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WEEKEND LADDER

A summary of the week’s results

05.04.2019

Week Ending 05.04.2019

Eco Blog

- There is an upturn from economic indicators. Few expect much more than a modest turn into a low growth year. To upset the apple cart is the persistence of tension between suppliers, who fret about their rising costs, and their customers, who are inured by flat to falling prices. Services play an increasingly important role, there too are early signs of price increases.

The smallest glimmer of an upturn has come as a relief after the relatively prolonged downward trend. The activity survey, PMI, indicates that March may have been the bottom of this cycle. Developed world manufacturing is now the laggard, held back by Germany and Japan. China has registered the fastest rate of growth in nine months, a likely combination of the reversion out of the Chinese New Year, the early impact of fiscal support and a bounce back after the imposition of tariffs that brought forward activity last year. The data also points to improving conditions in other parts of the emerging world, notably Brazil (with its best figures since 2013), Russia and sustained strength in India.

PMI Output/Business Activity Index

Source: IHS Markit, JPMorgan
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The question is, where to from here. The US pattern points to a modest outcome for 2019. Manufacturing is moving sideways rather than accelerating, and even services have not signaled a rise in demand. Similarly, China is widely expected to go through a mild upturn into the second half the year; a shadow of previous stimulus periods.

In reflecting on the medium term outlook, the consensus is worried but does not have a coherent storyline that suggests an imminent recession. As one commentator points out, there is not the major misallocation of capital that results in excess capacity or low return on assets. Nor is monetary policy too tight or tightening, as has been the case in most other end of cycle events. The two bugbears of the bears are US and China corporate debt. Yet, in the US, serviceability of debt is not a looming problem, given perfectly decent profit levels and low interest costs. The answer for China has long been that the majority of the problematic corporate debt is in state owned enterprises and could be nationalised or converted to equity.

If one (bravely) assumes that after whatever comes out of Brexit and there is a resolution of sorts on tariffs leading to the business sector feeling modestly more confident, the data should continue to grind upwards into the second half of the year. 

Feedback from meetings with global equity managers consistently note the cost input pressure that many companies are experiencing from raw materials, labour and particular business services, such as transport. To date, it has been hard to push these onto their customers, who have become accustomed to flat or falling prices. Even locally this is an issue, as reported in the press on the battle between the supermarkets and their suppliers. Unless the affected corporations concede to lower margins, there should be a mild upturn in inflation through the year. Even in services, this could be the case. Netflix, for example, has increased its subscription costs in the US and ride share services are hinting at higher prices to compensate drivers as they try to move towards a profitable model.

As we have often noted, the services sector does not get sufficient airplay in the headlines. A recent report discusses the split in services between Asia, the non-Asia developed world and elsewhere. While the share of the goods trade is roughly the same between the two major regional designations, the share of services still lies firmly in favour of the developed world at a 55% to 31% advantage. It is inevitable services will grow rapidly in Asia. Transport and travel currently dominate, but the growth is where Asia has advantages – online gaming, cloud services, software downloads, payment and financial systems. Add to that healthcare and education and the household sector will call the tune rather than manufacturing business in the longer run.

  • Consensus equity selections are now skewed away from leverage to high economic growth. While this is right for today, cyclical sectors will perform better if the upturn into the second half the year does eventuate.

Focus on Property

- The proliferation of co-working spaces has is being labelled a disruptor in the office property sector.

Co-working operators provide flexible office space on a short-term basis. Each location offers large, open common spaces and has a standard set of amenities and perks, such as trendy microbrew beer on tap, fancy coffee beans and ping-pong tables. The demand (and supply) for these spaces has grown exponentially in recent years and as a result could impact traditional office landlords in the longer run.

One of the well-known operators is WeWork, which opened its first location in New York in 2010 and now has nearly 600 locations in 27 countries. WeWork has been able to grab share  by pitching itself as a reliable tenant to regular real-estate companies, taking on long-term leases usually between 10-15 years which it then subleases to its customers for shorter periods of time at higher rates. This has seen WeWork attain a $20 billion valuation despite never turning a profit.

The demand for co-working spaces has been driven by the rise of the independent worker as operators target start-ups, entrepreneurs and freelancers. The rise of co-working spaces has come at a time of economic growth and therefore this model of office leasing hasn’t been tested in an economic downturn, especially given the initial phases of growth came from freelancers and entrepreneurs on short term leases compared with the long leases that WeWork agreed to. WeWork has slowly shifted its lease portfolio towards more corporations and now has clients such as IBM, AirBnB and Amazon where it manages exclusive offices for them. This has also allowed for the average lease term to increase from 7 months in 2017 to 21 months in 2018.

In an environment where demand for long-term leases has shrunk, traditional office landlords are increasingly having to transform their offerings. Shorter-term leases are now being offered and commercial landlords are incorporating co-working spaces into their planning, as well as striving to provide amenities that tenants have come to expect. This will change the way investors in office buildings approach cash flow and valuations as well as the risk profile.

Fixed Income Update

- The RBA was in the spotlight as ‘bears’ look for confirmation that the next move in interest rates is likely to be lower.

- Considering a strong start to the year for credit, we analyse liquidity in this market. 

Financial market participants appeared desperate to find dovish rhetoric from this week’s monetary policy statement from the RBA. While the cash rate was kept steady at 1.5%, the focus was on any variations to previous commentary. A slight change in the last paragraph had forecasters suggesting that the RBA is preparing the path for an explicit easing bias in coming months. It read “the board will continue to monitor developments and set monetary policy to support sustainable growth in the economy and achieve the inflation target over time.” While the change was nuanced, bonds initially rallied slightly and increased the probability of rate cuts for this year (which are now priced at 80% by October). Two data points that did subsequently reverse some of the gains were better than expected retail sales figures (February) and a record trade balance surplus.

  • We are surprised by the strong bias to a rate cut. We are of the view that a spike in unemployment (yet to materialise) should be the call to action.

Following the sell-off in credit markets late last year, investment grade (IG) and high yield (HY) bonds reversed these losses, posting strong performance in the first quarter of 2019. Returns are always a function of coupon income and capital gains/losses. With interest rates at lows, these positive returns were mostly delivered through spread tightening (due to the pivot in Fed policy) rather than the coupon. While the solid result will be welcomed by investors, the portion earned through capital gains may only be temporary, as spreads can fluctuate. In contrast, a higher coupon gives a guaranteed income, assuming no default or any other restriction.

Total return on ICE BofAML indices, 2019 year to date (%)

Source: FT, Bloomberg
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Valuing the risk premium for a corporate bond over a government bond is a judgement call. Individual credits will offer a margin based on their assigned credit rating, amongst other factors. Another issue that affects the whole market is the premium assigned to the perceived decrease in liquidity. This stems from banks no longer holding bonds as inventory on their balance sheet; a fallout from the financial crisis. Back in 2006 the average annual dealer inventory was $200bn compared to $20bn today.   

However, one could argue that banks have just become more efficient at facilitating bond sales. In the same period, dealer trading volumes have doubled from $12.5bn to $25bn. Corporate bonds now pass through at a quicker rate to arguably more stable owners such as pension funds and mutual funds that are unlikely to be forced sellers as the banks were during the crisis. 

Investment grade and High Yield corporate trading volumes

Source: M&G investments, Federal Reserve Bank
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  • Liquidity in markets is there until it’s not and one should never get complacent about it always being available. Feedback from fund managers is that corporate bonds (particularly in the US) currently have decent liquidity, with bonds moving on tight bid/offer spreads in small parcels. Larger deal flow can take a little longer to trade.  While the drawback of the banks’ limited inventory does reduce parcel sizes that can be readily moved, the outcome has its positives and should lead to a more stable environment for credit during the next downturn.

Corporate Comments

- Woolworths’ (WOW) announcement of 30 Big W store closures is overdue given an oversaturated discount department store market. An off-market share buyback will provide a benefit for taxpayers who can utilise the franking credits.

- The federal budget was not as stimulatory as expected, although polices and future spending will remain uncertain until after the upcoming election.

Woolworths’ (WOW) announcement covered two issues which were positive, if not unexpected, developments. A review of its Big W network has concluded with the decision to close approximately 30 stores over the next two years (representing 1/6th of its national footprint), along with two distribution centres. Restructuring provisions of $270m that will be incurred include costs associated with onerous long-term lease payments.

The store closures are a necessary action to arrest the size of losses from the division, which has struggled in recent years. The key issue for the discount department store category has been changing consumer preferences and an excess supply of the format. Sales growth has been below the broader industry for an extended period of time along with negative trends on key measures such as sales per square metre. While WOW’s announcement will help to address this issue, we note that the current winner across discount department stores, Kmart, is expanding, essentially mitigating some of the impact of the Big W closures.

WOW also announced a $1.7bn off-market share buyback following the completion of the sale of its petrol business. The buyback is expected to be marginally accretive to EPS for the company, although much more beneficial for low marginal tax-paying investors who participate.

While WOW has had been beating Coles in recent years, this is arguably more than factored into its elevated forward P/E of 22x, particularly considering the ongoing high competition levels across the supermarket industry.

WOW was one of the more likely companies that we highlighted as a capital management (either via share buyback or special dividend) candidate last year, with the backdrop of a possible policy changes if there is a change in the Federal Government at the upcoming election. The updated table is illustrated below, highlighting companies that have already announced capital management.

ASX Companies with High Franking Balances

Source: Company reports, Bloomberg, Escala Partners
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The federal budget passed without any significant reaction from markets, although was judged to be less stimulatory than anticipated. Personal income tax cuts were the centerpiece, which ordinarily should be quite positive for domestic consumption. The immediate impact, however, is diluted as the bulk of the proposed tax cuts do not kick in for a few years. Partially negating this was the more immediate boost to lower income households, who are more like spend any increase in income.

Infrastructure was another key area that received a boost. The additional spending added to an already considerable pipeline of work. The long lead times from when projects are proposed to when the work begins delays the impact and most are well into the 2020+ period before they commence. Nonetheless, the environment is set for an extended upswing for companies exposed to the cycle. Other sectors that received increased funding at the margin include health and aged care.

Finally, we would note that the market reaction was likely to be subdued given that it is immediately preceding an election and hence the implementation is contingent upon the Coalition retaining power. Nonetheless, the improved state of the budget adds optionality to increased spending to support the economy for whoever forms the new government.

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