Week Ending 06.11.2015
The RBA members have been busy, not by surprising the market on Cup day, but with a series of presentations. Philip Lowe (Deputy Governor) caused a ruffle commenting on the necessity of good data with particular reference to the housing market. Over the course of the year, the major mortgage lending institutions revised their value of investor credit in sequential months, effectively increasing the value of investor loans by $50bn and to a point where they represented 40% of outstanding loans, rather than the 35% reported at the beginning of the year.Enlarge
It was therefore inevitable that as the year progressed, we heard increasingly strident language from the RBA on the risks associated with investor lending.
This, in part, pushed the banks to raising rates on investor loans (before the current overall rate rise). In turn, a significant number of investors decided they were in fact owner-occupiers and reclassified their loans. The RBA castigates the banking institutions for their incapacity in providing what should be unquestionable data and the various regulatory bodies will undertake a review of data collection in the coming year. In part it’s a justification for the higher capital requirements at the banks; if they can’t assess their risks, they will be asked to create an ever larger buffer.
Another role of the RBA is to oversee payments systems. Some parts of this network have been left behind in their modernisation and Lowe referred to online bank transactions where magnetic tapes and punch cards determined the number of characters. A new system will overhaul this, removing the need for BSB numbers and opening up the description of the transaction to as many characters as required.
Then Assistant Governor, Michael Edey, weighed into the argument as well in a presentation to a property institute. After first noting the growing risks in residential property, he commented on the apparent turn in the sector as a welcome development. However, he then took on the commercial property sector, warning that rising prices had diverged from rental growth in the past few years.Enlarge
Impaired commercial property loans are typically the greatest source of risk in bank lending and the necessity to maintain ‘prudent’ standards would be monitored by the bank.
To cap the end of the week, the RBA released its statement on monetary policy. The focus was on a downgrade to the inflation forecast with the RBA expecting the CPI to be below 2% through to mid 2016. The spare capacity in the economy, low pass through of tradeable goods prices impacted by the $A and most importantly, low wage growth expectations, should result in muted inflationary pressures. The chart shows the wage growth by industry over the year to June and over the past 10 years. In aggregate, labour costs are rising at a 1% lower rate compared to the past decade. The impact is accentuated by the shift in labour force composition from mining-related to services. Average weekly earnings in the resource sector are about three times that of the household services sector.Enlarge
In turn, retail spending is running at an annualised rate of 3.7%, well below its longer term average of 5.2%. Clothing and household goods are far stronger than other sectors, while food and department store spending appears to have edged down again.
Secondary effects from China are visible in other regions. Germany’s manufacturing order book has taken a dive due to a slump in foreign demand. Autos have clearly had other factors (such as the Volkswagen emissions scandal), yet it appears that a broad-based slowdown is underway.Enlarge
The consensus view is therefore that Draghi will unveil further monetary measures in December, particularly in the absence of action from the Fed. Even in the UK, where the near-certainty of a rate rise was factored in earlier this year, the appetite has waned due to low inflation and the economic drag from the stronger exchange rate. This quandary on inflation is a repetitive theme amongst economic analysts. What will break the cycle is far from clear. In the meantime, the general easing bias has supported credit and bond markets.
Fixed Income Update
Last week we discussed the recent offshore issuance by BHP of an $8b multi-currency (EUR, USD and GBP) tier 1 bond, which was the second largest deal ever done after the Electricite de France issue in 2013. This deal highlights the appetite that offshore investors have for Australian domiciled debt and confirms the ability of our companies to raise funds in global markets. According to statistics collated in July this year, over 90% of the issuance from Australian corporates is in non-AUD currencies. Unsurprisingly, the majority of this is in USD, which makes up 62% of all issuance. The chart below depicts outstanding bonds by Australian corporates broken down by currency.
Issuance By Currency of Australian Corporates
The nature of global markets creates a two way flow, with our bond market being the recipient of capital inflows as foreign issuers are increasingly raising funds in Australia. Non-resident investors now make up a significant portion of the non-government bond market in Australia.
The number of offshore issuers in the Bloomberg AusBond Credit Index has risen from 10% to 45% in just five years. The chart on the following page illustrates the corporates by country that have outstanding bonds in our market.
Issuers By Country in Bloomberg Ausbond Credit Index
The changing landscape in global markets is beneficial to all parties:
· Australian Corporates have access to potentially cheaper funding sources and deeper and more liquid markets allowing them to increase their issue sizes.
· Australian Investors have a broader opportunity set for making investments, reducing concentration risk.
· The improving diversity of the Australian Bond Market makes it more attractive to foreign investors, increasing capital inflows.
This globalisation of credit markets is now implicit in fixed income funds with the majority holding cross border names. For investors this is a positive outcome as is widens the pool of possibilities and reduces specific country risk from economic events.
The major banks’ reporting season concluded this week with a full year result from Westpac (WBC) and a quarterly trading update from Commonwealth Bank (CBA). Compared to the other majors, these two banks are almost purely exposed to the Australian and New Zealand markets and have historically been able to generate higher return on equity as a result.
Westpac’s 6% earnings growth was market-leading over the last 12 month period, although well down on levels that bank investors became accustomed to over the years. The key drivers of the sector are shown in the table below; revenue growth has been at mid-single digits, the bad debt tailwind has now dissipated, net interest margins have contracted somewhat and cost growth has effectively been in line with revenue growth. Earnings per share have then further been impacted by a round of capital raisings. While these are yet to be fully reflected on a 12 month basis, the repricing of mortgage books will help to offset the additional share count.
Asset divestments have formed part of the strategy to improve the capital levels of the banks (Westpac has reduced its stake in BT; NAB has sold down its insurance business and is demerging its UK bank; ANZ sold Esanda). With a lower earnings base as a result of these, dividend growth (a key appeal for holding banking stocks in the current environment) is expected to be capped in the next 12 months. The possibility of dividend cuts has been floated by at least one broker, a scenario that could certainly materialise if bad debts were to normalise back towards historic average levels. In our upcoming monthly portfolio guide we will be reviewing our current positioning in the major banks.
FY15 Banking Scorecard
ALS (ALQ) held an investor day in the US during the week, with the company providing guidance for its first half result (to the end of September). ALS’s cyclical exposures (which largely relate to testing services for the mining and energy industries) remain the key risk for the company, although its performance over the last 18 months gives support to the view that conditions are not deteriorating any further. With a truly global business (78% of its FY15 earnings were earned offshore), recent falls in the $A will help to buffer the weak conditions in these cyclical divisions. Given a mix of favourable structural growth in its life sciences division (environmental, food and pharmaceutical testing) and a solid track record of bolt-on acquisitions in a fragmented market, we believe a small position in portfolios is justified.
ALS: Half Yearly Profit
Echo Entertainment (EGP) provided a trading update at its AGM this week, with a mixed result across its businesses. The company’s main gaming floor operations have continued on the good momentum of FY15, posting a double-digit increase in revenue for FY16 year to date. EGP’s flagship casino, The Star in Sydney, has again been the primary driver of this growth, which sees the group placed well to deliver a solid earnings outcome for the year.
The slight disappointment in EGP’s announcement was its commentary regarding its high roller (or international VIP) business. EGP reported that its revenues from its high rollers were down 34% compared to the previous year. On a ‘normalised’ basis, that is, adjusting for the casino’s expected win rate, high roller revenues were down 9%. The VIP operations of casino operators can be volatile at the best of times, with this accentuated by the relative success of the high rollers; the large hands that they play can impact the profitability of the casino. Echo’s VIP customer base has evidently enjoyed a good run in the current financial year, although these results tend to even out over time.
Echo had also been cycling a strong result (in the first half of FY15 its VIP business almost doubled its turnover from the previous year) as it and other casino operators in the region benefited from the shift away from Macau following China’s attempts to crackdown on corruption. We believe that the medium term outlook for EGP remains bright with the stock trading on a similar forward multiple to the broader industrials index.
The domestic property market, which appears to be closing in on a peak in the current cyclical upswing, was in focus this week with an AGM from Boral (BLD) and a half yearly result from CSR. Boral’s commentary suggested conditions remained robust in the first quarter of FY16, while CSR expressed confidence that conditions could be sustained in the medium term. As the chart from CSR below illustrates, the market cycle has been driven by the less material-intensive apartment sector (multi-residential) as opposed to detached dwellings.
Australian Residential Construction
CSR shares recovered some lost ground as its half yearly results beat expectations. The company’s building products division led the way, while its aluminium business was assisted by the fall in the $A. The longer term sustainability of these earnings is perhaps more questionable, given it faces a step up in electricity costs when its existing contract comes up for renewal in the next couple of years. Of the key commodities, aluminium is widely regarded as among the poorest in its fundamental outlook, with global demand growth (ex-China) recently turning negative.
After a number of successive halves of losses, CSR’s Viridian glass division eked out a small profit driven by better pricing and cost out, however it still falls well short of earning its cost of capital.
With a strong balance sheet, high dividend yield (albeit exposed to the cyclicality of its industry) and undemanding valuation, CSR may have some current appeal to value investors. Our preference in the sector is the higher-quality business of James Hardie (JHX), which is leveraged to the ongoing gradual recovery of the US housing market. JHX reports its half yearly result in two weeks.