Week Ending 03.08.2018
- Two productive signals for the Australian economy are exports, with a large trade surplus released for the year to June and infrastructure spending, the most likely trigger to improve domestic demand.
- Another week of tariff noise. On the positive is a potential agreement on NAFTA (US, Canada, Mexico) while the picture regarding China remains tense but may also prove to have a resolution of sorts later in the year.
The two current drivers of the Australian economy are unquestionably state-funded infrastructure spending and exports.
This week the June trade data showed a healthy surplus, rounding out export value growth of 12.9% versus a 0.4% in imports. Services have been the predominant factor in recent years and while the trend appears stable compared to the volatile commodity components, it cannot be taken for granted. The impact of the AUD, amongst other factors, is evident in the 2010-2014 period. The rural sector may be vulnerable in the near term. Drought conditions in key regions, tariff imposts that have unintended overflow and the potential closure of the live ruminant trade (meat makes up the largest component of rural exports) make this segment volatile. The swing factor, however, is clearly commodities. Volume growth may ease and put a greater skew to prices.
Export trade growth
The state-funded capital works programmes are now well underway. The vast majority of the spending is on roads and highways, with rail a distant second.
It is estimated that this spending will add directly 0.6% to GDP growth; an important addition as housing fades. Including the indirect impact not specifically related to the projects, the addition to GDP could be as high as 0.85%; a meaningful number in the context of current growth at 2-5-3%.
State and federal capital work programmes, forecast for fiscal years
Other factors that will come to the fore are whether the growth in construction jobs (up 7.8% yoy) feeds its way into wage growth, which is so far remarkably subdued. Then the question whether these assets will be sold to the private sector, the ‘asset recycling’ theme that financial markets like, but which may eventually add costs to consumers.
- The investable universe of stocks that benefit directly is limited. Further, the history of underquoting and cost pressures suggests that caution be exercised in such considerations. Rather, domestic demand may get a boost which, in turn, would raise the prospects of an upward move by the RBA.
The unfolding tariff debate will remain in the headlines at least until the US mid terms. The extent to which it is political will only become evident after that time. Nonetheless, the US may improve its position if negotiations can be resolved via a combination of trade-offs. The most likely trade agreement that is potentially put forward as a way to break the imbroglio is NAFTA (Canada, US and Mexico). The new government in Mexico may be willing to impose minimum wages, for example, as this (in any event) plays to its political aims. This is at the heart of the US complaints, with Mexican labour costs well below that of the US and an easy way for companies to have lowered their costs.
The other case for coming to an agreement is the realisation that the integration of production across these borders is high. The automotive industry has long stretched itself across NAFTA and it would be expensive to change now. Even in other mundane industries it matters. Proctor and Gamble in its Q2 profit release commented that it would be putting up prices of paper products (Pampers, for example) due to higher pulp prices, but also the 10% tariff on paper imposed on Canada, a large source of the commodity. US voters have no axe to grind with Canada and the large Hispanic component in the US would welcome a respite from tensions between the US and their countries of origin.
Conversely, the China tensions are likely to be sustained, if not raised. Imposing 25% tariffs on $200bn product (as has been flagged) would be most damaging to both parties. China observers believe the government tactics will contain a range of reactions. The most obvious has been the fall in the renminbi, though that is now likely to take a back seat, the other has been some easing in the monetary setting via an injection of liquidity into the system. This occurs with surprising frequency as the regulator looks to encourage lending, or conversely contain liquidity.
PBoC’s net injections and medium-term facility
China will be keen to demonstrate that its economy can cope with the pressure from the US. In turn, the US has realised that tariffs are not a simple or appropriate tool to close the trade gap. The optimists hope that the issue can be resolved while both claim to have achieved their goals, not an impossible outcome. Yet the political overtones and possible over reaction continue to reflect in investment asset pricing in emerging economies.
- It would remiss to suggest the trade dispute does not matter. However, in our opinion much is in the price of equity valuations and there is large number of companies where this cross-border trade has no impact on their operations. We continue to recommend allocations to EM.
Investment Market Comment
- Gold has historically been used a protection mechanism within a portfolio during times of heightened volatility and high inflation. However, the price of gold has been range bound in recent years.
Even though exposure to gold in an investment portfolio can be via a gold mining company, investment can also be directly into bullion. There are two different types of gold ETFs, those that hold physical gold and the ones that invest in gold miners.
As the name suggests, physical gold ETFs offer access to actual gold bullions, are held by the ETF providers in vaults around the world. There are two physical gold ETFs available on the ASX, BetaShares Gold Bullion ETF - Currency Hedged (QAU) and ETFS Physical GOLD (GOLD). The main difference between these two ETFs, apart from where the actual gold is held, is that QAU hedges the US dollar back to the Australian dollar.
Performance of gold spot price v ASX-listed physical gold ETFs
Historically the gold price has had an inverse relationship with US government bonds and the US exchange rate. With no major break in the trend that signals a meaningful reassessment of the fundamentals, the gold price has struggled.
Investors have traditionally looked to gold as an alternative asset to smooth out the volatility within a portfolio as well protection against inflation. While there have been a few recent spikes in financial asset volatility, it remains low compared to the past and inflation has barely budged.
Gold miner ETFs accesses a basket companies that are involved in exploration, development and the output of gold. This means investors will have an exposure to both equity and gold-specific risks. The leverage to the gold price itself varies for each of the miners depending on their output, mining cost and capital structure. Therefore, it is not unusual for the price of these ETFs to diverge from the gold price.
Performance of gold spot price v ASX-listed gold miner ETFs
There are two of these ETFs listed on the ASX, the VankEck Vector Gold Miners ETF (GDX) and the Betashares Global Gold Miners Currency Hedged ETF (MNRS). Both funds offer similar exposures, each with over 50% weight to Canadian miners. The main difference is that MNRS hedges back the currencies in in which the holdings are denominated.
ASX-listed Gold Miners ETFs’ Country Exposures
- An investment in gold miners is quite distinct from an investment in gold. Therefore, an investor needs to determine what the purpose of the ETFs is within a portfolio. Reducing volatility can be achieved in other structures, while alternative commodity sectors are potentially more attractive based on likely demand.
Fixed Income Update
- Central bank rhetoric and an increase in supply of US treasuries over the next 6 months pushes the US 10-year bond rate above 3% (briefly!).
- The Bank of England raises interest rates, while we examine the likely impact of Brexit on UK fixed income assets.
It was a big week for central bank meetings. The spotlight started on the Bank of Japan (BoJ), as a result of speculation that it may tweak easing programme, and join the US Federal Reserve bank, European Central Bank and Bank of England in unwinding stimulus policies. However, instead the BoJ reiterated its commitment to staying the course and its pledge to continue purchasing bonds so that 10-year JGB yields remain “at around zero per cent”.
- The prognostications from the BoJ can have global implications, given that the Japanese are one of the largest buyers of developed market bonds, including Australia. Any hint that local conditions are changing could influence their behaviour towards other country bonds.
By mid-week we had the outcome of the US Federal Reserve meeting in which it kept rates on hold (as expected). The next upward move is widely expected to be at the September meeting. Markets interpreted the accompanying comments as hawkish with the Fed stating " it expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labour market conditions, and inflation near the Committee’s symmetric 2% objective over the medium term. Risks to the economic outlook appear roughly balanced."
Adding to rates pressures was the US Treasury announcement of an increase in the funding required due to government policy spending. It is expecting to raise $329bn in Q3 and a further $440bn in Q4, $56bn higher than previously forecast. Bonds sold off and the US 10-year bond rose above 3% for the first time since May.
The US 10-year bond yield
- Movements in the US 10year Government bond rate are topical. It remains the barometer for investor confidence and is the benchmark for the setting of US mortgages rates and the risk-free rate used in equity valuations.
The Bank of England (BoE) also met and, as anticipated, lifted interest rates. Low unemployment and above target inflation warranted the 0.25% rate rise. As the UK moves towards Brexit, it is possible a weaker currency will drive inflation further, requiring further adjustment to rates. While the interest rates market is affected, Brexit is not expected to have much impact on local credit spreads. The UK investment grade index more attuned to global factors rather than the domestic economy as it consists largely of international companies (European banks and the French utility, EDF, dominate the top 10 holdings) or those whose revenues are primarily derived offshore.
The creation of the Eurozone and globalisation of financial markets has allowed UK companies to issue debt in other currencies, predominately US dollars and euros. As corporate issuance has grown in the last decade in EUR and USD, it has stayed relatively stable in GBP. Further, small and medium sized companies tend to rely on bank debt and private credit to fund themselves rather than financial markets. The High Yield (HY) market is therefore small in the UK.
Investment grade corporate issuance (GBP bn)
- Despite many of the large fund managers operating out of the UK, investments are in offshore markets. Exposure to UK fixed income assets is low in the funds we recommend and, as rule, home bias is uncommon in the asset class. It also highlights that the sub-indices within fixed income are often not what they appear at face value. For that reason, we do not recommend any ETFs for global fixed income.
- Rio Tinto’s (RIO) first half earnings were below par, but shareholders can continue to expect to receive a considerable return in the form of dividends and buybacks due to a healthy cashflow position.
- ALS (ALQ) may have turned the corner, with solid earnings growth expected across the majority of its divisions.
- Resmed’s (RMD) result met expectations and the company has a favourable outlook. Valuation is the key risk for many domestically-listed healthcare stocks.
Rio Tinto (RIO) kicked off reporting season with a 12% increase in underlying earnings missing expectations by approximately 5%. Volumes and pricing were largely known leading into the result, hence it was higher costs that were the primary driver of the earnings miss. Rising raw materials and energy costs, which were already evident in February, again held back the realised margin benefits from the ongoing focus on productivity gains that has been a feature of the sector for several years.
While this has been the case, it has been the rebound in commodity prices that has allowed the diversified miners to go through a process of balance sheet repair and ultimately, improved shareholder returns over the last 2-3 years. For Rio Tinto, the benefit from rising prices started to dissipate in the June half. Despite ongoing support from base metals, such as aluminium and copper, a modest decline in iron ore pricing offset much of these gains given its dominance in Rio’s portfolio.
Rio Tinto: Key Commodity Pricing
As we have previously noted, the key attraction of the diversified miners presently is the capital management initiatives that are being undertaken. Not only is a higher proportion of free cash flow being directed towards increased dividends and share buybacks, but this is also supplemented by non-core asset sales, the bulk of which is being returned to shareholders.
Rio again delivered on this front, with a 15% increase in its interim dividend (a larger increase in AUD terms given it is declared in USD) and an additional US$1bn on market buyback of its UK listed stock (which trades at a discount to the ASX-listed script). The after-tax proceeds of a further US$5bn in asset sales completed in the first half (largely from its coking coal assets) are also expected to be returned, although the form and timing is yet to be decided by the board.
As with BHP Billiton, Rio lacks any meaningful production growth in the medium term, although it and the broader industry’s restraint on capex is helping to support a buoyant pricing environment. The obvious near term risk is an escalation in the US-China trade wars. While this is the case, Rio’s valuation is relatively undemanding, albeit the valuation upside from higher spot prices has reduced over the last month following weakness in commodity prices. Nonetheless, with yield (>5%) and share buyback support, we believe an allocation to the sector remains appropriate for an Australian equities portfolio.
Laboratory testing group ALS (ALQ) also has links to the resources sector through its minerals testing division, although in recent periods it has been softer performance in its core life sciences division that has held back the benefits from increased mining activity. An update at its AGM was sufficient to give a large boost to its share price. Earnings guidance for its upcoming half year pointed towards 22% profit growth (at the mid-point of the range), indicating a high level of operational leverage to market conditions and illustrating the possible uplift when conditions across its key divisions are favourable.
We have held ALQ in our model portfolio on the basis of the strength of the consistent growth in its life sciences division (which has positive structural tailwinds) along with the resources recovery, the latter which has played out over the last 18 months. The company looks to have momentum on both fronts and a high earnings growth outlook in the medium term, helping to counter what appears to be a high shorter-term P/E multiple.
ALQ Earnings and HY19 Guidance
Resmed’s (RMD) quarterly earnings result was broadly in line with expectations, with a solid top line outcome across devices and masks. Industry growth for sleep apnea products continues to be quite strong and RMD has been reporting even better numbers following market share gains in masks following new product releases, although this is a cyclical element that can revert on new releases from its competitors. As has been evident in the current second quarter reporting season in the US, RMD’s earnings were also boosted by the one-off company tax cuts.
Recently, pricing risks have receded in the industry, which had previously led to some margin erosion following the introduction of competitive bidding in the US several years ago. The market opportunity remains significant for RMD given high levels of undiagnosed cases and supportive demographic trends, although this has not necessarily translated to increased awareness over time.
- As we recently commented on in our Asset Allocation piece, valuation remains the key risk for a group of healthcare stocks that are all currently producing above-market growth, such as Cochlear, Resmed and CSL. Our preference lies with CSL, which we judge to be the higher quality of the three based on management strength and consistent track record of perforamnce. CSL has also been a solid contributor to the performance of the Investors Mutual SMAs.
After a quiet start to reporting season, next week is somewhat busier before a crowded schedule in the following two weeks.
Reporting season schedule for next week:
Tuesday: Navitas, Shopping Centres Australasia
Wednesday: AMP, Commonwealth Bank, IOOF, SkyCity, Tabcorp, Transurban
Thursday: AGL, Crown Resorts, Magellan Financial, Mirvac, Orora, Suncorp
Friday: James Hardie, Newscorp, REA Group