Week Ending 05.08.2016
Outside Australia the main economic event of the week was the widely expected easing by the Bank of England (BoE). The cash rate was reduced from 0.5% to 0.25%, an all-time low. Other measures included another round of asset purchases, which allowed for some corporate bonds in the programme. A Term Funding Scheme has been introduced to assist lending banks and is designed to reduce the impact of low rates on the banks’ capital.
The BoE reduced its expected 2017 GDP growth for the UK to 0.8%. Many are forecasting a few quarters of negative growth, but it would be difficult for the BoE to do the same as it would imply their policy is already judged to be unsuccessful. That said, the annual average may still be achieved, with negative growth at the end of this year and for the first quarters of 2017. Inflation is now forecast to be 2.1%, a touch higher than before, with the expectation that the fall in sterling will drive import prices up.
The repercussion from the BoE rate move and monetary expansion will be in the credit market, supporting a position in an investment portfolio. The AUD has also felt the initial impact, with money once again chasing any yield, notwithstanding the cut here this week. The RBA may again find itself forced to follow external pressure rather than manage to internal circumstances.
Oil prices have again hit an uneasy phase, down 12% from their peak nearly a month ago. While any commodity price should mostly be a function of demand and supply interaction, oil is seen as a barometer of global economic conditions and has much greater direct impact on economies than any other commodity.
A bull case for the oil price has been based on the run down of rig counts in the US onshore fields along with continued disruption in the Middle east and Nigeria. To a large extent this has played out, though even a small rise in rig activity and persistence of production from existing wells is enough to change sentiment in the short term. Coupled with a rise in inventory and the impending ‘slow season’ for oil, the price is reactive to short term news. The US Energy Information Administration (EIA) shows the tight range of demand/supply and change in inventory. The surplus built from 2015 is still in the system, but growth has slowed.Enlarge
Supply events in oil markets can change relatively quickly and there is plenty of potential on both the up and downside. The consensus is still that oil prices will increase into 2017, though those betting on a quick and strong resurgence may well be disappointed. The longer run case for higher prices is based on a run off in non OPEC production and the unlikely return of full production from much of the Middle East.Enlarge
Nonetheless, oil prices should cycle their lows in this half and take the deflationary impact out of the global CPI. Whether that is enough to shift the trends in inflation expectations remains to be seen.
With so much attention on the developed world in recent months, some of the changes in the developing world have passed under the radar. The Indian upper house has approved the introduction of a GST to replace a raft of indirect taxes. The intent is to set the GST as revenue neutral at an average rate of 17-18%. This average rate is to be achieved via a 12% rate on basic goods and services, 18% as a standard rate on most items and a ‘sin’ rate of 40% on a small selection of goods. The economic impact should be broadly neutral, though it is hoped that tax collection will improve over time. More importantly, it reinforces the growing view that India is progressing with its economic credentials, which has seen more investors take positions in the equity market. Greater fiscal certainty will lead to lower funding costs as Indian government bonds rally.
Naturally, Brazil will be centre stage for a few weeks. And so it should, too, in investor circles with the equity index, Ibovespa, up 30% this year and the Brazilian currency (the real) rebounding 22% against the USD. The economic data has been gently underpinning this revival, though it would be premature to paint an overly optimistic picture. After 11 quarters of declining industrial production and a slump in capacity utilisation, the June quarter improved, with a 1.2% rise in production. Both business and consumer confidence has turned the corner, inflation has eased from over 9% to 7.5% and with high food prices moving out of the data, should fall to around 5% in the coming year.
Unemployment, however, remains high at over 10%, the fall in commodity prices has impacted the trade balance and most importantly, the political situation is still unstable. Faced with the potential for extreme pressure on funding its persistent fiscal deficit, the government has enacted a policy to restrict the growth in central spending. The main culprits are social services, particularly pensions, which are out of kilter with the stage of development in the economy. The chart shows the constant growth in expenses with very little by way of revenue for the government
Real Growth in Central Government Spending
Locally, the RBA impact on rates is covered in our fixed income section. The subsequent monetary policy statement was little changed from the previous month, though the expectation is now that inflation will be at the lower end of the long term band of 2-3% through to at least 2018. The RBA points to excess labour market capacity that is not evident in the unemployment rate, including the low participation level, flat hours worked and lack of any wage pressure. Further, the bank is of the view that the housing cycle is turning and that business investment would remain subdued in the absence of stronger demand. While another rate cut is possible, most view it less likely, particularly as the impact on the AUD is not being achieved through lower rates at this time.
Fixed Income Update
As anticipated, the RBA dropped interest rates by 0.25%, taking the official cash rate to an historic low of 1.5%. There was therefore little reaction in the bond market with yields falling 2-3 bp across the curve, taking the 5 year government bond rate to 1.47%.
As is often the case, the market appears to have over-reacted on longer-dated maturities, with the 5 year and 10 year government bond yields bouncing back to the same level as a week prior. The movement in the 5 year bond yield over the last week is shown below.
Australian 5 Year Government Bond Yield
In recent times, the RBA has lowered rates in months that have corresponded with the quarterly statement on monetary policy. If history repeats, we may thus see the market correct over coming months, taking out some of the further rate cuts priced in over the next year (presently the market is pricing a 60% chance of a 25bp cut by December and a 90% chance by May next year).
The response from the banks was to only pass on a proportion of the cut to mortgage holders, amounting to a reduction of 0.10%, 0.12% and 0.14% respectively from NAB, CBA and Westpac on standard variable loans. However, CBA has led the way with a rise in the spread offered to term deposit holders. One to three year term deposits were all increased by 50bp, taking them to 3.0%, 3.1% and 3.2% respectively.
Many investors buy short dated bank hybrids as an alternative to investing in term deposits. This readjustment in deposit rates raises the question of whether this is still a good risk/reward option. There are many things to consider given the complexity of bank hybrids and where they rank on the capital structure, but in simple terms an investor’s appetite for risk, desire for liquidity and yield should be considered. A simple comparison of these two alternative investment options is shown below.
In global markets, ten year Japanese government bonds (JGBs) began the week with their worst four-day run since 2003. This followed Friday’s decision by the Bank of Japan to expand its monetary easing by far less than expected and announce a “comprehensive review” of monetary policy to take place at its next meeting in September.
On Tuesday, the JCB 10-year yield peaked at -0.01%, its highest level since it turned negative in March. In the last week the benchmark yield has gained 23 bp in its biggest move since 2003. It is now trading at -0.08%.
The US high yield market has also come under pressure in the last couple of days as jitters grow over rising defaults in the energy industry. US high yield exchange traded funds have seen some outflows, the most since the Brexit vote.
Rio Tinto’s (RIO) first half result was in line with expectations, although some investors may be surprised to learn that earnings again slid, despite the more recent bounce in commodity prices. Underlying earnings almost halved from the first six months of 2015 while remaining relatively steady on the December half. As the earnings waterfall chart below illustrates, lower commodity prices reduced earnings by nearly two thirds for the half. Volumes were effectively flat for the period, while the largest offsetting factor to the price effect was more favourable exchange rates and the group’s ongoing cost reductions.
Rio Tinto: HY16 Earnings Waterfall
Unsurprising, the recently appointed CEO, Jean-Sébastien Jacques has made little change to the company’s strategy of maximising the cash returns from the company’s existing assets, returning capital to shareholders and undertaking selective yet compelling growth opportunities. While the iron ore miners have recently benefited from the recovery in the iron ore price, Rio’s growth within this sector appears to have now added a greater degree of discipline, with “value over volume” a recurring theme of its presentation.
The positives for RIO are that its balance sheet is in good shape and dividends are now on a more sustainable path after its progressive policy was scrapped earlier this year. This year may also prove to be the bottom of the capex cycle for RIO, with the company now forecasting higher spend on selected projects in 2017 and 2018, although still at materially lower levels compared to a few years ago. The shorter term risk for the company is if the recent iron ore rally proves to be unsustainable having been artificially boosted by some rationalisation in the steel sector and an uptick in credit growth in China. RIO itself has taken a cautious approach in its outlook, issuing a relatively downbeat assessment of the global macroeconomic outlook.
Shares in Downer EDI (DOW) rallied following its FY16 report, despite the company simply achieving its earnings guidance. Broker forecasts had been predicting a more pessimistic outcome for the contractor, which has performed well in a difficult environment over the last few years. While some of its competitors have faced criticism over the cash flow conversion of earnings, FY16 was another strong year for DOW on this measure. Further, the company’s balance sheet is robust, having reduced debt levels.
DOW is currently transitioning away from resources-led work, where revenues and margins have taken a hit as its customer base has wound back on capital expenditure and sought to achieve cost savings across the board. DOW has a better outlook on infrastructure-related work and the company also has three major passenger train project bids in play (rail and transport are the divisions with the highest ‘work in hand’), with significant bid costs to be expensed in FY17. The success of these bids is likely to be the near-term catalyst for the share price.
Downer EDI: Work in Hand
Despite a more positive outlook, DOW is still forecasting a slight earnings decline in FY17, which would incorporate the recently announced loss of its mining contract that it had with Fortescue Metals. In our model portfolios we have held Lend Lease (LLC), which is similarly exposed to this infrastructure theme, together with its property development division.
Tabcorp (TAH) reported a result that was in line with expectations, although the 9% improvement in profit was primarily driven by lower tax and interest costs. TAH’s business comprises of wagering (73%), Keno (15%) and gaming services (12%), which provides poker machine monitoring across NSW and Victoria.
Wagering is thus the core division, and the results for FY16 showed a slow pace of growth of 2.8% in betting turnover. TAH is running into the headwind of greater competition in the online space as consumers transition away from TAH’s retail outlets to online mediums. Mobile betting is attracting an increasing proportion of betting turnover and this is exposed to higher levels of competition. The competition has come from the incursion of international bookmakers into the Australian market and yields have fallen for the bookmakers in this environment. Higher marketing spend is the other outcome (TAH’s advertising and promotions expenses increased over 50% in FY16) with a saturation of betting advertising across most forms of media.
Tabcorp: Fixed Odds Sports Yield
With this softer wagering outlook, TAH has turned to an acquisition to supplement its earnings in the medium term, announcing the purchase of Intecq, which will add to its gaming services division. Regulatory risk is likely to be ongoing, as highlighted by the recent decision by the NSW Government to shut down the greyhound industry from July next year. A re-elected Federal Government with a slim majority may also pose some problems, with a number of the cross benches supportive of anti-gambling policies. TAH currently trades on a forward P/E of 22X and a yield of 4.9%, which looks fully valued despite the stock’s defensive characteristics.
Suncorp (SUN) investors may have been disappointed with a lack of a special dividend after this had been a feature of the company’s results in the last four years. The full year result was marginally below expectations, with earnings declining by 8% year-on-year as SUN’s core insurance division faced a tougher 12 month period. The challenges have included lower investment earnings, an improving (but still soft) top line growth and increased claims inflation.
This latter issue caused SUN to downgrade its insurance margin forecast late last year, and although some modest improvement was evident in the second half, margins remain well below the previous trend. Recognising that its ‘natural hazards’ reinsurance cover has been inadequate for some time now, SUN has increased its cover for FY17. This will come at an additional cost, although should result in reduced earnings volatility going forward.
SUN’s banking division printed a better result, with a good performance on costs and very low impairment losses. While this was promising, the focus is likely to remain on SUN’s insurance margin and the progress that it is making towards restoring this to a 12% underlying target. Within the sector, we have a preference for QBE, which has broader opportunities for margin improvement from self-help initiatives and will be a beneficiary of the (likely slow) pace of interest rate rises by the Fed in the US.
Next week is a busier schedule for reporting season, with the following companies due to release results:
Monday: Bendigo and Adelaide Bank, NewsCorp
Tuesday: Cochlear, Transurban, REA Group, IOOF, carsales.com
Wednesday: Commonwealth Bank, Fairfax, Computershare, SkyCity, AGL Energy
Thursday: Telstra, Magellan Financial Group, Goodman Group
Friday: James Hardie