Week Ending 04.08.2017
- The Bank of England talks down rates, growth and inflation in the short term while expecting conditions to normalise after Brexit.
- Pension liabilities are the other side of the bond market, and it’s not making it easy.
- Australian economic growth looks to a relatively benign Q2 outcome. Corporate profit margins however may see pressure unless prices go up.
With reasonable cause, the Bank of England’s Carney blamed Brexit and pushed out any rate hike well into 2018. The commentary raised the conflict between the unusual low volatility in financial markets versus the uncertainty in the economy as the difference in time frame - one focused on the next month or two and the other on the next year or two. Given a view businesses may delay investment spending, the bank also reduced its GDP forecast to 1.7% for 2017 and 1.8% for 2018. Inflation is expected to peak as the impact of the fall in sterling passes through, and the housing market is also said to be in a reasonable position with so called buy-to-let transactions moderating. The BoE makes a somewhat brave assumption inflation will return to 2.2% by Q4 2019; precision forecasting indeed!
The British central bank had done a household survey on their likely response to higher interest rates. Less than 10% said they would borrow more to fund spending, while most stated they would resort to savings.
This holds both good and bad news for economic growth; households in many parts of the world are self-selecting restraint on their debt levels given the absence of household income growth. On the other hand, consumption will be handicapped by modest savings, especially by those that make the most contribution to growth, families, which are more likely to have mortgages and a lower level of saving.
Business conditions in the UK have sent out mixed signals, leaving economists to grapple judging the real trends. The business council survey (CBI) shows buoyant conditions due to the larger export-oriented companies in its cohort, which have benefited from the fall in sterling and pickup in global trade. Conversely, the ONS (Office for National Statistics) provides a much more troublesome assessment. It covers a broad sample of companies with more than ten employees and would capture some of the tough conditions in sectors such as retailing. In the middle is the PMI, implying that UK industries are still expanding, but at a lower pace.
UK business surverys
These conditions may well be reflected in many other parts of the world. This is a good time for large outwardly looking growth companies capable of getting the best from low rates and wages; less so for those without pricing power.
Central banks are also increasingly allowing their staff to indulge in research and produce papers outside the mainstream policy talk. The Bank of England blog, Bank Underground, made the case that not only do low interest rates cause problems for pension asset returns, but that the volatility in bond prices creates havoc with pricing liabilities given moves in the discount rate. Brexit and the changing position of BoE on the direction of rates results in its own mini storm in liabilities in the past year, ironically as investment assets are at ultra-low measured volatilities.
UK defined pension assets less liabilities
It also paints a global picture. The outstanding unfunded liabilities for pensions is going to come at a cost to the economy over the coming decades. Without decent returns from low volatility fixed income, these funds are either going to show such deficits, or move even more into higher risk assets. Other investors may welcome this given it would result in a rise in valuations of these assets, but it does not solve the problem; rather, it adds to it.
Australian retail data continued it broadly based better trend. Housing approvals were solid, once again due to multi-unit dwellings. The impact of greater mortgage restrictions has had relatively little impact as demand remains solid. The expected fall in housing activity is therefore likely to be slow and moderate.
Retail sales growth was above expectations. However, the key difference was in value versus volume. Only avocado toast and lattes can hold their pricing power, with prices down in all other segments in the quarter. The volume burst may therefore be illusionary, driven by discounting and tightening margins. At least with low income growth, retail spending cannot be blamed for cost of living pressure.
The key for the sector will be the trend in wages, but also the reaction of households to non-discretionary costs rises through this year.
The impact of electricity prices even got a mention in the RBA statement on monetary policy which, along with the rise in award wages, is expected to put a floor under inflation. The comments noted uncertainty on the flow through effects of such prices and whether businesses could put their prices up to compensate for costs. On the other hand, the rise in the AUD will limit import inflation. Overall, the RBA gives the impression of comfort with respect to conditions and paints an upward trajectory for GDP growth as if we are in a normal economic cycle. Perhaps they had read the Bank of England statements referred to earlier!
Fixed Income Update
- The margin offered on US Corporate debt has traded tighter on capital flows into this sector.
- The growing issuance of ‘green bonds’ has resulted in new green bond funds, however, strict investment criteria prevent the purchases of many of the bonds on offer.
- The Republic of Iraq has issued its first independent bond in 10 years.
- On a lighter note, the ‘bond’ that is rumoured to pay $US150m.
The US corporate bond market is $8.6 trillion in size and growing, with May registering the largest inflows since 2009. As demand for corporate bonds outstrips supply, the credit spread on these securities contracts. The credit spread, or margin, is the difference between the yield of a corporate bond and a government bond with the same maturity. The average spread on investment grade US corporate bonds is at a level not seen since 2014, and is not far away from the level from just prior to the financial crisis in 2008.
Credit spreads on US corporate bonds in the last 10 years
Several reasons have been cited for the increased demand including:
- The Bank of Japan, Bank of England and the European Central Bank are all buying bonds under quantitative easing programs, driving corporate bond yields lower. The tight pricing has pushed investors to hunt for yield globally, with the US corporate bond market a beneficiary.
- The USD weakness has added to the attractiveness of these bonds. Offshore investors in Japan and Europe can get a reasonable lift in returns even when considering the hedging costs. The yield has risen further if left unhedged in recent months.
- Inflows have also come from domestic participants. As the US equity market trades at record levels, bond funds have benefited as investors seek value elsewhere.
Monthly purchases of US corporate bonds by foreign investors ($b)
In last week’s publication, we discussed the surge in the number of green bonds being issued in 2017 and the expansion into catastrophe and pandemic bonds. As highlighted then, corporates and sovereigns have become issuers of these bonds if they can link the proceeds to environmental and/or social projects. This includes a recent large ‘green bond’ issued from Apple, which raised $1bn to fund environmentally focused initiatives. The sovereigns of Poland and France have also issued green bonds. Europe accounts for most of these products, with France and Germany leading the way.
Country comparison: total green bonds outstanding (10 May 2017)
With green bond issuance hitting $113bn last year, dedicated green bond funds buying these products have also grown rapidly. However, they all have tight investment criteria which has led to many green bonds being illegible for purchase by the funds. Among the top 17 European green bond funds, total assets under management sits at only $1.4 billion; a fraction of the total. An example of this eligibility was a €500m green bond issued by the Spanish oil group Repsol, which was rejected by many of the funds, which citied concerns over the company. This is even though the bond itself was defined as ‘environmentally friendly’. We note this as many investors now seek products with an ESG skew. The practical reality of such investments is sometimes not matched by the rhetoric. In this case, a bond where the proceeds were intended for environmental mitigation sat in contrast with the operations of the issuer.
This week the Republic of Iraq had its first independent bond sale in more than a decade. The sovereign issued a $1bn 6-year bond at a fixed rate yield of 6.75%. The deal was said to be more than six times oversubscribed. This is its first ever marketed and syndicated international bond issue. Iraq’s bond was rated B- by both S&P and Fitch rating agencies.
In a different ‘Bond’ altogether, Daniel Craig has apparently signed on to play James Bond again in the next movie of the franchise. Rumours suggest that he has been paid $US150 million for two more films.
- Rio Tinto (RIO) missed on its half year result, although investors were impressed with the announcement of further capital management initiatives.
- Clydesdale Bank (CYB) posted a strong quarterly result and is ahead of its own cost cutting program.
- Suncorp (SUN) was sold down after reporting below the market’s expectations.
- Crown’s (CWN) additional shareholder returns from assets realised through the year continued, however its higher roller turnover has taken a hit.
- Tabcorp (TAH) hit the high end of its downgraded guidance, while attention will now turn to its tie up with Tatts Group (TTS), with the transaction being delayed this week.
Rio Tinto (RIO) was the first of the big mining companies this reporting season to show the benefits of the rebound in commodity prices to its bottom line. While its first half underlying profit of US$3.9bn was just shy of expectations, it was still more than 150% up on the first six months of 2016. Despite the sharp jump in earnings, this has only clawed back part of the prior multi-year decline, with the result lower than that of the first half of 2014.
Unsurprisingly, it was higher commodity prices that were the primary driver, with other factors such as volumes and cash cost reductions relatively insignificant. By commodity, iron ore remains the dominant division, accounting for more than 70% of group earnings. With its core Pilbara unit costs running at ~$14/tonne, the margin on this business (approximately 80% on current spot pricing) is key in the cash generation of the business.
Rio Tinto: 1H17 Earnings Bridge
Despite the step up in earnings over the last 18 months, RIO’s forward capex guidance has remain unchanged. As such, the company’s intention in allocating this excess capital is clear: firstly, paying down debt, and secondly, increasing returns to shareholders. The first part of the equation is now largely complete, with net gearing falling to 13%. This allowed the announcement of a much higher first half dividend, along with a US$1bn increase in its buyback program (applied to its UK listing, which trades at a discount to the ASX).
How long this high capital returns policy can be maintained will largely be determined by the sustainability of the recent commodity price rally, in particular, iron ore. After experiencing a dip in the second quarter of 2017, the price has risen again in the last two months, indicating that an earnings upgrade cycle may soon emerge.
RIO has recently been preferred by investors over its diversified big cap peer BHP Billiton due to its greater near-term capacity to return additional capital to shareholders and iron ore leverage. However, this latter exposure could quickly turn into a headwind if iron ore returns to a longer run price (as implied by the industry cost curve) of closer to US$50/tonne.
UK-based Clydesdale Bank’s (CYB) trading update was viewed favourably, with positive trends on several fronts. The bank reported respectable growth in its mortgage lending of 6% (annualised) for the nine month period, while net interest margins also expanded. CYB’s capital position also remains sound, with a CET1 ratio of 12.4%, within its target range of 12-13%.
Aside from the geographical exposure of CYB, the key difference in its outlook compared to Australia’s domestic banks is that a core driver of its expected earnings growth profile is a much greater opportunity to reduce costs. On this measure, CYB is tracking ahead of its stated targets, with a further reduction in its expected operating costs for FY17. With its current cost to income ratio tracking at around 70% and a target of below 60% within the next few years, the scope for improvement is still significant.
While the cost-out story is considerably less attractive than the company that is growing organically, this relatively predictable driver of falling costs is one that has some appeal in the current environment of scarce high revenue growth across the market. CYB trades on a similar P/E multiple to our major banks and we believe that the stock remains a good alternative to the major bank holdings of the typical domestic investor.
Suncorp (SUN) was marked down for its full year result, which missed analysts’ expectations by around 5%. The company has been classed as a turnaround opportunity stock since it experienced a blow out in claims inflation in its insurance business 18 months ago. SUN’s general insurance margin was rebased at a lower level, although has since shown some gradual improvement towards the group’s 12% underlying target.
A better pricing environment has also translated to higher top line growth, particularly in commercial lines, however premium growth of 4% for the year was still softer than expected. Heading into FY18, a higher natural hazard allowance (a somewhat necessary adjustment given the frequency that SUN has exceeded its budget) will be a headwind for the group’s insurance margin.
Suncorp General Insurance Margin
Of SUN’s other divisions, there was some parallels with its larger peers in its banking and wealth business, with relatively flat profitability. Lending growth was benign at 2% (although stronger in the second half), credit quality remains very robust with low impairments, and net interest margins improved on recent sector-wide mortgage repricing. Meanwhile, SUN’s New Zealand business was also affected by higher natural hazard insurance costs.
We believe that listed insurers remain a good portfolio hedge against rising interest rates and have preferred to gain this exposure through QBE, with its US-focused exposure.
The full extent of the fallout from the arrest (late last year) and subsequent conviction of Crown (CWN) employees in China for promoting gambling was revealed in the company’s full year result today. Normalised profit (that is, adjusted for a normal casino win rate) dropped 16% for the year, with the primary driver a 49% plunge in high roller turnover at CWN’s Melbourne and Perth casinos. Excluding its high roller business, the performance of the two casinos was relatively mixed. Main floor gaming revenue declined in Perth and was flat in Melbourne, while the opening of a new hotel in Perth helped to lift earnings.
Once a company with vast international ambitions, CWN has gradually withdrawn from many of these ventures, including its recent decision to not proceed with the development of a casino in Las Vegas and the sale of its stake in Melco Crown, which owns a number of casinos in Macau.
These decisions have provided the company with excess capital that has allowed it to return to shareholders through higher dividends and a share buyback, which was increased at this result. Its domestic-focused portfolio is now thus more comparable to other listed casino groups, SkyCity (SKC) and Star Entertainment (SGR). We have favoured the latter, which trades at a discount to CWN, despite owning more attractive assets in Sydney and Queensland that play into the international tourism theme.
Tabcorp (TAH) is another gambling stock that has underperformed over the last 12 months, although it delivered headline full year result at the top end of its recently downgraded guidance. TAH reported a 4% decline in profit over the year, with the company dubiously excluding the $46m EBITDA loss incurred in its UK start up, Sun Bets, in this figure. TAH’s core wagering division reported flat revenue year on year, with softer margins on a higher cost base on the back of investment in technology, marketing and compliance.
While there is operational improvement to be made in its existing businesses, TAH’s focus over the next year will be completing the proposed merger with Tatts Group (TTS). The timeline for this was pushed out today to give the companies the opportunity to include their FY17 results into the scheme booklet, with a shareholder vote now expected in October. The proposed combination has been viewed as compelling from the synergies that will be realised, though the estimation of these by the companies has been assessed by some as relatively optimistic.
Next week has a similar number of companies announcing full year results as this week, before the bulk of the market reports in the second half of August:
Tuesday: Janus Henderson Group, James Hardie, Shopping Centres Australasia, IOOF, Transurban
Wednesday: Cochlear, carsales.com, SkyCity, Commonwealth Bank
Thursday: News Corp, AMP, AGL Energy, Magellan Financial Group
Friday: REA Group