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WEEKEND LADDER

A summary of the week’s results

05.02.2016

Week Ending 05.02.2016

Eco Blog

Watching and waiting. This week gave no indication that economic trends have bottomed. Rather, central banks all took on a dovish tone. Following from the negative rates for new banks and deposits in Japan, the RBA stayed on hold, aligning itself to the comment from the Bank of England in noting weak inflation, sloppy wage growth and troublesome trends in exchange rates. 

On the other hand, the consumer is consuming at a steady if unspectacular pace. While the headlines suggest that local retail sales data for December was disappointing, that is, through the lens of seasonally adjusted numbers, nominal dollar values were up nicely across most sectors.

Source: ABS
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The seasonally adjusted data accommodates movement in public holidays, number of weekends in the month and the like. Companies do nominal sales and while seasonal changes are important, they may not be the guide to retail momentum. A version of seasonal adjustment is to simply look at three month change in nominal sales. This shows that, on balance, little is changing beyond the typical ebbs and flows.

Retail Sales

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Some may expected an upward movement back to the 5-6% growth pattern of a year ago given the labour market and bonus from low petrol prices. In our view, that higher level will have been the anomaly rather than the 4-4.5% we are observing at present. Inflation is low, income growth is soft and households are spending on perceived essentials such as education and health, as well as discretionary travel and entertainment, rather than measured retail spending.

The annual survey of the members of the Australian Industry Group, suggests self-help revenue generation and the currency are the primary points of upside for the business sector. Compared to 2015, CEOs of this sample are now much more positive, perhaps as the reality of the current economic situation is the expected state of play.  Nonetheless, responses to input costs and achieved price indicate that gross margins are expected to be tight.

Australian Industry Group CEO Survey

Source: AIG
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The glimmer of light resides with the fall in the AUD. Corporations want to be sure it will be sustained, and possibly continue to decline, before investment decisions follow.

On that count, this week was less than helpful. Fed members in the US backed away from the next rate rise, the payroll data was lighter than the market wanted and most importantly, the non-manufacturing services survey (ISM), fell back. The indications are therefore that last quarter of 2015 in the US will be weak and this could well extend into the first quarter of this year.

With these trends the two main watch points of the Fed, employment and prices, do not support another rate rise. The rationale to continue on the path of interest rates would then rest largely on the basis that they should progressively move and pay less attention to the ebbs and flows of data.

Is the prospect of a tick up in the AUD/USD enough to shake the RBA? Taking the last quarter into account, against our other trading partners the AUD is down versus the Yen (-3.3%), the Euro (-2.4%) the NZD (-1.3%) offset by the slight rise against the USD (+0.7%) and the surprise rise versus the GBP (+6.2%). The TWI, as per this week’s release from the RBA, has unsurprisingly trended down, but whether this is considered enough remains to be seen. On the other hand it is clear the last thing the RBA would want is for the AUD to creep up again. Dovish talk is likely to be the order of the day.

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For the forthcoming weeks, if not months, the attention will be with the economic momentum in the US to sense the interest rate outcome. Unlike the past where low/no rates were a positive, today the lack of growth is a greater concern. Elsewhere, China will inevitably be in the spotlight. The weak PMI reading in the past week shows that there has been no improvement in the manufacturing sector. How long the authorities there will let this continue or even whether they have the capacity to do much is a big question. Most of the financial market is focused on their management of capital outflows to support the currency. Here it gets even messier. There are no good options. A sharp devaluation would send a shudder through the region and be out of kilter to the normal efforts to slowing manage the situation. On the other hand, capital outflows can only be tolerated for a while. Regulation to stem the momentum is likely to send the wrong signal (panic?) and inevitably become impossible to sustain. Perhaps the best that can be hoped for at this time is a big fiscal programme.

Fixed Income Update

Following on from further accommodative policies by the ECB with their QE programme, the Bank of Japan took their interest rates (on new deposits from the commercial banks) into negative territory. With yields falling across the curve, the benchmark 10 year Japanese bond is now close to zero, at a record low of 0.03%. While there was no such thing as negative yields 18 months ago, they now account for 25% of the entire global government bond market. The move by the bank of Japan was unexpected and resulted in more than $1 trillion of government bonds turning negative after being positive a week earlier.

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The RBA also met this week, keeping rates on hold. There was little reaction from the market, with no change in their easing bias. The market is still looking for a rate cut to come to fruition by August this year; no change from last week’s market predictions.

Despite January being another month of underperformance for the high yield market, this market did see inflows in the final week and some relief for investors as spreads have tightened 54bp since the 20th of January. Stabilization in oil (on some trading sessions!) has been the main driver of performance, but the market has also been aided by a reduction in issuance. The new issue calendar has been reduced to $8.9 bn, which is the lowest January pipeline since 2009.

This week Standard and Poor’s cut BHP’s credit rating from A+ to A and left it on negative watch. Further downgrades may eventuate unless BHP changes its dividend policy and gives guidance on capital expenditure at its earnings release later this month. It also remains on review for a downgrade from Moody’s.

In October last year, BHP came to market with an $8bn multi-currency (EUR, USD and GBP) hybrid deal, which was the second largest issuance ever done. Falling commodity prices and uncertainty on China-driven demand has pushed these bonds below par. While the credit has staged a rally off the lows on the 21st of January, pricing remains quite weak. The chart below depicts the price action of one of these bonds since they were issued.

BHP US Hybrid

Source: Bloomberg
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Domestically, the BHP downgrade has put further downward pressure on Origin Energy’s subordinated bonds (ORGHA). Fears of an imminent downgrade by the rating agencies, and doubts on the likelihood of this bond being called, has pushed the security down to a price of $90.35 at the end of the week. This would yield 18% if it does get called (in December this year); a great return for those brave enough to take the gamble. However, a ratings downgrade below investment grade will trigger a mandatory deferred interest payment, which means there will be no coupon paid until  5 years have lapsed, an investment grade rating is restored or the bonds are called. Further, a ratings downgrade makes this bond cheap funding, strengthening the argument that they may not get called.

Corporate Comments

Macquarie Group (MQG) declined this week after the company provided a trading update on its third quarter performance. The company’s commentary was more cautious in its tone compared 2015, describing trading as “satisfactory”. Macquarie also provided some level of detail for its individual operations. While there was no change to its guidance with five of its divisions (expected to be either up or in line with FY15), the forecast for its Commodities and Financial Markets operations (which provides trading and financing services in fixed interest, commodity and currency markets and is thus more transactional in nature) was revised slightly lower.

From an investment perspective, after a number of years of strong earnings growth, the key question for Macquarie is whether the current cycle of earnings upgrades has run its course. Notwithstanding the view that profit may be nearing its peak and with its earnings boosted by a number of performance fees in its listed and unlisted infrastructure funds (see chart below), Macquarie has already been de-rated over the last year by the market. The stock is approximately flat year-on-year despite a profit in FY16 that is forecast to be close to 30% higher than FY15.

Aside from the performance fees that it has earned, the changes that the group has made over the last five years have also put it on a more sustainable footing in terms of consistent earnings, with a focus on boosting the annuity-like revenue streams from its funds management division. Macquarie is thus less reliant on market fluctuations and trading activity like other investment banks, to which it is often compared. We have stock in our model equity portfolios.

Macquarie Group Performance Fees

Source: Macquarie Group
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Tabcorp (TAH) was the first of the gaming sectors to report this week, with a less than enthusiastic response from investors. On an underlying basis, the company report a 7% increase in net profit, although this was largely a function of lower interest costs in the period.

While its Keno division showed good revenue growth in the second quarter, TAH’s dominant division is its wagering arm (accounting for close to ¾ of its earnings base). Tabcorp is currently caught in the trend of changing consumer preferences away from its monopoly retail outlets (which are losing market share) towards the online betting channel. This has not been too much of a concern for the company, with Tabcorp still reporting robust growth in online betting (even as recently as 1Q16), more than offsetting the declines in its retail turnover. It may be erroneous to extrapolate a weak performance in the December quarter, yet the attractiveness of the online market is balanced between strong overall growth coupled with what appears to be increasing levels of competition, advertising and promotional activity.

Tabcorp trades on a forward P/E of 18X with a relatively defensive earnings base that could come under pressure given the developments in the industry. One of the key attractions of the stock is a potential tie-up with Tatts Group (TTS) and the synergies that would be realised from combining the two groups. The companies ceased merger discussions in November last year, although the possibility of this alone is not a reason for investment. Tatts, which we have in our model portfolios, reports its results on 18 February.

South32 (S32) has been one of the more disappointing demerged stocks in recent years, although its woes are hardly any fault of its own, with commodity markets moving in one direction since it listed mid last year. The stock was one of the best large cap performers on the ASX this week, however, with a rebound in commodity markets lifting stocks across the resources sector. S32 was further helped by a market announcement where it foreshadowed the ongoing restructuring of its operations in an effort to reduce its costs across several of its assets.

Given the sharp correction across the commodity spectrum and the low probability of many markets achieving a balanced state in the medium term, a recovery to S32’s listing price would be an unlikely outcome. In the current environment, however, the relative winners in the resources sector will be those that can manage the downturn best. The two most important factors here are thus the state of the company’s balance sheet (highlighted by the downgrade to BHP Billiton’s credit rating this week) and the cash costs of its operations. S32 scores well on the first measure and not bad on the second and thus, despite its share price fall, remains in a better position than most. Further clarity around S32’s plans will be provided when the company reports in three weeks.

Ansell (ANN) has been viewed as a broad-based value industrial stock with a diversified product and geographic base. The company, however, downgraded its guidance for FY16 by approximately 10% this week, blaming a weakening economic environment (particularly in emerging markets) and volatility in FX markets.

ANN reports in $US, so the strengthening of its reporting currency has had an impact on its revised guidance and the downgrade is obviously lower when viewed in $A terms. A lack of organic growth has been one of the primary criticisms levelled at the company and its trading commentary for the early part of 2016 suggests that revenues may be falling (on a constant currency basis).

While it has looked to achieve grow via acquisitions in recent years, it has failed to have the same success in translating this to accretive earnings growth compared to some of its industrial peers. Facing a relatively difficult macro outlook and ANN’s full year guidance implying a level of recovery into the second half, the short term risks for the stock would appear to be on the downside.

For some time the three online stocks, REA Group (REA), Seek (SEK) and carsales.com (CRZ), dominated the performance tables. Over the past year, Seek has been the weakest of the three, down some 20%. Carsales, within our model portfolio, is up 11% while REA has largely been followed the market, down 3% over 12 months.

Announcing half year results this week, REA’s profit was up 28% and investors may wonder why such an outcome has not been supported by greater rewards. Even though expectations of double digit profit growth are factored in, a near 30X P/E leaves no room for error. In line was not good enough and the stock sold off. The dominant market share is perceived to be under some threat from the Domain site, with owner Fairfax Media trading at a much lower multiple. The property sector itself is seen as having peaked, though new listings are resilient.  Even an ungeared balance sheet is not always a positive as acquisition risk may arise.

REA was not on its own. Even with no news, market darling Domino’s Pizza (DMP) has retraced from its share price peak of over $60 to close this week below $53. Very high multiples can become dangerous and it takes considerable insight to understand the risks.


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