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WEEKEND LADDER

A summary of the week’s results

05.10.2018

Week Ending 05.10.2018

Eco Blog

- Housing approvals fall as the RBA weighs into the risks associated with household debt levels, pointing to the increased borrowing amongst lower income and older demographic cohorts.

- Amazon may be the trigger for a larger rise in US wage rates. Will prices then go up or will corporate profit margins give way?

- Global service sector growth is diverging. The US is racing away, but even Europe is on a solid growth track.

The August fall in housing approvals was no surprise; it was merely a question of the degree. Total residential approvals are now down 14% yoy, with apartment units at -24%.  While there is some teeth-gnashing on house prices, the reality is that the current slide is a simple response to lack of affordability and concomitant tightening of mortgages. The question is what impact the combination of these trends will have. The activity level will be seen in economic growth, to some extent compensation for by the ongoing infrastructure building that is, if anything, accelerating. Declining home values may dampen consumer confidence but could be a positive in the medium term as household cash flows are redirected.

A case is made that a large and stable rental market is good for an economy, as it introduces locational flexibility and the capacity to respond to lifestyle needs. Australia has one of the highest levels of home ownership in the OECD (outright owned and owner-occupied mortgaged). Further, the rental stock is largely in individual hands rather than owned by corporations or REITs, as is the case in other regions. This feeds into the over blown local mortgage market and limits the banking sector’s lending to business.

Source: National Agencies, RBA, APRA
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In a recent paper, the RBA considered the vulnerability of the economy to the housing sector, particularly noting that the banks’ balance sheets where largely similar. To some extent, this has been ameliorated by the recent tightening standards required by APRA and the relatively solid capital position of the banks. The predominant risk is judged to be with the household sector, with the RBA noting that low interest rates have been key. Any changes to employment conditions or an external shock would challenge a meaningful proportion of mortgages.  The distribution of debt shows that lower income groups have increased their proportion of total household debt, as have over 55 year old’s. Both these segments could readily come under income stress.

In a parallel vein, the potential for a new Comprehensive Credit Report may expose the loopholes that borrowers have been able to use to get access to more credit than otherwise. There has been an explosion in alternative sources of debt and it is not entirely clear that all leverage is accounted for. Even recent APRA data shows that banks don’t entirely abide by their own rules of serviceability in lending standards, with 6% of lending falling outside their parameters. Further, foreign banks have taken up some of the slack in high LVR loans. While these may be small in nominal terms (as APRA notes, up to $1.62 trillion in residential term loans from Approved Deposit-Taking Institutions), they demonstrate a near-addiction to debt that rarely has a happy end.

  • While wage growth may offer some redemption, the only fix is a longer-term period of household deleveraging. Consumption spending will inevitably be constrained.

In a step away from the usual economic data, Amazon’s announcement that it will pay a minimum wage of US$15/hour from 1 November has the potential to have significant flow on effects. The retail arm of the company employs 250k full and part time workers, but also 100k seasonal workers into the forthcoming holiday season (down 20k from the previous year due to automation). The move has come about due to pressure from labour advocates that point to the income divide between most workers and their executive teams across the US, but also is a function of the tight labour market and the shortage of seasonal participants.

Amazon does not disclose its average wage, though the mean in retail industries is $13/hour and $11.50/hour excluding auto and building materials.

The current minimum wage in the US is $7.25/hour. It is even lower, at $2.13/hour, for so-called ‘tipped workers’ in the restaurant and related trade in some states that then rely on customers to effectively lift their wages to a mean of $11.73/hour. 

The flow on effect of Amazon’s decision to other retailers and potentially the broader economy is inevitable. Target intends to get to a $15 minimum wage by 2020 (from a current $12), but also plans to hire 12,000 seasonal workers in this holiday period. Competition for low paid service workers is likely to be intense.

All other things being equal is that Amazon can take a hit to profit margins or pass on the cost to consumers. It is likely both will apply. US profit margins are at near historic highs relative to GDP, leaving scope for these margins to retrace based on higher input and labour costs.

Non-farm Business Sector: Labour share of costs

Source: US Burea of Labour Statistics
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  • How the US corporate sector deals with rising costs will be critical to the performance of the S&P 500 in the coming year. Increased capital spending towards automation may become a big theme.

The only word that described data out of the US this week was ‘strong’ and the divide between the US and the rest of the world is becoming stark. Aligning with the Amazon theme, it is the services sector that often gets less attention, while forming the largest segment of an economy. It also is least affected by trade; at least at this stage. The US service sector is on a tear (and therefore employment is too). While the European index has eased, it remains in solid expansionary territory. A modest positive for Europe is that there is labour slack (outside Germany) and wage pressures appears contained. The downturn in China is more concerning, given that growth in services is required to limit the constant pressure on credit-fuelled stimulus.

Services activity index

Source: IHSM, Nk/IHSM, ISM. CXN/IHSM/Haver
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  • Services companies have been in the sweet spot for much of this past decade. How they each adapt to cost changes along with regulatory pressure will differentiate the pack in coming years.

Focus on ETFs

  • Along with the sector reshuffle (in our weekend note last week) the US S&P 500 index had its best quarter in 5 years, surging 7.2%.

Investors holding iShares S&P 500 ETF (IVV) or SPDR S&P 500 ETF (SPY) to capture the performance of US equities have enjoyed the high returns over the past 12 months. Given that ETF providers have now sliced the broadly-based index into niche categories, it is worth looking at alternatives to the S&P500 for US equity exposures.

There are 10 unhedged US equity ETFs available on the ASX. Of these only three have outperformed IVV and SPY. The strongest performance has come from Betashares Nasdaq 100 ETF (NDQ). A significant proportion of the performance has been driven by technology stocks, with the top three holdings, Apple, Amazon and Microsoft, making up over 30% of the fund.

There are three non-market cap weighted ETFs in this peer group, Vaneck US Wide Moat (MOAT), BetaShares FTSE RAFI US 100 (QUS) and ETFS S&P500 Yield ETF (ZYUS). MOAT is an equally-weighted rules-based index that invests in companies judged by Morningstar to have a ‘wide moat’ and trading at a discount to the analysts’ fair value estimates. The two-year performance for MOAT is almost in line with the S&P500. QUS provides exposure to 1,000 companies weighted by total cash dividends, free cash flow, total sales and book equity value. ZYUS is based on 50 low volatility and high yield stocks. This last mentioned fund has significantly lagged its peers. All three of these ETF have a management fee greater than 0.30%, compared to IVV’s 0.04%.

US Equity ETF performance

Source: Morningstar, Escala Partners
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A broader option than that of the S&P500 is Vanguard Us Total Market Shares Index ETF (VTS). This fund follows a total market index, which increases access to mid- and small-cap companies along with large-cap. The fund provides more diversification as it consists of over nearly five times as many holdings as the S&P500. However, this perceived diversification could be overstated. Both IVV and VTS have the same top 10 holdings though IVV is more concentrated at 22% compared to VTS at 18%. Unsurprisingly, large cap stocks make up nearly 80% of the total US equity market and the performance attribution of small and mid-cap companies is therefore limited. As such, performance has been broadly in-line between the two indexes over the past 5 years.

  • We have discussed different approaches to the traditional market weighted indexes in past reports. For US equities, the simplest, broadest and most effective long-term option for US market is the S&P 500. For a specific view to be overweight tech the NASDAQ ETF can be considered. Other ETFs have offer overly complicated index methodologies have generally underperformed.

Fixed Income Update

- Positive US data and hawkish rhetoric from the Fed Chair has US bonds weakening and yields surging to their highest level in 7 years.

- Volatility continues for Italian bond markets as the country’s high debt levels weigh on sentiment.

US bonds rapidly re-repriced this week as yields surged, pushing the 10-year rate through 3.20%, a levels not seen since 2011, while the 30-year Treasuries reached a 4-year high of 3.32%. The “real”, or inflation-adjusted, yield on the 10-year Treasury bond is now 1%, also the highest since 2011.The biggest price moves were on the longer dated bonds, steepening the Treasury yield curve.  Strong economic data and better trade developments were coupled with hawkish comments from the Fed Chair Jay Powell which fuelled the sell off. Following on from last week’s rate hike, Powell said at an event this week that “Interest rates are still accommodative, but we’re gradually moving to a place where they’ll be neutral.” He then added “We may go past neutral. But we’re a long way from neutral at this point, probably,” The market remains vulnerable to a further sell-off with payroll numbers due out Friday US time.

Shift in US yield curve this week

Source: Bloomberg, Escala Partners
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There were no surprises in last weeks ‘dot plots’ that accompanied the FOMC meeting, which remained unchanged. However, the bond market has long lagged the Fed’s forecast for rates which indicates a fourth rate rise this year in December and a further 0.75% in 2019. This latest move takes the market closer to the Fed’s own outlook for rates.

The implications of a price move such as this is widespread across financial assets. Long duration (fixed rate bonds) are directly impacted as bonds fall in price. Purely for illustrative purposes (as we don’t recommend monitoring price moves on bonds on a daily basis), the result has been a -0.44% (annualised at -41%) return on the Barclays Global Aggregate Bond Index (hedged in AUD) in the last 4 days. This index is a long duration benchmark that measures fixed rate government bonds and investment grade corporates from 24 global markets. This is one of the biggest price moves within a few short days in the last few years.  

Indirectly, other parts of fixed income will also be affected. These include:

  • US mortgage rates which are set off the 30-year rate,
  • Higher funding costs for governments, banks and corporates. This will extend to offshore institutions that issue debt in the US.
  • Emerging Market currencies and bonds. USD funding will be more expensive and local currencies weaker as funds flow out of the region and into USD.
  • Domestic RMBS. Despite Australian RMBS having floating rate coupons, the suggestion here is that to offset higher funding costs the Australian banks will raise rates out of cycle with the RBA. In turn this will put pressure on mortgagees and could lead to a rise in defaults and a widening of spreads on RMBS product.   

We have recommended being underweight duration throughout this year. However, the case to start adding more duration into portfolios is strengthening given the latest rate moves.

While the higher bond yields in the US are in response to positive economic flows, the opposite is the case for Italian bonds which sold off again this week as the government prepares budget details to be handed over to the European Commission by the middle of October. Germany has already warned Italy that it needs to curtail its spending and debt levels as Italy’s budget deficit looks set to increase to 2.4% of GDP. As it stands Italy has the eurozone’s second largest debt as a percentage of GDP after Greece.  While exact details are still unknown, the size and composition of the Italian fiscal expansion increases the risk that the country will have a credit rating downgrade.

In response yields on the 10year Italian bond rose to its highest level since 2014 of 3.45% before easing back to 3.33% by the week end. The spread versus German bunds also expanded significantly. Italian banks also suffered as CDS (credit default swaps, which is effectively the cost of insurance on default) widened making it more expensive for them to fund themselves. This is even though many are working to clean up their balance sheets. Some are said to have held back on funding themselves this year in hope that market conditions would improve with Unicredito rumoured to have only covered a third of its funding requirements for the year.

Italian 10-year bond yield

Source: Bloomberg, Escala Partners
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  • Our fund recommendations have very little, if any, exposure to Italian banks. However, it is noteworthy given potential contagion into other European markets.

Corporate Comments

- The Bank of Queensland (BOQ) reported a low-quality result and the group not immune to the industry-wide challenges. The majors appear better value from a risk-reward perspective, with short-term yield the main attraction for investors.

- The interim report on the banking and finance royal commission has given few clues around further regulation for the sector, although a focus on responsible consumer lending would have a greater impact on the banks that are reliant on their retail business.

Bank of Queensland’s (BOQ) full year result was ahead of the market’s expectations, with a modest 1% growth in earnings per share and themes that were consistent with reports from sector as a whole. The quality of the reported figure, however, was poor and spoilt by several ‘one-off’ items that were taken below the profit line. These amounted to $36m after tax or almost 10% of the bank’s full year profit and included a number of regulatory, compliance and software charges which many of its peers include in their underlying cash earnings. Given these are often recurring in nature for a bank in the current environment, there is a strong argument to be made that BOQ should have followed the accounting treatment taken by the other listed banks.

Other aspects of BOQ’s result were mixed. A key positive was asset quality, with a group loan impairment expense at just 8 basis points for the half. Consistent with the rest of the banking sector, impairments have gradually been trending down for an extended period, although this earnings tailwind at some point will inevitably turn into a headwind for the sector.

An additional positive factor was a better than expected outcome on net interest margins (NIMs). NIMs have been a key issue for the banks over the last 12 months following a spike in wholesale funding costs that appears unlikely to recede. A recent round of mortgage repricing will help to ease the pressure on margins. For BOQ, the upside came from strong deposit growth, which surprisingly came at the same time as it reduced its pricing premium to its peers; the sustainability of this development is thus questionable.

Of more concern was expense growth that was ahead of revenue, leading to another rise in the group’s cost to income ratio, which has tracked higher over the last few years. As with the entire banking sector, revenue and credit growth is the major issue at present and is expected to remain challenging in the medium term. BOQ reported respectable growth in business lending, although well below system growth in its larger housing and consumer division. A tighter discipline around credit standards appears to be behind this and the most probable response to the recent royal commission is stricter lending standards across the board, further limiting domestic credit growth.

 The central feature that BOQ shares with the major banks is a high forward dividend yield of 7.0%, underpinning the current share price. The consensus view in the medium term is, however, for a flat dividend profile, reflecting the limited growth prospects and a high payout ratio in excess of 80%. A sound capital position provides some defensibility to its dividend policy, although a return to a more normal credit quality environment (forecast by few) and ongoing elevated cost inflation are likely medium-term risks. From a valuation point of view, the stock has moved from a circa 10% discount to the majors to a slight P/E premium today – possibly valuing the rising regulatory risks that the majors have faced in this time.

Bank of Queensland: Forward P/E and Premium to Majors

Source: Bloomberg, Escala Partners
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The banking sector had initially rallied late last week following the release of the interim report into the financial services industry, likely on the basis that it raised no new issues or potential left-field solutions that may have affected industry profitability. Most of these gains, however, were reversed this week given the uncertainty that clouds the outlook; with no specific recommendations made in the report it is difficult to forecast what the eventual response will be.

Nonetheless, the focus on responsible consumer lending should have a greater bearing on the outlook for the retail-orientated banks, Commonwealth Bank and Westpac. With the final report due early next year, the upcoming reporting season for the majors shapes as the more immediate catalyst for these stocks.

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