Week Ending 04.09.2015
As we tiptoed our way past a technical recession (two negative quarters required), the reality of low economic growth becomes more transparent. National income per capita has been in a negative trend for some time, as transfers from government are not adding to income while wages growth is at a low ebb.
The national accounts data showed good growth in financial services, information and media and health. However, even dwelling activity appears to have peaked, business investment is falling, while the government sector has picked up.
Output Growth by Industry
Weak retail sales data also followed, implying that the household sector is not immune to its situation. A striking feature of the July release was the quick run-off of the apparent boost from the small business package in the budget. The relatively high savings rate has had many suggest a renewed pickup in spending would emerge to lift growth. Yet, consumers are disinclined to retrace their hard fought buffer; no surprise given current uncertainty.
The persistence of the historical GDP trend outside the boost from commodities has been a function of the rise in population, consistent bouts of housing activity and related increase in household debt. As we have noted in previous weeklies, household liabilities are high and concentrated on those that typically spend – family formation households. Conversely, savings are held in older demographics concerned with retirement or funding their offspring.
Recent data also shows that population growth has slowed from the 1.5-2% p.a. rate of the past decade to 1% p.a.
The key remains with the business sector. Low enough interest rates and the fall in the AUD should revive the animal spirit of the investment market. There is good cause to believe Australia can escape a headline recession. What is probably required is the belief that the currency will remain low for longer, as well as against others (rather than just the USD). In our opinion, the cash rate need not fall further, rather, it is the cost of credit and magnitude of lending towards services and industries that will take up the cudgel outside of the typical norms of property and other asset-based businesses.
Meanwhile, the US indicates a steady pace of growth, accepting ebbs and flows. Employment growth is making persistent progress. A take from Haver Analytics based on the ADP/Moody survey of 411,000 companies representing 24m employees is reproduced below:
“Employment in the goods-producing sector rose an improved 17,000 (1.7% y/y). Hiring in construction posted a steady 17,000 increase (4.7% y/y). Manufacturing sector jobs improved a modest 7,000 (0.8% y/y). Jobs in the service sector increased 173,000 (2.3% y/y), down from the 248,000 high during June 2012. Jobs in professional and business services improved 29,000 (2.6% y/y) and trade, transportation and utilities employment increased 28,000 (1.9% y/y). Employment in the financial sector rose 13,000 (1.8% y/y).”
What is notable is the services sector. Industries such as construction are often the focus, yet are small in the context of other sectors. Small business employment growth was 2.6% yoy, versus 2.1% for mid-sized and 1.7% for large companies.
Somewhat farcically, financial markets are fixated on weekly payroll data in the lead up to the Fed meeting, as though the members will change their minds based on above or below expectations outcomes. One would like to believe the members have already concluded their deliberations and that the decision is largely made.
In Europe, European Central Bank President Draghi reinforced his commitment to easing and conveniently downgraded inflation forecasts, taking the Euro down a notch. In contrast, activity levels and credit growth is continuing at a nice pace, suggesting that, to date, Europe’s recovery can continue notwithstanding the blows from Greece, China and the Middle East.
The complexities of financial markets in recent years go beyond just the unusual interest rate settings to their close cousin of foreign exchange markets. Later in this weekly edition we highlight the movement in currencies with respect to emerging market debt. Another aspect is the large buildup of foreign exchange reserves in central banks.
Central Bank Reserves
The source of these holdings has been from current account surplus which in some cases, has had a huge boost from the commodity windfall. Countries tend to hold these reserves to support growth at some point in the future, such as in the case of Sovereign Wealth Funds, or to support the currency against capital flows.
The pace of reserve accumulation looks set to end in the coming year due in part to commodity prices and smaller surpluses in many Asian countries.
This will have repercussions on interest rates and currencies. On balance, it appears to support the continuation of the USD strength, as some countries seek to prevent their currencies from weakening too far against the USD. It also limits the capacity of central banks to raise rates without causing even further instability. In the longer run, Asian countries are likely to want to hold more in Renminbi, which will matter much more to them than the USD. Expect a lot of light to be shone on the change in reserves and foreign exchange movements in coming years.
Fixed Income Update
The last couple of weeks has seen some panic selling in the Emerging Markets (EM) debt sector. However, the catalyst for this dates back to three main themes which have been playing out for most of this year:
- A strengthening USD
- Falling commodity prices, particularly oil
- Weakening economic conditions in China
The long USD has been the most crowded trade of this year as markets wait for the Federal Reserve bank (Fed) to start raising rates. The dollar strength translates into foreign currency weakness. EM currencies have tested all-time lows recently with countries such as Russia and Brazil falling by 47% and 37% respectively this year. Over the same period, Asian countries, including Malaysia and Indonesia, have only fallen a ‘modest’ 26% and 17%, while Mexico and Australia have both declined 23%, as illustrated in the chart below.
While the Fed’s ‘renormalization’ policy for interest rates has played an undeniable role in the foreign currency weakness, downward pressure for many of these countries can be attributed to the fall in commodity prices.
Oil producers (such as Brazil and Russia) are the extreme cases with both taking a huge negative hit from deteriorating terms of trade. While growth has slowed, inflation has been rising as imports become more expensive. However, these inflationary pressures have been mixed across much of Latin America. While CPI across the region has risen to 8% from 4% in 2011, this has been skewed by a few troubled economies. Venezuela, for example has the highest inflation rate at 70%, while Mexico and Chile’s CPI has fallen in recent months.
Throughout this year the response from policy makers to falling commodity prices and falling local currencies has been mixed. Brazil, for example (and initially Russia – however they have now reversed to easing), responded by raising interest rates to ward off import inflation. However, most developed and developing countries have reacted by cutting rates to support their economies. India, South Korea and now China have all eased monetary policy in recent months.
Post the unexpected devaluation of the Yuan, Emerging Market spreads jumped more than 10% as investors sold EM debt in favour of safe haven bonds in developed markets. In addition, the fact that some leading EM countries are big commodity exporters to China weighed on the market.
While the general direction for emerging market bonds has been down, the impact on investors varies according to their currency exposure. The spread widening on the bonds, consistent with a risk-off sentiment, is only part of the equation. For foreign investors, it also depends on whether they are holding the bonds in local currency or USD and whether they have hedged out the currency risk. Unhedged positions of local bonds have seen greater falls as EM currencies have depreciated, whilst hard currency bonds (in USD) and hedged positions have been protected against some of this volatility.
For clients invested in a diversified mix of fixed income managed funds and direct bonds, their exposure to the EM sector is likely to be minimal (between 5-10% of FI allocation). The higher yield remains attractive and while there is greater volatility, the buffer from the coupon should not be ignored.
Markets remain focused on whether the slowdown in China and weakness in EM countries will delay the Fed’s plans for a US rate rise this year. The implied probability for a September rate rise, as indicated by the futures markets, has changed day to day. Currently the probability of a move is at 30%, down from 38% last week, as illustrated in the table below.
Rio Tinto (RIO) conducted an investor seminar that focused on its iron ore operations, reaffirming its views and forecasts on Chinese and global steel demand, the market and the costs in its own operations. In the Pilbara, RIO is forecasting that its production will grow to 350Mt in 2017 (from a level of approximately 310Mt this year), indicating ongoing additions to a well-supplied market. Unit cash costs, which have fallen 32% in the last 2 ½ years, should be expected to continue to trend down, led by a mix of increased productivity, lower $A and a higher level of automation across the network. RIO is currently employing various levels of automation across its trains, trucks and drilling programs, which has led to improvements in overall utilisation rates. Despite the iron ore price decline over the last 12 months, Pilbara iron ore continues to generate attractive margins; 61% at the EBITDA level in the first half of 2015.
Some market participants have become less upbeat about the prospects of further growth in steel demand in China going forward (including BHP Billiton), however RIO has still maintained its forecast of production in the country growing to 1 bn tonnes p.a. by 2030. The incremental demand from new capital stock should gradually fall over this time, with the replacement of older stock to fill the gap. Even with projections that are at the high end of expectations, the slowdown in demand growth compared to the last decade is clearly evident in the chart below.
Rio Tinto’s China Steel Demand Forecast
Longer term iron ore price forecasts have gradually come down this year as analysts have processed this weakening demand profile, increasing usage of scrap and the slow progress of marginal iron supply to exit the market. The major iron ore players should eventually take market share under this scenario given their low cost operations, however this should continue to come at the expense of weaker margins. Of the diversified miners, we have a preference for BHP Billiton, which has a lower exposure to iron ore.
Myer (MYR) capitulated to reality undertaking a 2 for 5 rights issue (raising $220m) to fund a redirection of the business. Some $500m will be spent over five years to refurbish and reconfigure its flagship and premier stores. Depending on landlord negotiations, up to 20 stores could be closed.
Myer Store Portfolio
New concessions, notably Topshop and Topman will be introduced, a strategy that is common in global department stores. Myer has noted that its womenswear has been underperforming both within its stores and even more so against specialties. Regaining this key territory is critical. The stores will therefore include casual spaces and beauty bars to encourage consumers to linger. Online investment and changing the media spend will form part of the strategy. Head office and distribution centres will be cut to size against the smaller footprint and to reduce costs.
The accompanying FY15 profit release painted the background, with net profit (pre ‘significant items’) down 21%. No final dividend was paid. Notwithstanding the new investment, the earnings outlook is challenging. By management’s own admission, FY16 is a ‘transitionary’ year. How well the business and the customer adapts to the new Myer is uncertain. For some time sales have been propped up by weekly discounts and margins eroded by sticky costs. We fear that this new strategy, not the first Myer has undertaken, may be too late.
After announcing a strategic review alongside its results two weeks ago, it was reported this week that Santos (STO) was fielding offers for a number of its assets as it looks to repair its balance sheet in the wake of the ongoing weakness in the oil price. While the timing of any such sale would be far from ideal given the depressed nature of asset prices in the current environment, an alternative option of raising equity would be equally unpalatable to the company and its investors following the sharp decline in its share price over the past year.
Two oil companies that are currently better positioned are Oil Search (OSH) and Woodside Petroleum (WPL), through a combination of stronger balance sheets, lower near-term capital expenditure commitments and low-cost operating assets. With this being the case, both would benefit from any distressed seller that could emerge in the industry. Given the optionality that OSH has in its portfolio, WPL would be a more likely candidate. OSH, however, would certainly look at consolidating its PNG position if STO were to sell (STO also has a smaller interest in the PNG LNG operation). It was also speculated this week that WPL was looking at making a play for OSH. For WPL this may make more sense, particularly if it believes that buying existing assets or companies is now more valuable than developing their own. OSH’s strong asset position would probably see it attract other foreign interest should a bid eventuate, although the PNG government’s stake in the company could complicate matters.
Reporting Season Wrap
August’s reporting season concluded at the end of last week and was one of the more disappointing of recent times. While a correction in global equity markets made it somewhat difficult to get a read on how individual results were received, the trend of companies hitting expectations improved after several companies missed guidance early in the month. The heightened volatility in equity markets was reflected in the large share price swings for companies that either just missed or beat their guidance. Below we discuss some of the key themes that emerged.
Results Below Expectations
There was a reasonably even balance between companies beating or missing their guidance or consensus expectations. A key issue, however, was that the size of the ‘misses’ was greater than that of the ‘beats’, hence overall market earnings growth for the financial year was 1-2% than forecast.
One of the more notable trends to come out of reporting season was a large number of companies that issued particularly weak guidance for the upcoming financial year. This was largely unanticipated by sell side analysts, who subsequently downgraded their forecasts for FY16. Further weakness in commodity prices throughout the month also led to downgrades in the resources sector. By the end of the month, earnings growth across the market for FY16 was approximately 3% lower compared to the start of the month.
Balance Sheets/Capital Management
Balance sheets remain quite strong, partly a function of a reluctance of many companies to reinvest in their business or growth options. The high dividend payout ratios adopted by companies has, in some cases, restricted their capex budgets, which will affect their ability to generate organic growth in coming years (this is best illustrated by the capital allocation decisions of the BHP Billiton and Rio Tinto).
Overall, dividends were typically maintained or increased slightly. Dividend growth in the industrials sector was broadly in line with earnings per share growth. Payout ratios across the resources sector, however, increased as dividends were held despite the large falls in profitability.
Industrial companies reported solid, but not spectacular, growth. Several “non-recurring” factors again influenced overall profit growth, including lower interest charges (from refinancing and lower debt levels) and cost out programs. A forecast outcome for FY16 of mid to high single digit growth would be a reasonable result, although we note that earnings are typically revised down over the course of the financial year. Sectors reporting above-average growth included retailers, gaming, those exposed to housing and healthcare.
The ASX 200 has several large-cap stocks that generate a large proportion of their earnings overseas. Investing in a basket of these stocks has been a profitable trade over the last 12 months following the depreciation of our currency. While this may be the case, the underlying operational performance of many of these companies revealed a weaker trend, particularly in the second half of the financial year. Stocks in this group would include Computershare, Ansell, Cochlear and Brambles.
As we have shown in the past, we present a table comparing the current earnings expectations of the market, split into three broad sectors (financials, resources and industrials) with a possible scenario to determine from a top-down perspective whether they may now be value in the market.
Financials: Financials present one of the more challenging cases to forecast, with varying outlooks for the different subsectors. The appeal of the largest of these, the banks, has retreated significantly in the last six months on the back of the realisation of a slower growth environment for earnings, but also from the drag to earnings per share from a larger capital base. REITs, too, are facing ongoing weak rental growth, while the outlook for diversified financials and insurance is overall somewhat better.
With interest rates expected to remain low over the following 12 months, the yield appeal of the sector could lead to a slight rerate of the sector, particularly given the recent increase in dividend yields of the major banks. A 5% EPS outcome for the sector looks to be fairly optimistic.
Resources: Were initially thought to offer earnings growth in FY16, although commodity price downgrades (particularly iron ore and oil) over the last few months have again swamped the efforts by companies to reduce costs. A best-case scenario may rest on current P/E multiples retained on the potential for a recovery into FY17 (more driven by costs and currencies).
Industrials: Select sectors here should again do much of the heavy lifting in FY16. Healthcare, which has been perhaps the most reliable and consistent performer over the past decade, is again expected to generate strong earnings growth. Retailers and consumer services stocks should also report reasonable growth. Consumer staples (dominated by the large supermarket chains) and telecommunications (largely Telstra) may again record sub-par growth. A 10% overall growth outcome would be a solid result in FY16, while the higher reliability of the earnings stream and low interest rates could combine to retain the premium P/E multiple across the sector.
The outcome of this analysis would infer that the Australian equity market, after a fairly significant correction, is presently close to fair value. The past few months have been characterised by a weaker earnings outlook (particularly in the resources sector), but also a de-rating of the P/E multiple, which is now close to its long term average.
S&P/ASX 200: P/E, EPS Growth and Scenario Analysis