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WEEKEND LADDER

A summary of the week’s results

01.07.2016

Week Ending 01.07.2016

Eco Blog

One week later, a high level view would be that Brexit has hardly mattered. Global equity markets have settled back to daily moves typical of the times. The FTSE is even trading higher than before the vote, as the fall in sterling is judged to benefit the index, with 72% of revenues from outside the UK. Credit markets have mostly taken the news in their stride and, while bond yields have fallen, some would argue that weak economic growth could have taken them there in any event.

That view glosses over many issues. The Brexit referendum is a precursor to a number of challenging political events - an October constitutional referendum in Italy, a US election and French and German general elections in 2017, amongst others. Even if they don’t surprise as per Brexit, there is highly likely to be a protest vote in each of these to unsettle the status quo.

The other repercussion an increasingly difficult outlook for interest rates. Across the board, the expectation is now that monetary policy will ease or stay on hold for some time.

Post 2008, a fall in rates invariably led to decent investment returns. This is less likely now on two counts. Firstly, the transmission of accommodative policy into the economy has come under scrutiny, with a growing view that it has reached its limit. Businesses have locked in low interest costs, but have been cautious on capital investment. Low rates instead undermine the financial sector and household savings.

More importantly, however, most asset prices are trading at above their historically averages. Few would be surprised that bond markets are at that point, inevitable when rates are at all time lows. The redeeming feature is that credit spreads are not extended.  

Equity markets do use bond yields as one component of valuation, but this risk free rate concept has little meaning in today’s world. Yet by other measures the major indexes are also far from cheap. High valuations can be justified if there are signs earnings growth is to improve; at present that is not the case.

The weak equity performance of the past twelve months has addressed some of this valuation issue as suggested in the chart below. It is important not to react to such long term valuations as buy and sell signals, rather consider them as one of the parameters which help form a decision on a portfolio. What it does indicate is that the S&P500 needs higher earnings growth to justify its valuation, while some of the emerging markets are, in turn, struggling due to macro factors.

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In revisiting the US economy, the labour market has been the critical feature of the recovery. A few years ago, an unemployment rate of below 5% would have been a guarantee of higher interest rates. Instead, low inflation and a host of other concerns have stood in the way. The current trends in the labour market may serve to confuse even more. It appears that both initial jobless claims and employment growth will both slow, implying that the job market has reached an impasse.

Other activity indicators are also unhelpful, bouncing around and lacking in a coherent direction.

Many investment houses have, however, turned their attention to the prospect of rising inflation in the US. The so called ‘core’ inflation which measures the trend in prices excluding the influence of cyclical prices and energy, has been relatively stable at around 2%p.a. The headline CPI can easily reach this level as the data annualises the fall in oil prices, while higher wage and rent costs push the core up too.

The inflation dashboard from the Federal Reserve of  Atlanta shows month on month rises in many components, with only inflation expectations lurking in the bottom of the range. A change in this indicator is likely to have a meaningful impact on bond markets.

Source: Reserve Bank of Atlanta
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China remains out of the headlines with the official PMI suggesting the manufacturing is neither growing or contracting. This is off the back of a declining rate of retail sales and fixed asset investment. Fiscal support is likely to pick up in the second half of the year, especially if the developed world growth, which supports so much of China’s manufacturing base, is weak.

Locally there was little economic news of note. The release of data on the financial sector showed weak credit growth, especially from business lending. That did not stop household debt from reaching a new peak, though the rate of increase has slowed in recent months.

Fixed Income Update

There has been heightened volatility across all financial markets in the last week, and while the moves have been modest in fixed income markets, they have been notable for an asset class known for its price stability attribute. As with equities the bond market reacted quickly to the announcement of the Brexit vote, but a week on most sectors have seen these movements fully retrace. The market is still undergoing price discovery, but it is worth highlighting this week’s movements in the two main aspects of fixed income - government bond yields and credit spreads.

Expectation of further monetary easing pushed down the yield of government bonds across developed markets. In the US, the fall in rates implies that the market doesn’t expect the Fed to raise rates until 2017, and is only assigning a 30% probability that they will do so by this time next year.

In the UK, the yield on 10 year Gilts (British government bond) hit fresh lows to below 1%. Following the Brexit vote, S&P downgraded the UK sovereign from AAA to AA, and Fitch lowered them by one notch. The EU was also put on negative watch while retaining its AA+ status for the moment. While one would expect this would trigger a rise in yields, this was not the case. Recent yield compression across key global markets is charted below.

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The globalisation of markets has been apparent over the week as Australian government bond yields also traded down to record lows providing capital gain for holders and a welcome buffer to other investment assets.

The bond market is now looking for further rate cuts by the RBA, with participants expecting that it will add in an easing bias in the commentary following next week’s meeting. The fall in rates now implies the RBA is projected to droprates at least twice more in the next two years and stay at those levels for the next five years.

5 Year Government Bond Yield in 2016

Source: Bloomberg, Escala Partners
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In this low interest rate environment, it is fair to say that sovereign debt is not included in a portfolio for its income yield. Government bonds are incorporated to dampen volatility and act as an insurance policy when equity and credit markets trade down. The strong performance of this sector immediately following last Friday’s events was vindication of their effectiveness during a ‘risk off’ event.

As expected, credit spreads widened out following the announcement. In a deteriorating credit environment, spreads on bonds lower in the capital structure increase at a greater rate; ie senior bank bonds outperformed subordinated bonds. Not surprisingly, European and UK markets felt the brunt of the move.

As noted above, the ratings downgrade on the UK sovereign had limited impact on the price of Gilts. However, the repercussions was more widely felt on the risk premium for UK banks. A 50% spread movement on UK bank’s senior debt was partly due to their country’s ratings change, in conjunction with uncertainty on how their future interaction with Europe. This is regardless of the fact that the UK banks are said to be extremely well capitalised.

The spread movement of the different credit components is illustrated below. Investment grade (€IG and £IG) spreads moved circa 20pb, while high yield (HYcorp and Cross, representing ‘crossover’, or debt straddling invesment grade and unrated) moved by 70bp. Coco (contingent convertible) is similar to our hybrids with equity triggers and illustrates the behaviour of such instruments in these events.

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Australian and US markets had modest spread widening for a day or two, but quickly reverted back to pre-referendum levels. As a guide, the Australian iTraxx which measures spreads on a basket of 5 year investment grade bonds, is now at 126, exact same level as Wednesday last week. Likewise, price movement in the hybrid market was a small blip on the charts. The majority of these securities are now trading at the same or higher price than a week ago.

Reduced liquidity in bond markets has been topical over the last 12 months.

Therefore it is worth noting some observations from fund managers in the wake of this ‘risk off’ event:

- While spreads on credit widened out, it was mostly transacted in the derivatives market (CDS – Credit Default Swaps) with very little volume trading in the physical corporate bond market.

- Buyers looking for bargains found few sellers, indicating a calm response from bond holders.

- Sellers were faced with a wider bid/offer spread and bids only available in small volumes.

- By contrast, liquidity in government bonds remained robust.

- The ASX listed market trading volumes remained at their daily average.

For the most part it is fair to say that fixed income weathered the storm well. Rising sovereign bond prices offset falling equities, and credit remained relatively stable.

Corporate comments

Equity markets have now had a week to digest the outcome of the Brexit vote. While the initial headlines and market impact were rather sensational, the initial sell off exaggerated the direct implications for the Australian equity market. Indeed, domestic equities have recovered a large part of Friday’s losses, although the dispersion between individual sectors and stocks has been wide. Broadly speaking, the direct impact for Brexit exposed companies is not significant in an overall market context, however it is the indirect consequences that will influence currencies and interest rates which stand to have a greater influence.

The negative economic drag from Brexit is likely to be concentrated in Britain and Europe, with the possibility of a recession in the UK and weakening consumer and business sentiment in the EU.

Very few companies have more than a 10% exposure to the UK. In quite a few cases it will be the currency translation impact that will be the key source of earnings downside (the Australian dollar has appreciation around 8% against sterling over the last week).  At most risk are NAB’s recent spin-off, CYBG (Clydesdale Bank), fund managers Henderson Group and BT Investment Management, Westfield Corporation and IRESS.. The financials stocks within this group have suffered the largest selloff in the last week as the impact to future earnings is likely to be greatest. Below we provide a brief comment on these companies.

- CYBG had performed well since initially listing as a stand alone entity in February. The company had been viewed as a value play in the sector (trading at a large discount to book value), with a new management team to drive top line growth and install a greater level of cost discipline to help lift the group’s return on equity. Costs savings remain the most likely key driver of earnings improvement for CYBG, but top line growth from lending would be expected to be lower following the Brexit vote. If the UK were to fall into a recession than an increase in bad debts would also be an inevitable outcome for CYBG and its peers.

- Henderson and BT Investment Management are two ASX-listed fund managers that also have significant earnings at risk following the Brexit vote. The potential impact is threefold:

- lower equity market returns would lead to lower fee income;

- a fall in sentiment would reduce fund inflows (and potentially fund outflows) as investors take their money out of the market;

- the fall in the pound would translate to a fall in earnings from an $A perspective.

With fund managers effectively leveraged exposure to the market (given a relatively static cost base), the potential for large swings in profitability is present. We have held Henderson in our model equity portfolios, with the company performing well where it has some control, including relative fund performance and net inflows. We also note reports that Henderson’s funds held up quite well amidst the sell-off last Friday. However, with the short to medium term outlook for the stock now more clouded, we will reassess this position in our next portfolio review.

Companies with a significant exposure to Europe is greater, although the economic fallout in mainland Europe should be more contained than the UK. Some of the larger cap names that may see earnings growth from Europe restricted would include Amcor, Brambles, Ramsay Health Care, QBE, Macquarie Group, Lend Lease and Domino’s Pizza.

Compared to the factors cited above, it is the prospect of a ‘lower for longer’ interest rate environment following the Brexit vote that has a greater capacity to influence all equity returns, including those in Australia.

Of large cap stocks, QBE Insurance and Computershare would have their respective earnings downgraded by the market given their exposure to short-term fixed interest investments.

High yielding stocks are the obvious sectors to look for buying options in this scenario, an extension of the multi-year theme that has driven investment returns. Sectors and stocks that fit into this include REITs, utilities, infrastructure, Telstra and the major banks.

S&P/ASX 200: Forward Dividend Yield

Source: Bloomberg, Escala Partners
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However, given the dividend yield compression that has already occurred across these sectors of the market, they are no longer as attractive as they once were, and a fundamental assessment of the earnings prospects is perhaps more important than ever. With the payout ratio of many equities quite high from an historical perspective, the level of earnings sustainability should be an important current consideration in buying individual equities for yield.

The major banks are a case in point. A rise in bad debts and higher capital requirements for the majors has led to earnings and dividend pressure, with ANZ also cutting its dividend in May’s reporting season. The other three may follow suit and so the current forward yield across these stocks may be 

somewhat illusory. Speculation that Wesfarmers may be pressured to cut its dividend suggests that other core portfolio large cap stocks may also be at risk.

In putting together a portfolio of stocks, we therefore have a preference for companies that have either low payouts or growing dividend streams and those that have a stronger growth outlook that is less reliant on any softness in economic conditions.

Vocus Communications (VOC) this week announced the anticipated strategic acquisition of NextGen Networks in a deal that will add a further level of vertical integration to the telco and give it the final piece of the infrastructure puzzle it did not own. The $800m acquisition is to be funded through a pro-rata equity raising, institutional placement of new shares and existing debt facilities.

Vocus Infrastructure Network

Source: Vocus Communications
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NextGen has a national fibre network which provides network backhaul services to connect metropolitan areas in Australia with more remote and regional areas. Vocus had previously been NextGen’s biggest customer, so is effectively moving from an access agreement to ownership.

As has often been the case with deals in the telcos sector, it is the expected synergies which make the assets more valuable in VOC’s hands compared with the previous owners (CIMIC Group and Canadian pension fund Ontario Teachers’ Pension Plan). The annual cost synergies are forecast at circa $30m (to be realised over a three year period), compared to the current EBITDA of the business of $62m. In addition, VOC expects to achieve savings of $8m p.a. on capital expenditure and the deal may also open up additional revenue options.

The acquisition is Vocus’ third major transaction in the last twelve months (the other two being Amcom and M2) and so the obvious risk is the short term is integrating all three businesses at the same time. Nonetheless, with a good track record in this area and with “high single digit EPS” accretion for the deal, we would expect good support from investors. We have VOC in our model equity portfolios given its solid growth outlook underpinned by market share gains as the NBN is rolled out around the country.

Earlier in the week Tatts Group (TTS) announced the sale of its UK slots business, Talarius, as well as providing a trading update for FY16. Talarius has been viewed as non-core and not material to the overall group’s earnings base (accounting for less than 2% of EBIT in FY15) and the price that TTS received was seen as reasonable.

Tatts’ trading update was in line with analyst expectations and was again driven by ongoing solid top line growth in its lotteries operations, up 9% in the 11 months to the end of May. The company’s wagering turnover was at a lower pace, with margins below target levels as a result of its investment in relaunching its wagering brand and high competition. We believe that TTS represents a solid defensive growth story, and the prospect of a value-enhancing tie-up with Tabcorp remains a possibility.

In a bold but well supported move, one of the largest acquisitions this year to date came from a smaller capitalisation companies, Mayne Pharma (MYX). The group is to buy a portfolio of generic products for US$652m off the global group Teva, which is being realised (as mandated by the US Federal Trade Commission) as part of its proposed acquisition of Allergan’s generic drug business.

Over the years Mayne’s business has transformed into a provider of generic and specialty pharmaceutical brands, with the bulk of its sales coming from the US. This acquisition will nearly double the company’s revenue to around $800m, though it will remain a small player in this large and complex market.

Mayne’s portfolio represents a wide range of products with relatively small sales. The advantage is that there are therefore few competitors and a lower risk of exposure to a ‘blockbuster’ drug. Conversely, it requires investment in support and the group has added a raft of new employees to support the products.

Funding has come from a placement, underwritten issue and some use of debt facilities. Shareholders have embraced the strategy and the stock price has risen sharply. The outlook is promising with the prospect of further growth from a pipeline of products awaiting approval. Large acquisitions inevitably carry risk. In this case regulatory issues and potential politically driven impacts from the US election coming from efforts to reign in healthcare costs add another element. The share price is now trading at a 23X P/E for 2017, as one of the growth stories with little economic impact and further upside relies on extending this momentum.

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