, rose 90bp in two days.  By mid-week it was priced at 268bp, which means it cost $268,000 a year to insure against a $10m Italian 5-year government bond defaulting.  At the beginning of May it was 90bp ($90,000) for this same protection and is currently trading at ~250bp ($250,000).

The beneficiaries have been German bunds, UK gilts, and US treasuries which have all had inflows as money seeks safe haven investments. The US 10-year yield, which broke through 3% again a couple of weeks ago, retraced to a yield of 2.77%, with the yield falling 15bp in one session.  Australian bond prices also rallied higher as part of the same ‘risk off’ trade. The last couple of days have seen markets settle down with yields in both the US and Australia drifting higher again.

  • Our recommended bond funds have little or no exposure to Italian government bonds. Conversely, many hold US and Australian duration, aiding performance over the week. The real risk is if the new Italian government pushes to some debt renegotiation, or at the extreme, re-denominates its euro bonds into devalued lire. Given that even Greece could not contemplate such a move, it appears highly unlikely at this stage.

The shape of the US yield curve continues to flatten. While not yet inverted, the difference between short dated and longer dated treasury yields has fallen to a new post-financial crisis low. The spread between two- and 10-year yields fell to 42 basis points this week. Financial commentary remarked on high US debt levels, demographic changes and digitalisation as reasons for low inflation and in turn low long-term interest rates. This, coupled with a rise in short term borrowing costs as the US treasury expands supply, are responsible for the continued flattening of the US yield curve.  Research out in March this year from the Fed found that an inverted yield curve is still the best predictor of a recession. To support this a poll conducted by the bond fund manager Pimco, that shows that the consensus view from sell-side economists and strategists is that there will be a US recession in the next 3-5 years.

Spread between 2 and 10-year US treasuries

Source: IRESS, Escala Partners
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  • Cynics may point to the low accuracy of economic forecasts, yet monetary policy has rarely managed a rate hike cycle without impacting on growth. Long duration bonds will them play their usual role.

Domestically, the ASX began calculating the Bank Bill Swap Rate (BBSW) using actual transactions at traded prices. The new methodology calculates the benchmark directly from market transactions during a longer rate-set window and involves a larger number of participants. Corporate bonds and bank hybrids which are floating rate, are set off this benchmark. The Australian major banks were found guilty of manipulating this rate settling, which brought about the changes.

Corporate Comments

- An improving cycle again lifted ALS’s (ALQ) full year earnings, although the company’s core life sciences unit has delivered mildly disappointing trends. The outlook for the company remains sound.

- Star Entertainment’s (SGR) investor day provided further clarity on longer dated capex projects, while the earnings mix for FY18 is of somewhat lower quality, driven by low-margin high roller activity. The company is one of the better exposures to the tourism industry on the ASX.

Laboratory testing services group ALS (ALQ) reported a full year result that, while meeting expectations, received a mixed reaction given contrasting trends across its business mix. For the 12 months, underlying earnings rose 21%, allowing the company to increase its full year dividend by a similar quantum.

The key positive takeaway from the result was the ongoing recovery in its commodity markets, with the exposure here typically reliant on exploration spending by resources companies. As illustrated in the chart below, global mineral exploration outlays have more than halved from the peak year of 2012, falling every year sequentially until 2016. While the turnaround since then has been relatively modest, the operating leverage in ALQ’s business is such that the rise in the 12 months led to 43% lift in earnings, with higher revenues and margin expansion.

Global Mineral Exploration Market

Source: ALS
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The more stable and reliable divisions of ALS is the company’s life sciences business. Here, the group provides testing services to a wide range of industries, from environmental to food to pharmaceutical. The organic growth profile of these non-cyclical business streams is backed by longer term structural trends and ALS has historically done well from small bolt-on acquisitions to further its footprint.

While life sciences underpinned ALS’s profitability through the more extreme period of the commodity price downturn, the expected uplift in profitability as the commodities cycle improved has not been fully realised. Its life sciences margins have disappointed in the last few years, in part due to higher levels of competition and in part due to some acquisition integration issues, although we note that ALS has historically had a good track record with acquisitions.

Despite this, the earnings outlook for ALS remains sound and the company’s balance sheet is in good shape, allow it to conduct an ongoing share buyback through this year. On near-term P/E multiples, the stock screens as relatively expensive, although this is countered by high consensus EPS growth over the next two years (19% p.a.), consequently on mid-cycle earnings the valuation is less demanding. We have the stock in our model equity portfolio.

Star Entertainment (SGR) held an investor day this week along with a trading update, which highlighted the long term demand drivers for the company. However, investor attention focused on the shorter term profitability and cashflow outlook, which was weaker at the margin.

SGR’s trading update noted a 16% rise in normalised (that is, adjusted for typical win rates) revenue for the half year to date, although the composition of the growth indicated a weaker translation to profits. The company’s high roller business (which relies on international customers) has continued to rebound from the weak period which followed the arrest of Crown employees in China. While the growth has been impressive this year (turnover is up 64% this financial year), the business is lower margin compared to the main gaming floor operations. Win rates have also been below typical rates, an unknown factor that can have significant influence on earnings and cash flows in any given year.

The key cause for some concern was an update on the expected costs of SGR’s Queens Wharf casino development in Brisbane. The total project costs have risen from an estimate of $1.8bn to $2.4bn. While there has been some higher than expected cost inflation built into this figure, it also included a 25% increase in the gross floor area – a much broader scope than originally planned, with the potential to achieve scale benefits given the larger footprint.

The higher expected costs and long-dated nature of the project (the casino is not slated to open until 2022) are likely to result in softer cash flow in the next few years, although the rationale for the investment remains sound and FY18 is the peak year for capex spend (illustrated on the chart). The demand profile for casinos in Brisbane and Sydney is largely a function of the high level of spending from the inbound tourist dollar, which is forecast to grow at close to 10% p.a. over the next decade, with China the dominant driver.

Star Entertainment: Forecast Capital Expenditure

Source: Star Entertainment
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Of the domestic casinos, SGR has navigated the weakness in volatile high roller business better than its peers and has achieved an impressive return on its investment in improving its casinos, particularly Sydney. The recent performance has been relatively solid, if diminished by weaker win rates which typically normalise over time. The stock is an attractive option, now trading on 16X, which is broadly in line with other industrial stocks that have a much more challenged outlook.

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