Week Ending 03.11.2017
- Expect ‘liquidity’ to test for financial markets in the coming year. It is hard to escape evidence that suppression of rate and central bank balance sheets have been the tailwind for assets for nearly 10 years.
- Economic activity remains high and could pick up further if the US gets going. China may lead the pack downward.
- Australian household spending is very weak. Wages are they key.
The big word sitting between economic and investment market is liquidity. Withdrawal of global liquidity through the reduction in asset purchases by both the Fed and the ECB is expected to change the dynamics across all asset classes. Even the level of buying from Japan is falling as the yield target has been met without committing a massive expansion of the balance sheet to the task.
Rate rises will work in an indirect way. At the margin, borrowing becomes more expensive and credit growth should slow. China is in this mix as well, though operating in its own style. Here there is a well-observed tightening of loose policy to a directed credit process. Small business and regional lending is being given leeway relative to property and big corporates. Overall, however, there is a general pull back from the stimulatory conditions of 2016 that have been solidly behind the higher than expected growth in economic activity.
At a micro level, debt growth is tightening in many regions. Locally, we are only too aware of the RBA and APRA’s move to restrain household debt. In the US, tighter standards are being applied to consumer credit outside of mortgages. In particular, there has been comment on the high growth in segments such as auto loans and student debt that is now causing some anxiety.
Countless charts show the correlation of the provision of liquidity as QE hit its straps relative to the behaviour of financial assets. Volatility fell to its lows as markets were sedated by the knowledge that rates will not disrupt the pattern. The change to rates will take time to be reflected in markets as indicated by the chart, which shows a two-year lag. If this pattern holds true, the latter end of 2018 will prove more challenging for equities.
Fed rate and Volatility
The support for financial growth assets in the short term, however, is firmly focused on the activity cycle, which has yet to show signs of peaking. Monthly PMIs continue to hit record levels of the past five years, with Europe remaining dominant in contributions. Input prices are under the most pressure in that region and some believe it is Europe that will surprise on the inflation front.
Data from the US indicates that the hurricane impact will be short lived. Sectors such as manufacturing show a fall in output, yet the labour market continues to tighten. More importantly, there are early indications that unit labour costs are on the rise.
At this rate, it is China that may well show the first signs of lower momentum given the stimulus has been curtailed for most of this year. We have previously summarised the views of some Sino experts that the newly instated central party is willing to see a softer outcome in 2018 as way of capping the credit cycle and re-establishing the mix of growth.
The combination of the change in spending priorities and the constraints low income growth has on the household sector were reinforced in the Australian Q3 data. On a sector level, if volumes held up, prices were down, as illustrated in the combination of the two through nominal sales data.
Nominal sales per capita
There is an expectation (more centred on hope at this stage) that wages growth might pick up into 2018. It is possible that low end wage jobs do achieve a one-off increase, yet history shows this is rarely the cause of an overall rise in income. The key sector is in the public service, with healthcare the largest sectoral employer in Australia. This is shifting to part time work, with a growth of 20% in part time health jobs versus 11% in full time in the past five years, which will limit the incremental impact.
The most likely source of wage growth is in the combined construction and housing sectors. Half the new full time male jobs in the past three years have been in these two industries, yet wage rates have been subdued. If the upturn in infrastructure comes before the housing cycle turns, there could be a bigger contribution to income levels.
Fixed Income Update
- The Bank of England raise rates for the first time in 10 years.
- Jerome Powell is elected as the next Fed Chair, with the current path of rate normalisation and balance sheet unwind expected to continue.
- Yields soften and credit spreads tighten resulting in a positive performance in fixed income for the month.
As expected, the Bank of England raised rates for the first time in 10 years by 0.25% to 0.5%. September inflation numbers, which rose to a 5 year high, cemented the outcome, which was agreed on with a 7-2 vote.
While the change was priced in leading into the announcement, market participants were closely viewing the commentary to judge whether this marked the start of a tightening cycle, or if it was a one-time reversal of the rate cut that followed the Brexit vote. The accompanying statement was interpreted as dovish, with future rate increases expected to be ‘at a gradual pace and to a limited extent’. The governor removed its previous statement that the market was under-pricing future hikes and, together with a downward revision on inflation and talk of the “notable impact” Brexit will have on economic outlook, the result wasa rise in bond prices. The yield on the 2-year Gilt, which is the most sensitive to rate policy decisions, fell 10bp, while yields fell across the rest of the curve by ~8bp.
President Trump announced Fed Governor Jerome Powell to be the next Federal Reserve Chairman. If confirmed by the Senate, Powell will replace Janet Yellen, whose term ends in February. Powell is expected to maintain the framework for policy normalization put in place under Yellen. This will include the current forward guidance for rates to rise gradually, with the projection being for three hikes next year if the economy performs as forecast. Likewise, Powell is expected to continue with the Fed’s plans for unwinding its balance sheet.
So far, the balance sheet reduction has been well received by markets without triggering a taper tantrum style sell off in bond markets. The question remains on who will be a buyer of Treasuries now.
Banks will be reluctant due to the duration risk of the product, even though they help achieve liquidity capital requirements. BOJ and ECB are unlikely as they are still undertaking their own QE buying. Further, sovereign wealth funds have suffered reductions in FX reserves as commodity prices remain at low levels.
US treasuries held by foreigners have fallen from 59% to 50% since 2014, and a reversal of this trend is not expected. That leaves reliance on the US corporate sector and domestic mutual funds to absorb the increased supply if prices are to remain at current clearing levels. While Powell will be hoping to avoid big changes, it is likely that yields on US treasuries will move higher as the Fed retreats buying and this needs to be absorbed by the US domestic market.
Domestic holders of US treasuries
Australian fixed income had a strong month in October, reversing losses from September. Bonds rallied as markets began to unwind some of the reasonably aggressive RBA pricing of rate rises (as early as May 2018) that had been factored in to the futures market. CPI was short of expectations and, together with weak retail sales, markets pulled back on the expected path for rates. Credit spreads also tightened over the month, supporting valuations in investment grade credit and hybrid securities. The Australian iTraxx index (measuring credit spreads on IG credit) finished the month at 65bp, down from 70bp at the beginning of the month.
Markets forward looking pricing of the RBA over the month of October
- National Australia Bank’s (NAB) result was soft but in line with expectations. The company has outlined a multi-year cost reduction programme that will require significant investment to undertake, with the market sceptical on its execution.
- Bendigo and Adelaide Bank (BEN) was marked down after it reported slower lending growth in the quarter.
- Amcor’s (AMC) first quarter has been below expectations, although the company has maintained its full year guidance.
- Boral (BLD) has benefited from a lack of rainfall in the September quarter and the underlying demand in key markets is robust.
- Woolworths (WOW) has made further ground on Coles, although will be cycling tougher comp growth in coming quarters.
National Australia Bank (NAB) continued the banking reporting season this week, with a result that was broadly in line with expectations. Cash earnings growth of 2.5% highlighted the relatively benign environment of the industry, on the back of 2.1% revenue growth for the 12 months. The dividend was unchanged for a third consecutive year.
Having now withdrawn from the UK, and with a renewed focus on the domestic market, housing lending growth is now as important as ever for NAB and its peers. On this measure, NAB’s market share has improved through this year, although the trade-off remains one of tighter net interest margins, a factor which may be compounded by growth weighted towards the broker channel. Net interest margins were flat year on year despite the repricing that has recently occurred across the industry, and the tailwind from falling bad debts has passed, which remain at or close to all-time lows.
The primary focus from NAB’s announcement was regarding its investment spending programme, with the company forecasting an additional $1.5bn cost to be spread over the next three years. The increased spend is being undertaken to help achieve a targeted $1bn+ of cost savings by FY20. With a targeted 10% reduction in its workforce, the cost savings are principally related to simplifying the business and increased automation. Additional restructuring costs of up to $800m will be incurred next year, and NAB have made the somewhat brave assumption of revenue benefits to materialise from better customer retention and market share gains.
With much of the benefit from the programme unlikely to materialise until FY20, implying shorter term downgrades to earnings based on higher costs (and limited top line growth), it could be expected that there will be a short-term rotation out of NAB into its peers. While ultimately it may prove to be the correct strategy for the longer term, given its poor track record of execution on such programmes, it is unlikely investors will give NAB the benefit of the doubt until evidence emerges of progress made. Moreover, while NAB has made the assumption that it will maintain its dividend into FY18, the risks have emerged to the downside given its increased costs, soft forecast earnings growth, requirement to continue to build its capital base and prevailing high dividend payout ratio.
NAB Investment Spend
The relatively tough banking environment was also evident in a trading update from Bendigo and Adelaide Bank (BEN) provided at its AGM. BEN noted that following the introduction of macroprudential measures from APRA that are designed to restrict lending to investors, competition (i.e. pricing) had since increased in owner-occupier lending. With BEN unwilling to sacrifice its margins and rather focus on “writing business at prices that reflect the risk being taken”, balance sheet growth for the half is now expected to be relatively flat. While BEN and Bank of Queensland (BOQ) have avoided some of the recent headwinds that the majors have faced (including the recently introduced banking levy and higher risk weights for mortgages) they remain exposed to the broader issues facing the sector, such as this and pressure on fees and charges; the recent removal of foreign ATM fees the latest case in point.
Packaging group Amcor (AMC) also provided a relatively soft first quarter update, although reiterated its full year guidance. The primary weakness has been attributed to emerging markets, a continuation of one of the trends of FY17. Some weakness has also emerged in the North and Latin American beverage market, with AMC now expecting a flat result in the first half for its rigid plastics division.
Finally, raw material input cost inflation has been problematic for the company (which is unsurprising given the oil price recovery), however, we would expect this to be a transitory headwind as AMC’s contracts typically allow for recovery of these, albeit with a lag. While the December half may ultimately prove to be a softer period for AMC, we remain attracted to the stock based on its defensive characteristics, strong track record of disciplined bolt-on acquisitive growth and exposure to offshore markets (and thus a weaker $A).
A more optimistic update was provided by Boral (BLD) which upgraded its FY18 guidance, primarily due to better performance in its domestic business. Favourable weather conditions were highlighted by the company, with below average rainfall through the September quarter. While this is clearly an external cyclical factor, the market environment is supportive, with growth in large infrastructure projects and pricing more than offsetting weakness in WA and the peaking of residential property construction. As we highlighted in our recent note on infrastructure, we believe that BLD is one of the better ways to invest in this theme. The stock has a solid medium-term growth outlook and trades on a reasonable forward P/E of 18X.
September Quarter Rainfall
Woolworths’ (WOW) quarterly sales were again in contrast to the soft figures reported last week by Coles, indicating further market share gains by WOW. Like-for-like sales growth of 4.9% was a commendable result in a deflationary environment, particularly in fruit and vegetables. Big W also showed a much improved result (sales +2.5%) as it looks to improve on a disappointing period of performance. The margin outcome to achieve this, however, is less clear and investors are unlikely to give management much credit until it becomes evident that the turnaround is sustainable and the losses the division has been experiencing are stemmed.
From here, a key hurdle for WOW will be continuing it strong momentum against Coles, which will become tougher as it begins to cycle stronger figures from the December quarter last year. While WOW is currently the pick of the two key supermarket chains, it is so in a poor sector that is facing high levels of competition and its valuation at 21X FY18 earnings looks full.