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WEEKEND LADDER

A summary of the week’s results

03.02.2017

Week Ending 03.02.2017

Eco Blog

-  A large trade surplus, complements of commodities, has put a floor in the AUD and points to a possible higher-than-expected mid year GDP, subject to stable domestic activity. 

-  Central bank attention is mostly on labour markets. Discussion centres on what level of unemployment may see a stronger push in wages, or whether those currently not in the labour market will hold down the wage levels as they re-enter the workforce. 

-  Consequences from the emerging US trade battleground may have secondary effects that directly affect investment portfolios.

The realisation of a trade surplus in the past quarter was not surprising, although the size of it was, with the ABS catching up with the trajectory of commodity prices. There was a broad spread across all components, while imports were, in turn, subdued.

Export Values to December 2016

Source: ANZ, ABS
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This feeds into a higher AUD, as the funding requirement for the current account deficit will be much smaller. The current account has remained in deficit for 25 years due to investment and government spending that has to come from external flows. While the Australian saving rate is adequate, it is not enough to balance out the capital requirements. Nonetheless, with the completion of the bulk of LNG projects reaching completion in the coming year and possible extension of the commodity cycle, the current account looks set to improve into the middle of the year.

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The AUD is likely to be capped by weak inflation and a flat rate outlook, but we flag a possible run in the currency if this trade surplus grows and nominal GDP jumps more than expected. In another release, housing approvals levelled off, yet the activity and therefore, GDP contribution, should linger until at least mid year.

The AUD exchange rate will also be affected by external economic trends. While the USD recently took a small hit, essentially from sentiment rather than fundamental issues, the data from the US remains upbeat. This does not mean a return to what some believe is ‘normal’ levels of GDP, as it is dependent on productivity alongside employment growth. Some of the modest gains in productivity are now diminished by the growth in unit labour costs, up 2.6% in 2016; the highest rise since 2007.

The interchange in these dynamics reduce the confidence in exchange rates. Bar the USD, which is judged to be around 10% above its long term value, and the GBP, which is about 15% undervalued, the other cross currencies are assessed to be within their valuation ranges.

Globally, central banks did little to sway views after their gatherings this week. The FOMC meeting in the US confirmed expectations rates would likely rise in June and again in December, with a few outliers of the view that three rises are possible. The monetary path in the US may be complicated not only by fiscal spending, but also the question of what happens to the Fed’s balance sheet, still holding US$4.5tr in treasuries ($2.5tr) and agency mortgage backed securities ($1.7tr).  A few Fed members have hinted that these holdings would become part of monetary management when rates reached 1-1.5%. This may cause a lag in the pace of rate hikes into 2018, as the implicit tightening from realising the balance sheet will weigh on the economy. 

The MPC (monetary policy committee) in the UK held rates at 0.25%, but upped economic growth to 2% for 2017 from 1.4%, pointing to the lower than expected impact from Brexit. Of note was the move to ‘equilibrium’ unemployment of 4.5%, rather than 5%. Given the rate is currently 4.8%, this may seem as somewhat irrelevant. However, it gets to an issue also raised by the new US administration. What is the unemployment rate really measuring in terms of slack in the labour market and economic health in general? The rise in the service sector has increased the part time employment mix and so-called underemployment points to a potential rise in labour use through hours worked, rather than new employees. The participation rate has also fallen in many developed countries. A rise in hours worked and a return to the labour market by the disengaged could see employment rise without much move in the unemployment rate. The majority of those that moved out of the labour market post 2007 were lower skilled/older men and their return will be dependent on the type of jobs that need to be filled.

We have had inbound enquiries on the consequence of the actions from the new US administration. Our comments are on the economic possibilities, rather than any judgement on their policy itself.

The headline questions are:

•  Will US economic growth accelerate enough to matter?;

•  What will happen to global trade?; and

•  And what are the other impacts of these?

There are a multiple of other issues, but these are not directly linked to the policy of the US administration.

US growth, as had been widely noted, has been improving for some time. It has not reached the heights that some expected for structural reasons (demographics, debt, etc). Naturally, the suggested levels of infrastructure spending, arm twisting on local manufacture and possible tax breaks may give the economy another boost. That has to be offset by higher debt, higher costs – wages and inflation from substitution effects - and tariffs. Most of the impact is likely to be in late 2017 and into 2018, with a small step up in the GDP growth rate to 2.5-3% quite possible.

Global trade is naturally more complex. Mexico is bearing the brunt, but that has limited global repercussions. German auto manufacture for export to the US is unlikely to have a major economic impact. It therefore points to a much broader trade barrier and tariff policy and focused on China. Here things could spiral if China, in a year that matters due to changes in the Politburo, decides to rebut the actions of the US. At this stage, there is no clarity on what could or might occur, but it would be remiss not to have this front of mind. As noted above, trade itself is only one component of capital flows. In the case of the US, its trade deficit is a function of its high level of imports for domestic consumption, rather than a shortage of exports. 

Further, like Australia, the US runs a deficit in funding capital flows. Forcing changes to trade may prove counter productive. At its extreme, a number of South American countries created trade barriers to protect local jobs in the 1990s. This had an unhappy ending. 

Inflation stands out as the most probable economic consequence of the above measures. That means that bond market and currencies will feature heavily in sentiment this year.

As noted in our Asset Allocation January report, equities are vulnerable given the change in the risk free rate. With such a large component of the past five year equity rally coming from multiple expansion, a contraction in multiples, even if earnings don’t change much, is perfectly normal. In other circumstances the acceleration in global growth and normalization of inflation would be positive for equity assets. The difference this time is the extent of the cycle already behind us and the pricing of equities. That has underpinned our view that portfolios should be close to their strategic equity weight and not overweight.

Fixed Income Update

-  Bond markets remain under pressure, notwithstanding short term relief.

-  Credit is considered the best spot, straddling the benefit of higher global growth and the potential of a further contraction of spreads and high demand for these securities. 

While attending the Financial Standard Chief Economists Forum this week, it became clear that the consensus view from many fixed income market participants is one of higher growth, higher inflation and higher interest rates in 2017.

Rates have been heading higher since September last year, which has caused a fall in the prices of fixed rate bonds given the inverse relationship between yields and price. The 10 year Australian Commonwealth Government Bond moved from $130 to $119 in the last three months. The rise in the 10 year ACGB yield is illustrated here against the price fall in the same bond to depict the impact that these higher rates are having on the bond price.

Yield (LHS) and Price (RHS) of 10 Year Australian Government Bond

Source: Iress, Escala Partners
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A consensus market view on interest rates does not mean that it is going to prevail. However, if proved correct, the coming months could be challenging for sovereign bonds as yields rise further. Many suggest that a pull back in rates might present an opportunity to reduce exposures to duration within portfolios, particularly where duration is derived from sovereign bond debt (as opposed to corporates) in the US, Australia and Europe.

Higher growth and inflation, while a headwind for sovereign bonds, is supportive (at least in the short term) for corporate credit. Credit spread tightening on investment grade debt has aided corporate bond prices to date and managed funds representing at the forum believe this is set to continue over the next few months. Arguably, they are simply stating their portfolios positions, which are overweight high grade and high yield corporate debt and underweight to sovereign debt. The chart below illustrates the credit spread tightening that has taken place over the last three months in the Australian investment grade credit market, as represented by the iTraxx index.

iTraxx Index

Source: Bloomberg, Escala Partners
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While we concur with the likelihood of these macro themes playing out in the first half of 2017, if global yields rise too high, or too quickly, this will put pressure on corporate profits and may result in a reversal of this spread tightening trend. However, it should be noted that US credit spreads have held up well considering the record amounts of corporate debt supply that has been issued out of the US since the beginning of the year. Corporate bond volumes are at their highs, an encouraging sign that liquidity is present.

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In the domestic listed hybrid market this week, Tabcorp Holdings announced its intention to redeem all outstanding Tabcorp Subordinated Notes (ASX: TAHHB) at its upcoming call date. An extract from the official statement is noted below.

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Corporate Comments

-  Downer EDI (DOW) delivered a first half result ahead of expectations, however the stock’s valuation is now pushing the upper boundaries for a cyclical company. 

-  Aconex (ACX) disappointed with a trading update and investor confidence is likely to take time to be restored.

-  Tabcorp (TAH) missed expectations with its result. The outcome and delivery of its proposed acquisition of Tatts Group (TTS) will be the key medium term driver of the share price.

-  James Hardie (JHX) also missed with its result, yet its operating environment in the US remains supportive.

-  QBE has denied takeover speculation and the stock remains a useful hedge in portfolios against rising rates.

Downer EDI (DOW) kicked off the first half reporting season on a positive note, with a solid result ahead of expectations and an earnings upgrade to the company’s full year guidance, leading to a 13% bounce in share price. Profit growth of 9% for the half was primarily driven by the group’s non-resources related exposures, including transport (roads and rail infrastructure) and technology and communication services. Despite the rebound in commodity prices over the last year, the contribution from its mining division was lower again, with Fortescue’s transition to an owner operator model at its Christmas Creek iron ore mine impacting revenues.

Other positives from DOW’s result included good cash flow conversion, an increase in work in hand (see following chart) and a stronger balance sheet with little net debt. This provides some optionality for capital management or for acquisitions over time. 

Downer EDI: Work in Hand by Service Line

Source: Downer EDI
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Downer has managed the downturn in activity across the resources sector as well as could be expected over the last several years and management have been rewarded for a sharp focus on costs, diversifying its market exposure and providing an honest assessment of market conditions by issuing conservative guidance through the years. Nonetheless, while there is the prospect of a better earnings environment in the medium term, after a sharp earnings multiple re-rate (from less than 10X a year ago to 17X today) over the last 12 months, in our view, this improved outlook is more than reflected in the current share price.

The positive share price reaction was in contrast to the sharp sell down in one-time market darling Aconex (ACX), which provides cloud collaboration platform software to the construction industry. The quantum of its downgrade was perhaps the most surprising aspect, particularly given that management had forecast earnings visibility for FY17 of in excess of 70% when reporting full year results last August. The subscription based nature of its typical agreements was thought to underpin this forecast. Several factors were cited for the downgrade, including the uncertain environment that has been created by Brexit and the US election.

Investors have been attracted to Aconex due to its market leading product, large market opportunity, high growth rates, scalable business model and high margins. A lack of similar local investment opportunities may have also played a part in the stock’s strong run to mid-2016.

While it has undoubtedly had very positive quality characteristics, the most challenging aspect is applying an appropriate valuation measure, with a wide range of potential earnings outcomes that could materialise for the company over the medium term. The stock was previously trading at the more optimistic end of these forecasts, which had been built on considerable earnings momentum. While the current weak performance may simply be a short term cyclical issue that will be overcome, the confidence of investors in management is likely to take time to repair.

Tabcorp’s (TAH) result was slightly below par, with underlying earnings growth of 5% for the half. Earnings from the group’s core wagering division grew at a slower 3% rate, with growth in digital (online/mobiles) turnover offsetting the ongoing declines in TAH’s retail outlets. The transition to digital betting (which has followed the high penetration of smart phones) has been a positive for the wagering industry. For TAH, a cost is the fact that its retail outlets (a key point of difference with its competitors) are losing overall market share. The lower barriers to entry within the digital medium has led to exponential growth in advertising, higher levels of competition and reduced margins.

Tabcorp is looking to turn the tables on these predominantly UK-based wagering companies by launching its own brand in the UK, Sun Bets, which is a partnership with News Corp. While it remains in its infancy (having launched last August), the losses from this investment have initially been higher than anticipated and may drag on earnings in the medium term.

Of course, the most important short term driver will be the proposed tie-up with Tatts Group (TTS), with an ACCC decision on the deal expected later this month and completion by the middle of this year. With a relatively benign earnings outlook, the realisation of synergies from combining the two companies will be a key factor for investors.

Building products company James Hardie’s (JHX) quarterly result was also below expectations, with similar issues that caused management to lower its profit guidance at its half year. The company’s top line growth was strong in its key North American division, again outpacing broader market growth. However, costs were higher than anticipated, which included accelerated and higher than planned manufacturing start-up costs ahead of a better demand environment. Key input costs were also higher, including pulp, cement, electricity and gas.

James Hardie: North America Input Costs

Source: James Hardie
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The positive for James Hardie is that is continues to generate impressive revenue growth, however, operationally its performance has been weaker. JHX had previously managed its manufacturing capacity well when markets were weak or falling, although has disappointed somewhat when conditions have improved. Resolving these issues would point towards a better profit outcome through FY18, while forecast price increases will assist in some margin recovery.

Speculation that Allianz had held takeover discussions with QBE Insurance gave the potential acquiree a boost this week, despite a denial from the company. QBE has been the best domestic example of the reflation/higher interest rates trade, with an earnings boost expected in coming years from its short-term fixed income investment portfolio as rates climb, particularly in the US. QBE has had a chequered recent history in what has been a relatively difficult global insurance environment and thus it is difficult to recommend the stock as a long-term core investment for Australian equities portfolios. At this point of time, however, we believe that the stock remains a worthwhile short term hedge for domestic portfolios against further upward pressure on rates, given the large part of the market that is negatively impacted by such an outcome.

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