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WEEKEND LADDER

A summary of the week’s results

07.07.2017

Week Ending 07.07.2017

Eco Blog

- Notwithstanding an apparent short term slowdown there is little to indicate that the US economic momentum is about to fade. Employment trends are a strength, not weakness.

- Australian retail sales and trade balance gave a welcome burst of better news and the worst of the GDP data is for the momentum behind us.

In the modern day of hyperactive trading, data gets to determine the direction of financial markets before it is put in context. There have been some softer US employment releases in recent months, with the instinctive reaction that this implies faltering US growth. 

In practice, the US is nearing full employment based on current participation at an unemployment rate of 4.3%. While higher than the notional 3% historically considered to be full employment, the it allows for a much more pronounced skill gap, lower flexibility in the work force and increasing part time or casual jobs. In addition, the US has greater cyclicality in some sectors such as construction and a large summer youth workforce. In the May non-farm payroll data, it was this youth element that resulted in lower than expected growth in jobs. Many ascribed that to the date at which they start summer jobs, as well as graduates moving into employment later than normal. The coming months may see employment growth improve, but perversely, also a rise in the unemployment rate as this cohort registers with the labour market.

Other indicators support the contention there is nothing amiss with the US economy. The services activity index reported a healthy uptick in June to a 57.4 reading (anything over 50 represents an increase in activity).

Source: ISM, BEA/Haver
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What is perhaps more remarkable is that the US no longer leads the pack in terms of growth momentum, but rather sits roughly in the middle. This may suggest that the US is operating at or near its capacity without causing it to overheat with the absence of inflation a notable difference to past cycles.  The case can be made that government policy has yet to offer any benefit to the economy as was widely anticipated.  Post the summer break this is likely to become a bigger issue.

Developed Word Output

Source: IHS Markit, JPMorgan, Nikkei, Caixin, CIPS
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Australian data also recovered from a pattern that has presented an increasingly worrying trend. Retail sales were well above expectations in May. History will likely judge the very weak sales in the early part of this year as an anomaly and the steady state circa 3.5-3.7% run rate as the longer-term pattern. This is supported by total income growth – wages of about 2.5% and the remainder from other income (dividends, interest, rent) and a slow but persistent run down in saving.

The ‘new’ level of retail sales

Source: ABS, ANZ Research
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It barely bears repeating, but it is logical that high household debt, subdued labour conditions and rising prices in utilities, amongst other non-discretionary imposts, may curtail any notion that spending can accelerate. But retail sales are also far from a perfect measure of household spending with sectors such as travel (including cars, which are included in the US retail data) and entertainment competing for the wallet.

The trade surplus widened in May driven by the recovery in coal exports. Resource exports dominate the goods sector, not to undermine the value of the rural sector. But it’s the services component that arguably holds the longer-term potential through travel and education; all the more important that the AUD remains where it is and that the sector is not subject to policy interference.

Source: CBA
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Meantime imports are hardly changing, reflecting benign domestic demand. Ironically an uplift in imports may be a good sign.

The implication from the surplus is mostly through the government tax income, though this time it is highly unlikely to find its way to households as the budget deficit remains the focus. State borrowing will pick up, given capital commitments along with the slowing property sector and stable payroll tax receipts. The investment programmes at state level have been meaningful in subduing the fall from the mining sector with this pattern to remain in place. We may well join the US in the acceptable, but mediocre growth camp.

Fixed Income Update

Fixed rate bonds performed poorly in June as yields rose in the last few days of the month.

- However, investment grade corporate Floating Rate Notes (FRN’s) and banks hybrids performed well despite some intra-month volatility in the hybrid market.

- Central bank commentary drives markets both offshore and domestically.

For the most part of the last four months, bond yields have been falling as the markets concentrated on weaker than expected economic data in the US and Australia. Trading in June looked set to continue on the same trajectory as bond yields held to a tight range. However, the speech from the ECB president Mario Draghi put an end to the recent bull run for bond markets, and a rather large reversal took place in the final days of the month. The 10 year Australian government bond yield ended up 0.20% higher to reach 2.59% and the 5 year rose 0.26% to close at 2.18%. The spike in yields resulted in a downward revision of pricing on the underlying bonds, and fall of over 1% on the government bond indices in June. We note that the domestic fixed rate funds that we recommend all outperformed the benchmark as they are either low duration or have positioned their portfolio to avoid such a move.

Bloomberg Ausbond composite bond index in the month of June

Source: Bloomberg, Escala Partners
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While fixed rate government bonds did not fair well in June, credit markets had a decent month as spread contraction supported valuations. The Australian iTraxx index (measuring investment grade credit spreads) was 4bp tighter on the month as the index moved from 87bp to 83bp. This contraction occurred despite the fact the ratings agencies downgraded the rating on many of the Australian banks, including that assigned to their subordinated and hybrid debt issuance. Floating Rate Notes (FRN’s) performed well in June given the coupons on these securities reset in line with interest rate movements as calculated by the bank bill swap rate index. This is in contrast to fixed rate securities that are re-priced as interest rates rise. The full return profile in June for Australian fixed income sectors, as determined by their indices, is shown below.

Monthly change in Australian market indices

Source: CBA
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If one were to look at the total return on the bank hybrid market in June it would appear that these instruments had a stable month, generating an acceptable performance of 0.53%. But there was noteworthy volatility in the asset class intra-month. While the widening in spread on these securities was somewhat short lived, it was attributed to recent volatility in bank equities, the credit rating downgrades, a European bank capital bail-in on a silmilar style security offshore and uncertainty around any revisions that APRA may make to the banks capital adequacy requirements (thus potential affecting supply). 

In the last few days of the month spreads contracted some 20-25 bp, unwinding the widening seen only days earlier. Reasons cited for the reversal include the ongoing chase for yield and perhaps a shift out of fixed rate product and into floating rate securities as bond yields moved higher at the end of June. Others have suggested that self managed super funds may have purchased a lot of hybrids as they parked ‘cash’ into June before the superannuation changes became effective on the  1st of July. The key is to be highly senstive to the price paid for hybrids and at certain levels they do not represent the return that should be required from such securities.

Average Major Bank AT1 Trading Margin

Source: BondAdviser
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The RBA kept the cash rate on hold at 1.5% this week and the accompanying statement was perceived as slightly more dovish than expected. This, together with the US FOMC minutes which indicated there was differing of opinions when it came to reducing the Fed’s balance sheet, lent to a lift in bond prices early this week. However, in the days following the European Central Bank once again took centre stage with the release of their minutes which showed that officials discussed dropping their easing bias. Global bonds once again resumed their market sell off, as yields pushed higher.

Corporate Comments

- Flight Centre (FLT) upgraded earnings. Its share price bounce has as much to do with a short squeeze than fundamnetals.

- Coca-Cola Amatil (CCL) has had further bad news from two key customers.

- Several headwinds that have affected Australian small caps are lifting.

After a succession of profit downgrades in recent years, Flight Centre (FLT) delivered better news to investors this week, confirming that it expects its full year profit to be at the top end of its previous guidance. The group’s second half profit has been assisted by expected record earnings in its North American and European divisions. Meanwhile, its core Australian operations have been improving, with good ongoing sales growth. With the stock one of the most heavily shorted in the ASX 200, the bounce in the share price was not overly surprising and disproportionate to the implied earnings upgrade.

Flight Centre: Forward EPS

Source: Bloomberg
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Revenue growth has not been the key issue behind FLT’s recent woes (although a soft consumer spending environment has not helped). Rather, it has been the high deflationary trend across airfares and the rise of low cost carriers, that has crimped its margins. In effect, this has meant that FLT has had to sell a greater number of airfares in order to generate the same level of sales. FLT noted that the discounting trend for international airfares that was evident in the first half (-7%) had lifted in 2017. Contributing to this pricing pressure has been high levels of capacity growth at airlines. While this may have moderated, a recent presentation by Sydney Airport points to reasonable growth again for Sydney through this year.

Sydney Airport: Capacity Growth

Source: Sydney Airport
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FLT has done an excellent job in countering the structural challenges of the consumer shift to online bookings, yet the environment is still likely to remain tough in the medium term. The consensus view from analysts this week is that the 50%+ bounce in FLT’s share price since late March has been excessive, with a modest lift in earnings over this time and significant P/E expansion. Now trading in line with the broader large-cap industrials index, it is hard to disagree with this assessment.

Coca-Cola Amatil (CCL) received a double blow this week on news that it had lost its contract to supply Domino’s, along with reports that Woolworths would not be stocking its new Coca-Cola No Sugar product release. Taken together, these two issues are unlikely to be material to CCL’s earnings base, although it does add to the overall negative sentiment surrounding the stock. The outlook for the company remains clouded, with its flagship Coke product still accounting for more than half of overall volumes and in structural decline at the expense of healthier options. While CCL has a representation in this space, including in water, its brand is much weaker, reducing its competitiveness where it is looking to acquire retailer shelf space. The key appeal of CCL at present is an attractive dividend yield and support provided by its share buyback, however these characteristics are more than offset by its challenging outlook.

After significant underperformance relative to large cap companies since the latter half of last year, small caps have since reversed some of this trend in the last two months, generating better returns in both May and June. With several key reasons for this dispersion over this time, it is worth revisiting the current outlook for this segment of the market and the positioning of small cap fund managers, many of which have underperformed their index in the short term.

Australian Small v Large Cap Performance

Source: Iress, Escala Partners
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The small cap sector of the Australian equity market is more susceptible to changing trends and investor preferences than traditional large cap managers. Liquidity is the key issue that underpins this higher level of volatility, both at an individual stock level and broader sector - the total market cap of the ASX 100 is $1.5 trillion, approximately seven times larger than that of the Small Ordinaries (stocks ranked 101-300 on the ASX).

Two separate trends emerged in late 2016 that would have had a significant negative impact on individual stock returns, given this liquidity constraint. Firstly, a number of industry super funds reduced their exposure to the segment and there has been some high profile portfolio manager departures that led to forced selling across a range of stocks. Secondly, anecdotally several large cap fund managers had previously been buying into small cap stocks given the absence of respectable earnings growth in large caps, although some have now retreated. In our recent contact with small cap fund managers, the prevailing view is that both of these issues have now passed.

The global equity rotation from growth into value equities has also had an impact in this time. If the assumption that earnings growth across the market is going to be more evenly spread following the synchronised economic recovery in recent quarters, a de-rate of high P/E growth stocks will likely be warranted. To a degree, this has already occurred in our market, which has negatively affected the performance of small cap managers who typically invest in high growth companies.

It is probable that the structure of the small caps index has also played a part. Relative to the ASX 200, the small cap index has a much lower weighting to financials and higher weighting to sectors typically aligned with a higher level of earnings growth, such as info tech and consumer discretionary. Notwithstanding, the latter has come under pressure this year, with soft retail sales and several downgrades across the sector.

Turning to valuations and the growth outlook, small caps currently look reasonably attractive. Looking at the industrials sector only (i.e. excluding financials and resources), the expected earnings growth for small industrials at 11.3% is superior to that of large caps at 10.8%. The large cap number, is somewhat inflated by CSL’s large weighting and high expected earnings rate, along with Telstra’s earnings, which are supported by one-off NBN payments. Eliminating these two from the calculation would bring large cap earnings growth down by approximately 2%.

The P/E discount of small industrials compared with large cap industrials has also expanded since mid-last year. The ~16% discount is close to the widest since the height of the financial crisis.

Small Industrials P/E Relative to Large Industrials (Ex Banks)

Source: Deutsche Bank
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We are of the view that an allocation to small cap equities is appropriate within an investors’ overall exposure to Australian equities, more so for those with a capital growth objective. Within our recommended funds, we believe that blending a growth-oriented manager (Regal Small Companies/Karara Small Companies) with one that has more of a value focus (JCP/Spheria) is an ideal outcome to de-risk portfolios from investment styles that can often dictate investment performance.

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