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WEEKEND LADDER

A summary of the week’s results

05.01.2018

Week Ending 05.01.2018

Eco Blog

- USD direction finely balanced with countervailing fundamentals that will be exposed in 2018.

- Europe could well get another leg up from France and a dark horse, Italy.

Judging the pattern of investment markets through the holiday period should be tempered by the distracted participation and low volumes. Nonetheless, the standout has been the soggy USD. The final FOMC minutes for 2017 carries a mildly dovish outlook, particularly for inflation. At this stage the Fed does not believe the tax cuts warranted higher rates. The three rate hikes implied by the median projection from the voting members stayed in place, while the market continues to price in less than three. In turn, the increasing likelihood the ECB will signal a change to its monetary settings, given the strength of activity in Europe, is another reason for dollar bulls to stay sidelined.

Forecasts are therefore muted in terms of direction, with this sample of global banks implying a modest drift towards a strengthening EUR/USD over 2018. Sceptics will point to the non-existent yield on a large proportion of European bonds as out of kilter with the case for a stronger Euro, but this is already priced into the exchange rate and it is the change to that position that would be one input to a currency move.

2018 EUR/USD Forecasts

Source: poundsterlinglive.com
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Another clue may come from the US Treasury market as the deficit is funded post the tax cuts, along with reduced buying by the Fed. Some of the rationale for the flat yield curve is the level of short term money currently being issued. If demand for Treasuries softens, the risk is that the long end (5yr plus) will need to reward investors at higher rates than today. Recent auctions for longer dated US Treasuries are reported as weak, implying that investors are awaiting higher rates or a weaker currency.

In the longer run the net capital position of the US has been deteriorating as its stock of foreign assets falls relative to its liabilities. The US has earned, what many refer, to as ‘exorbitant privilege’ in that it can offer lower yield on US assets (for example Treasuries) while investing in higher return assets outside the US. The composition of external assets and liabilities shows a distinct bias, with the US holding a very low level of external debt securities compared to direct investment and equities while foreigners fund the US deficit by holding a large proportion of bonds. Given the extent of the imbalance as the US attracted inflows in recent years, the only practical way for the net position to improve is for the currency to adjust. History shows that countries with high deficits in their net balance are associated with a weaker currency. In short, the US cannot self-fund its capital requirements and as global surpluses are declining, a fall in the USD stabilises the imbalance, as has been the case in the past year.

U.S. Net International Investment Position

Source: US Bureau of Economic Analysis
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It is highly unlikely that the US dollar status will be disrupted in the foreseeable future given the lack of a viable alternative as a reserve currency. But this position does cap USD upside.

With the changes to the US tax system, including deduction of interest expense, the nature of net capital movements to the US is clouded. Traders are of the view this is likely to result in greater currency volatility in 2018 which may also infuse to other asset classes.

Locally, the slight shift towards a tightening bias by the RBA, as well as relatively strong commodity prices has seen the AUD gain against the US in recent weeks, but well within its expected trading range.

  • Based on consensus, we do not have a strong directional view of the currency impact on unhedged investment assets at this time.  Unhedged holdings continue to offer a buffer in the event of a sell-off in risk assets.

Europe ended the year by confirming its status as the manufacturing leader for 2017. Within the region two countries will be of interest into 2018. France is warming towards a higher level of structural change and improved optimism from both business and households. The real surprise could be Italy. The forthcoming March election, at this stage, is likely to be more of the same, that is a grand coalition. One could argue that Italians would be shaken by anything but such an outcome.

On the quiet the economy has battled its way back to (for Italy) respectable GDP growth, expected to come in at 1.6% in 2017 and repeat that in 2018. Exports have been the key with a good showing in market share for sectors such as food, wine, leather, machinery and pharmaceuticals. The net external debt has improved from 25% of GDP to 15% in 2017. On the negative side, the legacy of the non-performing loans is not yet over. Capital investment is consequently poor given the reliance on bank loans and structural reforms are mostly absent. But there is an emergence of venture capital funding and other funding sources that could broaden the financial structure within Italy.

  • While the European index faded in the second half of 2017, the platform for a better equity performance is still in place as corporate leverage to higher revenues has yet to come through.

Fixed Income Update

- Fixed income performance for 2017 reflects the interest rate environment as rising yields on the front end are offset by a flattening yield curve and tighter credit spreads.

- A strong year for ASX listed hybrids despite some headwinds.

- CBA leads the way in 2018 with a new benchmark subordinated bond in the wholesale market - the longest without a call by an Australian issuer.

Fixed income performed as it should in 2017; outperforming cash investments, albeit with returns reflective of the low interest rate environment. Unhedged global bonds performed better than their hedged equivalent, with the Barclays global aggregate bond index in USD finishing the year 4% higher than the AUD hedged index. Given the increased volatility from currency exposure, the Australian dollar managed funds are usually close to 100% hedged to limit volatility. Returns would therefore be aligned with the hedged index on offshore investments.

2017 performance for investment grade fixed income indices

Source: Bloomberg, Escala Partners
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Considering a backdrop in which the US Federal Reserve raised interest rates three times during 2017, and domestically the forecast for rates unwound from an easing bias early in the year to rate hikes priced in for 2018, the returns were surprisingly respectable. The flattening of the yield curve in the US and the tightening of credit spreads both domestically and offshore aided performance and helped offset upward yield movements on the short and belly (middle or circa 5-year) of the rates curve.

The shrinking margin between short term and long-term rates in the US has caused much discussion in bond markets. In 2017, short term rates (driven by rate rises and the commencement of the balance sheet unwind) lifted some 70bp on 2-year US treasury yields. By contrast the 10-year government bond yields finished the year 5bp lower, which also marked the lowest level of volatility on this bond in 40 years. The yield on 30-year treasuries fell 30bp as inflation remained at low levels. 

The flattening of the US yield curve in 2017

Source: Bloomberg, Escala Partners
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2017 marked a strong year for the Australian listed debt market, as credit spreads tightened on hybrid and subordinated bonds. While globally credit rallied, it was perhaps the fall in supply that really supported valuations.  The listed debt market contracted ~$4.6 billion in the year as banks opted to redeem maturing ASX listed subordinated bonds and instead issued in the wholesale markets. Notwithstanding, the market did face some headwinds throughout 2017 which included:

  • A downgrade by S&P and Moody’s. The former lowered the credit rating on the major bank subordinated bonds to BBB and the hybrids to BB+. While listed securities aren’t allowed to carry explicit ratings, the hybrids are now equivalent to a non-investment grade security in the OTC market.
  • Banco Popular in Europe bailed in their bank hybrids, highlighting the risks of these instruments.
  • The ASIC chairman made negative comments to the press on the risks of buying hybrids.

While short sell-offs followed these events, the market bounced back quickly ending the year strongly.

Cumulative Change in Average Major Bank AT1 Trading Margin

Source: Bondadvisor
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Issuance has already started in the domestic OTC credit markets, with CBA this week selling a $1.25b 30Y Tier 2 bond at BBSW+1.53%. Demand was said to be strong, with the issuer receiving over $4.5billion in orders with life insurers, pension funds and money managers among its buyers. The bond priced tighter than its initial talk of BBSW+ 1.75%. According to a Bloomberg article, this bond is the longest maturity benchmark-sized Tier 2 bond without a call option by an Australian lender.

While only a small proportion of CBA funding requirements, it extends the maturity profile improving the match between assets and liabilities. Further, it demonstrates the persistent demand for long dated paper by institutions looking to, in turn, match their long-term pension and other obligations.

Corporate Comments

- Companies appear much more willing to restructure their asset base. It does clean up the corporate structure, but is not always a positive to EPS.

- The implication of the US tax reform is yet to be factored into earnings.  The 2018 financial year profit reports will require detailed interpretation for Australian companies with US operations, rather than a reliance on reported numbers. For the S&P500 it inevitably will be even more challenging to understand the full impact.

Asset restructuring – mostly sales – remains the flavour of this period. In the past few weeks, Wesfarmers (WES) has sold (subject to FIRB clearance), its Curragh coal mine for $700m plus a potential two-year earnout if coal prices are above US$145/ton. The Bengalla mine is yet to be sold with the potential for similar proceeds. The net result is a dilution to EPS for 2018, though the contribution from this division has been highly variable over the years.

Resource Division

Source: Wesfarmers
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This is a welcome move given the inconsistency in profit from the resource division, but puts even more pressure on the Coles supermarkets in its battle with Woolworths to gain share. At the margin, it also opens the door for some ESG investors who excluded the stock due to its coal mining activities.

After much pressure, Ardent Leisure (AAD) will sell its Bowling Entertainment business in 2018 following the process of realising its Marine assets, leaving the local Theme Parks (Dreamworld) and US based Main Event as the core activities. Both of these have promise, yet require capital and constant renewal to retain consumers’ interest. Modest signs of recovery have emerged, but shareholders are yet to experience the merits of the new strategy.

Dulux (DLX), a favourite mid cap stock for housing related investment and management stability, is exiting its loss-making China coating business.  A pattern of acquisitions by a number of companies into Asia over the past decade is partly being unravelled as returns have been well below par.

Each of these is a company specific example, but they point to a pattern that will have broader repercussions. Ironically at a time of low interest rates, companies are reducing their balance sheet and reverting to their core operations. Ambitious expansion plans are viewed unfavourably with banks and resource companies at the forefront of restrained revenue growth strategies. The emphasis is uniformly on cost reduction.

  • It reinforces our view that the Australian equity market is predominantly a source of income rather than capital growth. This may mean that index returns (as opposed to the accumulation return) barely holds their real value.  Optimising the balance between Australian equities for income and other regions for growth is an important allocation decision for portfolios.

Another recent feature is initial commentary as companies come to grips with the changes to the US tax regime. Brambles (BXB) preliminary assessment is that there will be a non-cash US$125-155m benefit due to the reduction in the net deferred tax liability. It notes, however, that “a number of measures...could negatively impact Brambles” and offset the notional reduction in headline statutory tax. Similarly, Computershare (CPU) also will adjust for deferred tax and parallels Brambles comments on other implications, “including new interest expense limitation rules, the anti-base erosion rules and the anti-hybrid rules”.

Even US-based company specific analysis of the consequences of the tax reform is light on the ground. The deferred tax restatement applies to many global companies with the likes of Shell, Barclays, BP and Credit Suisse all reporting a big impact alongside locals such as Citigroup, General Motors and IBM.

The US 2018 reporting season is therefore likely to be messy and open to interpretation. While much will be non-cash, it will affect the balance sheet ratios. Then there will be the investment decisions that now have different inputs such as interest deductibility and depreciation. Buybacks have been a meaningful feature of the S&P500 for much of the period post 2009, funded by credit. As cash flow turns to investment decision to benefit from the deduction in the coming five years, buybacks may fade.

  • While the S&P500 has, to date, continued its rally, we recommend that non-US equities form at least half the global equity allocation.  The potential for a confused interpretation of US company results and lower support from buybacks, along with already high valuations is only partly balanced by the ongoing success of high profile companies.

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