Week Ending 05.09.2014
Some weeks ago at the Jackson Hole summit, Mario Draghi of the ECB indicated a clear intention to provide further monetary support to the European financial system. Since then the geopolitical events in Ukraine and the Middle East have, in all likelihood, pulled this forward, as there have been increasing signs of Eurozone weakness. The ECB is not known for hasty moves, and it took financial markets by surprise on the announcement this week that interest rates (the interbank refinance rate) and interest paid on deposits at the central bank would both fall. Journalists enjoyed announcing that the deposit rate at the ECB is now -0.2%, a clear disincentive for banks to linger in cash.
But the most important moves are on the asset purchase front where the ECB will buy Asset Backed Securities and bank issued covered bonds (bonds backed by specific pools of bank assets). Typically, these highly rated instruments are held by financial institutions to meet their capital requirements, or to repo into the bank system for liquidity management. In essence, the ECB is working to push banks and investors towards other assets where the lender is more likely to use this source of credit in the real economy, as opposed to sitting on a balance sheet.
The success of quantitative easing will probably require history to judge. Central banks, however, have a limited set of tools to achieve their aims of stable real economic growth, and in the absence of other ideas, QE is likely to be the one we will have to learn to live with. The implication of the ECB move was immediate: equities moved up, bond prices too as yields fell, and the Euro eased to a 14 month low against the USD.
While there was a sense of relief and pride in Australian GDP growth for the 2nd quarter of the year (+0.5% for the quarter), taking annualised growth to 3.1%, given the low momentum elsewhere in the world and now unbroken 23 years of economic expansion, the contribution mix to this figure remains somewhat problematic. Exports contributed 1.4% of GDP, while domestic demand rose by a less than stellar 1.4%, with inventory rounding out the numbers.
Few will be surprised at the nature of domestic demand – housing is making the largest contribution (that is, housing activity, not house purchases which do not add to GDP), consumption spending is middling, business investment is weak and the government is not here to help – public demand grew by 1.1% in real terms.
The sector breakdown is just as telling, shown in the chart below. Housing-related growth is at the top, the shadow of mining activity is passing - as can be seen from the negative quarter growth compared to the annual data - hospitality remains strong, and a broad range of services are in demand. On the other hand, retail, wholesale and logistics are weak. Manufacturing popped up a fraction in the final quarter, apparently attributable to on flow from housing rather than more broadly-based manufacturing activity.
Output Growth by IndustryEnlarge
We would not want to be seen to be talking down the economy. It is notable that a number of bank economists have turned on a positive tone supporting the RBA’s efforts to rekindle ‘animal spirits’ in the economy. There are a number of indicators emerging which suggest there is a slow and modest improvement in domestic activity.
Most still pin their hopes on consumption spending, pointing to the relatively high level of current savings and potential from the wealth effect (which purports that households consume some of their wealth) due to the rise in asset prices. The offset is the weak employment market, low wages growth, and uncertain tax environment. We concur that spending will pick up pace during this year, but that services and non-discretionary sectors are likely to continue to get marginal dollars.
Retail sales for July were quite strong. Using actual data rather than seasonally adjusted or trend, the negative trend in department stores turned positive (a possible seasonal shift in promotional sales) and other segments maintained their reasonable pace. As previously noted, it is the ‘café and restaurant’ segment that continued to be the stellar performer, up 12% in the month and 11% on a three-month rolling basis.
As identified by most economists, the more important dynamic for long term growth is investment spending. For some time, expectations have been rising that there will be a lift in capital investment on a global basis. This rationale is multi-fold, including the lack of asset replacement and therefore aging capital stock; the rapid change in technology, which should give a first starter advantage to renewal; and the low cost of capital in specific industries.
It is these selected industries where the greatest potential lies - those less dependent on consumer spending habits, but rather where there is structural change.
In the US, the most obvious is in the energy sector, and the bulk of global equity fund managers have some exposure to a company providing services to energy capital spending – Baker Hughes, Haliburton, Schlumberger, Technip as examples. Even in this sector, large integrated oil companies are reducing spending while new comers, together with investment in less well known options, is picking up. The required investment is also changing rapidly, from traditional oil wells to shales; so too the cost. The chart below shows the relative cost of land well drills across the options for the US.
US Drill Costs per WellEnlarge
The absence of such a theme is arguably the missing ingredient to a credible transition out of mining in Australia. At this stage, the best options for growth would appear to be out of our services sector with tourism, for example, continuing to trend up, notwithstanding the high A$.
The ABS released the July arrivals and departures data this week. Focusing on the inbound side, the number of people coming here on short term visits rose by a healthy 8% in the 2014 fiscal year.Enlarge
The table above extracts some of the details, and we note a number of features:
· Notwithstanding much heralding of conferences and while they may be a high spending sector, it is a small, low growth segment. Visiting friends and holidays is not only the largest component, but the highest growth at 15% and 10% respectively. The secondary benefits of a migrant population are evident here;
· Stays of over a month are modest, while those of 1-2 weeks are growing the fastest; and
· Unsurprisingly, Asia is not only (and by some margin) our largest source of visitors but also growing the fastest. The more traditional tourists from New Zealand, Europe and the US are now lagging the average, though central and northern European visitor numbers remain relatively robust. ‘Another shrimp on the barbie’ is unlikely to be a call to action from potential Asian visitors.
We wonder how many companies have sought to directly benefit from these trends; frustratingly, there are virtually no options on the equity market in which to participate.
On the eve of the finals of the greatest game on earth, Foxtel has initiated a round of price cuts to its packages. Notwithstanding the high level of personal consumption of media, the local sector continues to challenge investors seeking capital growth. Foxtel can be accessed through the ‘new’ News Corporation (NWS) or Telstra (TLS), though this round of price cuts is likely to mean a fall in revenue before a possible rise in subscriptions. The reality is that both free-to-air and pay TV face an uphill battle against Youtube or Netflix, and even local upstarts from within the free-to-air listed sector, such as Nine Entertainment (NEC) Streamco. Foxtel’s only real competitive advantage lies in sport coverage.
The best performing ‘media’ investments on the ASX remain the likes of Seek.com, Realestate.com or Carsales.com. Yet the investment bank universe is solidly in favour of stocks such as NEC, Seven West Media (SWM) and News Corporation, with NEC one of the highest buy rated stocks. We have read through the propositions and while there is the inevitable upside from a revival in advertising revenues, some restructuring and cost out, it is otherwise hard to discern why these companies should be part of a medium to long term portfolio. The most recent best performer has, in fact, been Fairfax Media (FXJ) reflecting its lift from a near death experience as it reduced its debt load and more progress on cost-cutting, yet the outlook appears to be as gloomy as ever for the mainstream print business.
Media is an important sector for investors, given the daily consumption by virtually all on the planet. We believe the best returns will come from the global participants. Google is likely to be the most important company for some time that provides access to advertising revenue, and locally we remain firmly of the view it will be companies such as Seek (SEK) or carsales.com (CRZ) where the upside case has credibility.
In a week where the iron ore price hit a five year low, it is worth revisiting the impact that this would be having on BHP Billiton (BHP) and Rio Tinto (RIO). BHP and RIO provide their various sensitivities to commodity prices when they present their results. For BHP, a US$1/t change in the iron ore price changes its FY15 net profit by US$135m. In RIO’s case a 1% change would impact its 2014 full year earnings (it operates on a calendar year basis) by US$122m.
Since 30 June, iron ore has fallen US$9.50 – if one were to assume this current pricing outcome to extend over the rest of FY15, both companies would take an approximate US$1bn hit to their full year profits. This would represent a 10% downgrade to RIO’s profit, and about a 7% downgrade to BHP’s more diversified earnings.
To a certain degree, a weaker pricing environment has largely been factored into analysts’ expectations, not only next year, but over the next few years. The chart below shows forecasts for the iron ore price over this time frame, with many expecting a long-term price of around US$90/t. Declines in the commodity’s price this year have been driven by increased output from the four major suppliers to the market, which have outpaced demand growth. The drop has been so dramatic because of the steepness in the cost curve, with the lower cost supply from the majors effectively displacing much higher cost mining operations, including domestic supply in China. As the large miners continue to add volume to the market in coming years, this displacement is expected to continue further. The iron ore price, however, is expected to hold up better given these new low-cost tonnes will be displacing a much flatter part of the cost curve.
Iron Ore: Pricing and Forecasts
Despite the declining price, however, it should be noted that BHP and RIO are still, and will continue to, generate high margins from their respective Pilbara operations. The two companies have superior low-cost assets compared to most in the market, they have a scale advantage over smaller operators, existing infrastructure and attractive brownfield projects in place to increase their volumes further. While a price of US$85/t or $US95/t may have a significant impact on a marginal producer, this matters less so for BHP and RIO, whose share prices should be more influenced by the longer term dynamic between supply and demand. At present, the two stocks screen as better value options compared to most sectors of the market.
Reporting Season Wrap
The August reporting season was fairly solid for the Australian market. While the 12% earnings growth recorded by the overall market appeared to be a high number at face value, this was enhanced by a mining sector that saw earnings grow by nearly 30%. Profit growth in the financials and industrials sector was thus in the high single-digit range – still a reasonable result given the varying challenges faced across the economy. Earnings largely met analysts’ expectations leading into the results, and thus there was a balance between stocks outperforming and underperforming upon their results release.
A key thematic of reporting season has been the focus on dividends. Globally, bonds have rallied further this year, including in Australia, and hence investors have again turned to other asset classes in the search for income. ASX companies adapted to this demand by surprising on the upside with their dividends, particularly in the industrials sector. As a general rule, companies that lifted their dividends above expectations outperformed on the day of their result, regardless of the quality of their actual profit figures or outlook for FY15.
Capital management initiatives are an extension of this theme. Suncorp, Telstra and Wesfarmers all returned additional capital to their shareholders via special dividends or share buybacks. It should be noted, however, in the case of Wesfarmers and Telstra, that this excess capital was the result of asset sales through the year, and not from underlying earnings. Nonetheless, investors were generally prepared to overlook this fact. Companies that disappointed on capital management, most notably BHP Billiton, were punished by the market.
The chart below shows that the dividend payout ratio of the market remains above average, which will thus limit the ability of many companies to increase their dividends in excess of earnings growth in coming reporting periods. What the chart doesn’t show is the different sectors of the market – banks and industrials are currently paying out close to 80% of their earnings in dividends at present, while resources are below 50%. The progressive dividend policies of the large diversified miners led to dividend growth lagging that of their earnings growth – an exception to the trend of the broader market.
S&P/ASX 200: Payout Ratio
A natural consequence of a high payout ratio means that, in the absence of additional leverage to balance sheets, less capital is available for companies to reinvest in their businesses. Low rates of capital expenditure could thus lead to subdued top line growth in the medium term.
Top line growth for many companies remains hard to come by. Overall, industrial stocks were able to grow their revenue by around 4% on average. Much of the composition of earnings growth is thus being generated from the various cost out programs from the majority of large-cap companies. This is expected to continue into FY15, however it could be argued that the quality of cost reduction is improving. The refinancing of debt has led to profit growth from lower interest costs in the last couple of years – it is more than likely that the benefits of a lower interest rate environment have already been realised over this time, and hence further cost out in coming years should be more sustainable in nature.
A positive takeaway from the reporting season was the limited revisions to forward earnings across the market. The chart below shows the change in earnings expectations since the beginning of August, the change in share prices and the FY15 EPS growth currently forecast. Sectors with higher growth into FY15 generally outperformed, including energy and healthcare. The mining sector fell on the lack of capital management from BHP and declining commodity prices over the course of the month.
S&P/ASX 200: Earnings and Price Movements since 1/8/14 and Forward EPS Growth
The table below details the FY15 earnings expectations for the various sectors of the market. At this point in the year, the forecast profit growth for the market of just 5.2% is unusually low. The changing drivers of the market’s growth is also quite interesting. Energy stocks are key in the resources sector, with a full year of earnings from PNG LNG for both Oil Search and Santos, and Woodside’s higher earnings from the repricing of some of its legacy LNG contracts. Mining is expected to be flat – a rebased iron ore price is important here, offset by further cost savings measures and increases in volumes.
The lack of any meaningful growth in the financial sector is driven by a lacklustre outlook for the banks - an issue we have previously highlighted. Industrial stocks are again expected to record high single-digit earnings growth – a combination of the aforementioned anaemic top line outlook and cost savings.
S&P/ASX 200: P/E, EPS Growth and Scenario Analysis
In the columns in the right side of the table, we have put forward a scenario analysis to get a sense of the market’s current valuation. Current price to earnings multiples are a little above historic averages, so for each of financials, resources and industrials we have assumed a slight P/E contraction. For each sector, we have also assumed a higher rate of earnings growth – a credible scenario given the low expectations of the market and the highly probable component coming from cost reductions, particularly in the resources sector. This scenario generates a similar index mark to where it currently sits, reflecting the fairly full valuations of many companies that make up the index.