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WEEKEND LADDER

A summary of the week’s results

02.06.2017

Week Ending 02.06.2017

Eco Blog

- No signs of improvement for the Australian economy. First Quarter GDP next week likely to confirm recent trends in retail and capital expenditure.

- Headlines on housing continue as the Reserve Bank of New Zealand looks to add additional risk controls specifically noting debt to income. The RBA may well follow suit.

- China is on the watch list given it is one of the primary nominated risks for financial markets. Other parts of growth in Asia are providing mixed fortunes. India may not hold the short-term promise some had hoped for.

Indications for the Australian GDP data due for release next week point firmly to a weak number, with the movement in inventory now the swing factor. Capital expenditure spending was barely positive in Q1 at 0.3%. Any pickup is far from obvious. Non mining companies suggest they are anticipating a 3.7% rise in 2017/18, though these numbers don’t always translate into reality. Mining is somewhat more predictable given the project based nature of investment and firms are allowing for a 22% fall in spending in next financial year. The decline is the legacy of the large scale LNG developments which are nearing completion.

Mining investment spending

Source: ABS, ANZ Research
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As rail became a dominant form of transport in the mid to late 1800’s a standardised time became essential. Previously there was differentiated times in towns and cities based on a local sundial or just whatever the clock said it was.  Taking this comparison to economic data, where any event or calendar impact can be variable, it plays havoc with measuring trends. Australian retail sales growth for April was reported at 3.1% year on year, much higher than expectations. The chances are that the movement in the timing of Easter is the bulk of the cause, along with the payback post the March cyclone activity on the eastern sea board. While adjustments are made, they rarely capture the complete impact. If the date of seasonal sales moves within the calendar, it also impacts on what is consumed. Apparel is the best example driven by summer and winter buying. This time, the rise in supermarket sales may be mostly due to prices as fresh food supply was restrained by the weather events.

The reality is that retail sales have no trigger for improvement, indeed the opposite applies given potential rises in tax (Medicare levy) and weak income growth.

House prices edged back in April, according to CoreLogic and the banks are subjecting their borrowers to mortgage stress tests based on higher interest rates. But what if house prices fall enough to tip investors into negative capital? At the RBA meeting next week it is almost certain rates will remain on hold. However, following on from New Zealand’s RBNZ meeting, the RBNZ’s commentary may paint a bigger picture of its assessment of the risks associated with housing.

Banks in New Zealand are required to provide data to the RBNZ on a broader range of metrics for housing lending. Sensitivity to interest rates can be readily assessed across the book. However, the central bank is more concerned because interest rates are historically low, its flexibility is restrained and that these rates have ramped up debt to income to excess levels.

Share of new lending with high debt to income (DTI) ratio

Source: Private data supplied to the RBNZ
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China continues to send out mixed signals. The official PMI implies that the economy is chugging along towards its 6.5% GDP growth target. Conversely the private index, Caixin/Markit, which samples smaller non-government enterprises shows that factory activity is contracting.  The recent sovereign downgrade highlights the persistent problem for China at this stage of its cycle, there is an inevitable slowdown in GDP or there has to be stimulus and associated debt. For financial markets, the question of whether a number of China A stocks will be included in the MSCI index, will become clearer on 20 June. However, it is fairly obvious that it is only a question of when and by how much.

Other Asian economies are experiencing mixed fortunes. South Korea has bounced back towards a 2.8-3% GDP range as exports and investment spending improve. Conversely in Singapore, a decent GDP trend is disguising a very soft household spending cycle.

Growth in India was disappointing in Q1. Many attribute this to the drag from demonetisation last year which sought to bring cash into the formal banking system. Yet the economy remains highly dependent on agriculture and government spending. The upcoming introduction of GST and other efforts to bring the economy into a tighter framework are far from easy. Nonetheless GDP growth of circa 7% is still the base case. But it is not, at this stage, another China, with the absence of a large component of fixed asset formation the most telling feature.

Sector contribution to India’s GDP

Source: CEIC, Bloomberg, ANZ Research
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Fixed Income Update

- Strong performance for Australian fixed income markets in May.

- The yield differential on Australian and US 10-year government bonds narrows with implications for the AUD.

- ASX listed bank hybrids continue to rally despite the credit downgrade last week by Standard and Poor’s.

- Low volatility in the US treasury markets signals that the Fed’s communication is judged credible.

The Australian fixed income markets posted strong performances in May, outpacing global bonds. This was due to the narrowing of the AUD-US yield spread as rates lifted in the US, while Australian rates fell driven by the divergence in monetary policies. The Federal Reserve bank in the US is still expected to raise rates at their June meeting, while the RBA is expected to hold, with the futures market pricing a 25% chance of a rate cut by year end.

Performance results for fixed income sectors in May

Source: Escala Parters, CBA, Bloomberg
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The difference between the yields offered on US and Australian 10-year government bonds has narrowed to just 16 basis points. In addition to the varied bond performance as noted above, the rate differential is a major driver of the exchange rate and over the last 20 years the dollar has followed this trend, albeit with a lag. The last time the differential was this low was in March 2001, when the Australian dollar was at US50¢ compared to US74.4¢ now. If historic trends are to hold true the spread in yield between the Australian and US 10 year government bonds is indicating that the Australian dollar is now overvalued.

Yield differential on Australian and US 10y bonds vs the exchange rate

Source: Escala Partners, Bloomberg
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The fallout from the Australian government’s budget and last week’s credit downgrade by Standard and Poors has caused a significant fall in bank equity prices and credit spread widening in senior and subordinated bonds. The Australian iTraxx (credit index) has jumped from 80 to 85 bp over the last week.  

However, despite the ratings downgrade, spreads on the bank hybrids have tightened, which suggests that these securities are predominately held by individuals who don’t take the ratings into account. Hybrid securities issued by the major banks with maturities in the middle part of the curve (2-4 years) have increased in price over the last week, with credit spreads tightening some 50bp on select securities. Macquarie Bank hybrids have also performed well, while insurance companies have been the biggest beneficiary, possibly because they didn’t have a ratings adjustment. Prices on longer dated hybrids are unchanged.

Our view is that the market is overstretched. We continue to see the benefits of holding an allocation to this sector for income generating purposes. However, for those investing in this asset class for capital gain, the inflated pricing also suggests it could be a good time to reduce holdings.

Of note is the current low levels of volatility in both equity and treasury markets. For US treasuries the MOVE index is used, which measures the weighted average of the expected volatility of 2, 5, 10 and 30-year Treasury yields. Recently, this index has dropped to 55, well below its average of 97 and only slightly higher than the record low of 49.

The question is does this low volatility in treasuries indicate that a correction is imminent.  Looking back on previous rate rising cycles, we would only expect volatility to surge and yields to spike if the market is caught off guard and the Fed raises rates more aggressively than forecast. When the Fed raised rates in the mid 1990’s, and then in 2013 (when they simultaneously announced they were winding back their quantitative easing program) the markets were caught off guard resulting in Taper Tantrum. However, when the Fed increased rates in the years 1999 – 2000 and  2004-2006, volatility actually fell.However, when the Fed increased rates in the years 1999 – 2000 and  2004-2006, volatility actually fell.

Volaitlity of the US Treasury markets in previous rate rising cycles

Source: Capital Economics, Reuters
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Using historic data, a sharp correction in volatility levels to the upside is only likely to occur if we see an unexpected change in yields. If the Fed continues to communicate well with the market and rate rises are gradual, volatility in US treasuries is likely to stay low.

Corporate Comments

- Analysis of the impact of the bank levy alongside trends in credit growth point to a likely period of modest returns for the sector.

- Retail stocks are facing a range of challenges. Can JBH emulate its big US equivalent?

- Global trends in interest rates and growth dominate the best performing ASX stocks this quarter. This contrast with the very distinct pattern in the US, most easily observed in the comparison of the S&P500 and NASDAQ.

Two debates within the domestic equity market remain under microscopic scrutiny. Have bank stocks been overly punished by the tax levy, housing risks and credit ratings? Will retail capitulate to Amazon and supermarkets indulge in a margin destructive round of competition?

The summation on the bank levy is that earnings will be 1-2% lower than previously. Regardless of suggestions that it will collect less than the government has forecast, it seems safer to assume that the methodology will be tweaked to ensure it does deliver the expected revenue.  It now comes down to the capacity to pass on this in pricing and then the trends in loan growth which determine the fundamental outlook for the banks.

From an initial reaction that much of the levy could be recaptured in stealth product pricing, the view has shifted towards a competitive landscape for quality mortgage growth. Interest only loans are still too high, representing 36% of the latest data, above APRA’s 30% guideline. Overall, housing credit is still has some way to slow down and detract from bank sector growth. A pickup in business lending is possible, though the industry sectors that undertake expansion may not fit the lending profile banks are accustomed to. Further, deposit trends show that businesses are cash rich while the growth in deposits from the household sector is fading.

In summary, it’s hard to make a case for an improvement in revenue for the banking sector. As each looks to maintain or grow share, competition is likely to erode efforts to expand margin.

Total lending growth for the big four banks

Source: Deutsche Bank, APRA Note: Based on 12m growth
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Lowering deposit rates also represents a challenge. At the margin banks are increasingly differentiating pools of savers. Smaller deposits and SMSFs are get slightly better rates than bigger sums and other entities. How far the banks can extend this remains to be seen.

The consensus view is that dividends are safe for the moment, though some analysts are entertaining the possibility of a cut. In our opinion, this would be a last resort with other ways to retain that capital, such as underwritten dividend reinvestment. Nonetheless, there is no free lunch; retaining high dividend payouts means capital has to come from elsewhere and reinvestment dilutes the potential growth in the dividend in the long run as the share count increases.

As noted before, we are of the view banks equity prices will do little more than track sideways, while still subject to downside if there is a broadly-based equity sell off. Key to managing the portfolio weight in the banks depends on the investors requirements.

The uptick in retail sales did little for the share prices as investors are focused on the challenges facing bricks and mortar retailers. Suppositions on Amazon’s impact can, for the moment, be sidelined to a discussion on the outlook for discretionary retail spending, the relevance of past formats such as discount department stores, and the competition in supermarkets with a history of one winner at any time. All of these point to a difficult period for our retail sector.

The restraint being exercised by households is well known. Without real wage growth, uncertain employment prospects and the rise in part time jobs, high debt and the increase in non-discretionary, cost such as education and health, it is not surprising that consumers are cautious.

The past growth in the number of stores in some formats is also coming back to haunt retailers. A good comparable sales growth trend invariably saw retailers look to expand their footprint along with the fear competitors would sidle alongside them to capture some of their sales. Putting their hand on any new store therefore was important and unsurprisingly property developers were encouraged to grow centres. There is little question that the number of discount stores is in excess of the community requirements. Even in supermarkets, productivity of new stores has faded and the emphasis is turning back to same store sales which can only be extracted from nearby competitors.

Of course, the impact of a behemoth such as Amazon cannot be ignored and the recent pain suffered by US department stores is evidence of what could take place here. One US retailer has been singled out as standing above this with a parallel here. Best Buys (BBY.US) is achieving positive comparable sales and been rewarded by a rerating of its earnings. The company is the world’s largest retailer of electronic products with sales of US$40bn.

The path to its share price performance has however been far from even. It required restructuring of its store base, particularly its global expansion, big cost savings ploughed into lower prices and a tight reign on cash flow (low dividend payouts for one) while undertaking buybacks as the stock traded on a low multiple.

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The opportunity is there for JB Hi-Fi (JBH) to prove its local credentials and emulate BBY’’s success. This may mean a reconsideration of its recently acquired Good Guys store base, reconfiguring its core stores towards the product base that it should emphasise, increase its service offer and retain capital for such spending. On the positive side, other smaller and less flexible retailers will lose more. Based on price comparisons, JHB is not far off Amazon on high end items, while it will need to cut its price points in lower end. The impact can be restricted to products that matter. JBH has been working on its online presence for some time and had gained a decent position from which to head off some of Amazon’s impact.

Whether these changes are captured in todays valuation is a debatable point. The stock is trading at 13X forward earnings, though this may be irrelevant given the risks lie further out. A dividend yield of 5% may need to be pared back to ensure there is capital in the kitty.

All up, it’s another lesson for the Australian equity market. Paying for profit growth from rising margins where there is an entry path for competition or changing dynamics inevitably gets unwound.  High payouts supporting high yields may not be in investors best interest.

The equity market overall is proving an idiosyncratic source of returns. In an effort to corral a theme, the past quarter has seen yield sensitive stocks recover in line with the movement in the bond market. Stocks such as Transurban, APA, Sydney Airport and Dexus are amongst the top performers.  In illustrating that the yield curve plays an important role for these company valuations, the path of global rates (up) versus Australian rates (flatter) in coming months, may be an interesting test to see if our market will value independently of global equity trends. Based on history, we should expect to follow any reversion out of the yield trade in line with global stocks.

A second feature has been the relative performance of globally oriented stocks. Last week we discussed Aristocrat, one of the stars of the quarter, along with Qantas, Amcor, Brambles and Treasury Wine. These have their own rationale, but generally have a unifying theme is low dependence on Australian household demand.

Globally the picture is quite different. Much is made of the contribution of FANG (Facebook, Amazon, Netflix, Google (Alphabet, and therefore more correctly, FANA) to the rise in the S&P 500. The contribution has been broader than that, but it is true that a few sectors are doing the heavy lifting. The relative performance differential between the NASDAQ index and the S&P500 has rarely been more pronounced at nearly 10% over the past 12 months.

NASDAQ v S&P500 - 1 year index

Source: Escala / Bloomberg
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Information Technology is 23% of the S&P500 and Computers is 43% of NASDAQ. Healthcare weights are about the same, though S&P is skewed to traditional lower growth, lower risk companies compared to biotech in NASDAQ. The large industrial sector (32% weight) contains an eclectic group of companies predominantly focused on a narrow sector and domestic growth. Conversely the S&P equivalent sectors operate under globally competitive and variable conditions. It raises the question of whether NASDAQ is going to become the more important index for non-US investors given its unique mix. The other parts of the S&P500 resemble the rest of the world. Yet the valuations are richer in the S&P and is skewing global investors towards Europe and Emerging Markets for more interesting options.

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