Week Ending 04.03.2016
A surprisingly strong final quarter Australian GDP release and upward revision of Q3 took the annual economic growth rate for 2015 to 3%. The positive news, however, was dampened by the detail. Household spending through consumption and housing contributed 2.1% of the 3%, and came at the cost of reduced savings. In simple terms, consumers spent more than they earned to lift GDP; clearly not an ideal scenario for growth. Real household income (adjusted for inflation) actually declined 0.3% in the fourth quarter due to low income growth, representing the combination of wages and other forms of income such as government benefits and interest. On a per capita basis, the numbers are even worse, with a fall of 2.3% in real income. For a cohort with one the highest debt/income levels in the developed world, running down savings does not add confidence to longer-term growth.
Turning the focus to what lies ahead, the trend of services compensating for mining, at a GDP level, is almost certain to prevent any near term marked deterioration in reported GDP. Health, education, financial and property services are sustaining employment, but these industries are capex-light, resulting in weak business investment data. Productivity growth is also therefore very slow.
If the current momentum is to change, the most likely factor would be either an upward movement in investment in sectors such as tourism and infrastructure, or a deterioration as households decide that spending savings has reached an uncomfortable level. January retail sales eased from the relatively robust run into the end of 2015, especially in discretionary sectors, with department stores showing the strongest pull back.
To that end, the RBA has also noted that monetary policy is not capable of generating long term growth with “sustained long run growth...to come from innovation, risk taking and productivity”. This puts the 2% cash rate as the most likely outcome for some time yet, notwithstanding the discomfort that the central bank would have in the rise of the AUD.
In turn, the RBA would be hoping the soft spot in the US economy is well and truly behind it and that the Fed does another rate rise, taking the USD with it. The evidence for this is improving. Employment data shows no signs of turning down, and states with below 4% unemployment are experiencing wage gains of 3-4%. Construction activity has picked up, as has manufacturing. The suggestion that the stronger USD is hurting the economy looks overstated, skewed to reflect the feedback from listed companies with global operations rather than a structural shift in production facilities. An example comes from the release of light vehicle sales, encompassing autos and light trucks.Enlarge
The imports share of the passenger car market is 25%, and only 15% in light trucks, with local production growth well exceeding imports even in the past year. To suggest growth might accelerate would, however, overstate the reality. The non-manufacturing index is levelling off at 53 (50 is no growth and 53 therefore indicates modest expansion) coming off its peak of 60 a year ago. The looming election is likely to see business take a backseat on committing to new investment.
As we have mentioned in a number of weekend notes, the potential transition to a slight upturn in inflation in the US could be one of the more important developments due to the impact on fixed income markets and corporate earnings. Indications are that rising prices in healthcare and housing market rents are already underway and, more recently, even goods inflation is showing signs of firming.
European growth, too, appears to be holding up, with industrial production rising slowly but steadily. Germany is the engine room, yet in 2015 Spain and Ireland were the star performers. This year, Spain’s growth is expected to remain solid at above 2.5%, with Italy coming off a low base. German GDP growth is forecast to be steady at 1.7%. The nature of growth though is undergoing a transformation. A long tail of export-led momentum could well swing to a net trade deficit next year, as global industrial production remains soft and China (in particular) sees falling investment spending. Conversely, domestic demand and government spending is picking up rapidly. Some is due to the circa 1m migrants that have come in the past year, a component from fiscal loosening in advance of the forthcoming elections, and the other from reasonably robust overall domestic demand, driven by rising house prices after many years in the doldrums. Even after this increase, apartment prices in Germany’s most expensive city, Munich, are only €4,000/sqm compared with €11,900 in London or €6,500 in Paris, for example. Outside Munich, the other major cities are well below European norms.
German Residential Real Estate
While Europe has been shaken by the weakness in its financial sector, there are still investment opportunities that arise from themes such as this changing pattern in Germany. Fund managers report that European companies are taking on structural changes to their costs in light of low inflation, and may now have more earnings upside than many US companies which have been down this path in recent years.
Fixed Income Update
In the last couple of weeks, banks have increased the yields offered on term deposits, reversing the trend of falling spread to BBSW. As a guide, a year ago banks were paying 82bp over BBSW, before falling to 40bp at the end of last year, but have now risen to 60bp. Within this, the banks opportunistically raise or lower the spread in different maturity buckets to coincide with their own preference for funding. For term deposits under 30 days, the spread is significantly lower. This short maturity offers little value, as it is not a reliable source of funding. Two month money is also not favoured, with 3 month to 1 year term deposits the preferred maturity where the banks are prepared to pay up and offer a higher rate. The chart below shows the spreads on term deposits over the BBSW rate for varied maturities in the last 3 years.
Term Deposit Margins over BBSW
- The reason for the recent spike in yields offered on term deposits can be attributed to a number of reasons.
- The increase in the cost of wholesale funding for the banks in the last few months. This has been in the form of an increase in the spread or premium over the risk free rate that banks pay when issuing a bond. Term deposits offer a cheaper source of funding than issuing bonds at this time.
- This week’s GDP figures showed that the savings rate has fallen in the year from 9.1% to 7.6%. One would therefore assume that banks have also seen a fall in the growth in term deposits and are looking to attract more funds.
- Banks have also recently increased the rate payable on investment housing loans. They can therefore afford to pass some of this rate rise on to their term deposit holders.
- The better-than-expected GDP figure led the yields on Australian futures higher, as the argument for further rate cuts by the RBA weakened slightly. Prior to the data release, the market was pricing in an 86% chance that rates will be cut by 50bp in the next 12 months. This probability has now fallen to 72%.
Tatts Group (TTS) received some unwelcome news this week (and a timely reminder of the regulatory risk that is often involved in the gaming sector) when the High Court of Australia overturned a decision that had originally awarded it $540m as compensation for the loss of its right to operate poker machines in Victoria.
To refresh, TTS and Tabcorp (TAH) had previously held duopoly poker machine licences (outside of Crown Casino) since the mid 90’s and had an agreement with the Victorian Government that compensation would be paid in the event that the licences were awarded to another party. In 2008, the Victorian Government decided to restructure the gaming industry, which resulted in the loss of the TTS/TAH duopoly and turned over the operation to the pubs and clubs where the pokies were located. These were relabelled as “entitlements” instead of “licences” and, with the new structure, the Government walked away from its commitment to reimburse TTS and TAH. The decision has resulted in a lengthy court battle between the parties which culminated in this week’s decision in favour of the State of Victoria in both cases. (TAH was originally unsuccessful with its claim while TTS was).
Hence, while TTS has operated for a number of years without the poker machine business, the company was still expecting to be in a position to return its compensation consideration to investors (~25c per share) in the near future. While there is thus no ongoing impact to TTS’s continuing operations, the stock’s valuation has been cut by the higher debt levels it will now carry.
The upshot from this week’s decision is that it may pave the way for the reopening of merger discussions between TTS and TAH following the removal of this point of uncertainty. The two companies walked away from talks late last year, unable to agree on acceptable terms, with significant synergies forecast by analysts by combing the groups.
The banking sector has been knocked around in the last couple of weeks following the release of another headline-grabbing report from an international investor highlighting the high relative valuations of Australian residential property compared with other countries. Notably, bank shares have recovered all initial losses following the release of this report and have been among the best performing large cap stocks this week, no doubt assisted by a GDP print that was ahead of expectations and a general return of ‘risk-on’ trading by investors around the world. While acknowledging that Australian house prices are high on almost any measure, below we note some of the counter claims that have been put forward against an imminent collapse in prices.
Firstly, high house prices are an issue that regulators and the RBA (which has been reluctant to cut interest rates that could have help push prices even higher) is well aware of, and changes have been made in recent years to limit more speculative behaviour. These include stricter credit assessment for borrowers, more stringent loan serviceability assessments (i.e. ensuring borrowers can still make repayments should interest rates rise) and limiting growth in investor loans for individual institutions. While these changes will not de-risk the existing mortgage books of the banks, they should limit the risks of mortgage loan losses from new loans.
The existing mortgage loan book of Australian banks would also appear to be in better shape than other countries that have suffered a housing price collapse. Australia has a low proportion of risky low doc lending and there is a lack of honeymoon, or introductory rates, that step up after a given period. The proportion of high loan to valuation (LVR) ratio loans has been falling over the last few years and borrowers have taken the opportunity of low interest rates to build their balances in mortgage offset accounts to the extent that this buffer now represents more than two years of repayments.Enlarge
Dynamic LVRs notably sit at 50% or less for each of the major banks. It is true that interest only loans have been prevalent among investors, however this may simply be driven by a desire to maximise deductibility of interest payments and provide a higher level of flexibility. Research from ASIC has shown that interest-only loans have been made to borrowers with characteristics that may provide some comfort. They tend to be lower LVRs at origination and higher-income borrowers are well represented in this category.
Some of the factors cited above are a result of an improvement in mortgage serviceability for the vast majority of borrowers. While house prices have continued to outpace income growth, record low interest rates has meant that interest payments as a proportion of income has actually fallen since the GFC. Low interest rates are thus an important factor in ensuring that this mortgage serviceability ratio remains contained. This does not appear to be a significant risk in the near term, although a normalisation of interest rates at some point would no doubt provide a more challenging environment for borrowers.
The two other key risks to Australia’s housing market are higher unemployment and policy uncertainty, particularly regarding negative gearing. The unemployment rate has so far been relatively resilient, as Australia has transitioned from the mining investment boom over the last few years,
However the latter issue of policy change is more likely to create uncertainty in the next 12 months. Another factor that has probably received less attention is the potential for oversupply, particularly following recent strong housing construction. The effect of this would typically be contained to individual regions or cities rather than nation-wide, although the losses could still be material.
In summary, we do not dismiss the high level of debt in households and high house prices as a risk for the banking sector. However, at this time there is no compelling argument that there is a risk that should be priced into the equity valuation. That said, while the recent rally in banks stocks is, in our view appropriate, we would not carry excess exposure to this sector in portfolios.
Reporting Season Wrap
Half yearly reporting season has just concluded and, on balance, was an improvement on recent trends. More companies beat consensus expectations than missed (although this is not an usual outcome), yet the bar was not set particularly high. Individual stock volatility in response to earnings announcements was very high, particularly so for companies that were within a few percent of guidance.
On a positive note, forward guidance was somewhat more optimistic than investors had been anticipating. As a result, the level of downgrades to earnings estimates was at its lowest level for a number of years. Despite an improvement on more recent reporting seasons (particularly last August), the Australian market underperformed several international markets in February, most notably the US.
The best sectors of the market were broadly as expected leading into reporting season. Housing-related stocks reported strong results, benefiting from higher levels of dwelling construction and guidance by these companies remained robust. The gaming sector also produced good numbers, as the casinos were among a small group of tourism-related stocks that are riding the tailwind of a weaker AUD. Several offshore industrials reported better than feared, with little slowdown evident from emerging markets. Discretionary retailers showed a pick-up in conditions and while diversified financials were also generally better, macro concerns contributed to weaker share prices.
Of sectors that are disappointing, resources remain the biggest earnings drag across the market. The banks also remain in a low-growth environment, the domestic insurance sector is showing signs of a maturing cycle, while the larger industrial sectors of telecommunications and supermarkets are feeling the effects of rising competition.
Total dividends for the market were lower for the half, although this was almost entirely due to cuts from the resources sector. The move from progressive dividend policies by the major diversified miners was well-documented, although dividends were also lower across the rest of the sector on the back of much lower profits. Dividends for BHP Billiton and Rio Tinto are expected to continue to transition lower in the next 12 months, holding back broader market dividend growth.
Elsewhere, dividends from industrials edged up, with a high payout ratio maintained. Commonwealth Bank, the only of the four majors to report, elected to maintain its dividend for the half; the first time in several years that investors have not enjoyed higher dividends. This decision, by what is regarded the safest of the majors, may foreshadow similar conservatism (and even perhaps dividend cuts) by its three peers when they report in May.Enlarge
The resources sector experienced another significant contraction in earnings in the December half and profits for the full financial year could be down 50% or more. While commodities were lower across the board, those that Australian companies are most exposed to, such as iron ore, coal and oil, were among the worst performers. In the last six to 12 months, maximising cash flows and protecting balance sheets has taken a much higher priority than growth opportunities, and this has been reflected in sharply lower dividend returns to investors.
Industrials have the brightest prospects for earnings growth across the market at present and this played out through reporting season. This has not translated to stronger overall growth for the market as these companies have a low representation in the index by weight, compared with high weight challenged sectors, such as the supermarkets, insurance and telecommunications (or Telstra). Across the industrials sector, cost out continues to be a key factor in an environment whereby revenue growth is, on average, low. Revenue trends, however, were slightly more positive in the half, although it remains to be seen whether this momentum can be maintained.
Tighter credit markets and bad debts at cyclical lows led to a heightened focus on these issues for the banks. The bad debt cycle is still to show little sign of reverting to longer-term historical levels and this remains one of the risks to earnings growth over the next few years. Of the other factors driving earnings for the banking sector, credit growth remains in a mid-single digit range and funding costs have been rising, although this has been offset successfully by the repricing of mortgage books.