Week Ending 07.04.2017
- The second quarter of the calendar year may see economic momentum ease back and challenge the high expectations for growth. This is likely to be a temporary setback.
- The impact from the move in interest rates and possible structural changes in Europe and China’s imbalances will shift investor sentiment more than nuances in economic momentum.
- Risk assets have moved ahead of the curve and may take a breather into the second quarter of the year.
There are two looming hurdles in interpreting economic data. Off the back of a strengthening trend from a wide range of indicators, the expectations have moved ahead of the reality. Nowadays, any sign of lower than (high) expectations is treated as a sign of malaise rather than the normal ebbs and flows of activity. We have noted the big rise in confidence in the US. Using an amalgam of surveys, the current activity indictor, based on this judgement of sentiment, is well ahead of actual activity surveys
Current Activity Indicator, Annual Rate of Change
The second is that there is an unknown adaption to the change in pace. Interest rates are rising and government policy settings are uncertain. How households and businesses react to this remains far from obvious.
In the case of the first mentioned, locally it is clear that the cyclone and floods in Queensland are going to impact on GDP in Q2. Extracting this from other issues may be tricky, and the RBA therefore has even more reason to remain sidelined. In the US, auto sales have slumped due to the emphasis on buyer incentives in the latter part of last year which pulled forward demand, and manufacturing indices point to a softer tone. There are also signs that the strong data from China is going to take a step back given the curtailment of credit growth. These are more than likely to be seasonal or specific issues that do not undermine the medium-term direction of an upturn in economic growth through this year.
Behavioural changes will have a bigger impact. The regulatory effort to clamp down on Australian housing investment will almost certainly impact approvals and activity in coming months. In the US, rate rises are changing attitudes to lending and credit growth, especially in funding household discretionary spending, which may take a step back unless wage growth accelerates.
Risks in China have increased, a result of a complex set of issues relating to the housing market, questions of bank asset quality and capital controls. Without guidance from the central authorities on how they will deal with this as a whole rather than piecemeal, financial analysts are left guessing.
Disaggregating the noise from the signal will be a focus as this transitional environment plays out. We are often reminded that financial market performance and GDP growth is poorly correlated; that is, economic growth is not a good indicator of stock market performance. Rather, it is the secondary impacts and attitudinal changes that determine investment returns, as markets pre-empt conditions from an existing valuation base.
Nonetheless, after a big rally based on expectation rather than real profit change, it is not surprising that investment markets are taking a breather. Another dimension is required to restart the animal spirits. There are a number in the wings. Eventually it is likely the US administration will get something through Congress that will benefit the corporate sector, be it tax cuts, regulatory change or investment incentives.
A post-election France may be another cause to take a positive view on Europe’s potential to maintain its current momentum. There have been reports the incumbent German government will suggest a round of tax cuts as part of its re-election package. Not only is this expected to appeal to the locals, but indirectly respond to the growing German current account surplus that troubles Europe, as it should stimulate domestic demand. Germany’s tax rate is relatively high, less so within Europe, but certainly compared to global rates. An idiosyncrasy is the ‘solidarity tax’ of 5.5% added to the corporate rate which came from the reunification with Eastern German.
Proportion of Tax Collected From Various Sources
While the imbalances in China are unresolved, the forthcoming National Party Congress will want to see the trends stable, if not positive. An optimist might hope that China will take more steps to contain credit growth while dealing with state-owned enterprises and continue down the path of opening its financial system. In mid-year, the MSCI will once again decide if China A shares are to be included in the index.
Local dynamics are at a challenging point. The high-profile discussion and regulation on investment housing excess is likely to see the activity (economic, not necessarily transactional) fall into 2018. The pickup from investment spending becomes even more essential, as well as the reliance on commodity prices. At this point, the RBA’s greatest wish is for a fall in the AUD, however the persistence of respectable commodity prices, an improved current account and the weakness in the USD appears to have dampened those hopes for a while.
In short, after a stellar six month return for risk assets matched by a fluctuating but generally positive ride from fixed income, the prognosis is that the second quarter of the year will prove to be more difficult.
Fixed Income Update
- The RBA has kept rates anchored at 1.5% for the eighth consecutive month, with some market participants still forecasting further rate cuts.
- Australian government bonds recovered in the second half of March to finish the month in positive territory alongside other domestic sectors of fixed income.
- Emerging market bonds offer potential for higher yields but also come with heightened levels of risk.
As expected, the RBA kept rates on hold this week at 1.5%. While this did not cause any significant market reaction, there has been a notable decline in Australian interest rate expectations over the last few weeks. Previously, the rise in house lending dampened suggestions of rate cuts by the RBA. However, following APRA’s announcement that it will require banks to reduce their share of interest-only mortgages, the door is now open for the RBA to cut rates without quite as much concern for the impact on housing debt. The consensus across the market is still in favour of rates being on hold for the remainder of 2017, however, the rate cut camp is gaining momentum again.
Australian Cash Rate
March was a solid month for Australian fixed income assets, with all sectors posting positive performance. Corporate credit bonds benefitted from spread tightening, while bank bill swap (BBSW) rates were range bound. Government bonds had a somewhat bumpier ride throughout the month, as bond yields rose leading into the US rates decision before easing directly afterwards. The result was a v-shaped recovery for government bond indices within the month, and an overall 0.5% return for the Australian fixed income index (Bloomberg Composite Bond).
Bonds issued by governments in emerging countries (EM) are often included in portfolios seeking higher yields and diversification. However, one must always be mindful of the risks that are inherent in these higher yielding opportunities and be prepared to tolerate the heightened volatility that accompanies them. Ten year South African government bonds offer a yield in excess of 8%, which is superficially attractive in this low interest rate environment. This week, the ratings agency Standard and Poors downgraded South Africa’s foreign currency denominated bonds to below investment grade (from BBB- to BB+), in addition to cutting the ratings on their local currency-based bonds. (These remain investment grade).
The result has been a fall in the price of the bonds and a 10% drop in the currency. For unhedged investors, the consequence is a downward re-valuation on both fronts – the currency and the bonds. The chart below tracks the price movements in South African 10 year government bonds and the spot exchange rate over the last 6 months. The price falls following the ratings downgraded is evident and the ongoing volatility is pronounced.
South African Government Bonds and Exchange Rate
Overall, emerging market debt has performed well in the past year, as other countries in the sector have benefited from higher commodity prices or tighter financial management. While EM debt is therefore higher risk, the degree of diversity limits the single country impact.
- Patchy retail sales are unhelpful, as a number of consumer spending stocks find themselves under scrutiny.
- IAG has downgraded its earnings outlook following an assessment of the impact from Cyclone Debbie, while Suncorp (SUN) may emerge relatively unscathed.
- Coking coal prices have spiked given the supply disruption that the cyclone has caused, however is unlikely to result in a material earnings uplift for the ASX-listed coal sector.
- Telco valuations have become more attractive in recent months, however there are risks to all stocks in the sector.
The discretionary retail sector has been of unusual interest in recent weeks. Firstly, headlines came from the questions on Harvey Norman’s accounting of its franchise relationship. This was followed by the stake Premier Investment has taken in Myer and lack of clarity on the intent. This week, JB Hi-Fi (JBH) lost the head of its Good Guys division, acquired last year, and in an unusual move, replaced him with a previous CEO of the group, Terry Smart. At the same time, it released data showing strong same store sales of 8.2% at JB Hi-Fi, but a softer 1.2% at the Good Guys. Long regarded as one of the better domestic oriented companies, the timing of the Good Guys acquisition and its structure may prove to be a bit more challenging for the group.
Capping off the sector news was an update from The Reject Shop (TRS), stating that all states had experienced a fall in sales in Q3 and that the group would make a loss in the second half of the year and was unlikely to pay a dividend. While TRS’s woes are a function of its small sales base, its typical customer comes from passing shoppers rather than as a destination. As such, it is an indicator that the weak sales data from the ABS is real. Consumer spending is proving to be highly selective, with a winner and loser circle likely to become more evident through this year.
Among ASX-listed companies, the two parts of the market that are most exposed to earnings risk from weather are the large domestic general insurance companies (principally IAG and Suncorp) as well as the metallurgical (or coking) coal industry.
IAG announced this week that it was reducing its forecast insurance margin by 2% for FY17 as a result of the costs that it will incur in the wake of Cyclone Debbie. The second half of FY16 has turned out to be a relatively challenging period for the general insurance industry, with the costs of Cyclone Debbie following the Northern Sydney hailstorm event in mid-February. Suncorp informed the market before the event that its reinsurance plan was likely to absorb the impact of Debbie, although has not updated the market since then.
While SUN may fare better in this instance, it has only come about because of the company’s new reinsurance cover that it put in place for FY17. Most of the recent focus in the listed domestic insurers has centred on claims inflation and the prospect of improved investment returns in a rising interest rate environment. However, reinsurance (which is effectively insurance for insurers to protection from large hazards such as Cyclone Debbie) has again returned as a topic of discussion. Adequate reinsurance cover has been a problem for IAG and SUN for an extended period, with both companies consistently exceeding their forecast allowance in any given financial year (this is despite a significant step up in their respective allowances over this time). While some of this is due to an increased frequency of smaller events, the chart below illustrates that major weather events have also been more common over the last decade.
Major Weather Events in Australia and New Zealand
The immediate impact for IAG may mean a cut to its dividend for the second half, however in the medium to longer term the result may not be overly negative. While reinsurance costs may rise again for IAG and SUN for FY17, the ability of the insurers to pass this additional cost onto its customers would be expected to be reasonably high given the concentrated nature of the market. In the insurance sector, we have had a preference for QBE, which is making good progress on its cost out program and has better leverage to the US rate rise cycle that is already underway.
The coking coal sector is another that has already seen a significant impact as a result of Cyclone Debbie, with prices spiking as much as 40% in just the last week. Australian metallurgical coal production is very important in a global context. Queensland accounts for in excess of 80% of Australian metallurgical coal production, which itself is approximately half of the seaborne global market.
With such a concentrated market supply, coking coal is thus highly susceptible to supply shocks, which have happened in the past when cyclones have hit Queensland. Flooding outages and infrastructure damage has led to estimates of 15-20Mt of production lost to trade, equating to around 5% of global annual seaborne market trade.
Some parallels have been drawn with the production outages and price spike that occurred following the damage caused by Cyclone Yasi in early 2011 (as illustrated in the chart below). Few analysts are as bullish that this rally will last as long, with several factors leading to this view, including a more developed spot market (a high proportion of coal has historically been sold on contract pricing), a lower steel production growth environment and the fact that 2011 was also impacted by strike activity in several Queensland mines.
In terms of domestic listed exposures, there is likely to be limited impact to the earnings of the key players. BHP has significant coal operations in Queensland (in partnership with Mitsubishi and Mitsui), but may miss much of the spike through lost production and its preference for spot pricing over contracted. In any case, the effect of short term commodity price movements are diluted by its diversified portfolio. Rio Tinto has smaller coal exposure again, while Whitehaven Coal predominantly produces thermal, as opposed to coking coal.
The Australian telco sector has been challenging area for investors over the last 12 months. While much of the focus has been on earnings downgrades and a sharp P/E de-rate of the smaller players, TPG Telcom (TPM) and Vocus (VOC), Telstra (TLS) too has struggled, dropping more than 20% since July in against an index that has made double digit gains.
Many of the issues that the sector has faced have been well documented. These range from industry-wide problems, such as how each company transitions to an NBN environment and a heightened level of competition across most market segments, to stock-specific problems, such as the integration hurdles for Vocus and the upcoming earnings cliff for Telstra due to the loss of earnings from its copper infrastructure network.
The table below outlines the key valuation metrics for three primary listed players. All three companies are now trading at a significant discount to the broader market; somewhat warranted given the downgrade cycle affecting the sector and what is now a relatively benign growth outlook.
Telco Sector Key Valuation Metrics
For a large-cap company, Telstra’s valuation looks attractive at face value, on a 13X P/E and dividend yield of 6.4%. The EPS growth, however, masks the one-off nature of the NBN payments that the company is receiving from the Federal Government. The company’s true underlying earnings is actually in decline, which leaves a question mark over the sustainability of its dividend (a core reason for owning the stock). We believe that this will be factored into the stock’s valuation over time, providing further downside risk if the company is unable to find additional sources of earnings.
The outlook for TPG Telecom and Vocus also has an element of uncertainty, however we have a more favourable view of these companies on the basis of market share gains (particularly TPG) and cost synergies (Vocus). TPG’s greatest challenge will be managing its margins in this NBN transition, along with a high capex programme to establish its own ‘last mile’ connections. For Vocus, it will be more about delivering on its integration promises. Both stocks are now without risk, however we remain of the view that they are better proposition than Telstra on a risk-reward basis.