A summary of the week’s results


Week Ending 03.04.2015

Signs of a slowing in housing credit and a fall in building approvals would be welcomed by the RBA on the eve of the monthly meeting. Based on February data, investor loan growth is annualising at 10%, whereas owner loans are growing at 5.7%. Approvals edged back by 3.2%, though this series is notoriously volatile. The seemingly unstoppable Sydney market and bias to investor loans rather than owner occupiers will be a difficult dynamic for the RBA and APRA. Macro prudential policies designed to limit bank credit growth in certain sectors is likely to be actively pursued by the regulators.

Business credit growth is tracking 5.6%, but concentrated in commercial property, another worry for the RBA.

Among the plethora of surveys is the NAB Anxiety survey, its title a likely self-fulfilling prophecy. Government policy now registers as the greatest concern, followed by the perennial cost of living. This stands in contrast to the low CPI, yet households are more attuned to the rise in medical expenses, education, and utility bills rather than the low inflation in the goods sector. And even with low interest rates, paying off debt is ever more important, based on the survey. Potential policy changes from the budget can be expected to influence households to delay consumption and the next few months data may well be on the soft side.

The RBA assessment therefore will be under scrutiny next week as they have to deal with the housing dilemma, falling iron ore prices, soft inflation and stable but relatively elevated unemployment. Consensus is heavily weighted to another cut, with a few of the view they will wait until May in order to reflect on the growth data for the first quarter.

The China PMI was a touch better than expected indicating that production and employment have been relatively stable post the New Year break. Export orders, however, fell back and SME’s are consequently struggling as is evidenced by the HSBC PMI that surveys these companies in contrast to the official version with its emphasis on large corporations. The long US west coast port strike may be the reason for this soft trend in exports and its resolution could see exports lift in coming months.

PMI by enterprise size

Source: Barcap

Many however believe GDP growth will not achieve the stated goal of 7% for the year, with the real estate market a significant drag on growth. Authorities have eased some of the constraints imposed such as on second mortgages, but with high inventory and sluggish price momentum, it’s unlikely to have a significant effect.

The consequence for the moment is that the challenging conditions for resource companies have, if anything, become even more so. Iron ore is under considerable pressure having punched its way below levels most considered to be a floor. How low can it go? Supply growth suggested that there will need to be mine closures or some restraint on volume before there is any relief. The chart shows the extent of volume growth over the past decade compared to other commodities. The point is further made that supply disruption in iron ore are infrequent compared to the potential in copper or oil.

Copper, iron ore, oil supply indexed to 2006

Source: Barcap

Stimulating economic activity is proving a challenge in most regions, none more so than in Japan.  After the negative impact of a consumption tax and subsequent deferral of a further increment, there is hope 2015 will deliver a better outcome. So far the evidence is underwhelming with real household spending barely in positive territory. Industrial production is patchy at best with February showing a surprise drop after a promising number of months. The divergence in performance in the industrial sector, as can be seen in the charts below, shows the few segments of manufacturing production that are gaining ground.



Japan does things differently in many ways. The government has recently instituted a JPX Nikkei index 400 where the constituents are required to have achieved certain return on equity and profitability. Many of the current stocks in the Topix do qualify as there has been a notable shift towards investor friendly behaviour. Another initiative, the Corporate Governance Code to be implemented mid-year, is designed to encourage divestment of the passive holdings of listed equities unrelated to the operating business that is common within corporate entities. 

China and Japan may at times be at odds with each other, but that has not stopped an influx of Chinese tourists bent on shopping. The Economist reports the ‘four treasures’ purchases of brand name rice cookers, vacuum flasks, ceramic knives and high tech lavatory seats. Aside from the idiosyncratic nature of this list, it is a reminder that the global household sector has many aspects that challenge traditional thinking about spending (and therefore investment) patterns.  


Locally we have noted the pressure on traditional retailers from changing consumer behaviour and disruptive models. At least as much blame could be attributed to a ‘head in the sand’ approach where tough decisions on investment into online, inventory writedowns or store closures are only taken when profits have already tumbled. Globally retailers have been somewhat more proactive. In the US, online after much investment, is a meaningful component of most successful organisations.

In the UK Kingfisher, an eponymous home and hardware group, has initiated a major programme of store closures to rationalise space it no longer needs given the change in consumption patterns. It would appear most likely that these trends will find their way to Australia in the next few years providing a potential headache for retailers, associated service providers and retail REITs that have not adapted.

Fund managers who meet with tech companies around the globe highlight that perhaps we do not fully appreciate the disruption from this vast sector and therefore the investment opportunity. A recent missive that came our way included comments ranging from the attitude to dress codes and therefore the apparel sector, the race for talent with tech now exceeding finance as a preferred career for high flyers, the marriage of low tech processes such as logistics with an high tech interface, the huge growth in cyber security and the latent potential from data. An investable touch point was that notwithstanding the performance of this sector in recent years, Apple is trading below the average P/E ratio of regulated utility companies in the US.

Fixed Income Commentary

Last week saw the issuance of a new $4.25 billion Australian Commonwealth Government Bond (ACGB) with a 2035 maturity. The deal priced at a yield of 2.865% amidst an order book that was well oversubscribed with strong demand from a range of varied account types, 30% of which were offshore.

The success of this new issue bodes well for the AUD$26.75 billion of bonds (not including corporates) that are estimated to mature in April. This will mark the largest month on record for AUD maturities with ACGB, four semi-government and some SSA’s (Supernational, Sub-sovereign and Agencies) all coming due.

2015 $A Debt Government Maturities


As these old bonds mature and some are replaced with longer termed debt the Australian bond index will also extend out significantly. Government issuance makes up about over 80% of the Australian bond index and re-weighting by ETF’s and funds tracking the index should see not only an extension of duration but also a flattening of the yield curve as a whole.

In global markets, and at the other end of the credit spectrum, sits High Yield/Non-Investment grade bonds. With issuance by the energy sector making up around 15% of the total high yield market in the US, led by the increase in shale oil production, the recent fall in oil prices has seen spreads widen out across the market.

As can be seen from the chart below, yields hit their highest level in 2 years in December 2014. Yet with low default rates and favourable credit conditions, this sector has had rapid inflows particularly in the last 6 weeks. Some $12.2 billion in new money has flowed into US High Yield funds in 2015 as part of a broader interest in fixed income amid a turbulent stock market.

The High Yield market has rewarded its investors by returning 2.3% year to date, outperforming the Barclays U.S Aggregate Bond Index and the S&P 500.This is a reminder that even in a low rate environment, investment opportunites can present themselves to those funds with flexible mandates.

Source: Bank of America Merrill Lynch

Company Comments

Chevron closed out of the large stock overhangs in the Australian market over last weekend when it sold its 50% stake in Caltex (CTX). Chevron had been a long-term shareholder in CTX, and the doubling in CTX’s share price over the past 18 months was likely sufficient incentive to cash out its position. The move was also perhaps not too surprising given Chevron’s stated divestment target of US$15bn over the four years to 2017 (the sale will raise approximately a quarter of this target).

Much like the big diversified mining companies, the large multinational oil companies (including Chevron) are currently entering a phase of reduced capital expenditure, cost reduction and a focus on improved returns to shareholders. Chevron will maintain a significant presence in Australia, particularly through its interests in two large-scale LNG operations in Gorgon and Wheatstone.

Outside of the existing Chevron representation on the CTX board, there is unlikely to be any material change to CTX’s strategy. What it does do, however, is raise the prospect of a distribution of the $1.1bn franking credit balance on which the company is sitting (equivalent to $4.17 per share). CTX’s new domestic shareholder base will be in a much better position to utilise these franking credits than Chevron was and so there is a high probability that the company will now consider either a special, fully-franked dividend (which could be structured in a similar way to Tabcorp’s recent special dividend) or a share buyback with a high franking component (similar to that recently undertaken by Rio Tinto).

ASX 200: Companies with Largest Franking Balances (as at last balance date)

Source: Bloomberg, Escala Partners

For investors interested in stocks that may have the potential to release excess franking credits, the table above details the companies with the highest current franking balances (as a percentage of their current market capitalisation). These balances are based on the most recent annual reports, so in most cases will not reflect any recent capital management initiatives undertaken by companies (such as Rio Tinto, Tabcorp and Harvey Norman).

A number of the list are unlikely to be inclined to consider capital management given a difficult operating environment (such as Mount Gibson, Skilled Group and MMA Offshore), while for others it could be due to a concentrated shareholder structure (Premier Investments and Fortescue Metals). It would appear that the most obvious candidates have already recently distributed these to shareholders, although BHP Billiton would be another large-cap possibility if its balance sheet continues to strengthen.

After a stellar run, childcare provider G8 Education (GEM) has had a more difficult period. Uncertainty on policy and execution of its acquisition driven strategy have overridden the macro theme and the fragmented market that has leant itself to its roll-up growth.

This week the group reported that the acquisition of eight centres, part of a larger deal involving 25 centres, would be delayed until November resulting in a circa 5% fall in earnings expectation for the fiscal year. Based on its December year end, the company is now trading on a 13-14x multiple. If some of the concerns on the business model can be addressed, this represents clear value in a good sector.

The key is now how management go about funding the growth intentions. High valuation made equity issuance attractive and the board therefore moved to pay out the bulk of its earnings while introducing a DRP. We sense major shareholders will discuss with the company whether this is in the best interest of long term investors. A cut in the dividend rate would create a more sustainable self-funding model at a time regulatory uncertainty also means the operating  risks are higher than before.  GEM has done well to incorporate its acquisition into its business model by managing costs and raising the occupancy of its centres. In our view there is no suggestion they are failing in this regard, however we will keenly watch developments on the funding side to support our investment case.

At its AGM QBE noted that the insurance market remained tough, but that the combination of cost reduction and possible realisation of its Australian mortgage insurance business meant that its balance sheet and cash position could result in a lift in dividend.

The stock has been a tough call over the past few years with prospects for improved performance eroded by industry and structural concerns. As the local sector represented by IAG and SUN is now seen to be at peak earnings (on the insurance side), investors have turned to QBE to fill that gap.

The chart below however shows how quickly the thesis can unfold with the valuation moving rapidly either way. In our view this makes it a difficult stock to recommend to those with a longer time frame in mind. The attraction appears to center on the relative call rather than absolute value and its higher rating of the past is arguably no longer deserved given that the acquisition driven growth is no more.

QBE PE relative to ASX200