Week Ending 06.03.2015
Readers of this report will see the addition of a segment on fixed income markets. In this new segment we will comment on recent trends specific to this asset class both domestically and globally. As many investors may be developing their familiarity with fixed income, we welcome any feedback. If fixed income assets are to fulfil the role of relatively stable, low risk returns, holders of these assets should understand their trading pattern and therefore capacity to achieve the desired outcome.
A slew of releases did little to change the local perspective. Against expectations the RBA did not cut the official interest rate. Yet the market continues to price in a certain cut (in fact two, based on the futures market) and therefore the lack of action by the RBA this month saw only a modest reaction in currency and equity markets.
Strong housing approvals would typically see a positive tone towards economic growth. Again, with the data essentially showing a persistent skew to multi units across a narrow geographic spread, it was arguably more of a signal about the problem in the housing sector than the merits of possible growth contribution.
January retail sales growth was seen as reasonable by economists, less so by equity retail analysts. Headline trend growth was stable, but within the segments, only the housing related sectors showed much strength, suggesting lower fuel prices have had little impact on spending. Food retailing was very weak, with only 2.6% growth in the month, supporting the contention that Woolworths and Coles face a tougher environment.
Rounding it out was the Q4 2014 GDP release showing that Australia’s economy expanded by 2.5% in the year. Domestic final demand edged up 1.2% with the bulk of the remaining growth coming from resource exports. Most would by now be well familiar with the issue: housing is the sole source of domestic strength and on the other hand, resource volumes are, unsurprisingly, doing well enough.
In China the central planners have recast their growth expectations for the year at 7%. Sceptics will question whether the reported GDP growth is meaningful, but in our view, that misses the point. Even if the data is not entirely reflective of the growth rate, it is consistently measured and the trend likely to be correct. There is also a large volume of corroborating data on imports, exports, lending etc, which do imply the growth rate in the country has been very solid over the past decade.
But the reality of arithmetic and economic development is fast approaching with the pace of growth likely to move relatively rapidly towards 5%. There are precedents for this, shown in the chart below. Economic growth falls as the wealth, measured by the size of the economy per capita, grows.Enlarge
Some are already forecasting lower than 7% growth for this year on the basis that the property market will be weaker than desired, yet the authorities are unwilling to support, given the risks of unsustainable lending in that sector.
Financial market attention will be on Europe as the first major tranche of bond purchases by the ECB commences. This is not the start of quantitative easing (QE), as the ECB has been providing liquidity and buying bonds since 2011, yet the intent over the coming months will more closely resemble the path taken by the Fed. The ECB will buy €60bn of existing bonds at market (not face) value with maturities of between 2 and 32 years and a minimum yield of -0.2% (the negative deposit rate). The purchases will be spread across all Eurozone countries and over the range of maturities of their bonds. Outside of government bonds, the purchases will include bank issued covered bonds (backed by assets), other select asset-backed securities and issuance from quasi government organisations.
As bonds are trading above their face value, the market value of purchases is a lower proportion than originally assumed. Bounded by the other capital restrictions, the table below shows the expected level of purchases the ECB will be making of each country’s outstanding bond issuance. Sharp eyes will notice the absence of Greece, where the lack of investment rating precludes it from this programme.
ECB Bond Purchases
There is naturally much debate on the effectiveness of this QE. Most likely, the positive transmission mechanism will be indirect. Funding for the corporate sector will be easier, given where interest rates will be anchored and that they are likely to be able to issue low-cost, relatively long maturity paper. Households will not face much in the way of interest rate costs while finding deposit returns unattractive. If they buy financial and other investment assets and these perform reasonably, the longer term wealth effect will then be helpful. Near-term, however, the lower euro is mostly likely to have a beneficial impact, both on exports and on stabilising any negative trend in inflation data.
The US will be focused on the labour data out on Friday. Recent indicators suggest the trends are somewhat patchy and it may be that the recent bate of icy weather impacts on the short term numbers. The port dispute, which has seen much of the west coast trade disrupted for some months (famously depriving the Japanese of KFC fries over Christmas, an apparently traditional gastronomic indulgence) is likely to have hurt the job market and will take up to 1% of Q1 GDP. Anecdotally, however, there is enough to support the view that the US is still making decent economic progress. At a recent meeting at Escala, a senior executive from Brambles mentioned the costs it had incurred from shortages in trucking fleets (both vehicles and drivers) in the past 6 months. There would be good reason to believe this is not the only pocket of pressure given the relatively lengthy recovery in the US in contrast to capital investment levels.
Fixed Income Commentary
Since the beginning of this year we have seen two new deals come to market in the hybrid sector. ANZ raised $850m through the issuance of a 10 year, non-call 8 (i.e. the bond has a term of 10 years and cannot be called in the first 8 years) additional tier 1 (AT1) at a margin of +360 basis points (bp). Following this, NAB issued a 7 year, non-call 5 AT1 deal for $1.25bn at a margin of +350 bp.
A flurry of hybrid primary issuance in the latter part of 2014 contributed to some spread widening across the curve at that time. It became evident that market participants were actively switching out of some of their existing holdings to take up the new deals. This, together with uncertainty around the Murray report and rating changes from S&P, saw existing hybrid bonds trading below par for the first time. The graph below shows the uptick in spreads in the hybrid market since August last year.
However, so far the secondary market appears to have absorbed this year’s new issuance with ease. We may still see some switches take place, however, it feels like new money is returning to this asset class, presumably as a ‘search for yield’ given the recent spread widening versus rate cuts by the RBA. Market reports suggest that we will also see a new non-financial subordinated bond and hybrid bond from another major bank over the coming weeks.
Away from the listed market, the Australian credit sector has been fairly steady of late with limited supply assisting the performance of the secondary market. Global investors continue to buy Australian assets, which offer some of the best relative yields, accounting for underlying credit risk. The few deals that have come through domestically have been well supported. The Macquarie 5 year senior bond that launched last week was three times oversubscribed.
Australian issuers also continue to access the global bond markets, as was seen with the recent Westpac subordinated 12 year, non-call 7 bond. This issuance was done in $A out of London and achieved a better cost of funding for Westpac than if they issued domestically. In contrast, local investors buying Australian issuers denominated in foreign currencies, are getting additional yield when hedged back to $A given the pick-up in carry from the currency conversion. We frequently therefore see these held by our recommended domestic fixed income fund managers.
Globally, credit continues to find support, however Europe appears to be outperforming (likely in anticipation of the ECB buying referred to in our eco blog) the US at the moment with expected QE helping spreads, while in the US some profit taking has seen levels trade sideways. Many global participants are focused on opportunities in emerging markets such as Mexico, where improving fiscal conditions are expected to see bond yields fall.
Suncorp (SUN) and IAG updated the market on the financial impact that they expect from claims related to Tropical Cyclone Marcia in Queensland. SUN expects a pre-tax cost of between $120m and $150m from the event, while IAG’s estimate is between $60m and $90m. While these events are obviously cannot be forecast, the chart below from SUN reveals that the domestic insurance environment has been reasonably accommodative over the last few years. This has followed a couple of difficult years for the industry when faced with the Christchurch earthquakes, flooding in Brisbane and Cyclone Yasi.
Suncorp: Natural Hazards since 1967
The key question for investors will be the likely impact that this event (along with the storms in Brisbane late last year) on its ability to fund further special dividends. SUN has now already exceeded its initial FY15 hazard allowance and has conceded that it is unlikely to achieve its 10% ROE target for the year. While further adverse events could put its dividends at some risk, the consensus view is still for a further special dividend payment at its full year result, although perhaps at a lower level compared to last year. We believe that this will provide support for the stock over the next six months.
FlexiGroup (FXL) this week announced that it had acquired Telecom Rentals NZ, a subsidiary of Spark New Zealand (previously known as Telecom New Zealand, the country’s incumbent telco operator) for NZ$106m. Telecom Rentals is a leasing provider of IT and telecommunications equipment, primarily to the commercial and government sectors and was considered to be a non-core business for Spark. The acquisition price of 5X FY16 net profit and 1.2X book value appears reasonable and will effectively double the size of FXL’s business in NZ, which has been the company’s highest margin division.
The transaction builds on several other acquisitions that FXL has made over the last few years, which have been successfully integrated and have been value accretive to the company through the synergies it has been able to extract. We believe that FXL remains a sound small-cap alternative investment in the financial sector, with an attractive valuation, strong track record of growth and execution on its strategy and high return on equity.
Macquarie Group (MQG) this week announced the purchase of an aircraft leasing portfolio for US$4bn and an associated capital raising to fund the acquisition, doubling its existing portfolio. The business will add to the group’s corporate and asset finance division and is expected to be approximately 5% accretive to EPS by FY17. The transaction is a demonstration of MQG utilising its now slightly more expensive script to acquire assets more cheaply, with its strong capital position providing this opportunity. We like MQG given its large international exposure (with earnings growth assisted by a weaker $A), improving trading conditions and reasonable valuation.
Reporting Season Wrap
February’s report season for the Australian market was largely in line with expectations. With earnings expectations relatively subdued (approximately 2% EPS growth for the half), the strong share price gains for the month appeared to be largely unjustified. Below we discuss some of the key themes to emerge.
Subdued Revenue Growth/Solid Cost Control
Companies that did beat expectations achieved this primarily as a result of better performance on the cost side of their business, as opposed to revenues. The results of BHP Billiton and Rio Tinto were a good demonstration of this theme as they beat the estimates of analysts by around 5%. Aside from the two big diversified miners, other companies with significant cost saving programs include Asciano, Suncorp, AMP, QBE, Qantas, Boral and Caltex.
The dividend payout ratio again edged higher for the half, while the number of share buybacks is starting to increase. While they faced falling profitability as commodity prices weakened further over the six months, the progressive dividend policies of BHP and Rio Tinto also meant that their respective dividend payouts ratios increased materially. Rio Tinto and Tabcorp distributed their excess franking credit balances to shareholders via share buybacks, while other companies to instigate or continue existing buybacks included CSL, Amcor, Orica, Nine Entertainment and Seven Group.
Balance sheets across the market remain in relatively good shape. With few companies making large acquisitions and/or willing to commit to significant capital expenditure projects over the last few years, debt has been paid down, even despite the more attractive debt funding opportunities available to them.
Benefits from a Lower $A
Investing in companies that have a large offshore exposure has been a relatively successful strategy over the last 12 months. Weakness in the $A finally started to emerge six months ago, providing a significant tailwind to many of these companies (which is expected to continue into the second half). The dividends of many stocks in this category are also declared in $US, helping to boost dividend growth across the market.
Some Pockets of Strength
Some areas of the market are showing solid earnings growth or an improving outlook, although in most cases, this is reflected in elevated valuations. As a sector, health care has retained its large P/E premium as a result of fairly consistent earnings delivery by the largest companies. The diversified financials sector has generally been performing quite well, benefiting from robust investment markets. The residential housing market remains in good shape, and this is flowing through to a select few retailers. Some of these trends should continue over the following 12 months. From an investment perspective, the options are generally limited by either high valuations or a lack of any quality exposure to the theme.
Little Change to Earnings Estimates
With results on average in line with the market’s expectations, earnings revisions were also quite limited. On a market-weighted basis, earnings for FY15 are expected to be flat. Of course, the lower earnings of the resources sector are playing a key role in this outcome. The earnings of the mining and energy sectors combined are currently expected to be approximately 25% lower this year, with the rest of the market at mid-to-high single digits.
Below we have revisited the updated data from reporting season in our Market Predictor Tool. For those unfamiliar with this model, rather than forecasting a value for the ASX 200 based on a simple valuation of aggregated earnings, we prefer to consider the value in the major and distinct segments of the ASX 200; that is, resources, financials and industrials. The determinants of earnings growth are different in each and the price multiple that is historically applied is also very different.
We show consensus earnings and then propose a scenario that may be realised to assess if there is value based on a change in circumstances or growth.
Our rationale is as follows:
- Financials earnings (mostly probably banks and diversified financials rather than REITs) may see modestly higher earnings than currently forecast. Costs at banks could fall more than anticipated or credit growth prove slightly better than expected. While bad debts are well below historic average, they are unlikely to tick up in the early stages of any economic recovery as it take time for these to emerge.
Conversely, we have tapped down the P/E multiple to be consistent with the above view that a slight rise in credit trends will be forthcoming. In those circumstances, the financial market will start to price in higher interest rates and the yield trade will require a higher return; in other words, dividend yields will need to rise. In short, we believe the financials sector is not a one way street; returns are likely to be either yield compression due to falling rates and very weak credit growth, or credit growth improves the EPS outlook, but reduces the attractiveness of the yield.
- The upside for resources companies is most likely from another round of cost cutting. We have therefore a modestly higher EPS number than the market, but believe the valuations are already high enough given the uncertainty on the outlook for commodity prices. As a broader comment, markets tend to pay up for top line growth rather than cost cutting, even if the EPS momentum is the same.
- As is always the case, industrials are a mixed bag. But a brief glance at the data on the following page shows how expensive some sectors are compared to growth expectations. We have (somewhat generously) assumed EPS growth can be higher than forecast. The sources of this would be a greater than expected fall in the $A (which would on the other hand imply economic pressure), cost reductions, or a higher rate of household spending.
Even with these relatively bullish assumptions, we find it hard to see overall value in the market. In summary, stock selection will therefore become critical, with a focus on companies that are able to extract more than others from the current circumstances.
S&P/ASX 200: P/E, EPS Growth and Scenario Analysis