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WEEKEND LADDER

A summary of the week’s results

07.09.2018

Week Ending 07.09.2018

Eco Blog

- Upward revisions to reported GDP for FY18 now suggest that growth was in fact solid. The outlook, however, is still finely balanced given the tenuous position of the household sector.

Second quarter Australian GDP was better than expectations, taking the annualised growth rate to 3.4%. A combination of public sector consumption (+1.0% q/q), the legacy of housing activity (1.7% q/q) and a solid period for the mining sector (+5.1% q/q) offset weaker non-mining investment (-1.7%q/q) and low wage growth (non-farm 0.1% q/q or 1.8% y/y). The cautious interpretation of the data references the downward revision of the comparable Q2 growth for FY17, flattering the rise this quarter, along with upward revisions for most quarters of the 2018 fiscal year. The major bear point was the fall in the savings rate to a post-crisis low of 1%.

In the coming half, the public spending contribution should accelerate further and exports are likely to add again. Included in net trade is services, specifically tourism, where Australians travelling overseas (service imports) contributed -3.8%. The argument is that the weaker AUD has shifted some spending to lower cost destinations or deferred the innate local desire to explore the world.

This coming financial year will be determined by the combination of employment growth, which appears to be ticking along, and the patient wait for wages to pick up. The trigger for the latter could come from structural shortages in some sectors, e.g. construction workers, or the public sector putting through wage rises sufficiently so to require the private sector to match them.

Profits and Wages shares (% of GDP at factor cost)

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  • The summation is that the outlook for growth is a little better, while the vulnerability of the household sector is once more exposed. The necessity of wage growth becomes pronounced and the RBA is likely to leave any monetary tightening on the table if it goes back to savings rather than housing before it raises rates. The chances of a rate move are on the upside, but the time frame is long dated, particularly given recent movements by the banks.

The outlook for China has reached a nexus point. Growth has slowed, as is evident from the Caixin PMI Index and other data releases. Notably, the services sector is sluggish, in contrast to its supportive trend for most of the past year.

Corporates have nominated rising cost pressure as one of their concerns. Raw material prices are up, no surprise given the fall in the renminbi, and along with wage rises have not been passed through in prices given slower than expected demand.

The government has taken incremental measures to ease financial conditions. The minimum personal tax threshold has been raised from RMB3500 to RMB5000/month. In addition, there are a boarder range of deductions for education, child and elder care, health and housing. On the flip side, tax will now be applied to all household income rather than just wages. The end result is a higher level of support for low income workers, for example, who are expected to receive an 8% rise in disposable income. The government can afford the impact on revenue given its intake had been growing faster than the economy for the past 18 months.

Other traditional stimulatory measures have also been implemented. A general easing in loan availability through a range of mechanisms will compensate for the clamp down on shadow banking.

Broad credit growth, year on year

Source: Deutsche Bank, PBoC, WIND
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The second bout of trade tariffs are now in the offing. The consequences are likely to be further accommodative measures in China, which also increases the chances of a misstep. It is hard to paint a positive scenario for either side of this battleground in the near term.

  • The Chinese equity market has taken a dive since trade became the hot topic. The stronger USD has not helped nor the problems, though entirely unrelated, in other parts of the emerging market sector. So far, corporate earnings growth has held up, given most listed companies focus on the domestic market. For the patient, we recommend holding positions and for those with a long-time frame adding to the weight can be considered.

The 2019 forecasts for GDP growth in India comfortably exceed that of China at 7.4%, versus 6.5%. On a per capita basis, however, China will still edge ahead. In contrast to the weak Chinese equity market, the Nifty 50 (top 50 stocks in the index) has been on a tear in the past few months. The buyers have been entirely locals and the top five stocks (Reliance, Infosys, TCS, HDFC and Hindustan Unilever) account for the bulk of the returns. The return to global investors has been undermined by a sharp decline in the Rupee to a two-year low.

INR/USD rate and GDP growth

Source: Bloomberg, Haver, ANZ Research
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India’s promise is compromised by structural deficiencies. The currency is a fall out of the persistent current account deficit and volatile foreign capital flows, along with the general aversion to emerging markets. Government spending remains a predominant determinant of growth (even more so now as a general election looms), resulting in a fiscal deficit (-3.5% of GDP) commonly determined by low productivity measures such as commodity price support or other forms of market intervention.

Important global services and industries such as software services and pharmaceuticals have largely stalled in growth and the dependence on the rural sector is high. Oil imports create a vulnerable foreign trade position and external remittances have also slowed.

The opportunity in India remains high given its population growth and relatively low GDP per capita. Recent efforts to formalise the financial system have been somewhat hit and miss, but most agree that they are heading in the right direction.

  • India is often referenced as a potentially appealing investment option. We note that many global funds do hold a position in their equity market, predominantly in financials where non-state banks are well capitalised and benefit from the efforts to being India into the formal banking system from a cash society. The country is also looming as a battle ground for consumer tech companies with the likes of Amazon, Alibaba and Walmart (recent acquisition of Flipkart) all actively seeking to become top dog.

Focus on ETFs

- The tailwind of the falling Australian dollar has been of great benefit to unhedged global equities, however, hedged investments could be considered limited to Australian investors.

Increasing investing overseas through ETFs, managed funds or direct stocks comes with the associated risks of currency fluctuations and therefore the question of whether to hedge. This question comes at a time when the AUD has fallen by over 10% against the USD in the past 12 months and nearly 35% since it peaked at $1.10 in June 2011.

Out of the 117 ASX-listed ETFs that offer an international exposure there is only 6 that come in both a hedge and unhedged version and these typically follow broadly based indexes. ETF providers use foreign currency forward contracts designed to offset the fund’s currency exposure. This can lead to increased risks as well as coming at a cost where one can expect an additional fee of 5 to 10bp to the cost of an unhedged version.

Using a hedged fund offsets the risk of currency fluctuations given an pure investment market return. However, there can be benefits to remaining unhedged. In June 2011 the S&P500 was index was at 1,200. Today, the Australian dollar has fallen to $0.72USD and the S&P is at approaching 2,900. An investor would be clearly have been significantly better off in the unhedged version of the iShares S&P 500 ETF (IVV) compared to the hedged version iShares S&P 500 ETF Hedged (IHVV).

S&P500 vs Australian Dollar and iShares S&P 500 ETF (IVV) v iShares S&P 500 ETF Hedged (IHVV)

Source: IRESS, Escala Partners
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Notwithstanding this extreme example currency fluctuations are less important as currencies tend to revert to their assessed fair value.

Source: Bloomberg, Escala Partners
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ETFs in other assets classes usually come in a hedged version. ETFs that track commodities are typically traded in USD and then hedged back into AUD to give an exposure to commodities without taking on currency risk.

In terms of fixed interest ETFs, all of these are also hedged back to the AUD. Therefore, to participate in currency movements one has to access globally listed ETFs. Vanguard Intermediate-Term Treasury Index ETF (VGIT.US) tracks a market weighted index of fixed income securities issued by the U.S. government. 

Vanguard Intermediate-Term Treasury Index ETF USD v AUD Performance

Source: IRESS, Escala Partners
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In this case currency hedging offsets the exchange rate risk on international fixed income within a portfolio, yet it also increase the volatility of returns. Although investors would have significantly benefitted from the upside of the recent fall in the AUD it changes the role of fixed income in a portfolio. The traditional role is as the defensive allocation within a portfolio with the aim of steady moderate returns.

  • The exchange rate of a currency is a relative product of interest rate differentials, inflation expectations, terms of trade and purchasing power parity. There are several portfolio specific factors that investors should evaluate when considering a hedged allocation. Generally, higher global equity weights should consider some degree of hedging. In the case of fixed income hedging predominates. The case for unhedged bonds is based on portfolio insurance ( given the likely move in the AUD in a risk off event) or to tactically position based on assessed shorter term movement in the exchange rate.

Fixed Interest

- The risk off environment favours the Australian fixed income market with decent returns posted for August.

- We note some composition and pricing changes on US student loans and commercial mortgage backed securities (CMBS).

The Australian bond market had a solid August, with yields following the offshore lead down, thus supporting bond prices. The ongoing trade dispute, together with the problems arising in the emerging markets (Turkey and Argentina) created a ‘risk off’ sentiment, which favoured defensive fixed income assets. Locally, the change of prime minister also added instability.

Australian government bonds were the best performer in the high-grade quality asset pool, with the index returning 1%. Perhaps surprisingly, hybrids also had a strong month at 1.06%, however, this figure is distorted by the 16% return of SVWPA following the announcement of value accretive options by the issuer.

Australian fixed income returns in August

Source: CBA
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  • The often negative correlation between high quality fixed income assets and riskier credit markets such as the emerging markets was evident last month as the latter got a battering while the more defensive assets posted strong performance. When allocating to riskier higher return debt markets this should be offset by the inclusion of an allocation to government and/or investment grade bonds from the developed world.

Despite hitting new headlines for all the wrong reasons in the financial crisis, the global securitisation market remains buoyant. Mortgages from residential and commercial properties together with student loans, auto loans and consumer financing are regularly pooled and bonds are issued using the interest cashflows and principal payments from the portfolio. The bonds are effectively securitized against the underlying assets. This asset class is a significant part of the corporate bond market.

Of interest, is some recent pricing and composition changes in this asset class. Within the subsector of US student loans, the delinquency rate (the number of loan balances that have just become overdue by more than 30 days in each quarter) has fallen to a 12 year low of 8.8% (although notably still high) in the first half of this year. While lending volumes to students has been falling over the last 5 years, the size of the outstanding student loans is up $500bn in 8 years and is now in excess of $1.5trn. The reason for the fall in delinquency rates and rise in debt levels is attributed to the low unemployment in the US and debt relief programs that have reduced the minimum payments but allowed the amount owed to grow (as the interest rate remains unaltered).   

US student debt pile swells past $1.5tn mark

Source: FT
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  • Student loans are the worst-performing area of consumer credit and rarely, if ever, considered by our recommended funds. While contagion to other securitised bonds is not expected, the bigger concern is the long-term drag this debt burden will have on the US economy as young people are financially strained to buy a house or invest in business.

Another interesting trend in the securitisation market is the pricing changes for US commercial mortgage backed securities (CMBS). During the public deal process, a series of bonds are issued off the same pool and are tranched into different credit ratings, offering varying levels of risk and return. Within investment grade  bonds are made available with a AAA rating down to BBB-. Despite being less risky, AAA rated tranches have fallen in price of late compared to the lower rated BBB- bonds from the same pool. The pricing gap has now fallen to its lowest since May 2017, with the spread averaging 2% between the two, a fall from 6% in January 2016. 

Some reasons cited for the pricing divergence are:

  • Given the AAA rated bonds are fixed rate (unlike Australia where they are floating rate), the rise in US interest rates has seen prices fall. With more rate rises expected investors have shifted out of the AAA rated bonds and into other securities that are floating rate such as bank loans.
  • Low global interest rates remain, as does the search for yield. Investors are moving up the risk spectrum to gain higher returns, favouring the lower tranches of these deals.
  • The supply into the CMBS market has increased, with issuance levels higher in the first half of this year than the same period in 2017. The AAA rated tranches are the largest and the increased supply has weighed on prices.

CMBS 2.0 BBB- spread minus CMBS 2.0 AAA spread (basis points)

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Corporate Comments

- August’s FY18 reporting season was weaker than expected. Aggregate earnings growth for the market was approximately 7%.

- The key themes were dividends over capex, emerging cost pressures in some industries and an expanding premium attached to high growth companies.

The FY18 reporting season for the Australian market was disappointing, with a higher proportion than usual number of companies missing consensus expectations. Volatility, too, was above average, with individual stocks recording more extreme price reactions on the day of reporting. Below we outline some of the key takeaways for the month.

Respectable Earnings Growth

The earnings growth for the market was 7% for the financial year, a reasonably solid outcome. As is typical, the sector contributions to growth was much more mixed.

Following on from the momentum of FY17, resources led the way, with earnings growth of approximately 20%. While less stellar than the previous year, commodity prices continued to trend higher over the course of the financial year, leading to a cycle of earnings upgrades. The energy sector was among the best performing given the lagged recovery in oil compared to other commodities. A weaker Australian dollar helped translated earnings into the domestic currency.

Financials were weighed down by the large banking sector. A mix of cost growth (regulatory, compliance and IT), slowing credit expansion and margin pressure from higher funding costs all combined for lower earnings for the sector. Domestic-focused insurers were better, while financials that are linked to markets were generally stronger.

Finally, industrials were a typically mixed bag. Health care was reliably solid, recording earnings growth in the mid-teens. Telecommunications was a drag again, with the effects of competition and the nbn constraining profits. Cyclical companies exposed to resources were generally stronger, while several more defensive industrial companies experienced a contraction in margins.

Companies Missing Expectations/Downgraded Guidance

We have noted in recent months that earnings expectations for the market have held up quite well through FY18, countering the usual pattern of downgrades as the year progresses. In this context it was perhaps unsurprising that more companies than not fell short of these elevated forecasts and recorded an ‘earnings miss’ on consensus.

Forecasts were downgraded across the market for FY19. While this occurred for a high proportion of companies, the average downgrade was fairly limited.

Dividends and Capital Management

Higher dividend payments continue to have priority in the allocation of free cash flow by ASX companies. While earnings were slightly weaker than forecast, dividends held up well, with the payout ratio of the market edging slightly higher (on a forward basis the expected payout ratio of the market has been relatively steady at 70%). The most notable increase was among resources companies, which had previously rebased dividends amid the downturn in commodities a few years ago. The payout ratio of the major banks increased in FY18 as dividends held steady despite a slight decline in earnings per share.

Special dividend payments (Adelaide Brighton, IAG, Suncorp and Woolworths) were a feature, while several share buyback programs were either initiated or extended (BlueScope Steel, Crown, Janus Henderson, Qantas, Rio Tinto).

ASX 200: EPS, DPS and Payout Ratio

Source: Bloomberg, Escala Partners
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Capital Expenditure

With the preference for dividends, this naturally led to a continuation of low levels of capital expenditure, indicating that few companies are investing for growth. Nominally capital expenditure levels rose slightly in FY18, yet it was off a low base and below the average of the last decade.

In some cases, particularly in the resources sector, capital expenditure levels have been increasing after prior years where all discretionary spend was cut, with cash flow maximisation and balance sheet preservation more immediate priorities. Capital discipline, however, is clear and so the recent increase is a function of both cost inflation and the catch up in investment required after this period.

Cost Pressures

Cost pressures was one of the key themes of reporting season. With escalating prices across many key commodities, inflation in raw materials was realised across many industrial companies. Likewise, transport costs rose sharply over the year, reflecting the rebound in the oil price. After a multi-year period of limited growth in wages, pockets of pressure were also revealed, particularly in the resources sector but also in companies that operate in faster growing economies overseas. Finally, some major sectors, have faced a continuation of the cost trend that has been in place for some time; a good example is the banks with compliance and technology costs.

In some cases, these cost pressures have been passed onto customers via higher pricing. More common, however, has been cases whereby a company does not have an inbuilt mechanism to allow for this, and hence it has partly been absorbed, leading to margin pressure. This margin pressure is likely to persist until there is stabilisation in the underlying commodity prices that are behind the costs.

Balance Sheets

Across the market, balance sheets are generally in pretty good shape, with low levels of gearing. This is particularly evident in the mining industry, with excess cash being used to pay down debt over the last few years. With interest rates similarly low, metrics such as interest coverage ratios remain at high levels. These factors have allowed capital management options to be pursued, as noted above, either in the form of special dividends or share buybacks. Additionally, it has given companies additional options to pursue M&A activity in the current environment.

The High-Growth Premium

In terms of investor reaction to results, the key takeaway from reporting season was the increasing premium attached to high growth/high P/E stocks, with momentum being a key factor underpinning performance. We have noted this for several months, and was a key driver of the broader index’s returns in FY18. The dispersion between low growth/high dividend paying companies and companies in sectors such as health care and information technology expanded once again in August, despite the latter group only reporting in line with expectations. It is somewhat unsurprising that these stocks have been among the weakest performers so far into September with the Australian equity index declining through the first week of the month.

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