Week Ending 04.05.2018
- US economic trends have improved but are far from the growth rates of past cycles.
- A recent rally in the USD is expected to be capped by a low return on Treasury yields after hedging costs and a view the currency is still expensive.
The pace of growth in the US services sector has moderated in recent months. The composite index of non-manufacturing activity remains high (last reading of 56.8, where over 50 indicates expansion) but is retracing from the peaks of early this year. Services is a large proportion of all developed economies and arguably more important than the constant focus on goods manufacturing and retail sales.
Commentary from the respondents to the survey centred on the uncertainty created by the tariff debate (both NAFTA and China) and the potential effect on the cost of goods. Other issues raised was a shortage of transport workers (resulting in cost pressure for many companies) and capacity issues in the services side of construction. Generally, companies appear concerned on their ability to recover any cost increases via pricing.
For the services sector, demand from households is key and the lack of income growth compared to previous cycles is a significant limitation. The real growth in disposable personal income (DPI) is notably below previous cycles.
Cumulative Growth in per capita real DPI from cycle through to peak
The trend is hardly a surprise, as wage growth has been low compared to corporate profit share.
Associated with this has been the weak capital investment cycle. Corporates have been far more inclined to buybacks or operating technology updates rather than capital improvements. Therefore, the corporate profit share has not been recycled back into the economy in the traditional employment and wage route, but rather rewarded the relatively narrow cohort that are large holders of equity assets.
Net Private Business Investment and Profits* as % of GDP
These issues raise the complexity for the Fed. And changing to its set pace of rate rises risks sending a signal that it has lost faith in the recovery, yet the household sector will be met with higher interest costs at a time that wage rises are still subdued.
- The economic growth in the US will invariably pick up this year, but is self-limiting. It appears that equity markets are also unwilling to push out the premium on US stocks given policy uncertainty and rising rates.
In a typical fashion, the overcrowded weak USD view unwound in April. We have noted that for many regions, especially Europe and Japan, the higher yield in US bonds was undermined by the high cost of the currency hedge. While some suggest the weaker European data damped the Euro, the more likely explanation is that with US 10-year yields near 3%, the positive return after hedging had crept back.
These moves are then exacerbated by short term traders such as hedge funds or algorithmic investors.
The consensus is still biased to USD weakness. European growth should pick up in forthcoming months and in the US, the trade uncertainty and large Treasury issuance are expected to dampen a further rally. Past experience, however, shows that an apparently rational argument for currency movements can be frustrating in the short to medium term.
The reality is that the weaker USD through 2017 has only partially unwound its overvaluation based on purchasing power parity.
USD Purchasing Power Parity
Another version is the trade-weighted value of the USD against its history. In this case. It is around its long run average. The chart, however, shows how persistent currency cycles typically are. That makes part of the case for renewed USD weakness at some point.
- The AUD is judged to be at fair value in the mid 70c range to the USD. It may yet weaken against the Euro and the Yen. We recommend that any hedging is based on the weight to global equities and the willingness to see through shorter term currency cycles.
Real Trade-Weighted Ex Value of USD vs Major Currencies
Investment Market Comment
- April equity movements struck a positive note. US earnings were in focus and meeting expectations while the ASX also managed a better month notwithstanding the pressure on the financial sector.
April proved to be a positive period for equities with the exception of China’s Shanghai CSI 300 index. China stocks faced numerous headwinds given the uncertainty in the outcome of trade talks between the US and China. In addition, slowing credit growth and tightening policy weighed on the index as the authorities look to introduce stricter regulations on riskier financing methods to reduce systemic risks.
In the US, the index was supported by energy stocks, which finished the month nearly 10% higher. Sharp rises in oil prices, with the West Texas Intermediate and Brent up 5.7% and 8.4%, respectively underpinned the sector.
The US quarterly reporting season kicked off, with over 50% of companies within the S&P500 reporting to date. Given the tax reforms expectations of earnings growth was high. These seems to have been met with over 75% of companies that have reported beating estimates, yet the tepid reaction implies that most was priced in.
S&P 500 Earnings above, in-line, below Q1 2018 estimates
The utility sector was among the top performers in the US finishing 2.05% higher in April. This is somewhat surprising as the rate-sensitive and capital-intensive sector was faced with a near 3% 10-year bond yield. However, on a year rolling basis utilities have considerably underperformed the broader market. As we touched on last week, defensive stocks such as in the utilities, real estate and consumer staples sectors that provide a stable dividend have struggled over the past 12 months as investors revalue these based on the rising cost of capital.
1-Month and 1-Year S&P500 Performance
Locally, after finishing each of the first three months of the year lower the ASX200 rebounded 3.9% in April. However, over the past 12 months local shares still lag the rest of the world. Energy, materials and healthcare led the gains with all major sectors finishing in positive territory. Energy stocks rallied on the move in the oil prices, whilst a 12.5% increase in the price of the aluminum boosted the materials sector.
The healthcare sector advanced on new-record highs from CSL and Cochlear. Apart from reports of a record flu season relevant to CSL, there were no material announcements for either. The USD recovered ground and as both CSL and Cochlear generate over 45% of its revenue from the United States investors may have used these stocks to participate in a currency move.
Fixed Income Update
- The rates market sold off in April as the US led yields higher, with the 10year Treasuries breaking through 3%.
- Credit products faired better as spreads stabilised and tightened slightly over the month. Hybrid securities were the biggest beneficiary of this move as this asset classed recouped most of their losses over the quarter.
- AMP hybrids traded down as the findings from the royal commission weighed on prices.
- Central bank activity this week included monthly meetings by both the US Fed and the RBA. Focus was on commentary as rates remained on hold in both regions.
The performance of fixed income markets was mixed in April. In a reversal of the prior month, credit held up while the rates market weakened. The US set the pace with yields on 5year treasuries rising by 0.30% and 10year USTs by 0.20%, pushing the yield through 3% for the first time since 2014. This is significant for a number of reasons, including that the majority of consumer loans in the US are fixed rate, with mortgages, auto loans and other lending being set from the 10-year treasury note. Short dated rates, as expressed through Libor, remained elevated in April after jumping some 30bp in March.
Rate moves were more tempered in Australia with our 5year ACGB only rising 0.12%, while the 10 year also failed to keep pace with the US, up 0.16% over the month. However, given the long duration that is inherent in global bond indices (issuers have extended term over the last few years), these rate moves wiped out coupon income for the month resulting in a slightly negative performance in April.
Credit performed better given spreads stabilised and finished the month slightly tighter (Aussie iTraxx tightening from 0.70% to 0.65%) with the hybrid market also posting a strong month at 0.90% return. The Composite ASX listed interest rate securities index fell 0.23% in April, but this was driven by listed Treasury bonds (-0.33%).
Performance of ASX-listed securities in April
- Translating this to fund performance for the month, results were mixed. Long duration style funds (eg JCB, Legg Mason Brandywine and Pimco) had drawdowns in their unit price, while credit funds (JP Morgan Global Strategic Bond Fund, Kapstream, Macquarie Income Opportunities) and bank hybrids all posted positive performance.
The AMP listed securities were in the bottom two performers in April on the ASX. AMPPA fell -2.45% and AMPHA by -1.13% due to negative media exposure from the banking Royal Commission. This week these two securities fell further following Standard and Poor’s response to the commission findings, placing AMP Ltd (including insurance subsidiaries, and all debt issues including its subordinated issues) on negative credit watch. Despite the positive correlation between hybrids and equity, it should be noted that the price falls were significantly different in magnitude, with the equity falling by 19% in April.
Price movements in AMP hybrids and ordinary shares
The US Fed left interest rates on hold, with the next move by the central bank likely to be in June. The rates market viewed the accompanying statement as slightly dovish given talk of the Fed’s confidence in its inflation outlook, and the use of the word ’symmetric’ inflation target which was interpreted that the Fed might tolerate inflation shooting above the 2% target. The statement also outlined the US treasury’s funding schedule, with additional borrowings of $33.9bn to be issued in short dated securities, in which the market showed little reaction.
Domestically, the RBA kept rates on hold again this month as expected. In the accompanying statement it noted:
- It is comfortable with the current level of rates in its support of the local economy.
- The increasing of U.S. short term rates, the flow on effect it has had on BBSW and the contractionary impact it will have on domestic borrowing, even without an official rate rise.
- A reasonable growth and employment outlook, tempered with uncertainty surrounding the outlook for household consumption and debt levels, as well as continuing to communicate a confidence in increasing wage inflation.
- There was a mixed reaction to two of the major four banks that reported this week. The restructure of ANZ’s book has reduced its risk profile and the company is in a good position to extend its share buyback in coming periods. There was a more muted response to NAB’s result, with high one-off costs and a dividend that is under pressure.
- Macquarie Group (MQG) again beat its earnings guidance, although the expectation is for flat growth into FY19.
- Price discounting by Harvey Norman has led to a downgrade in JB Hi-Fi earnings. The Good Guys acquisition has been far from a success to date, although synergies will support earnings in the medium term and the stock’s valuation is undemanding.
ANZ was the first of the major banks to report its half year results, with its strategy of simplification, involving the divestment of non-core assets and a reallocation of capital towards the higher-returning segments of its portfolio continuing to gain traction. The bank’s earnings growth for the half was 4% and slightly ahead of expectations, although the underlying factors driving this were arguably of low quality given a cyclically lower bad debts expense. After a spike in bad debts in 2016 that stemmed from its commercial and institutional loan book, ANZ’s provisions have since steadily fallen back to a similar level that of the other major banks.
ANZ: Total Provision Charge
ANZ also received a tick for sound cost control in the half, with expenses falling 2%, while its ROE improved slightly to 11.9%. Income, however, was slightly down, reflective of the benign credit growth environment and the rationalisation of its lending book. Additional headwinds were also visible and will feature into the second half, including the inclusion of the tax levy on the major banks, recent increases in funding costs that have the potential to impair margins and the costs of the Royal Commission (expected to total $50m for the year).
We currently have ANZ as the only bank in our model portfolio based on several factors: it trades on an attractive multiple, its dividend is on a more sustainable path after it rebased this in 2016 at a lower payout ratio, and its capital position is the strongest among the majors. This latter point sees it well placed to return additional capital to shareholders over and above the committed $1.5bn buyback previously announced as it continues to divest non-core assets.
NAB meanwhile reported a slight miss on its earnings, which were flat on an underlying basis. Once previously disclosed restructuring costs are factored into the equation, however, net profit fell 16% for the year. NAB also kept its dividend unchanged, although the sustainability remains a point of contention given a flat earnings profile (with potential risks to the downside from soft margins and benign credit growth) and a prevailing high payout ratio in the mid 80% range.
The key talking point of NAB’s result was on costs and the lack of any real benefit flowing through from its accelerated investment program announced six months ago. The program is perhaps the most ambitious among the major banks, with an increase in automation intended to allow NAB to reduce its workforce by approximately 4,000 by the end of FY20.
As a result of this increased investment spend, NAB’s FY18 expenses are expected to grow at between 5-8% and notably, this number excludes large one-offs and restructuring costs. Further, implementing the program in the half resulted in the bank’s staff numbers increasing over the six months, despite 521 ‘productivity’ retrenchments.
NAB: FTE Changes
The somewhat unsurprising announcement that accompanied NAB’s profit release was the decision to divest its MLC wealth management and platform business, a trend that is consistent with the other majors, with the subject of vertical integration attracting a high level of scrutiny thanks to the ongoing Royal Commission. NAB will explore various separation options, including an IPO or trade sale, with this not expected to be completed until the end of next year.
The bull case for NAB centres on its overweight exposure to business banking (which has a better outlook and fewer risks compared with a slowing mortgage lending market) and belief in its target of flat cost growth over FY19 and FY20. The solid yield is another feature often cited, although as we highlighted above, we view the dividend as a greater chance of being cut over the next few years compared with its peers as the sale of MLC will further reduce its earnings base.
Macquarie Group (MQG) impressed with its result, easily beating its 10% earnings growth guidance. The company recorded 15% growth for the year, allowing for a 12% increase in its full year dividend.
As is typical with MQG results, there were several volatile items that contributed to profit growth in the period that cannot be considered to be repeated in following years. This year, performance fees in its asset management business were higher than usual (and more than double the figure of FY17) and asset realisations in the Macquarie Capital division were a further positive.
Notwithstanding, MQG has still done a sound job in transitioning to annuity-like earnings streams over the last few years and this has been reflected in a higher level of consistency in its profits year on year. Unlike many other listed stocks, its share price growth through this period has been underpinned by profit growth as opposed to simply P/E expansion.
Macquarie Group Profit
MQG also provided guidance for FY19 for the first time, with earnings expected to be ‘broadly in line’ with FY18. We would highlight that, in more recent times, MQG has developed a track record of issuing relatively conservative guidance which it has then exceeded. This is somewhat understandable given the difficulty in forecasting the contribution from its capital markets facing businesses. While some of the items above will be a headwind into FY19, a weaker AUD has the potential to support earnings given that around two thirds of the company’s earnings are sourced from international markets. We believe that MQG remains an attractive diversifying option in the financials sector of the market.
JB Hi-Fi’s (JBH) trading update included an earnings downgrade of approximately 3%, sending the shares lower. The group’s sales guidance remained unchanged and importantly, the core JB Hi-Fi store group has continued to perform well and in line with expectations. The brand recorded comparable sales growth of 4.0% in the third quarter, a commendable figure in a tough retail environment and noting that it was cycling a tough comparable period.
JBH’s downgrade hence related to the performance of its acquired Good Guys business. The Good Guys sales have been quite variable in recent quarters and while this has been tracking as expected through this year, it has come at a cost to margins.
Amazon has been highlighted as the potential risk to margins over the medium term, yet the likely instigator of increased price competition has been Harvey Norman. In effect, Harvey Norman has looked to take advantage of the disruption to the Good Guys business from the change in ownership (with reports that this transition has not gone as smoothly as hoped, with turnover of some store managers following the switch from a joint venture to a corporate-owned network). This is a strategy that Harvey Norman has utilised in the past and there is thus the potential for this competitive environment to also impair JBH’s earnings into the next financial year as it looks to protect its market share via lower pricing.
While this week’s downgrade is a setback for JBH and the underlying retail environment is difficult, we believe that the stock remains good value, trading on a FY19 forward multiple of just 11X. With its low-cost operating model, a proven ability to adapt to changing consumer trends, and synergies still to be realised from the Good Guys, the company is better placed than most to deal with the challenges that lie ahead. On an attractive yield, the stock is in the Martin Currie SMA portfolio as well as our own model equity portfolio.