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WEEKEND LADDER

A summary of the week’s results

03.03.2017

Week Ending 03.03.2017

Eco Blog

China is likely to portray a stable, but progressive, path for its economy at this weekend’s Congress. Dealing with excess capacity and associated industry debt is high on the agenda. 

- US domestic policy is proving highly complex for the new administration. Reforms are headbutting the budget and there are flow on ramifications for the household sector. Trade battles are just as complicated.

- Europe is about politics this year and it may well crystalise the future of the currency union.

At recent economic presentations, there are three dominant topics: 1) expectations for China; 2) US policy implications; and 3) what will happen in Europe this year.

China will hold its National People’s Congress over this weekend. From an economic point of view, the expected official GDP growth number may attract some attention. It will probably be set at 6.5% (compared to a range of 6.5% to 7%), though the language may matter more. The emphasis on ‘prudent, balanced, stable’ growth suggests that the authorities are unlikely to make significant changes prior to the 19th National Congress of the Communist Party in November. However, they may reinforce their willingness to reduce excess capacity and restrain credit growth. These two aims go hand in hand, as there has been a misallocation of capital to industries with spare capacity, which is now proving a drag on the economy and is the likely source of any bad debt problems in the future.

The problem of spare capacity has been highlighted from within the system. Back in 2014, the State Information Centre provided an indication. The list is skewed to heavy industry and state owned organisations.

Overcapacity in Chinese Industries

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Others have compiled longer lists based on low return on assets, high liabilities and the proportion of loss making firms. Again, the same culprits feature in mining and basic industries.

As we have previously noted, the reduction in capacity in steel has worked in Australia’s favour, with improved profitability pulling along iron ore prices. Now that demand has improved, the question is whether this capacity will slowly find its way back into production. This fine balance between improved demand for steel, supply constraint and profitability is key to extend the iron ore rally and implicitly lift Australian GDP.

The high level of private sector debt in China is a frequent topic. Apart from longstanding China bears, most believe it can be handled, as the bulk sits with local governments and state enterprises. In effect, some form of nationalisation is probable. On the other hand, the progressive move to opening up the current account is seen as a positive, with a long term aim of a floating currency.

The consensus view is that until the healthcare act is resolved, other major initiatives from the US administration will be muted. The US budget is likely to become a major point of tension within Congress as it grapples with the inevitable pressures of receipts versus spending. In this financial year, revenue from personal and payroll taxes are running above their historic average, while corporate tax is 3% below its average.

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The other side of the equation, naturally, also presents challenges. The Office of Management and Budget (OMB) states that 70% of the budget is ‘mandatory’, that is, based on laws and not approved by Congress. The bulk is net interest expense, medicare, social services and education. There are likely to be savings that can be made to the implementation of the programmes, but, as a whole, the spending is set. Discretionary spending is dominated by defense at 49% of the total, followed by the component of programmes in education and health that are not set by law. The rump is environmental, science and space programmes, transport and agriculture. Many of these are likely to be attacked as unnecessary, but will also inevitably hit some states and interest groups hard if wound back. Congress members are likely to go into battle to protect their turf.

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Economists therefore believe it will be well into 2018 before much impact from domestic policy comes a reality. That has not stopped investment markets from anticipating outcomes and points to the probability that equity returns have run ahead of the reality.

Trade issues are just as complicated. Bilateral arrangements (as a substitute for regional ones such as the TPP) will take years to come about. This implies the administration may choose selected high profile areas, while by and large adhering to existing conditions. Even though some form of tariff or barrier is part and parcel of everyday trade, reporting is likely to focus much more on this issue now. That, in turn, risks a tit-for-tat and escalation into a bigger agenda. In reality, it is hard to see how the US can put an import tax or tariff in place without hurting consumers.

On the Fed, there is a growing consensus that rate hikes will be more frequent than currently priced into markets, reinforced by the strong jobs numbers this week. Along with many current issues, this is messy, given the changing composition of the members and the unknown implications on inflation of any domestic policies.

With European growth improving substantially to the point that inflation in Germany has reached an uncomfortable level, it would be a pity if the momentum were ruined by messy politics. The Netherlands will set the tone this month (with a general election on March 15), though a difficult coalition is inevitable. France will follow and while the number of candidates is small, the likely win by the anti-EU Le Pen in the first round may raise concerns. French are dedicated voters, with a turnout of some 80%. The sheer level of voters Le Pen must convert makes her success in the second round less likely. Macron may therefore emerge as the winner with a proposed agenda to reform the institutions in the EU. If Merkel in Germany holds on for a last term, some economists believe the chances of reform in Europe are enhanced, given this will be her last chance to make it work. In the long run, currency unions don’t hold up, but there is a possible smaller and better aligned group that could emerge.

Fixed Income Update

Hybrid deal issuance continued this week with a new tier 1 security by Challenger.

- Macquarie Bank followed in ANZ’s footsteps with a USD tier 1 bank hybrid issue.

- Credit spreads have contracted to their lowest level in two years. Does this mark the bottom of the range?

The new issue pipeline in the domestic listed debt market remained buoyant this week, with the announcement of a new tier 1 security by Challenger Limited. This will be new supply for the market, but with an expected issue size of $350m, the impact on other secondary securities should be minimal. It is a relatively long-dated capital note, marketed at BBSW +4.4% - 4.6%, with a call date after 6 ¼ years, or conversion to equity two years subsequently. The length of the note, the credit rating of this issuer and the small issue size lends itself to a riskier investment opportunity for those with a tolerance for potential volatility in the pursuit of higher returns.

Last year, ANZ brought an inaugural USD bank hybrid to market. This was the first by an Australian bank, as regulatory requirements in offshore markets have made issuing in this part of the capital structure a challenge, as taxable USD-denominated revenues are required. The security was a mandatory convertible bond, with a fixed rate coupon at 6.75% and the first call date in ten years. The fixed rate structure, USD currency risk and lengthy maturity has resulted in volatility in the capital price for Australian investors; albeit, so far it has been a very successful transaction, remaining above its issue price since inception.

ANZ Tier 1 Bank Hybrid

Source: Bloomberg, Escala Partners
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Following that lead, Macquarie Bank announced a similar bond, with an issue size of $750m, a coupon range of 6.125% and a call date after ten years. Demand was extremely high, with the order book said to have been at over US$10bn.

February was a healthy month in terms of performance for fixed income assets. Bond yields stabilised in Australia and softened in the US, supporting asset prices. The real outperformance came from credit spread tightening, which has been broadly contracting since February last year. As a reminder, the credit spread on a bond is the premium above the risk free rate and paid to the investor for taking on the credit risk of the issuer. When looking at a longer term chart of these moves for a basket of investment grade credit (the iTraxx index), the current low point looks dangerously close to previous cycles which marked the bottom of the trend. Caution should be taken when adding to credit portfolios in this environment.

iTraxx Index

Source: Bloomberg, Escala Partners
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Corporate Comments

Harvey Norman’s (HVN) poor corporate governance has been masked by a favourable cyclical conditions.

- Lendlease (LLC) beat expectations and has retained a good pipeline of work that underpins its forward outlook.

- QBE’s environment is stabilising, allowing earnings growth to be supported by cost out and rising investment yields.

- Spotless (SPO) disappointed again with its result and faces an uphill battle to restore investor confidence.

Let us be upfront. Harvey Norman (HVN) screens poorly on governance with complex disclosure and a lack of independence on the board. The half year result took this one step further, with investment bank analysts denied any opportunity to question anything from the formal announcement.  We make mention of this as it can influence portfolios.

Investment bank analysts tend to relay what is stated by companies, many times without confronting issues to avoid alienating their relationship with the company. On the other hand, companies can give a stilted set of responses to queries rather than admitting any failure or uncertainty. We have therefore shifted from relying on analysts and direct stock calls towards balancing portfolios with managed accounts and funds where the portfolio manager and team can assess companies independent of this feedback loop. Mostly this involves contact with suppliers, customers and competitors. Nothing is fail safe, yet it is worthwhile to at least exclude contradictory evidence.

Harvey Norman does not want its case examined. The confusion is about the relationship with its Australian based franchisees where the arrangements are atypical. They do not have any ownership rights over the franchise; their working capital is part of HVN and they can accrue ‘support’ if the franchise is not achieving returns (without indications on these returns). Additionally, the corporate entity has invested in a holiday resort in Byron Bay, an agricultural company and resource sector housing, amongst other sidelines. By and large these have required writedowns, and while small, raise the question why the decision was made in the first place.

All this, in our view, obscures the merits of the group. Gearing is low, the product offer has proven relatively resilient to e-commerce and the group own property assets. It is a decent path to investing in housing-related cycles. Managed funds tend to take selective positions when conditions are favourable; whereas a direct portfolio would, in our view, struggle to assess the investment case.

Lendlease’s (LLC) half year result was viewed favourably by investors, with a profit beat leading to modest earnings upgrades from analysts. Profit growth of 12% was a commendable result, taking into consideration a much higher tax charge. Enthusiasm was tempered by the fact that the company’s profits were boosted by an asset sale. As we have noted before, this is not an atypical outcome for LLC, with earnings from asset recycling leading to a fairly lumpy profit profile over time.

LLC again spoke to confidence in its outlook from the high level visibility that it has across its business divisions. The company’s investments division (~40% of earnings) provides an annuity-like revenue stream base, while the construction and development divisions are more cyclical in nature. While its development arm has been strong and supported by its domestic apartment projects, the construction outlook is improving, as illustrated by the expected future spend on large road and rail projects in Australia. A number of tenders are expected to be announced shortly for Melbourne, including the Metro Rail and Western Distributor, providing a catalyst for the stock in coming months.

Australian Engineering Outlook

Source: Lendlease, ABS
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The primary investor concern on LLC’s outlook has been on the risks of its domestic apartment development business. With a high level of supply coming to the market in a short space of time and supported by offshore (particularly Chinese) buyers, some had predicted a spike in default rates on LLC’s presales. This is yet to materialise, with LLC’s default rate less than 1% for the period and below its historical average of approximately 3%. Of more concern was that settlements are currently taking longer than usual, and hence this trend is worth monitoring.

LLC share price has trended higher over the last six months and, despite this, the group’s valuation remains relatively attractive, trading on a forward P/E of just 11X. While a solid pipeline of activity and well-capitalised balance sheet, we believe that the stock remains a good alternative to more passive real estate groups that are largely dictated by interest rate movements.

QBE also released a positive result, although following this, a negative regulatory ruling in the UK on personal injury claims restricted further share price gains. While earnings were stronger on the back of higher than expected reserve releases, the key positive outcome for investors was a 10% lift in the company’s final dividend along with the announcement of a $1bn buyback (to be conducted over the next three years). An absence of any additional negative surprises would also have given confidence to investors.

Globally, the general insurance market remains quite difficult, although the trends have improved from the broad reduction in premium rates of more recent years amid a competitive pricing environment. An FY17 target of ‘relatively stable’ gross written premium implies little change through this year. With top line growth still restrained, it has been left to better underwriting performance and expense reduction to improve the company’s profitability, with QBE delivering on its targeted savings across reinsurance, claims and other expenses.

Of course, this program can only support earnings growth for so long, although additional savings are expected to again help profitability in the next two years. The other part of the earnings equation is an improved return on its US$25bn investment portfolio, which is primarily in short-term fixed income securities. The anticipation of further interest rate hikes by the Fed has been the principal catalyst for QBE’s strong recent rally and while rate expectations have since plateaued, the company’s guidance for this year would still represent a positive turnaround on 2016.

It is difficult to view QBE as a long-term Australian equity core holding due to its chequered history of problems over several years, although presently it has good momentum in its underlying business and investment earnings. We believe that the stock will remain an effective hedge to interest rates, which may negatively affect much of the rest of the market.

QBE Investment Portfolio

Source: QBE
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Spotless (SPO) left it to the last day of reporting season to come clean on one of the more disappointing results of the month. The company missed expectations with its earnings, issued guidance significantly below consensus and cut its dividend, in what was overall viewed as a significant reset. A large impairment and restructuring charge of close to $400m rounded out the bad news.

After issuing a surprising downgrade in late 2015, which was largely attributed to difficulties in integrating some acquisitions in its laundries division, the resolution of these issues was expected to see the focus turn to the fairly steady, moderate earnings growth of a business that is leveraged to the outsourcing trend. What has emerged since, however, is evidence of pricing and margin pressure across much of its commoditised service portfolio, with the benefits from higher-margin PPP contracts failing to offset this trend. In turn, attention has switched to the company’s balance sheet, which may require repair should the current trends persist.

In order to address its situation, SPO’s new management is adopting the fashionable ‘shrink to grow’ strategy of rationalising its long tail of small underperforming contracts to focus on its larger, more complex contracts, which are typically higher margin. With many existing contracts multi-year in nature, this process will take time to play out and provides an additional challenge to management seeking to re-establish the organic growth path of the business.

With many value stocks in the market enjoying a solid rebound in fortunes in the last 12 months, SPO has been left behind, given ongoing question marks over multiple aspects of its business. SPO clearly has the potential to re-rate should it resolve these issues, however unfortunately the risks would appear to remain on the downside in the medium term.


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