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WEEKEND LADDER

A summary of the week’s results

06.07.2018

Week Ending 06.07.2018

Eco Blog

· Australia’s retail sales were better in May and the trend has improved this year, albeit off a low base.

· Expansion in commodity volumes and prices have underpinned Australia’s recent trade surplus. Sustaining this momentum will help achieve Australia’s moderate economic growth.

· Trade has remained at the forefront of investor concerns this week. A prolonged negotiation period between the US and China has the potential to weigh on the investment decisions of companies and disrupt economic growth.

Australian retail sales for May surprised on the upside, with a 0.4% rise in May and followed a similarly encouraging result for April. Delving into the data revealed reduced enthusiasm for the headline number. Department stores and clothing and footwear led the gains, although there was possibly some catch up given the unseasonally warm April. Other more discretionary categories, such as cafes, restaurants and takeaway were weaker, suggesting limited residual cash flow for households given higher inflation in the essential goods and services categories. On a state basis, Victoria and NSW continue to lead the way.

Overall, the trend in retail sales growth has improved through the first half of 2018. However, the annual growth rate still remains weaker than recent years at less than 3%. High household debt levels and subdued growth in wages is likely to blame, while other factors such as rising fuel prices and a cooling housing market are also unhelpful. The lack of any meaningful contribution to economic growth from households is helping to keep the RBA patient in its approach to lifting rates.

Australian Retail Sales Growth (Trend, Year-on-Year)

Source: ABS, Escala Partners
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Providing more support to Australia’s economic growth in recent quarters has been robust trade figures. Australia’s trade balance has been positive for much of the last 18 months now, with growth in exports driven by commodity prices and volume growth.

This proved to be the case again in May, although a trade surplus of $0.8bn was short of expectations, with April’s data also revised downwards. Export growth of 4% was driven by solid gains across LNG, coal and iron ore, outpacing a 3% increase in imports. LNG in particular, has been a standout so far in 2018, with volumes continuing to grow as major projects are completed or ramp up to full production, while pricing has obviously been strong. With contract prices typically based off Brent pricing subject to a lag of three months, this bodes well for this momentum continuing through to the September quarter, although this will be at a time when the volume impact is expetced to taper.

Key Commodity Exports: Year-on-Year Growth in Value

Source: ABS, Escala Partners
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Domestic housing is unlikely to be a reliable source of GDP growth going forward and with a weak consumer, government spending and ongoing strength in the trade figures are a likely requirement to support Australia’s circa. 3% growth rate. The possibility of China’s growth slowing at a faster rate than anticipated is a risk to this outcome.

Trade has remained topical this week, with the US set to impose tariffs on US$34bn of Chinese imports as of today. The official announcements to date are judged to have only a marginal impact on growth given the size of the markets targeted. Further, the consensus view has certainly been for any tariff announcements to be limited in nature, although there has been more uncertainty in recent weeks given the threats to include a much broader set of goods if China were to retaliate.

Even if these threats are not carried out, a lack of any clear resolution in the short term has the potential to result in increased volatility in investment markets. While Australia has largely escaped any of the negative effects to date (our equity market has potentially benefited from safe haven flows in the region, while a weaker AUD has helped), movements in other markets have pointed towards a more cautious stance. Other equity markets have generally been weaker over the last month (particularly China, which has also seen a depreciation in the renminbi), while some commodities, such as copper (-10%) have corrected.

Disrupting the fairly solid pattern of global economic growth is the other short-term risk. A lack of any certainty is likely to weigh on investment decisions, a factor which was noted by the FOMC’s June minutes, which were released this week. The Fed noted that some companies had already “scaled back or postponed” capital spending plans “as a result of uncertainty over trade policy.” While the recently announced tax cuts in the US have been a positive development in lifting investment and have added to the momentum (see following chart), the risk in coming months is that this stalls in the wake of trade worries.

US Capital Goods New Orders (Year-on-Year Growth)

Source: Bloomberg, Escala Partners
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Investment Market Comment

· The STOXX 600 is widely-quoted and used as a proxy for measuring the performance of European equity markets.

The STOXX 600 is a market capitalisation-weighted index of 600 European companies. There are 17 country markets that are covered by the STOXX 600, each with their own unique sector exposures. As such, these differences lead to a variance in performance in each of the sub-indices, which will impact the STOXX 600.

STOXX 600 Regional and Sector Weights

Source: iShares, Escala Partners
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The three biggest countries represented in the STOXX 600 are the United Kingdom, France and Germany, which combined, make up nearly 60% of the index. The UK’s FTSE 100, Germany’s DAX 30 and France’s CAC 40 are three popular European stock market indices. Each is market capitalisation-weighted, consisting of their respective country’s biggest companies. Naturally, the sector weights for each of these indices will differ to that of the STOXX 600.

The STOXX 600 has been amongst the weakest regional performers in the past year. One of the primary reasons for this is the structural underweight to technology. Globally, technology makes up nearly 20% of the MSCI ACWI, but only 5% of the STOXX 600. The most recent issue has been on the political front with the uncertainty in Italy, which until recently had been the best performer index in the Eurozone.

Selected Country and STOXX 600 Sector Weights

Source: iShares, Escala Partners
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Over the past year the CAC (France) has outperformed the other major components. Oil and gas company, Total SA, the biggest weight in the CAC 40, is up almost 16%. In addition, the biggest sector exposure, consumer discretionary (which includes France’s specialisation in luxury goods) has been another strong performer, with shares in LVMH (Louis Vuitton Moët Hennessy) up nearly 30% in the last year.

The FTSE’s largest exposure is in financials. HSBC Holdings is the largest company within the index at 7.2%. The rise in the oil price has lifted oil stocks such as BP and Royal Dutch Shell, which are the next two biggest companies in the index. A rise in commodity prices tends to favour the FTSE 100 as the index is weighted towards resources companies.

The DAX still has 16 of the original 30 companies from 1987. The largest five companies (SAP, Siemens, BASF, Allianz and Bayer) make up over 40% of the index and these companies are capped at a weight of 10% each to reduce the influence of index heavyweights. Consumer discretionary is 17% of the index, with automotive companies such as Daimler, Volkswagen and BMW falling under this sector.

· The STOXX 600 is a broad representation of the European markets. Yet the higher weights are in global companies. This can create opportunities to pick up stocks sold off in an aversion to European economic or political issues. Active management therefore does pay off, though tactically ETFs are a useful alternative.

Fixed Income Update

· The US high yield market has held up well in the current rate tightening cycle, which is an unsurprising outcome compared to history.

The US high yield market is the marketplace for bonds that are rated below investment grade (Moody’s BB+ and below). Rating agencies assign lower credit ratings to these companies based on their assessment of the company’s likely ability to pay interest and principal on borrowings. Characteristics that are assessed include balance sheet strength, the stability of the sector in which the company operates, the length of the company’s trading history and sustainability of future cashflows.

Even with the lower credit rating, a very large and liquid bond market enables these companies to raise debt, while offering higher returns to investors that are willing to risk capital. Lending to these companies is considered a higher risk investment compared to investment grade companies given they are more likely to default.  Moody’s have done research on historic default rates over a 35-year period, which helps investors make judgements on the probability of default for a given credit rating. As illustrated in the chart below, the probability of default significantly increases with lower credit ratings and longer maturities.

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Improving global growth in a backdrop of low interest rates has been favourable to corporates, resulting in the high yield default rate in the fourth quarter of 2017 falling to 3.3%, which is well below its historic average. Falling defaults coupled with low interest rates (even as the US raises rates), encouraged yield-starved investors to pour into this asset class in the last couple of years. Issuers benefitted from both the increased demand 

(resulting in tighter credit spreads) and low absolute interest rates. This allowed them to issue more debt, for longer periods and with weaker covenants. The US high yield market is now close to double the size it was ten years ago and credit spreads are close to pre-financial crisis levels of 2007.

Many have talked of the impact that a rising interest rate environment in the US will have on the high yield market. These bonds are issued as fixed rate securities (albeit the duration is on average lower than for an investment grade bond), where the price falls as rates rise. However, the interest rate component is only one determinant of the price, with the credit spread of an individual issuer being the other. Credit spread tightening has the potential to offset the negative impact of interest rate rises. This differs greatly to sovereign bonds that don’t have a credit spread to cushion the price from a rise in rates. While historically there have been annual drawdowns as rates rise, the performance outcome has been more positive than negative.

Performance of High Yield in Rising Rate Cycles

Source: Bloomberg, Escala Partners
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This asset class has so far held up well during the current rate hiking cycle by the US Federal Reserve. Since the tightening of monetary policy is due to economic strength, this favours corporates and lowers the risk of default. Further, issuance levels have fallen in the last couple of months, limiting supply. On a rolling 1-year basis, the high yield index is still positive, and the total return on this asset class is positive year to date. The higher cost of funding for this sector will start to impact issuers only as debt refinancings occur in the future. This is likely to result in a lag in the effect that higher rates will have on this sector.

· We have a limited exposure to this market through the JP Morgan Strategic Bond Fund. The manager is focused on security selection and investment in higher quality companies within high yield. The mandate is flexible, giving the manager the ability to increase and decrease exposure based on the judgement of valuation. Allocating to high yield increases diversification within a blended fixed income portfolio and can boost returns.

Corporate Comments

· The Australian equity market posted good returns in FY18, with another year of double-digit growth.

· Style bias was a key factor in fund manager returns, with resources and growth stocks leading the way. The valuation of the latter is starting to look stretched.

· Small caps had an even better year and were assisted by commodity price strength.

Australian equities again posted solid returns in FY18, with the ASX 200 Accumulation Index gaining 13% over the twelve months. A rally into the end of the financial year, as global equities weakened, left the local index ranked high against its international peers. There was a wide dispersion in returns across individual equities and the various sectors of the market, more so compared to recent years. The overall drivers of the market’s returns have hence been quite narrow, with a select group of stocks contributing to the index’s returns.

The chart below illustrates the total return of the market and sectors for FY18, broken down by the change in 12-month forward earnings estimates, the change in the forward P/E ratio and the dividend yield.

ASX 200 Sectors: FY18 Return Composition

Source: Thomson Reuters, Escala Partners
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The following observations can be made:

- earnings growth was the predominant driver of returns for the market in the year, a pleasing development and in contrast to the prior trend of P/E expansion. While global interest rates were pushed higher over the course of FY18, domestic rates have lagged this cycle and hence it is likely that the negative affect of higher discount rates has not been factored into Australian equity valuations as of yet.

- as a result of this, interest rate sensitive sectors of the market (such as infrastructure and REITs) posted respectable returns. This group of stocks experienced losses in the first quarter of 2018 before staging a recovery in the June quarter as rate pressures eased.

- the mining and energy sectors produced very strong returns throughout the year, resulting from a significant uplift in earnings forecasts on the sustained commodity price recovery.

- industrial sectors that produced solid earnings growth included info tech, health care and consumer staples (while the latter index is dominated by the larger supermarkets, it also includes smaller companies such as Treasury Wine, A2 Milk and Costa Group). While this was the case, the return performance of this group was as much driven by P/E expansion, reflecting the increasing growth premium attached to such stocks in the Australian market, a factor which we have noted on several occasions. A weaker Australian dollar through much of this year has also helped this group of stocks, with many deriving a high proportion of their revenues from overseas markets.

- there was soft performance from the large financials sector, which was somewhat of a drag on the returns of the broader market. This is reflective of the benign growth outlook for the major banks (which has softened further over the past year), along with a slight de-rating of the earnings base which has intensified as a result of the Royal Commission. A high dividend yield has been a key supporting factor in total returns.

- telecommunications was the primary laggard, which is a result of the much-publicised issues at Telstra. High levels of competition and margin compression as the nbn rollout continues to weigh on the earnings of the sector.

Consequently, fund manager returns were largely dictated by style and sector bias. Managers who focus on yield (who are more likely to be overweight financials, REITs, utilities and telcos) would have struggled to match the index’s returns, even with good individual stock picking. FY18 was also challenging for value investors who would typically hold fewer health care or technology companies.

The following chart also shows the divergent performance of value and growth in the Australian market over FY18, as represented by the MSCI indices for growth (which is based on characteristics such as earnings per share growth) and value (P/E ratio, book value and dividend yield). The outperformance of the former, particularly since the beginning of the year, has clearly been quite material.

MSCI Australia Value and Growth Indices

Source: Bloomberg, MSCI, Escala Partners
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To a degree, the factors described above have been further amplified in the small caps space, which is tilted towards higher growth companies. We noted 12 months ago the valuation gap argument for small caps, which has since closed as a result of a robust rally in FY18, with the Small Ords Accumulation Index gaining 24%. The performance of small resources companies (up almost 50%), which as a group have higher costs and operating leverage to commodity prices, have certainly contributed to the index’s performance over the year. We will expand further on the outlook for the Australian equity market in our upcoming quarterly asset allocation research note.


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