Week Ending 07.08.2015
The focus from the RBA meeting was less on the cash rate and more so the language around the currency, which has seen the AUD pop up in the last few days. The nuance between whether the currency has adjusted or is adjusting lead to a debate on the fair value of the AUD and its likely path from here. To date, the significant fall in the terms of trade (price of exports versus price of imports) has signalled the decline in the exchange rate against its trade weighted index. The other driver is the interest rate differential with forward markets pricing in the potential for another rate cut here versus the rate rise anticipated in the US.
However, in the near term it appears the AUD has found a floor and, by most estimates, is close to its short term fair value. Forecasts are for a flat exchange rate in the near term, while the majority expect further downside unless economic growth improves or commodities regain ground.
Australian retail sales (June release) appear to have settled into a growth range of 4-4.5%p.a. Household goods and specialty apparel stores are showing strong growth, while department and discount stores lag. The June data showed particular weakness in food retail at 2.7%, an ominous sign that the pricing strategies of the supermarket groups is restraining the sector growth rate.Enlarge
The strength of household goods parallels the activity in the housing sector. Possibly the greatest divide in economic outlook within Australia is the path for housing activity (that is, building not reselling), over 2016. The higher GDP growth forecasts rest heavily on a sustained period of housing related construction and therefore, this pattern of consumption spending. However, others are of the view that building will substantially slow through 2016 and, in turn, curb overall spending patterns.
The July labour force data served to confuse rather than illuminate. Employment growth of 38 500 was above expectations however, perversely, the unemployment rate rose to 6.3%. Western Australia, Victoria and Queensland saw notable rises in the unemployment rate, while New South Wales held to 5.8%. The Northern Territory with an unemployment rate of 4.2% and participation rate of 76.1% (versus national average of 64.9%), is right on top. Variable labour force numbers have been a talking point for some time with ABS sampling possibly picking up differential samples too frequently. Nonetheless, it appear that the unemployment rate has stabilised in the 6-6.5% range.
The weakness in quite unrelated commodity prices is notable. From beef to milk to oil and base metals, the trends have been one way.
The macro picture for oil (or for that matter most commodities), is typically focused on demand and supply. Clearly these are dominant, yet far from the only factors. Currency also plays a major part. US dollar strength has directly influenced the cost curve for commodity producers given their currency weakness. The local wage and the energy cost component of commodity producers has declined such that they can economically sustain or even grow production, reinforcing the cycle. Previous estimates of the marginal costs at which some producers would exit the market have simply changed.
The other factor is political and power plays. The instability in the Middle East is potentially having a significant impact on oil prices with Saudi Arabia, Iraq and the UAE pumping out increasing oil in the face of falling prices and softening demand. Saudi Arabia’s production recently hit an all-time high of 10.6 barrels per day, just over 10% of global demand. Iran will likely join this later this year. Russia too, has increased its output as the rouble’s fall vastly improves its received price, while economic need dictates the outcome.
Some may wonder why all this was not predictable. But even the International Energy Agency expresses a degree of astonishment at the interplay and outcome so far. They point out that US tight oil, the first peg to fall, will barely move the dial and, in their view, prices need to move lower to induce a full supply response. Perversely, however, countries reliant on commodities have to pump out more while taking on board a big currency hit, which in unstable regimes has all kinds of uncomfortable consequences.
It would also appear that inventories are unusually high. This data point is not measured as such, rather it is an outcome of the implied balance. Some of this is due to a relatively exuberant US ‘driving season’, the summer phenomenon – demand is up 3.2% YOY and fractionation results in excess supply of other components while refinery openings which require stock have added to inventory. In short, low and possibly even lower, oil prices are ahead with the IEA not expecting any upturn before 2016.
The region with the greatest benefit from low commodity prices is by all accounts Europe, given it imports the bulk of its consumption. This may have helped its recent recovery, not least by keeping a lid on inflation and, therefore, interest rates. But there is more at work. While the services sector has been solid, the manufacturing industry is doing reasonably well, too.Enlarge
Spain is now rapidly accelerating and even Italy and France are making ground. The implication is that the ECB is likely to maintain its current bond purchase programme without any new measures. A modest rebound in the Euro may be on the cards.
This will compete with the US data. This week, the influential Atlanta Federal Reserve member suggested a September lift-off. Wage data, remains key and after last week’s disappointing Employment Cost Index, the complexity of the US labour market is worth further comment. With 41% of US employees earning less than $15/hour, and some high profile states now setting that level as the minimum within the next few years, average wages in the US are very likely to rise at some point.Enlarge
Of the major stocks, Suncorp (SUN) was first out of the barrier. Portending things to come, it would signal a relatively benign in-line reporting season, but with a cautious outlook. Many of the trends are likely to be repeated in other industries.
Aggregate gross written premium (GWP) was flat over the year, reflecting the mature conditions in the insurance sector and some pressure on pricing. Market share requires a reinvestment of savings and industry conditions suggest there is little reason to expect stronger premium growth in coming years. Underwriting margins came under pressure in the second half of the fiscal year, yet an unexpected rise in investment income saved the underlying insurance outcome from deteriorating. Natural hazards dropped the final contribution for the insurance division this year, but most analysts look through this volatile component when assessing the outlook for the group.
As always, regulatory issues loom, with a government taskforce looking into the premiums in cyclone affected areas of QLD. Suncorp is the largest provider and may find itself at the mercy of the political interests in the region.
The banking profit benefited from provision release due to improved credit metrics and decent housing loan growth, similar to the major banks. SUN has more scope to reign in expenses, which would be the predominant determinant of growth in the current slow credit environment. The Life division, making up 11% of pre-tax profit, has stabilised with lapse rates lower after commission reforms.
The dividend remains a key investor focus and a higher than expected half year dividend was supplemented with a lower special payout to align with forecasts of a total 50c/final. At present reserve releases should allow for these specials to be sustained. The estimated yield of 6.7% for FY16 is core of stock support at this time. The incumbent CEO may in time take a different view on the use of the excess capital, particularly if there is a desire to grow outside the current business. We have supported investment in SUN for some time and it has delivered as expected. Capital gains however are likely to be harder to come by in the next year or two and entry levels should be opportunistically selected.
Elsewhere in financial services, recently listed Genworth Mortgage (GMA) with circa 40% of the lenders mortgage insurance sector, was not saved by an earlier than expected special dividend and the high yield. The stock fell sharply as the combination of the flow on from changing regulation on investor loans, lower earned premium assuming the housing sector cools off and headline grabbing comments on delinquencies in Western Australia and Queensland mining regions hit sentiment. With a flat earnings and possibly risky profit outlook, the FY16 yield (excluding specials) of 10% does not provide sufficient inducement. Within its result pack, the group provided an insight on the delinquency profile of mortgages based on year of origination and maturity. As one would expect most new mortgages start off well, paying on time. On the opposite end, after around 7 years, once again, unsurprisingly mortgage risk is low. After 3-4 years from initiating a mortgage that homeowners come under pressure. GMA has been clear on the emerging development of higher problem mortgages of this vintage in WA and QLD.Enlarge
ANZ, after stating its comfort with its capital position, has turned to an institutional placement and share purchase plan rather than restrict itself to a trickle in dilution through the DRP. The group will raise $3bn at a 5% discount to its last price to take its regulatory CET1 ratio to an estimated 9.2%. All banks sold off both to fund the raising and taking into account the potential for capital requirements at CBA and WBC. But ANZ’s trading update did also not help, noting a rise in provisions due to assessed risk in the mining and agricultural sectors. The message that the tailwind of falling provisions is over could not be clearer.
The new CEO at Oxforex(OFX) gave his first impression of the outlook for the business at the AGM. The group focuses foreign exchange money transfers offering tighter spreads than most banks and higher service levels. Having struggled to gain support in its early months since listing, the upbeat assessment saw a sharp reaction in the share price, up 12% on the day. While the near term profit expectations were slightly ahead of the market, the aim to double revenue in 3 years through broadenings its transaction base, regional spread and investing in technology to improve access to its product.
We see continued scope for non-banks to focus on parts of the financial services sector. To this end we have included Veda and Flexigroup in our model portfolios. It is not a quick or easy path to performance, but in our view this represents an opportunity for disintermediation of a sector where the entrenched systems and operations handicap flexibility and pricing.
As the oil price continued to weigh on stocks, Origin (ORG) sold its 53% interest in New Zealand’s Contact Energy raising A$1.65bn. The proceeds will be applied to reduce debt but will have only a modest impact on the debt/EBITDA ratio given the loss of earnings from Contact. Nonetheless it’s a sensible move in that Contact has had volatile earnings and strategically makes little sense as the APLNG project nears completion. However, for the moment ORG is captive to the bearish oil price outlook and investors will have to exercise patience to realise the anticipated value from APLNG.
Given the “GFC like” falls in commodities over recent months, the market was bracing for some bad news in RIO’s result released this week. The result was greeted with some relief as their numbers were mostly in line with those of leading analysts. RIO’s underlying profit fell 43% but impressively, cash generation fell only 19% due to a strong emphasis on cutting costs, capital expenditure and tightening working capital. Impressively, at spot iron ore prices (US$40) and FX the cash cost would be US$15.20/t. RIO now expects 120 million tonnes of annual capacity (owned by other producers) to be removed from the market this year with an additional 45 million tonnes also at risk. Against this, RIO expects an additional 110m tonnes of new capacity to hit the market. A net reduction of up to 45m tonnes. RIO’s CEO, Sam Walsh, alluded to the possibility of the market coming in to supply/demand equilibrium rather than oversupply. Whilst an optimistic view, it does pay to be one of the cheapest producers in the world. He stated: "If I step back from it and look at demand for our products, almost without exception, the demand is strong from China, whether it be iron ore, copper, gold, silver or diamonds, the demand is strong and that indicates that the fundamentals are much stronger than some external pundits are saying."
We removed RIO from our model portfolio some months ago given the uncertainty surrounding the resource sector and at this stage don’t feel compelled to revisit the stock despite some value emerging.
Fixed Income Update
As widely expected the RBA kept rates on hold at 2% this week. While only 9% of market participants were expecting a rate cut, most were eager to hear if the easing bias remained. The statement was, for the most part, unchanged from last month’s. Post the RBA meeting, bond yields were modestly higher across the curve with the common view being that rates are more likely to be on hold for the foreseeable future as opposed to being cut anytime soon. That said, the futures market is still pricing in a 45% chance that the RBA will cut the cash rate by 25bp before the end of this year, and a 75% chance within 12 months (down from 100% prior to the RBA announcement).
Concerns of overheating in the domestic housing market (notably Sydney and Melbourne) have perhaps hamstrung the RBA’s flexibility in cutting rates further. In response, they have looked to APRA to do the heavy lifting and help curb the investment side of the housing market. Just in the last month we have seen APRA enforcing this message and the result has seen some significant changes by the banks on lending rules and margins for residential investment loans. Both variable and fixed rates on investment lending have been increased between 20bps and 30bps by most of the banks. In addition, maximum loan-to-value ratios (LVRs) have been lowered to around 80%.
The month of July saw a rebound in the performance of the Bloomberg Composite bond Index which many of the long duration Australian fixed income bond funds are benchmarked against. The index increased by 1.3% from its lows at the end of June. While the second quarter was challenging for many of the fixed income funds, as yields backed up and credit spreads widened, the month of July saw a stabilisation in the credit markets.Enlarge
Over in the US, the treasury market responded to some hawkish comments made by Atlanta Fed president Dennis Lockhart. His comments centred around his support for a September rate hike saying that “...the economy is ready and it is an appropriate time to make a change...”. The curve jumped higher following these comments, US 5-year yields are up 13 points to 1.65% on the week, while US 10-year yields are up by 12 points to 2.27%.
Westpac launched their new 5.5 year tier 1 capital note security this week. The deal was well received by the market, allowing Westpac to upsize their issue to $1.25bn, up from an initial indicative amount of $750m. Further, the deal priced at BBSW +400 which was at the tighter end of their price talk. Initial indications are that there was over $1.45bn in firm interest, leaving some possible demand on the table for secondary trading.