Week Ending 04.11.2016
• Australian retail sales perked up, though the trend is undermined by price momentum rather than volume. Trade data was also better, following the resurgence in commodity prices. Weak imports bear watching; a partial recovery would indicate improving domestic demand and investment
• US inflation support the long anticipated rate hike. But the economic direction remains clouded given the maturity and weakness of the current cycle.
• European unemployment is substantially improved since its peak in 2012. Structural hurdles are likely to limit further labour market recovery without policy changes.
At the headline level, September retail sales growth was better than expected, limiting the annual rate to 3.3% from 2.9% in August. Household goods sales walked out the door, rising 2.4% in the month, while apparel sales took a step back. The trend that attracted attention, however, was the rise in prices rather than volumes. A good proportion is likely due to the sharp increase in fresh food prices as was evident in last week’s CPI.
Retail Prices Rise While Volumes Ease
The trade data contrasted with the retail trend, as imports of consumption goods fell in September, taking the annual decline to 8%. The implication is that inventory levels are falling and forthcoming data will be keenly watched to see if there is a turnaround. The general weakness in capital goods imports suggests there is no imminent lift in investment spending and that the wind down of the LNG projects is well under way.
Australian Trade Data
Export growth picked up in the month, underpinned by resources and coal prices in particular. Here, too, this change in pattern will become important into 2017 as the improved terms of trade add to national income.
Whatever the political outcome next week there are some unstoppable trends. US inflation is on the up and the Fed’s language is already in the market; a rate rise appears almost inevitable. That begs the question, is this really troubling markets? Inflation has been the aim of monetary policy for some time and the (small) success should be welcomed given it usually indicates that demand and pricing is improving.
Yet, as we have come to acknowledge, this cycle is evolving at a very different pace compared to the years since inflation targeting by monetary policy became the primary cause of central banks (from around the 1980s). The inflation debate will now turn to an exotic mix of the persistence of wage growth, impact of fiscal spending (if it does come about) and the direction of large weight sectors, health and housing. Health costs look likely to rise regardless of policy, while housing appears to be levelling off.
European data is grinding in a better direction. Using standard measures (rather than individual country definitions of participation), German unemployment is at a ten year low and, at 8.5%, close to its low prior to the financial crisis. Spain, France and Italy are the culprits in making Europe’s employment numbers look poor. The suggestion is that Spain has a major skills mismatch, but also is partly due to long term students who are counted as part of the labour force. Or perhaps it’s the weather…?
Fixed Income Update
Amidst a challenging environment for fixed income, we discuss the following topics:
• The importance of diversifying within a fixed income allocation; highlighted in a month of falling bond prices.
• Australian banks are put on negative outlook by one of the ratings agencies.
• A subordinated bond is not called in the European market, highlighting the risks of bonds lower in the capital structure.
Investment portfolios are usually structured across equities and bonds, given the negative correlation that typically exists between the two asset classes. However, last month these correlations broke down, with long fixed rate bonds and equity moving in the same downward direction. At the same time, the positive correlation between equity and credit also went against trend, with credit spreads tightening. This resulted in a positive performance for floating rate notes, including bank hybrids and subordinated debt. The table below shows the performance results for these sectors in the month of October.
Asset Class Returns in October
While it is true that there was a significant global bond sell off throughout the month - with yields in Australia, the US and Europe climbing to roughly five-month peaks - this only impacted part of the fixed income universe. Fixed income portfolios that have adopted a blended approach to managing duration and credit risk would have been broadly neutral in October, with offsetting performance from different sectors.
Inflationary expectations has been one of the drivers of the October bond sell off. Unsurprisingly, inflation linked bonds had their second largest inflow of funds since 2007. Appetite for funds with floating rate exposure has also increased.
This week, the ratings agency Standard and Poor's (S&P) placed 25 Australian banks, insurers and buildings societies on negative watch, citing concerns about rising household debt and property values. It includes the likes of AMP, Bendigo and Adelaide Bank, Bank of Queensland and Macquarie. S&P placed Australian sovereign debt on a negative outlook a few months ago, which implies a revision for the four major banks because of the ‘government support’. Unlike that ratings risk, this recent revision could be more relevant for debt instruments as it could impact the stand-alone credit profile (SCAP) of these issuers.
As highlighted in previous publications, bank hybrids and subordinated bonds trade at a higher yield because of where they sit on the capital structure, in addition to the discretionary nature that the issuer has to call the bonds at particular dates. Issuers of bank hybrids also have discretion on paying coupons (although they would have to stop dividends).
This week the UK bank Standard Chartered decide to exercise their right to not call one of their subordinated bonds at the first available call date. It was cheaper for them to keep the bond outstanding than to redeem it and refinance. Following the announcement, the price of the subordinated bond fell $13.
This event highlights the risk that is embedded in these types of securities. It is worth noting that Basel 3 compliant Australian bank hybrids mandatorily convert to equity if not called, so they do differ in that they would not be kept outstanding for the purpose of cheaper debt funding. However, they may not be called for differing reasons and investors should be aware of this possibility. That said, it would need to be a compelling motive as the bank would risk alienating investors and suffering reputational damage.
• ANZ’s result was in line with expectations, however the bank continued to show progress on its strategy to focus on the higher returning parts of its business.
• Flight Centre (FLT) issued guidance below the market’s expectations, with ongoing airfare price deflation the primary issue.
• Orica’s (ORI) earnings fell again for FY16, however improving commodity markets may point towards a stabilising environment in the medium term.
• The fortunes of Fairfax (FXJ) continue to be tied to Domain, which has experienced a soft period to the start of the financial year.
ANZ continued banking reporting season this week with a result that was broadly in line with expectations, although boosted by a low tax rate. To refresh, with a new CEO taking the reins earlier this year, the bank’s strategy has shifted to one of simplifying the business and reducing exposure to its lower-returning divisions. In particular, this has meant a run off of its institutional book as well as a reduced presence in Asia. This evolution continued this week with ANZ’s decision to exit its retail and wealth business across Singapore, Hong Kong, China, Taiwan and Indonesia. The bank also revealed that it was exploring divestment options for its Australian wealth management business.
ANZ’s result was thus relatively messy, with several one-off items and charges leading to an 18% decline in cash profit. The charges included a transition to a more conservative policy for expensing its software costs and various restructuring costs. On an underlying basis, the result still reflected the relatively benign earnings environment for the sector. For the 12 months, ANZ recorded income growth of 3.5%, expenses were relatively well contained with 0.9% growth, while bad debts almost doubled off the ultra-low levels of recent years. Similar to what we have seen across the sector, net interest margins were also marginally weaker despite the mortgage repricing that occurred 12 months ago.
ANZ Provisions (Bad Debts) Charge
All up, this led to a 2.5% fall in underlying earnings. While the other major banks have so far resisted doing so, ANZ had already taken a reset of its dividend at its half year result, with total dividends for the financial year down 12%.
With a shrinking institutional book and a focus on cost cuts (ANZ reduced its employee headcount by 7% over the year), the investment case for the stock is very much like other large caps that are facing a low top line growth outlook. While a sharper attention on cost cutting may provide some earnings support in upcoming reporting periods, the pressures from compliance and technology are unlikely to subside. The primary target for credit growth remains domestic mortgages, although this is now consistent across the majors following the changes made by ANZ and NAB over the last two years.
The two key risks for the sector in the medium term remain a further normalisation of bad debts and the possibility of additional regulatory capital requirements. ANZ has outperformed its peers over the last few months, yet the stock still trades at a discount to the other majors and screens as the value play in the sector.
Flight Centre (FLT) disappointed again with guidance for FY17, with the mid-point of its range equivalent to a 4% fall in earnings for the year. As the company highlighted in recent updates, airfare deflation has been particularly high, impacting the group’s margins. In the first few months of FY17, average international airfares have fallen by 7% compared to the same period in FY16. Other factors were also noted, including subdued trading in the UK and the US on various concerns, including the Brexit vote and the Zika virus.
While lower airfares are certainly a positive for overall airline industry traffic growth, the high level of discounting currently being seen is detrimental for FLT given its sales commissions are linked to the airfares that it sells. Elevated airfare deflation evidently makes this equation difficult. More encouragingly, the group reported 9% growth in ticket volumes for its Australian business, outpacing growth of the broader industry. This again countered a key criticism that the company cannot succeed in an industry where sales have been transitioning to online channels.
Most of the hurdles that FLT has had to overcome in the last few years appear to be more cyclical in nature, although a persistence of a number will lead some to conclude that they are structural. Should the current deflationary airfare environment remain for an extended period it is difficult to see a reversal of the company’s fortunes. While this may be the case, the stock continues to trade at a relatively attractive valuation, with a P/E of around 12X and has a strong balance sheet that could potentially be used to buy back equity.
Orica’s (ORI) full year result met expectations, with a 7% decline in underlying earnings. As a mining services provider, the company has faced a challenging environment over recent years. While the mining services industry has experienced top line and margin pressure as its customers have wound back sharply on capital expenditure, ORI (as well as Incitec Pivot) has had the additional burden of oversupply in its key ammonium nitrate market, particularly in the Australian market. The group has subsequently battled a multi-year downgrade cycle.
Like many in the industry, the natural counter to this hit to earnings has been to target its cost base. ORI has its own ‘business improvement’ program in place, which delivered $76m in savings for FY16. As the chart below illustrates, however, this was less than half of the negative drag from lower volumes and pricing.
Orica FY15 to FY16 EBIT Waterfall
For the medium term, some enthusiasm can be drawn from the recent spike in coal prices, ORI’s largest commodity exposure. However, ORI still expects further earnings headwinds from multi-year contracts that roll over in FY17 (a $60m impact) and between $50m and $70m from input cost increases; combined the earnings impact may be similar to that of FY16.
At this stage, the company is forecasting ammonium nitrate volumes (the primary revenue driver) to be broadly flat for the year. A stabilisation in its environment would likely be viewed as a good outcome for investors. A share price recovery over the last few months now sees the stock trading on a forward P/E of 16.5X, implying somewhat of an earnings recovery in coming years. ORI was less bullish about the outlook, however, noting that it will remain “conservative” in the current environment.
For Fairfax (FXJ), its property portal Domain is critical for the group’s future success and thus this was again going to be the focus of its AGM. FXJ had surprised the market back in August when it reported that listings in July had been unusually weak. The trend had improved since then, however new listing volumes to the end of October remain 18% down in Sydney and 5% in Melbourne. While Domain is the growth engine of FXJ, the link to the property market will inevitably result in an element of cyclicality in this business. The old media assets that FXJ retains in its portfolio, particularly its print division, likely have little value, therefore the key investment thesis for FXJ is the implied discount the Domain division trades on to its key competitor, REA Group (REA).