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WEEKEND LADDER

A summary of the week’s results

03.07.2015

Week Ending 03.07.2015

Eco Blog

Into a new financial year, we have checked the four major banks economic forecasts for direction and points of difference.

- GDP FY16 growth forecasts range between 2.6% and 3.2% after an expected 2.3% for the past year. The swing factors are the length and extent of dwelling investment and the magnitude of the contribution from exports. The general assumption is that consumption and public sector spending will lift in FY16.

- Headline inflation is forecast to be 2.5-2.8% compared to a 1.7% for this past year. Much of the anticipated increase is due to the reversion of fuel prices and an uptick in food which will bring the headline back into line with core or underlying inflation.

- Based on these banks, the chances of the RBA moving over the coming twelve months is low with all expecting the cash rate to remain at 2% over the period. Nonetheless the 10yr bond yield is predicted to follow the US rate hike widely anticipated this calendar year and end FY16 at around 3.25%, compared to 3.08% at present.

- The AUD/USD estimate is in a tight band of 0.75-0.72. More controversially the Euro/USD is implicitly expected to be near parity as most have the AUD/Euro at 0.72.

In short, these forecasts imply a soft improvement in the Australian economy based on a gentle uplift in consumption spending and a small amount of public sector stimulus. This week’s retail sales, below forecasts, reinforce the reluctance of households to grow their balance sheets.

Australian credit momentum appears to be levelling off with growth now more dependent on the business sector. An uptick here could feature in coming months if the SME budget measure has an impact, however there seems little question that credit growth will not feature heavily in this economic cycle.

Total Credit Growth

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This was reinforced by a sharp swing back in the Australian PMI to 44 (this index measures whether manufacturing is expanding or contracting with 50 indicating it is flat-lining). The fall in mining related sectors and now the progressive closure of motor vehicle production is insufficient to offset manufacturing related housing requirements. Increased export of production goods post the fall in the A$ has barely registered. Other global events may have overtaken the free trade agreement (ChAFTA) signed with China in mid-June and Australia participation as the sixth largest shareholder in the Asian Infrastructure Investment Bank this week. As Westpac noted, in our relatively short history we have only had four major trading partners and the charts below suggest we are only just on the cusp of the China era.

Source: Westpac
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Some will be discomforted by the potential for Chinese investment here to include use of Chinese labour through temporary work visas on approval by the Department of Trade and for infrastructure projects in excess of $150m. In this case infrastructure includes a much wider range than the common definition. Time will tell if this adds to our productive capacity. The flow the other way into China will rely on improved access for commodities, specifically soft commodities, but more importantly services such as health, professional services, education and the like.

After reporting a suboptimal 6.4% GDP growth for Q1, China’s growth in Q2 is looking like more of the same. Certainly industrial production, PMI momentum and export growth are below par and it is the services sector that would have to lift GDP to the target of 7%. A small rise in the GDP deflator will support reported GDP, though this is mostly a technical feature than indicative of changing activity.

Global manufacturing momentum eased into mid-year. The rate of change in Europe still remains good, interestingly concentrated outside Germany, though France is behaving as expected – little sign of any improvement. The US economy is clearly still making progress, but the rate of change does appear to be ebbing away, with the regional surveys showing sluggish growth. Japan is flat-lining; the Tankan survey reinforced that this week, while Asia is soft. The South Korean drop in manufacturing activity is somewhat overstated given the significant impact the MERS (Middle Eastern Respiratory Syndrome) has had there.

Source: Markit
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These trends, which have been building for some time, suggest that this economic cycle will have to find other sources of growth than manufacturing. The services sector is harder to measure, yet the fact that it is much bigger than production often escapes notice. For some time those that have been surprised by the relative resilience of the Australian employment data, would have noted that it has been services that has held things together.

Before one construes that services are skewed to the public sector, one of this week’s employment releases out of the US shows the overwhelming bias to jobs in this category from the private sector.

Source: Haver Analytics
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However, the broadly based overall payroll release for June was softer than expected at 223,000 and previous months were revised downwards. The unemployment rate however eased by 0.1% to 5.3% due to a decline in the participation rate of 0.3% to 62.6%, the lowest since Oct 1977. The debate on participation is a global issue and likely to feature in resetting expectations of employment levels in coming years; implicitly on household income and savings behaviour as well.

On a lighter note, cocoa prices have shot up this year due to production cuts in Ghana. Talk is that chocolate content is being subtly dropped and bars are becoming smaller. Even equities have not escaped with short positions in Chocoladenfrabriken Lindt and Spruengli and Barry Callebaut doubling in the past few months. Usually a temporary phenomenon, we encourage chocoholics to be mindful of the risk of chasing higher valuations.

Fixed Income Commentary

With the Greek crisis escalating to a whole new level this week, it is no surprise that heightened volatility continued in the global bond markets. As expected the yields on Spanish, Italian and Portuguese bonds were all up, with yields moving 10% higher ( some 25bp) on 10 year bonds during Monday’s trading. Even though this is quite a significant move, it was not considered over- reactive, and perhaps shows that contagion to these European countries is not a huge concern, especially with the ECB continuing their QE program as usual. Further, Europe may now be well placed take the fallout from Greece, due to stronger economies, healthier banking sectors, smaller fiscal deficits and greatly reduced linkages to Greece itself.

To support this theory, the spread of Portuguese, Spanish and Italian 10 year bonds to the German 10 year bund remains narrow. Back in 2012 this spread widened to over 14% for Portugal and 5% for Italy and Spain, whereas now that spread differential is down to 2.2% and 1.5% as can be seen below.

Spreads on Peripheral European Government Debt

Source: Bloomberg, Escala Partners
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This week, developed countries such as Germany, the US and Australia have seen capital inflows into their bond markets as a ‘flight to quality’ ensured.

The volatility in bond markets over the last few months has been driven by varying factors, with the Greek crisis becoming just another event that highlights the market vulnerabilities. However, it is worth noting that the traditionally ‘safe haven’ assets within fixed income such as US Treasuries and German bunds have been at times more volatile than their perceived riskier cousins such as Emerging Market and High Yield debt.

When looking back over the last 3 months it is interesting to see the market movements of the 10 year German Bund vs the Emerging Markets (as benchmarked by the JPM EMBI Global diversified Index) and the US High Yield market (BofA ML HY Index). During the same 3 month period these markets have all experienced an overall downward trend with increased levels of volatility. As can be seen from the chart, investors purchasing German bunds at the top of the market in mid-April, have seen their asset price fall by 6.1% by the end of this financial year. Comparatively an investor of the Emerging Market Index will only be down 2.3% or 1.2% for US high yield.

Total Return for Fixed Income Sectors vs German Bunds

Source: Bloomberg, Escala Partners
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For investors, this chart highlights the need for diversification within this asset class, as ‘quality’ bonds can still lead to a temporary valuation loss.

Credit spreads have had a tough time these last few days, with spread widening across Investment Grade and High Yield markets. The Australian iTraxx index - which measures performance of credit in the domestic market – experienced moves in line with the current risk off sentiment. Volatility in this sector is in contrast to the relative stability we have seen in credit over the last few months, particularly in the wake of the rates sell off in April and May.

Domestic hybrids have also sold off this week with select names getting hit harder than others. The equity downturn at the start of the week, coupled with the end of financial year have contributed to these price moves with liquidity drying up as the end of year approached. The CBAPD’s, for example, have moved about 18bp wider to a spread of 4.4%.

Company Comments

Origin Energy’s (ORG) share price has been particularly volatile over the last two weeks for reasons other than the oil price. The issue has involved the company’s Queensland LNG project, APLNG, and the willingness of its biggest customer, Sinopec, to take delivery of gas from the commencement of production later this year. Suggestions emerged that Sinopec might delay the start up of the project or slow the ramp up, adjusting its requirements to account for a weak demand environment in China. Sinopec is a large Chinese state-owned energy company and also has a 25% equity interest in the APLNG project.

ORG addressed the speculation in a release early this week, stating that Sinopec’s sales contract is structured as a take-or-pay agreement, thus giving a high level of protection for the project. ORG noted that Sinopec does, however, have flexibility as to where it directs its cargoes, although the sale price that Sinopec would receive for these may be suboptimal, given the current well-supplied status of the spot market. The chart below illustrates this situation, with spot prices trading at a discount to contracted prices in recent times.

Asian LNG and Oil Prices

Source: Australian Department of Industry and Science, Argus and Petroleum Association of Japan
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While it would appear to be a very unlikely outcome that Sinopec would attempt to walk away from its 20 year contract, it nonetheless is a demonstration of customer concentration risk, with Sinopec accounting for 7.6 mtpa of the 8.6 mtpa that APLNG will produce. Historically, Australia’s LNG has predominantly been sold to Japan and South Korea, and Sinopec also does not have the same long term track record as these markets. ORG’s share price has recovered some of the lost ground since the announcement and pleasingly confirmed that APLNG is on track for first production in the last quarter of 2015.

One of the key takeaways from these developments over the last few weeks is that, similar to many other commodities, LNG markets are well supplied, thus putting downward pressure on pricing and reducing the likelihood of new projects getting off the ground. While existing producers and projects that have already commenced construction (or nearing completion) are protected by long-term contract arrangements, the appetite for new capacity is expected to be limited over the next few years.

The issue is one that will become increasingly important for Woodside Petroleum (WPL), which has pushed ahead this week with its joint venture partners on Front End Engineering and Design (FEED) on a floating LNG development of the Browse gas field. A lower oil price (in which LNG prices are typically linked) and marginal economics could be the least of WPL’s problems if there is no end buyer for the product.

Asciano (AIO) gave a boost to the local infrastructure market when it confirmed that it had received a takeover proposal from Canadian group Brookfield Infrastructure and had engaged in discussions with the company. The deal would involve a combination of cash and scrip, valuing AIO at $9.05 per share. Ever lower costs of funding has been a significant tailwind for infrastructure equities in recent years (Transurban and Sydney Airport being two local examples), however AIO’s operating exposure has perhaps seen it miss out on this to a certain degree. The offer price represents an approximate 10X EV/EBITDA multiple, which would be at a discount to the recent takeover of Toll Holdings by Japan Post. Brookfield is a large global infrastructure investor, with over US$200bn of assets under management and was previously speculated to have been interested in Asciano’s Patrick ports business.

The fact that AIO is trading at the approximate mid-point of between its prior close and the bid value would imply a degree of uncertainty of a deal being completed. One key reason would be the reluctance for domestic investors to accept the international stock of Brookfield as part of the consideration. Secondly, it could be viewed that Brookfield is investing at a particularly opportunistic time, with AIO almost through a material capital expenditure cycle that will see it deliver a better cash flow outcome in coming years. The offer could potential be improved by releasing the franking credits on Asciano’s balance sheet via the return of a special dividend.

While the company remains in its current limbo situation, and with a deal far from complete, our recommendation for existing investors is to hold. We would advise against entering any new positions in the stock until the outcome of the current negotiations is clear.

The Australian Government this week downgraded its iron ore forecasts for 2015 and 2016 by 10%, in line with the recent trend in the analyst community. The Department of Industry and Science noted that the chief demand driver of the market over the last decade, being China’s steel production, is forecast to contract in 2015 and 2016 at the same time that the seaborne supply of iron ore increases. While China’s own high-cost domestic production is expected to fall by 60mt in 2015, this will fail to offset the increase in tonnes from the two major markets of Australia and Brazil. Increasing the bleak outlook for the market in the medium term is Vale’s 95 mt project Serra Sul (this project alone would add around 2/3rds of Fortescue Metal’s entire production), which should come online in the second half of next year.

The iron ore price has been quite volatile in the last four months, yet the underlying equities (with the exception of Fortescue) have been less so. All have underperformed the underlying commodity, reflective of weaker equity markets as a whole and the aforementioned medium and longer term downgrades across the sector.

Iron Ore and Miners: Last Four Months

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G8 Education (GEM) has launched a takeover offer for Affinity Education (AFJ), a similar childcare provider which only listed at the end of 2013. Affinity’s share price largely marked time since listing, tracking between $1.10-1.20, but following some concerns on its balance sheet and profit momentum, the share price fell sharply in the last two months to a low of $0.49. GEM has aquired 16.4% of the company on market and is now offering AFJ shareholders 1 GEM share for every 4.61 AFJ shares, representing circa $0.7/share. If consumated, this would imply approximately 5.4X EV/EBITDA based on AFJ FY15 earnings guidance.

This is clearly an opportunistic move by GEM given the fall in Affinity’s share price and there is no certainty of success. While the price implies a higher multiple than GEM’s stated objective to acquire centres at 4X EV/EBITDA, the size of the prize in this case could well warrant the higher price. We have supported investment in GEM following the childcare consolidation theme. While the stock has been weak as investors reassessed the rate of growth, we remain of the view a small holding in the stock is justified.

GWA Group (GWA) announced a slight mark down to its FY15 guidance, along with costs associated with the restructuring of its business. The company has undertaken significant change in recent times as it has divested non-core divisions, including its problematic Gliderol garage doors business. The experience of the company shows that not all companies exposed to a strong cyclical theme – in this case, the domestic housing market – will be beneficiaries of such. Highly competitive behaviour in its markets and a much larger exposure to houses, as opposed to apartments, are just two of the reasons for its problems.

Two small consumer stocks moved sharply this week. Kathmandu (KMD) recieved a takeover offer from Briscoe of New Zealand based on a 5 for 9 scrip and NZ$0.2 in cash, valuing the company at $324m. Briscoe is a listed retail chain of homeware stores and the Rebel Sport operations in New Zealand, with its founder, Rod Duke holding some 78% of the equity. If this deal goes ahead, the intent is to continue the Australian listing and investors would become part of this rather disparate selection of formats. Investors are left in a difficult spot of a very new CEO and a beaten up share price due to a recent downgrade or throwing their lot in with a successful but unusual company.

After years of pain and restructuring Pacific Brands (PBG) upgraded its FY15 guidance, citing decent sales in Bonds and Sheridan. The sustainablity of profit however remains questionable with its major wholesale customers, discount department and department stores, struggling with revenue flow.

We note some of the small company events as we are always on the lookout for alternative stocks for portfolios. By and large these are screened out due to the unreliablity of earnings and structural flaws.

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