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WEEKEND LADDER

A summary of the week’s results

02.11.2018

Week Ending 02.11.2018

Eco Blog

- Australian economic trends cement in a modest outlook. The CPI is soft, the domestic credit pulse is weak, while housing approvals point to a mid-2019 fall in activity.

Australian economic data sustains the pattern of portraying a soft, but acceptable tone. At a headline level, the CPI came in at 0.4% for the quarter, or 1.9% at an annualised rate. The trimmed mean was a touch lower at 1.8%. Childcare deducted 0.2% in the quarter as the new subsidy led to a 11.8% decline in prices. On the upward trajectory are fruit and vegetable prices, presumably reflecting weather conditions, while travel charges, particularly international airfares, have risen 4.1% yoy. Notably, utility prices are benign at 1.9% yoy, though are likely to change into Q4.

  • The summation is that inflation is below the RBA band and serves to reinforce the official flat rate expectations.

Private sector credit increased by 4.6% p.a. Housing expanded by 5.2% with the investor component barely positive. Business sector credit growth appears to be stabilising at 4-5%, though not enough to support an emerging capital investment theme.

Australian Private Sector Credit Growth

Source: RBA, ANZ Research
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  • Slowing lending will restrain growth, yet it is well accepted that the household sector should deleverage given the debt growth in recent years. Short term pain for long term gain.

As usual, housing approvals were mixed. Apartments snapped back, with Victoria registering an outsized gain. Nonetheless, this still leaves a downward trend and approvals may not result in a build. The pattern suggests that residential construction activity could persist into mid-2019 before the impact on GDP is obvious.

  • Most investment managers are of a similar predisposition, mulling opportunities that have a low reliance on domestic growth.

The US Employment Cost Index rose by 2.8% yoy, continuing its upward gentle acceleration. The well-followed Atlanta Fed wage tracker aggregates a number of wage cost indicators, which show a consolidation in growth at the high 2% level. The bulk of the activity in both labour market growth and wages has been in services.

Wage growth tracker, weighted series

Source: Current Population Survey, Bureau of Labour Statistics
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The fall in unemployment to below 4% was considered a trigger for wage growth. Instead, participation has picked up and workers appear too disorganised to demand higher salaries. Similarly, it is clear that companies did not recycle tax cuts into benefits to their workers, in contrast to the comments made at the time. It may well be that productivity gains, the informal nature of the job market and skew to services contain wage growth for this full economic cycle.

  • Comments from US companies after their Q3 profit reports included cost pressure from raw materials and tariffs, particularly steel. So far they suggest that they have passed these on in prices, but stated that further price rises would become harder. If so, profit margins will turn.

The consistent message from China is edging towards more stimulus. The most recent Politburo meeting noted the economic slowdown, but the rhetoric was also clear that the rate of growth would not subsume the quality of growth. Reports from local governments reinforce this mix of goals. They are being told that environmental restraints would continue to apply, while also being asked to show growth in investment.

Further fiscal measures are expected into 2019. The government has recently clamped down on tax avoidance for very high income groups and a new tax ruling for expatriates that live in China for more than half a year. It signals another step in income redistribution, with more tax cuts expected for lower income subsets and small business.

There are two other key areas to watch. So far, property prices and sales volumes have held up. Any hint of weakness may result in an easing of restrictions posed on residential investments. 

Property price index yoy % change

Source: Deutsche Bank, NBS, WIND
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The other is infrastructure spending. Many have noted the low headline growth in fixed asset investment of 5.4% year to date. In fact, private spending, manufacturing and property investment has been growing at up to at 8.9% this year. It is the 3.3% growth in infrastructure that has held back the total growth. The authorities have been concerned on the misallocation of capital at a local level, combined with corruption and debt levels at state-owned enterprises. Construction companies within the recent reporting season have noted an upturn in forward orders, which points to an uplift in local spending.

  • The outlook for China is finely balanced and unusually dependent on confidence and sentiment. Nonetheless, the government has the wherewithal to support cyclical softness in the hope external conditions settle down.

In the meantime there are some signs that manufacturing activity in Europe has bottomed. Germany, as the powerhouse, saw a meaningful softness in Q3. That is mostly ascribed to the auto sector that has reset to the new Worldwide Harmonised Light Vehicle Test Procedure and dragged down auto production. It also raised the integrated nature of the European supply chain where countries from UK to Slovenia experienced softer manufacturing output in the quarter.

German monthly new car registrations

Source: Autovista Group
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Services remain relatively stable, particularly pricing which has resulted in a lift in inflation.

Overall growth may remain modest, but it appears that the trajectory will, at worst, flatten out rather than continue a falling trend. That said, of all the major regions, Europe looks ill-positioned to cope with a downturn or to turn on the fiscal tap. The disunity in approach is telling and with a new head of the ECB in 2019 there is some uncertainty on monetary support.

  • Europe failed to build on its unusual strength from 2017, lacking a coherent policy to rally business into investment spending. Nonetheless, the conditions are not as dire as painted by the constant political headlines. Global fund managers remain cautiously allocated to the region, citing a lack of interesting opportunities rather than business conditions.

Focus on ETFs

- Passive ETFs aim to replicate the performance (after fees) of specific indexes. The performance inevitably consists of capital growth and income returns. How well an ETF replicates this mix will be determined by multiple facets, which can be used a guide in selecting an appropriate ETF.

There are a wide range of ETFs that can be used for income and investors can look at past distributions to assess that metric. However, is not always the most accurate method for evaluating an ETF’s yield. ETFs will usually pay dividends based upon dividends of underlying holdings. Yet some ETFs can pay distributions which differ from dividends, as they are a return of capital from trading the securities. The frequency of these trades depends on the methodology of the fund and can have a tax impact. ETFs often hold many securities they can be required to trade throughout the year. This selling can cause gains, which ETF providers will need to pay out as capital gains distributions. These anomalies can distort distributions and this could be the case with sector specific ETFs that were affected by the October GICS reshuffle, especially with the tech companies that have shown significant capital growth in the past few years. 

Dividends for Australian based equities ETFs play a large part of the overall performance. iShares S&P/ASX 200 ETF (IOZ) and SPDR ASX200 ETF (STW) both follow the ASX200 and therefore, should produce similar income returns. STW changed to paying income on a semi-annual basis to quarterly in 2016. IOZ has a spike in income in 2015 due to the ETF moving from the the MSCI Australia 200 Index to the S&PASX200. Consequently, the history of distributions is affected.

Dividend amounts  & Franked Components of large cap Australian ETFs

Source: IRESS, Morningstar
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As the above chart also demonstrates STW has a slightly lower yield, however, it has the higher franked dividend component and may therefore suit investors that can optimise franking.

There is always the option of reinvesting the income distributions paid. The reinvestment decision should reflect your overall investment needs, should an investor be using an ETF income purposes then accepting the cash would be in their best needs. However, for those investors using ETFs for long term investments dividend reinvestment plans can help to optimise long term performance.

Fixed Income

- US and Australian bond yields diverge in October, with bond prices in Australia finishing the month up whilst the US rates market falls.

- We discuss the offshore leveraged loan (bank loan) market and the factors that have and will drive credit spreads.

- CBA come to market with a new ASX listed bank hybrid.

October was a somewhat bumpy month for bond yields. The month began with a sharp rise in interest rates, with the US 10-year Treasury yield gaining 15bp within three days. Equity weakness followed in response to the higher ‘risk free rate’ and bonds subsequently strengthened, leaving yields just 4bp higher by the end of the month. The yield curve, however, steepened over the month with 30-year Treasury yields tracking higher, while the short end of the curve was broadly unchanged.

In contrast, the domestic 10-year government bond yield fell 10 bp over the month, which has boded well for performance of Australian funds with a long duration bias. These lower yields have shifted out the prospective timing of rate rises by the RBA. At the beginning of the month, the futures market was assigning a probability of close to 80% that the RBA would raise rates by November next year; this was lowered to 64% by the end of the month. Domestic credit spreads widened over the month, with the Australian iTraxx index trending up to 82bp from 76bp.

US and Australian 10year govt bond yields in October

Source: Bloomberg, Escala Partners
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  • Australian funds with long duration have benefitted from the lower rates over the month leading to positive performance. Results for credit and offshore bond funds have been mixed.

In the last few years there has been significant growth in the offshore leveraged loan market. These are loans to companies that have credit ratings below investment grade and are typically secured against the company’s assets. A search for yield and the floating rate structure of these deals in a rising rate environment has attracted capital. Further, strong earnings growth, improved interest coverage ratios and low default rates have spurred demand and subsequently tightened credit spreads. The medium interest coverage ratios (ICR) of loans is at 4.3x, well above levels considered ‘stressed’ and consistent with periods of high default rates (of around 2x). The number of lower-rated borrowers (CCC rated) in the market is also below historic averages. The market appears healthy based on these metrics. 

Tracking the periphery: Few issuers report interest coverage

Source: ICE BofA Merrill Lynch, Credit Suisse, Factset, Guggenheim
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The high leverage of these loans and weaker covenants has attracted the attention of the Fed, Bank of England, International Monetary Fund and Bank of International Settlements. Debt ratios of companies have risen, with around 50% of the US and 60% of the European market reporting outstanding debt at 5X EBITDA, surpassing pre-financial crisis levels.

The heightened demand for these products has led to a rise in “covenant-lite” structures, as lenders compete for deals and give up some protections such as posting collateral, restricting asset transfers and repayments of loans when the company is in breach of set interest coverage ratios or debt to EBITDA levels. Moody’s believe weaker covenant quality may lead to a reduction in recovery rates should a bankruptcy occur.

As the Fed raises interest rates we expect this will create headwinds for loans which are floating rate. The borrowing company’s cost of funding will rise, interest coverage ratios will fall and it is likely that earnings growth will slow. The high debt levels within the sector and lighter covenants may also have an impact. However, it is expected to take a year or two to take effect.

  • We rely heavily on the expertise of specialist funds (such as the Bentham Global Income Fund) to do the due diligence on these complex debt instruments and avoid bad loans. Credit spread widening is likely as rates rise and one should be cautious of sizing into this sector at this time. Instead, we wait for opportunities to increase allocations. 

As expected, CBA began marketing this week with a new capital note (Commonwealth Bank Perls XI, CBAPH) with an expected maturity (issuer call) in 5.5 years at a margin of BBSW + 3.70%-3.90%. The pricing is in line with other similar issues, such as ANZPG.  

  • For those that don’t need volume, there are some compelling secondary market options available such as CBAPD which are shorter (four years) and at a margin of +3.7%. However, for those seeking a sizeable parcel, we note the difficulty in getting set at an acceptable price in secondary trading; which the new issue may be more appropriate for these investors. Any legislative changes to franking credits will also affect the pricing of hybrids and should be considered.

Corporate Comments

- Results of the major banks illustrated the various Royal Commission impacts: direct legal costs, client remediation and slowing mortgage lending growth. Key points of differentiation reside in their respective capital positions and dividend policies.

- Macquarie Group (MQG) lifted its full year guidance at its half year result, which showed a pickup in transactional activity.

- The strength of balance sheets in the mining sector is now translating into special dividends and share buybacks. BHP Billiton joined this theme this week with a material shareholder return announcement.

The banks’ half year reporting season was expected to produce a messy set of results, which proved to be the case with ANZ and NAB this week. The reported figures were impacted by long list of ‘one-off’ costs, including restructuring, costs related to the Royal Commission (RC) and associated client remediation that has followed. While these material items were a drag on the headline figures, the half was also the first period whereby the transition to tighter lending standards (in response to the RC) was visible through another leg down in mortgage lending growth.

ANZ’s result was judged to be in-line with consensus and respectable given the fairly challenging environment. Underlying revenue and costs were both down, reflecting both the bank’s ongoing strategy to de-risk its exposure to institutional lending as well as weak industry-wide credit growth. The key positives to come out of the result were a solid performance on costs and another benefit from falling bad debts (itself an outcome of its strategy), with this charge falling to a post-GFC low, helping ANZ to catch up with the rest of the industry after it had been lagging on this measure in recent periods.

ANZ’s key differentiator with the rest of the sector is in its capital position. Compared to the other majors, it was an early mover in terms of rebalancing its portfolio and completing asset sales while additionally re-basing its dividend and payout ratio at a time while its peers held dividends stable. Consequently, its CET1 ratio now stands at 11.4% (well above the new APRA target of 10.5%), while the completion of remaining announced asset sales will boost this by a further 0.5%.

A flat dividend for FY18 reflected the somewhat uncertain outlook in the short to medium term, however this capital position has given it flexibility with regards to capital management. There is a growing expectation that this will allow ANZ to extend its current $3bn buyback program, although a lack of franking credits will mean that this is more likely to be on-market

NAB’s first half was likewise broadly inline, with a 2% decline in underlying cash earnings and a flat dividend. As with ANZ, the retail banking division was the primary drag on earnings, while its traditional core strength of the business bank reported a modest 3% increase in profit, helping to alleviate some of the headwinds. The year was characterised by a temporary lift in investment spend as the bank restructures to increase productivity and automation of some functions, helping it to reach it 4,000 employee reduction by the end of FY20.

NAB: Profit Growth by Division

Source: NAB
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The benefits from this program are expected to flow through over the next two financial years, with NAB guiding towards flat expense growth over this time period. As with the rest of the sector, revenue growth remains relatively benign and thus the operating cost leverage to an improvement in profit could be somewhat limited. In the current low-growth environment, the dividend has greater significance for the banks and NAB appears attractive on a yield of 7.8% and a P/E discount to the other majors.

This likely reflects the ongoing concern over its high payout ratio of close to 100% and its weaker capital position relative to its peers. With this in mind, NAB can be regarded as the highest risk/reward option among the majors; a successful execution of its strategy could see earnings growth and its relative valuation close, while the downside situation from the various challenges could see a dividend cut and sell off in the stock.

The challenges of the major banks were in contrast to that of Macquarie Group (MQG), with another commendable half year result and an uplift to its full year guidance, in keeping with the company’s recent trend of issuing conservative guidance. It was the more cyclical or transactional divisions that provided the uplift to MQG in the half, being Commodities and Global Markets and Macquarie Capital. Earnings in Macquarie Asset Management (MAM) declined, although this was due to lower performance fees (which can be volatile from period to period), with base fees higher on a growing FUM base.

MQG’s share price held up relatively well through October given its inherent leverage to asset prices (including the equity market) and the recent pullback may limit the positive earnings revisions that will filter through over the next week. Among ASX-listed financial stocks, we believe that it offers a diversified and more favourable outlook compared to the major banks (which have multiple headwinds). We have the stock in our model equity portfolio.

Macquarie: Earnings Waterfall

Source: Macquarie Group
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BHP Billiton’s US$10.4 shareholder return announcement should have come as little surprise to investors who have recently been following the stock, as the company had previously foreshadowed returning the proceeds from the sale of its US shale energy portfolio. It also followed similar announcements from Rio Tinto and Fortescue Metals, reflecting the higher preference mining companies have been giving to maximising shareholder returns in the current commodity recovery upswing.

For BHP, the key unknown was the composition of the proceeds in terms of special dividends and/or a buyback of its ASX or UK-listed stock. The proceeds are to be evenly split between a special dividend to all shareholders and an off-market buyback its ASX shares.

In the past, buybacks of the UK-listed stock have made more sense for BHP and Rio given the premium that the local listings have traded. In this instance, the decision is likely to have been influenced by the potential change in franking credit policy for Australian investors following next year’s Federal election (as we highlighted in a recent note) as its franking credit balance would consequently be less valuable.

While a higher buyback proportion would have been more preferable for long term investors than the one-time sugar hit of a special dividend, the US$5.2bn buyback will nonetheless still be circa. 5% accretive to EPS. Further, with the company retaining a sound balance sheet and gearing at the low end of its target range, additional buybacks and shareholder returns may be anticipated if commodity prices remain supportive. With upside from spot pricing, a fair valuation of <6X forward EV/EBITDA and capital management optionality, we continue to believe that an allocation in domestic equity portfolios is warranted.

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