Week Ending 06.05.2016
Budgets can be viewed through a political lens, or within an economic framework, but rarely have much impact on financial markets. Deficit size and funding programmes have some resonance for credit rating and bond markets, certain elements may affect a handful of companies and the confidence of households can be moved, yet there is a disengagement elsewhere. In this budget, the deficit is expected to persist until well into the 2020’s. Government debt is forecast to increase from $427bn today to $640bn by 2026. With interest rates low, it is unsurprising that 60% is expected to have a maturity date of more than 10 years and some banks are looking to a local bond issue with a maturity date of 2041. While in the past Australian bond maturities were typically shorter, long dated bonds are common and 100 year maturities are not unknown.
The economic forecasts imbedded in the budget assume modest GDP growth of 2.5% to the end of the 2017 fiscal year with 3% factored in thereafter. Inflation is expected to edge up very slowly over some years to 2.5% and the unemployment rate stabilise at 5.5%. The forecast allows for an AUD/USD rate of 0.77. The most controversial part is the terms of trade, where the budget office has to make an assumption on the iron ore price. Following the recent recovery in iron ore, Treasury now assumes US$55/t, up from US$39/t last year.
In our fixed income section we will cover the impact of the RBA rate decision. The final analysis will be forthcoming when the minutes from the Reserve Bank’s meeting are released. The key element is the expected inflation rate, with the RBA appearing to concede that low inflation is likely to linger for much longer than anticipated. Arguably, it was the slowing rise in house prices and low rental growth, as measured in the recent CPI release, which tipped the balance in favour of the cut. The onus to keep a lid on housing has been shifted to regulation and APRA, while the banks’ appetite for increased mortgage assets also is evidently lower.
Current conditions present at a complicated set of possible outcomes. The iron ore price may be vulnerable later in the year as some of the participation by short term traders diminishes. Certainly, the spike in steel prices sits at odds with global manufacturing trends. If so, the AUD may ease back and the RBA can afford to stay on hold. Speculative trades could also unwind with some of the recent strength attributed to a rise in AUD/USD positions.
Retail sales for March sent mixed signals. While solid at 3.6% year on year, the main impact appears to have been in apparel pricing outside department stores. This sits at odds with the CPI and therefore may be a function of seasonal and idiosyncratic factors rather than any indication of a solid rate of growth. Few other sectors showed any notable trend. Retail spending only picks up about 25-30% of household behaviour, the rest going on services such as utilities, education, health, savings, mortgages, entertainment and the like. Increasingly store based sales are far from a good measure of household behaviour.
On the other hand, the dovish Fed could see rates in the US remain unchanged for the rest of the year. US$ weakness could once again ensue. That puts more attention on US data releases after the soft trend in the first quarter. Some early indicators suggest a slight improvement. Auto sales in March were up 5.2% in seasonally adjusted terms and consumer lending has also lifted. Overall, the US household sector has largely shrugged aside global concerns and possibly even politics with the continued improvement in the labour market.
The stalwart of the services sector has also turned the corner, registering a decent expansion rate. These surveys benchmark a number of factors, with any reading over 50 indicating a positive rate of momentum. In this case, shown below, employment and pricing for services have led the charge. Data to date implies that the second quarter of growth may be challenging for the Fed. Only low inflation or a particular global trend is likely to stand in the way of expectations of a rate rise.Enlarge
Fixed Income Update
Market sentiment was mixed at the beginning of the week as participants priced in a 50/50 chance of a rate cut leading into Tuesday’s decision. The recent exceptionally weak CPI data and the high AUD currency obviously prevailed as major concerns for the RBA, leading to a 25bp reduction in the cash rate to 1.75%. The impact of this is felt across the board on fixed income assets with different implications for fixed vs floating rate held products.
Short duration credit funds largely hold floating rate notes and fixed rate bonds with a short maturity (tail end bonds). The duration of these funds is usually within a year, meaning that on average the whole portfolio will have reset to the lower interest rate environment within that time frame. While the tail end bonds may have a temporary price kick, this will fall as the bonds get closer to maturity and there is a ‘pull to par’ (the bonds mature at $100). Further, as they mature the fund will need to reinvest funds at the new lower interest rates. As for floating rate notes, these are nearly always benchmarked against the bank bill swap rate (BBSW) which has shifted lower as a result of the rate cut. Following the RBA announcement, the front end of the BBSW curve has fallen the most, while the longer end did the majority of its heavy lifting upon release of the CPI figures. The chart below shows the bank bills rates curve a month ago, following the CPI figures and after the RBA rate cut.
Australian Bank Bill Yield Curve
The domestic listed debt market has also had an immediate leg down in yield as the majority of these securities are floating rate notes that are mostly priced as a fixed margin above the 3 month BBSW rate. This rate has fallen from 2.275% two weeks ago to 2.045% today. At the next roll date (usually 3 monthly) these securities will have their coupons set at the new lower rate, translating to a lower coupon payout to investors.
However, the prevailing interest rate is only one component of the return in these products. The other is the credit spread, which is determined by the market’s tolerance to the risk of the asset. A low interest rate environment is often favorable to credit spreads as investors seek out yield opportunities in higher risk products, such as bank hybrids, increasing demand and therefore driving up their price.
Owners of long dated government bonds and high quality fixed rate products are the biggest benefactors of the recent rate cut. As interest rates are locked in at a higher level, this reflects positively on the price of these bonds given their higher coupon payments. Most investors gain exposure to this sector through domestic government bond funds and long duration credit bond funds that are benchmarked to the Bloomberg Composite Bond Index. The chart below shows the price action of this index in the last year. The last week has seen a positive shift upwards following the rate cut.
Bloomberg Composite Bond Index
While interest rates have moved across the curve, the changes have not been universal. For example, the spread (interest rate differential) between 3 year government bonds and 13 year government bonds has narrowed since mid last year. This has resulted in a flattening of the Australian yield curve, and highlights the low growth, low inflation and low interest rate environment that the market is forecasting. A popular trade idea that we have heard in the market this week is a yield “curve steepener” which is a reversal of this spread compression and would see longer dated government bond yields trade higher compared to the front end of the curve. The chart below illustrates the recent spread in these two government bonds in the last year.
Australian Government Bonds - Yield Spread
The half yearly reporting season for the banks was predicted to be difficult by many analysts and this proved to be the case this week. The primary talking points were bad debts, dividends, margins and capital levels; all of which affected the individual banks to varying degrees.
As we have discussed before, the bad debts cycle in the Australian banking industry has been a significant tailwind and driver of profit growth for the sector since the height of the financial crisis. The results of the major banks this week confirm that the cycle has turned over the last 12 months, with increases (in varying degrees) in bad debts charges across the board. Generally speaking, the increases in bad debts have not been broad-based across the economy, but rather limited to a number of specific sectors (resources and the dairy industry in NZ were the two most cited by the banks). However, the large institutional names that have caused the banks problems, while small in number, are large in size and thus have caused a material uplift in bad debts and drag on overall bank profitability.
Further to this, we stress that the increases in bad debts have not been driven to above-average levels but more closer towards what might be expected through the cycle. Nonetheless, this normalisation has been (and will likely continue to be in coming reporting periods) a headwind to earnings in the half. For example, the isolated impact of higher bad debt charges was -6% on Westpac’s profit before tax and similarly -8% for ANZ. The table below sets out the key takeaways from results this week (and from February’s half year number for CBA).
Major Banks: 1H16 Results Summary
Several other trends were apparent from results this week. Cost growth across the banks remains high relative to revenue growth, putting pressure on margins. High regulatory and technology costs continue to hamper the efforts of the banks to reduce overall costs. Net interest margins were relatively unchanged for the half despite the mortgage repricing that each of the banks undertook late last year; an increase in wholesale funding costs squared the ledger here (see following chart). The primary revenue driver, credit growth, has been hampered by APRA’s crackdown on housing investor lending. The return on equity across the sector has dropped down following capital raised in the last 12 months and looks to have suffered a permanent drop given the increased regulatory capital burden. This has translated to negative earnings per share growth for the sector for the half year. With capital and bad debt headwinds likely to persist over the next 12 months, we are comfortable remaining underweight the sector in our model portfolios.
Banks' Short Term Funding Costs
Looking at the detail of the individual results, Westpac’s profit missed consensus by approximately 3%, driven by higher bad debts than expected and non-interest income. Four large single name exposures were the cause of the high bad debts; outside of these, the bank’s bad debts charge was flat. WBC’s asset quality remains quite sound, and with a strong capital position, domestic household consumer focus and lower exposure to the problem areas of the economy, the bank’s dividend is under less pressure than its peers.
With a new CEO, ANZ’s result was more keenly anticipated than its peers. ANZ arguably has the most work to do to restructure and reposition its business in the current environment and the path forward was set out with several key priorities. The most significant of these was the decision to simplify its business and look to exit non-core and low returning operations, particularly in its institutional division. ANZ’s actual earnings were much lower as a result of several one-off provisions the bank took, including the change to more conservative accounting of technology expenses. A 7% cut to the interim dividend completed the reset by the new CEO.
ANZ’s underlying result was mixed. The major criticism is its overweight exposure to the problem credit areas we noted above. In addition, its larger Asian exposure also resulted in greater bad debt losses in the region. These negatives more than overshadowed the better performance of its domestic consumer business, which showed strong cost control and market share wins in lending. ANZ continues to trade at a significant discount to its major peers and although the bank has more elevated credit issues, is considered to be the highest risk/return option among the four.
The highlight of National Australia Bank’s (NAB) result was a sector-leading outcome on its bad debts expense of just 14bp, although the second quarter charge was higher following an exceptionally low first quarter. Margins surprised on the upside, and a satisfactory earnings outcome allowed the bank to maintain its half year dividend. However, with a weaker capital position compared to its peers and the current dividend above NAB’s target payout range, the potential for dividend cuts in coming periods will be monitored.
Macquarie Group (MQG) also reported this week, with earnings largely meeting expectations. Profit growth of 29% for the year was a solid result (although the number was assisted by a lower tax rate) and a 20% hike in the final dividend was ahead of expectations. Macquarie’s annuity-style businesses (banking and financial services, asset management, and corporate and asset finance) drove the result, with improved earnings across each of these divisions.
Looking at the earnings detail, half-on-half numbers and guidance for FY17 all suggest that the environment will become more challenging for MQG. Macquarie’s capital markets-facing businesses is forecast to face more subdued conditions over the next 12 months, and while this now represents less than 30% of the group’s earnings, the volatility from these divisions can impede overall profit growth. A slowing in mergers and acquisitions activity and the recent rebound in the AUD are two factors that could create a headwind for profitability in FY17. The sustainability of high performance fees across its infrastructure funds is a further hurdle to overcome. In Macquarie’s favour is an undemanding valuation, a high dividend yield (now ~6.2% on a trailing basis) and an increasing proportion of annuity-style earnings.
Trading updates came thick and fast this week for ASX-listed companies, with a large investment conference in Sydney providing one of the last opportunities prior to the end of the financial year to inform investors of the current environment. The week was notable for the lack of earnings downgrades across companies presenting, with the majority reaffirming previous guidance.
Star Entertainment Group (SGR) was marked down slightly following an update on its performance. As we have noted, the December half year was particularly strong for the company in terms of the level of activity at its casino properties, with the downside of a low win rate against its high roller customers.
These growth rates have slowed somewhat in the first four months of 2016, although still remain at respectable levels. It appears that the key drag has been some disruption from capital works as SGR upgrades its properties. The recent robust growth rates that SGR has achieved followed significant capital investment, particularly at its flagship Star casino in Sydney. With favourable tailwinds for its business, including a lower AUD stimulating international visitation (and noting that more than 20% of Chinese tourists visit one or more of the company’s properties) and the resilience of the gaming sector in times of economic weakness, we have the stock in our model equity portfolios.
Mantra Group (MTR) also taps into this Asian tourist theme well, with the company illustrating the trend in its presentation while reaffirming its upgraded full year guidance. Outside of China’s closer neighbours, Australia competes well against destinations such as the US and European countries. China’s outbound tourist numbers are expected to more than double between 2012 and 2020, with these figures consistent with passenger data reported by Australia’s major airports. Industry supply growth has struggled to keep pace with demand, resulting in a favourable trend in its key measure of RevPAR (revenue per available room). Helping this has been the fact that it has been cheaper for existing operators to grow their portfolio via acquisition as opposed to building a greenfield development; the incentive for industry growth has thus been low.
China Outbound Tourism
Transurban (TCL) held an investor day with a detailed presentation of a large pipeline of potential expansion opportunities for the toll road company.
TCL is in the enviable position of controlling extensive toll road networks in the three major cities on Australia’s eastern seaboard. As a result, it is well placed to participate in any further extension of toll roads in these cities because of its track record of delivery and the advantage it would have over any competitor in bidding given the synergies that it could realise through integrating adjacent roads into the network. The development pipeline is significant in each city, even beyond the $11bn that is currently either committed or in negotiations.
TCL is also looking to its long term future and the benefit that it is likely to receive from the eventual rollout of connected and autonomous vehicles. The key positive for TCL is that it is expected to result in an increased capacity on its network (TCL believes that capacity could be potentially doubled in dedicated lanes for connected or autonomous vehicles) with an overall 10-25% capacity increase by the 2030s. The increased safety of these vehicles would also reduce congestion caused by accidents, further increasing road capacity. The chart below illustrates a potential timeline for the rollout of this technology (level 0 represents no automation, while level 4 represents complete self-driving automation).
US Vehicle Fleet by Automation Level
While we can acknowledge the strong performance of TCL, both operationally and with this translating to impressive share price appreciation, our primary current concern is from a valuation perspective. Its attributes described above make it an attractive investment proposition from a qualitative perspective, however there are still risks in its business, including from a rise in bond yields and the potential for revenue to disappoint in a deflationary environment (given its CPI linkage in its annual toll increases).
Woolworths’ (WOW) third quarter sales were weak, with a -0.9% like for like growth in the supermarkets; the fifth quarter of negative sales growth. A further investment of $150m was announced to improve price points and store execution. Big W is also making no momentum, with a loss likely this year. WOW is attempting to turn a big ship right at the time food inflation is low, Coles has hit its stride and as Aldi intends to accelerate its store rollout. While the sheer size of WOW works in its favour, the profit margins will almost certainly settle at no more than 5%, some 2% below their level only a few years ago. Headline growth is also likely to become workman-like at roughly nominal GDP. While that is not the worst outcome, the stabilisation strategy is far from compete and will take time.
To add insult to injury WOW had its credit rating downgraded. Retail leverage can be deceptive as the liability from the lease obligation is not always shown as part of the debt. The stock has been hit hard with this report and some may start to take the view the bad news is factored in. To some extent we would agree, but the time it will take to become an appropriate investment choice is possibly a couple of years away.
Super Retail Group (SUL) provided a trading update and as well as outlining the restructuring of the problematic Ray’s Outdoor stores. Comparable sales growth in the third quarter was strong in all segments. Auto rose by 4.5%, sport by 6% and leisure by 4.5%, with gross margins improving in the first two. Leisure sales have included the clearance of dated stock in Ray’s and margins there will be weaker. Ray’s will be substantially trimmed to 17 stores with 23 to close. Dealing with the consequences of this acquisition from some years back has been a large management distraction and its resolution can see the attention shift towards the sport and auto segments, both of which have done well but will face increased competition from existing and new entrants to the category. SUL is trading on a relatively high 2016 P/E of 17X, however with the changes at Ray’s this is expected to be 14X for 2017 and supported by a franked yield of 5%. While SUL has been a somewhat disappointing investment, it now has the potential for stable moderate earnings growth.