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WEEKEND LADDER

A summary of the week’s results

05.05.2017

Week Ending 05.05.2017

Eco Blog

- A weak first quarter GDP trend in the US does not undermine the global growth thesis, with labour markets indicating a persistent strength. Right now, Europe is proving the standout region.

- This does not necessarily translate into higher equity prices. Financial conditions may tighten more than expected if economic growth is stronger and wage costs increase.

- With a longer wait that most sports teams, Australia may print its first current account surplus since 1974. It is likely to put a floor to the currency, though relative interest rate differentials are pulling in the opposite direction.

A purist rationale for seasonality in investment markets and economic momentum has yet to be put forward. For some years, US Q1 GDP data has been weak compared to the signals from business and household surveys. Whether it be weather or other factors is up for debate. We are seeing weaker trends in activity into the second quarter of the year, yet there is a widespread view that GDP will pick up through the course of the year. It may well be the timing of the April break that is affecting the data to date.

On the positive side, employment growth shows no signs of peaking.  In the US, the rate of improvement will invariably slow, given the now modest level of unemployment. The key is income growth, currently at 5.5%, notably higher than the wages growth, given the contribution from proprietor income, rent received, transfer receipts and interest income. Personal consumption spending growth of 4.7% is therefore well supported and leaves the saving rate at a more than acceptable 5.8%.

In the meantime, Europe is on a tear (in a relative sense) with a steady pattern of employment growth. While the headline level of 9.5% unemployment is high, there are specific countries behind that number. France (10.1%) and Italy (11.7%) represent the unreconstructed labour markets, with low flexibility and high protectionism.

Spain at 18.2% is always a call out. However, unemployment in Spain is in part a function of its measurement, where many students are on unemployment benefits and the number of foreign born unemployed is double the Eurozone average. The Bank of Spain estimates that the stable rate of measured unemployment in Spain is 16%. 

Germany is the standout, having absorbed many migrants, yet holding its unemployment rate to a low 3.9%. Elsewhere, the labour markets are within acceptable ranges, typically sitting at an unemployment rate of 5-6%.

Number of unemployed persons, Eurozone, (compared to previous month)

Source: Eurostat
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Other indicators in Europe are also heading in the right direction. Headline inflation may soften as energy prices cycle their recovery and food remains volatile, but in the meantime there is a sharper pricing tone coming into the services sector. Capital goods orders and business investment is on the rise, leading to higher demand for bank credit.

Bank Loan growth in Euro Zone

Source: Datastream
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If the political risks in Europe can be put aside, the potential growth may surprise. Renzi’s return to the mainstream of Italian politics already is one step there and France may be the next big one this Sunday.

A follow through in fixed investment spending, be it from government-led policies or corporate spending, would cement in growth through 2018. In the US, uncertainty on the tax status of investment could see companies await anticipated changes, and infrastructure spending is battling the debt ceiling. It may therefore be other regions that move ahead of the US through 2017. Australia is possibly in that corner, given the likelihood of such programmes from the government in the forthcoming budget.

The most identifiable economic risk to respectable GDP growth in 2017 is if financial conditions tighten unexpectedly. This could be due to currency movements, widening spreads in credit markets and, of course, interest rate rises outside those factored into the futures market.

However, as we consistently remind investors, this does not imply benign investment markets. A retracement of the recent rally can find many causes: lack of follow through earnings due to margin pressure; a credit event, with some pointing to pressure on the balance sheets of several retail-related companies due to changing consumption; excess leverage, where it has been put to buybacks rather than income producing assets; and a non-market related, untidy, unwind of an exchange traded fund (ETF). As these funds have spread with higher leverage, irrational propositions and stock lending to recoup the costs given low fees, their risks are unknown.

Australia printed a rare trade surplus for March and could well scrape to a current account surplus for the quarter, the first since 1975. That said, the usual downbeat economists noted that this was not the best way to achieve the outcome. Export values are up, yet have already turned down into April; a highly cyclical non-monetary gold export number had an outsized contribution and imports may lift into the coming quarter as the shift in Chinese New Year and Easter dates distorted the data in the first quarter.

Nonetheless, the size of the current account deficit of the past is far smaller and implies the AUD will be less vulnerable to these capital flows. A new dynamic for the AUD is yet to evolve. Foreign demand for AGCBs (government bonds) is moderating, the carry trade (yield differential) is less attractive and investment flows into Australia are also muted. On the other hand, our imports of capital equipment for LNG projects has long peaked and import demand, in general, is soft. The most likely cause of a fall in the currency would come from global financial instability, a downturn in China, or an unexpected rise in global interest rates. The other side would look to commodity prices, a hawkish RBA and a surprise in domestic demand.

Fixed Income Update

- Fixed income posted positive results across all sectors in April

- Demand for inflation linked notes has risen with inflation expectations

- The US treasury has floated the idea of issuing a long dated government bond

Positive performance results were posted across fixed income sectors for the month of April. The breakdown is shown below.

Source: CBA, Bloomberg, Escala Partners
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Long duration strategies proved to be a favourable trade, with Australian government bonds returning 0.89% on the month. However, the month was one of two tales. In the first three weeks of April, bonds rallied strongly in response to geopolitical risks and the French election, with the yield on both 5 and 10 year Australian government bonds falling 0.25% over that period.

The days following the French election and the announcement of US tax reforms led the market to reverse more than half of those gains into the end of the month. The result was that rates were still lower across the curve by some 10bp, with the yield on 5 and 10 year ACGBs finishing at 2.12% and 2.57% respectively.

Given the price sensitivity that long dated bonds changes in yields, the longer end of the yield curve outperformed short-dated securities. The chart below shows the impact that rates movements had on price performance for a given maturity over the month.

Source: CBA Fixed Income Research
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Credit spreads also had a relatively bumpy ride, with the Australian iTraxx index widening out 10bp mid-month before reversing again. Despite the intra-month volatility, the iTraxx closed April broadly unchanged at 82bp. Elsewhere in domestic credit, bank hybrids had a strong month (returning 0.74%) while performance on investment grade floating rate notes (FRNs) was a soft 0.16%.

In offshore markets, global high yield and emerging market securities performed well, but the real outperformer was the inflation-linked index market (up 2.3%). With the expectation of higher growth and inflation across the US and Europe, inflation linked notes are a good way to protect portfolios in this environment, as the price moves up in line with inflationary expectations (all other things being equal). This view has been reflected in the demand and subsequent outperformance of this asset class over the month.

Global inflation linked note index – April performance

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There was little to note from the RBA meeting this week, with bond markets unchanged following the announcement. The market consensus continues to be that rates will be on hold in Australia throughout 2017, with a small number of experts maintaining an easing bias. No rate hikes are priced in domestically until the latter part of 2018.

There were reports this week that the US government may issue an ‘ultra-long’ bond, that is beyond 30 years (perhaps 50 years) to fund fiscal spending. This follows in the footsteps of countries in Europe, Mexico and the UK. Speculation has led to a steepening in the long end of the yield curve.

Despite the US Federal Reserve Bank leaving rates on hold this week, the market pushed yields higher after the announcement, as the focus shifted to a rate rise at the June meeting. Strong labour data in the US compounded this view and significant movements took place into the end of the week across the US rates curve. The futures market is now pricing in a 95% chance of a rate hike at the next Fed meeting.

Corporate Comments

- ANZ and National Bank (NAB) reported similar benign growth trends in their half year results, with dividends unchanged from last year.

- Macquarie Group (MQG) beat expectations again with its full year profit, however is pointing towards softer growth into FY18.

- Sydney Airport (SYD) turned down its option to develop the Western Sydney Airport as expected, which may impair its longer term growth options.

- Star Entertainment’s (SGR) trading update was slightly softer than anticipated by the market, although the company remains well placed for an improved result in FY18.

- Vocus Group (VOC) disappointed with its second downgrade in six months. Confidence in management is now very low, although it retains a valuable asset base.

- Woolworths (WOW) showed an improvement in sales growth, however the medium to longer term margin outlook for its core supermarket division is uncertain.

This week was the first of the half-yearly reporting season for the banks, with ANZ and National Bank (NAB) posting their results. ANZ’s result was a slight miss on expectations. While its headline underlying earnings growth of 13% looked impressive, it was primarily driven by a non-repeat of the large institutional credit impairments. In addition, the bank’s earnings had a larger boost from items such as trading income (typically volatile in nature), along with profits realised on a number of asset sales (including its 100 Queen Street property in Melbourne).

The other key drivers of ANZ’s result were largely as anticipated. Net interest margins declined marginally (despite the mortgage repricing that has occurred in the last year). A solid outcome was evident on cost control, with the company able to reduce its overall cost base.

The downside was evidence of ANZ’s strategy to simplify its business model, by reducing its capital allocation to weaker-returning divisions and divest assets and lower likely longer term growth. An anaemic revenue growth figure looked worse, given that this was supported by one-off factors and an earnings gap that will be left by these recent asset sales is expected to be in excess of $500m. In an environment whereby credit growth is already soft for the industry, revenue growth will remain a challenge for ANZ in coming periods.

Nonetheless, a positive outcome from ANZ’s result was a strengthened balance sheet, with the group’s common equity tier 1 (CET1) ratio increasing to above 10%. Relative to the other major banks, ANZ is well placed from a capital perspective, having cut its dividend already to a more sustainable payout ratio in the mid-60% range. While the threat of tighter capital requirements from APRA is ongoing (the regulator is still to provide further clarity on its requirement for the banks to have “unquestionably strong” capital positions), in this absence there is a consensus view forming that ANZ may be in a position to return capital to shareholders.

ANZ Asset Divestments

Source: ANZ
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In contrast to ANZ, NAB’s result was a slight beat on expectations with profit growth of 2%, although there was some common ground with the ANZ report. Trading income was strong, helping a fairly soft revenue growth figure; net interest margins were flat; bad debts were marginally lower; and expenses were fairly well contained, growing at 3%. NAB also impressed with its capital position, with good build in the half.

While there is a high degree of correlation between the returns of the major banks in any given time period, the valuation disparity between the four has closed over the last 12 months. The two restructure/turnaround banks (being ANZ and NAB) outperforming their more relatively stable competitors, Commonwealth Bank (CBA) and Westpac (WBC). This has been justified with the recent results from ANZ and NAB. CBA and WBC are also more exposed to housing credit, which has been targeted by APRA from both a growth (limiting investor loans) and returns (with increased capital now required to be held against housing loans) perspective.

Macquarie Group’s (MQG) full year result was also ahead of expectations and continued its recent history of beating its own conservative guidance. The profit, however, was perhaps of low quality, as it was assisted by a low tax rate. The key surprise was the jump in its final dividend to $2.80, well ahead of analysts’ forecasts. Including the interim dividend, MQG’s dividends were up 18% on FY16, thanks to its strong balance sheet position, a solid result in what has been a slowing dividend growth environment across the market.

MQG was able to grow its earnings by 7.5% for FY17, which was an impressive result considering that the previous year included a much higher (>$400m) contribution from performance fees from its infrastructure funds that were maturing. As we have previously highlighted, the profit growth in MQG’s annuity-style businesses (which include asset management, corporate and asset finance, and banking and financial services) has provided a solid foundation for a more predictable earnings stream, which has been realised over the last several years. While MQG’s valuation has become more demanding after a rally in its share price in the last six months, the stock remains a useful diversifying option in the financials sector that is dominated by the major banks.

Macquarie Group Profit

Source: Macquarie Group
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The first week of May is typically busy for trading updates from companies who take the opportunity to update the market on the current environment at a large annual equities investment conference in Sydney. Below we discuss some of the more notable updates from this week.

Sydney Airport (SYD) presented at the conference, announcing that it would forgo its right of first refusal option to develop and operate the proposed new airport in Western Sydney. The decision was unsurprising given SYD’s previous commentary on the onerous terms set out by the Federal Government and the risks involved in the project. While the decision demonstrates sound capital discipline, it does eliminate the most obvious longer term growth option for the company.

The new airport will remove the monopoly status that SYD holds over the region. However, this is very much a long term threat to the company, with the airport not expected to be operational until the second half of the next decade, well beyond the investment horizon of the typical equity investor.

While the passenger growth rates at SYD will undoubtedly slow following this, its superior location will still leave it as the preferred option for most airlines and travellers alike. Moreover, there will likely be an opportunity to mitigate the earnings impact by transitioning to a greater share of international traffic (at the expense of domestic). By SYD’s calculations, international traffic generates 70% of passenger revenue for the company, while only using 15% of available airline slots.

Sydney Airport: 2016 Slot Usage and Revenue Generation

Source: Sydney Airport
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Like Sydney Airport, Star Entertainment’s (SGR) growth is underpinned by growth in tourism in Australia. A trading update this week was somewhat softer than the market was anticipating. Revenue growth of 4% for the first four months of 2017 was a step down from the faster pace SGR reported at its half year results, however some weakness was expected given the timing of the Chinese New Year.

SGR’s trading through FY17 has been impacted by ongoing capital works at its Sydney and Gold Coast properties, along with a fall in high roller revenues resulting from the fallout following the arrest of Crown employees in China late last year. The recent completion of these works (which have been a key driver of improved performance in the past) provides a platform for better momentum into FY18. With its leverage to Australian east coast tourism, including the key markets of Sydney and Brisbane/Gold Coast, we believe that the stock remains a good option among industrials stocks.

Vocus Group (VOC) was one of the key companies to disappoint at the equities conference, with the company downgrading its full year profit guidance by approximately 20%. We have favoured VOC in the telecommunications sector over incumbent Telstra (TLS), as it has undertaken a series of large acquisitions to become a vertically integrated company covering both the consumer and corporate sectors of the market.

The earnings downgrade this week was the second major revision in the last six months and while it was partly attributable to a review of its accounting policy on several large projects (now recognising this profit in future periods), earnings estimates across most its divisions were also reduced. It is now clear that integration task has been much more difficult than anticipated leading to higher costs across the group, which has been compounded by the loss of several senior managers over the last six months.

While VOC still has clear ongoing risks to even its reduced guidance, some glimmer of hope is provided by its solid asset base and its positioning in the telco sector relative to its competitors. VOC does not face the same margin headwind of TPG Telecom given it has been predominantly a reseller of Telstra services, and it is not losing its fixed line infrastructure broadband margin like Telstra. Our thesis of market share gains as the NBN has been rolled out has proved correct, however the benefits from this have been overwhelmed by poor delivery by its management. VOC’s issues do appear to be fixable rather than structural in nature, although the realisation of value is unlikely in the short term and may require a change in management to occur.

Woolworths (WOW) reported 4.5% comparable sales growth in its supermarkets for the third quarter of FY17, building on its improvement of the second quarter. This relatively strong data is clearly at the expense of Coles, as was highlighted last week in our note on Wesfarmers. Now that WOW has some wind behind its sails, better growth can be factored in, though at this stage, the number is still cycling a negative trend of a year ago and may well normalise to 2-3% through the latter part of 2017.

Big W, however, painted an unattractive scenario, with sales declining by 6% and little suggestion that is about to turn. The loss in the second half year is now expected to be around $120m compared to $80m previously. The weaker sales in both Kmart and Target increasingly point to a major structural problem for department stores. There are too many in Australia and with online plus other global competitors in the key apparel sector, the reconstruction of this retail format is long overdue.  A big writedown of lease obligations looms.

WOW’s management were at pains to point to higher cost in this half year in supermarkets and therefore margin growth is still some time away. The difficult question is therefore what the competitive situation will be in coming years, along with the realistic margin that supports sufficient, but not excess, returns in the sector. This invariably results in a wide range of valuations from the low to high $20s for the stock. Currently trading in the middle of this range, we don’t see any reason for long term investors to add to holdings.

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