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WEEKEND LADDER

A summary of the week’s results

06.01.2017

Week Ending 06.01.2017

Eco Blog

Expect more politics and policy shifts through 2017.

Early data shows that economic momentum picked up into the end of 2016. Inflation in Europe is also on the rise. Historically, the first quarter of the calendar year is weaker and new evidence on the trends will be important in setting the tone for markets in the early months.

- China is again tightening capital outflows while also further opening the bond market to foreign investors. Internationalisation of the renminbi is a clear goal.

After a year with an intense focus on events, 2017 promises much of the same. The only change is the shift in emphasis to Europe and, later in the year, to China for its important party congress where there is expected to be a transition to new Politburo members.

Events and Risks to Watch in 2017

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Alongside politics, central banks are in the spotlight, as there is no longer any reasonable certainty that asset purchases will continue to be the policy tool of choice.

Offsetting some of this uncertainty is the pace of economic momentum, which took a step up into the end of the calendar year. Global manufacturing, as measured by the PMI surveys, experienced a remarkable bounce in December, taking the aggregate to its highest readings since early 2014. Any reading above 50 implies growth.

European growth was bolstered by the relatively weak currency as well as improving domestic demand. Many emerging economies represented a mixed bag, largely due to internal circumstances than any change in global trade, with Asia leading the pack.

A solid rise in input costs has not only come from this level of activity, but is also a repercussion of the stronger USD, which resulted in a significant rise in commodity prices in Europe and the emerging world.

Manufacturing PMI

Source: Markit
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Right on cue, the US provided some tangible data on one of its sources of manufacturing growth. Auto sales spiked in December to an annualised 18.4m units. The import share hovered at just over 20%, well down on the peak of 30% in 2000. The upturn in sales may be due to incentives and future releases will be keenly watched to judge if this is an established trend. The gas price income bonus, improving employment and a pickup in household wealth has led many economists to expect US consumption spending to accelerate. Along with other indicators of activity in the US, these trends have been emerging from well before the election, yet are likely to be captured as evidence that the new government has created a path for higher growth.

Inflation is another feature that is likely to be predominant in economic discussion this year. European inflation ended the year at 1.1% and at a (relatively) eye-popping rate of 3.5% annualised based on the past three months. German 3-month inflation has hit 4.9%.

The inconceivable of a few months ago may well loom this year – the ECB can claim its title as the disinflation slayer and wind back its accommodative stance.

After a slow news period mid-2016, China will once again be a taking point in financial markets. The authorities are persisting with small initiatives to slow the capital outflow which is, in part, dragging down the currency. In turn, there has been a rise in domestic credit issuance given to compensate for the capital moves. Increasingly, there is discomfort on the level of private sector debt in China.

On the other side of the equation, the government is taking steps to make it easier for foreigners to gain access by opening up the path for investment into renminbi (RMB) bonds. Over time, this is likely to result in the inclusion of China bonds in global indexes and the internationalisation of the RMB.

China is currently sixth in global payments as measured by SWIFT. SWIFT is a global network that is used by the majority of interbank institutions for information on financial transactions.

Global Payments by SWIFT

Source: Deutsche Bank
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This clearly understates the value of Chinese trade, which is likely to move to the local currency as it becomes integrated into the global financial system.

Australia remains on the leading edge of Chinese economic ebbs and flows. Notwithstanding much discussion on weaker global trade, exports are the swing factor in our GDP. This year the terms of trade will be all important in determining national income, the likely path of the AUD and interest rates. A highly probable recovery in stated GDP by midyear rests on the price of commodities.  The biggest risk to that outcome is an untidy set of developments and loss of confidence in China.

Fixed Income Update

The pace has slowed on rising yields for Australian government bonds.

- Fixed rate investment grade bonds have price stability despite the spike in yields.

- Australian sovereign has avoided a ratings downgrade and maintained a AAA rating (for now!).

- Riskier fixed income sectors outperformed in 2016.

The yield on the Australian 5 and 10 year government bonds is close to the same as five weeks ago. This is despite the fact that both bonds hit their highest yield level for the 2016 calendar year on the December 15 when the US central bank raised rates and added hawkish commentary to its forecast for further rate rises. However, in the last ten days yields have edged back down and are now back at the same level they were a year ago.

Australian 10 Year Government Bond Yield

Source: Escala Partners, Iress
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Much has been documented about the lift in bond yields over the last few months. While this reflects the interest rate sensitivity of these instruments, long-dated fixed rate corporate bonds have been better insulated due to credit spread contraction over the same period. For a 5-year investment grade corporate bond, this spread tightening has broadly offset the fall due to the interest rate movement, resulting in prices being largely unchanged. For this reason, we prefer adding duration though corporate bonds as the credit spread is often negatively correlated with the rates market, decreasing volatility.

Just prior to Christmas we saw the mid-year economic and fiscal outlook (MYEFO), where the treasurer updated the budgetary position. There was concern that Australia’s sovereign could get downgraded. This comes on the back of the negative outlook that the rating agency Standard and Poor’s has already applied. However, the sovereign downgrade was avoided, with three rating agencies (S&P, Moody’s and Fitch) all maintaining their existing rating of AAA, though S&P maintain a negative outlook.

It is widely expected that if a ratings downgrade does occur, it will be initiated by S&P and on the back of the final budget announcement in May this year. However, it is likely the bond market will be pricing in this eventuality a lot sooner. A downgrade of the Australian government will also lead to a ratings downgrade for the major banks given the sovereign offers them an explicit guarantee.

If this were to eventuate, there is likely to be weakness in the pricing of bank senior bonds and government bonds as credit spreads widen. The higher cost of funding for the banks will lead to higher lending rates across their portfolios. Bank hybrids have a stand-alone rating which is not expected to be downgraded, but will potentially add to volatility in this sector.

After a strong start to performance in 2016, fixed income markets gave back some ground in the second half of last year. Global bond markets outpaced our domestic market in investment grade credit, while the riskier sectors (such as the domestic hybrid market, offshore high yield and emerging markets) all had a good year. The 2016 calendar year performance figures, denoted by their index, are shown below.

Source: Iress, Bloomberg, Escala Partners, CBA
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Corporate Comments

ANZ announced the sale of its 20% interest in Shanghai Rural Commercial Bank, which will improve its capital position further ahead of the delayed Basel IV framework. 

- The sale of Woolworths’ (WOW) fuel business has provided much needed cash flow for the supermarket division. Early signs of an improvement in sales is likely, but there is much more to be done.

- Bond proxies were sold off in the second half of 2016 as bond yields rose. This relationship has decoupled in the last two months, and while on a relative yield basis they appear fair value, the risk remains on the downside. 

- The battle for control of Tatts Group (TTS) has continued to develop over the last few weeks, with TTS rejecting a competing offer from a Macquarie consortium in favour of its original agreement with Tabcorp (TAH).

ANZ this week continued on its steady progress of simplifying its business to focus on its higher-returning operations with the sale of its 20% stake in Shanghai Rural Commercial Bank (SRCB). The disposal follows other recent divestments, including Esanda Dealer Finance and its retail and wealth business. It is also consistent with the bank’s intention to refine its Asian focus to its institutional operations in the region.

The sale will realise $1.9bn for ANZ with the deal completed at a price-to-book ratio of 1.1x net assets. ANZ had made its initial investment in SCRB in 2007 and the business contributed $259m in earnings for ANZ in the 2016 financial year, or close to 4% of ANZ’s profit.

The key benefit for ANZ will be a 40bp improvement in its common equity tier 1 (CET1) capital ratio, which would likely take the bank to the top of its major peers in Australia. The banks have been increasing their capital ratios over the last couple of years after APRA lifted capital adequacy requirements, which has had the effect of reducing profitability, reflected in a rebasing of return on equity across the sector. There remains the possibility that the bar will be raised again, although the timing of this looks to have been pushed out beyond 2017, with the international Basel IV framework experiencing several delays.

Some of the pressures that the banking sector faced in 2016 eased into the second half of the year. These include bad debt charges (which have levelled out after rising from historically low levels), competition in the pricing of mortgages and deposits, falling interest rates and the pressing need to improve capital ratios. The earnings outlook has thus improved at the margin, although growth across the sector is still expected to be relatively benign thorough this year.

Dividend pressures have also levelled off, as illustrated in the chart below. It shows the change in analyst estimates for FY17 over the last two years. Estimates have been revised down from strong dividend growth to slight cuts. To date, ANZ is the only bank of the majors to cut its dividend, however there is now greater comfort emerging in the short term for the reasons cited above.

Bank Dividends: FY17 Revisions

Source: Bloomberg, Escala Partners
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Woolworths (WOW) has devolved its direct link to fuel retail to a partnership with BP. The headline number of a $1.8bn transaction needs to be judged with some caution. WOW has to contribute to the discounts on fuel through its rewards system and absorb some additional overhead. Further, it is likely the ACCC will require BP to sell some of the sites, as it would otherwise dominate a number of regions. The finalisation of the sale is expected to take around a year.

The transaction itself is slightly negative to EPS (estimated at between 2-4%) but will provide WOW with some much needed cash flow to refurbish the supermarkets. Industry feedback suggests WOW has stemmed the tide with same store sales possibly edging back to positive territory. However, it is likely costs have gone up and operating margins down to achieve this outcome. To get real sales momentum will require improved standards at stores and a renewal of the offer. Some of the early refurbishments suggest WOW will move modestly upmarket in an effort to differentiate from the inevitably growth of the discounters. In short, this would compromise a solid home brand assortment at competitive prices and a range of specialised categories such as bakery, sushi bars and serviced butchery.

The optimistic may get caught up in momentum based on better than expected sales. WOW does appear to have bottomed in terms of relative performance, but it will take quite some time to reach a new stable platform of operations. For one, Coles is unlikely to take loss of share in its stride and the impact of Aldi and Costco can only intensify. Patient investors may see acceptable returns but should also not expect the “old” share price any time soon. That was based on profit margins and lack of investment that resulted in the current malaise. Trading at circa 20X earnings and a 3% yield, WOW does not strike one as a bargain.

The yield trade has been a key driver of equity returns over the last few years as bond yields have tracked lower, with investors bidding up equities with bond-like characteristics of predictable dividends. This has been a big driver of returns across REITs, utilities, infrastructure stocks and Telstra over this time.

As bond yields began to climb in the second half of 2016, the trade began to reverse, with a significant correction across these sectors of the market. This was true until early November, where bond yields consolidated at high levels, however (as the following chart illustrates), the performance of bond proxy stocks has since recovered in line with a general strength in equity markets. Utilities has been the most notable in the recent rebound, although this has in part been assisted by a takeover proposal for one of the largest stocks in the sector, Duet Group. Nonetheless, REITs, infrastructure and Telstra all appeared to have decoupled from the 10-year government bond yield in this time.

Bond Proxies and Australian 10 Year Government Bond Yield

Source: Bloomberg, Escala Partners
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With the prevailing consensus view that there remains upward pressure on bond yields through this year as inflation picks up and the Fed continues on with further hikes to the cash rate, it is difficult to see this basket of stocks outperforming the broader market through the year. For this reason, we are comfortable remaining underweight these sectors in our model equity portfolio. If bond yields instead flatline from here, is there any value in these stocks?

The following chart, which shows the yield premium of bond proxies compared with the ASX 200, suggests that they are at least at fair value. REITs, utilities and infrastructure all currently offer a dividend yield of approximately 0.5% above that of the market. While admittedly slight (and this is less attractive given the predominantly unfranked nature of these dividends), this is above the average of the last two years. The premium on Telstra shares is even higher still, although this likely is more due to the difficult earnings environment that the company faces and the sustainability of its dividend once the NBN is rolled out. The major banks, which also trade on relative yield measures, have fallen to an average 1.0% premium after outperformance in the last six months.

Bond Proxies: Dividend Yield Premium to ASX 200

Source: Bloomberg, Escala Partners
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Tatts Group (TTS) has been in play as a takeover target after it received a long-awaited bid from rival Tabcorp (TAH) in October. Following this, a competing offer was received from a consortium which included Macquarie and a private equity group. While the consortium pitched its bid on the basis of superior value with an attractive cash component for control of TTS’s core lotteries division, as we noted after the announcement, it also involved somewhat unrealistic assumptions for the valuation of the wagering and gaming businesses of TTS. TTS has since come to the same conclusion, continuing to prefer the TAH bid after highlighting several other inconsistencies with the assumptions used by the consortium.

There remains the possibility that the consortium will return with a further bid, with the key prize the monopoly lotteries licences that TTS holds. However, with the preferred bid and advantage of being able to realise the greatest synergies across its lotteries division, TAH remains in the box seat to complete the deal, with the most significant hurdle to overcome being clearance from the ACCC.




 


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