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WEEKEND LADDER

A summary of the week’s results

07.10.2016

Week Ending 07.10.2016

Eco Blog

•  Central banks are unquestionably under pressure, not least from external interference

•  US data is supportive of a rate rise, but the related oil and currency trends are far from obvious

•  The Australian economy is stable at the headline level, but changing much more below the surface. In that light, China property trends and capital flows bear watching.

After much discussion on the incapacity of central banks to shift the dial on economic growth, they are now facing retribution from their political masters. In the US, one of the presidential candidates suggested Yellen was undermining the economy; in Japan the tenure of Kuroda (governor of the central bank) is under pressure after inflation refused to resurface; and in India the newly appointed head of the Reserve Bank unexpectedly cut interest rates by 25bp to 6.25%, even though the economy is growing at 7%. Locally, even the RBA is as much dealing with the ups and downs of the housing property market as it is with broader economic considerations to which it is mandated.

As usual, the US jobs data out this evening will be another pointer to the option of a December rate rise. The initial claims for unemployment insurance suggest a decent level of growth in the labour market. The four-week moving average of claims fell to 253,500, the lowest level since December 1973. Ironically, states with a Republican leaning have the lowest unemployment claims, notwithstanding their suggestion the economy is on the blink.

Through September, activity measures in the US point to better growth in months to come. The services-based ISM Index rose sharply to 57.1 from 51.4 in August. All dimensions improved including, for the first time in a while, prices. Factory orders were down year on year, but up on sequential months and once again, broadly based. While the US election could yet be a disruptive event, the Fed may be at pains to reinforce its independence and the chances of the long-awaited rate rise are improving.

Bond yields are moving up in anticipation of the rate rise and increasing signs that inflation may edge upward too, or at the very least, found a floor. Oil prices have been on the up, setting in a potential circular pattern. Higher oil prices imply higher inflation and a likely rise in bond yields; higher oil prices may be indicative of improving economic activity, not only in the US but also in emerging economies as well as reasonable trends from Europe. Any indication oil prices may move further should set the tone for capital spending, which in the case of oil has one of the largest multiplier effects on the economy. At face value, this implies a strengthening USD as the rate curve should steepen. These days, however, we have become accustomed to trends that don’t match up with historic patterns.

In this recent cycle, the oil price and USD have moved in opposite directions and if this pattern persists, currency moves may run counter to many expectations. For those wanting to express oil in currencies, a favoured trade is long Canadian dollar/short Australian or New Zealand dollar. Elsewhere, expectations of even further weakness in the GBP have many currency traders pairing it off against the euro, supported by the view that further easing at the ECB is unlikely for the moment. All this adds up to a highly complex and at times contradictory expectations for an AUD investor. The typical measures of value for the AUD imply it is slightly expensive. The volatility and uncertainty however, reinforce our view that some currency hedging is appropriate for global equity allocations. 

Local economic indicators presented a stable, yet uncertain picture. Retail sales came off a low in July, retracing to an annualised run rate of 3-4% growth. Building approvals steadied as well, but consumer confidence took a knock in its latest reading. All these data points, however, don’t point in any particular direction. The longer term picture does, however, indicate the extent of changing dynamics in the local economy. GDP growth is only a headline; it is the mix that tells the bigger story.

Australia Economic Growth

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China’s housing market is again in the news. The central government’s stimulus of the past year has found its usual home in asset prices. Not only have house prices in major cities rocketed up 20% in tier 1 and 2 cities, but auction prices for land indicate very high expectations that this will continue. In many cases the land price is above that for assets with completed dwellings. Further, this time a mortgage cycle is in place, whereas in the past home buyers largely used cash.

Share of Mortgages in Total RMB Loans

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The government is likely to tread carefully to reign this in. Limiting loans in specific regions, disallowing ‘hukuo’ (residential rights) registration and outright regulation are all expected to creep in. However, with a major Party Congress due this time next year, when five of the seven members of the Politburo retire, the authorities will be reluctant to take more severe measures. In the meantime, the capital outflow has now been partially redirected to local housing. But the path for the reminbi remains downward  (currently at its low for the year against the USD) and will contribute to holding back global inflation in consumer goods for some time to come.  

Fixed Income Update

In this week’s fixed income segment we have addressed:

•  The performance of fixed income asset segments in September

•  Recent movements in the domestic yield curve

•  The strong correlation between bank hybrids and equity – clearly evident given the recent stress of Deutsche Bank. We will also discuss the impact this has had on other markets

•  New issuance for the Australian government

There were mixed performance results in September for local fixed income assets. The overall return was negative for the Composite Bond Index due to the large weighting (~80%) in government bonds, which are predominately long duration. Yields on the long end of the curve rose (bond prices fell) in response to a number of central bank meetings. While no decisive action was taken by any one central bank, the general sentiment was that further easing will be limited. In contrast, credit spreads tightened over the month, which was favourable for bond prices of financials and other corporates, resulting in positive returns. A snapshot of returns for September is shown in the table below.

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This last week has seen a further rise in domestic yields as the global theme of less central bank easing dominates headlines. Perhaps adding to the domestic rates move was the inaction by the RBA on Tuesday, keeping interest rates on hold at 1.5%, together with talk of a new long-dated government bond issue (discussed below).

Move in Australian Yield Curve in Past Week

Source: Bloomberg, Escala Partners
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The woes of Deutsche Bank have been well documented, and it has had significant implications for both its equity and bond pricing. While its senior debt securities fell ~ 6% when news first broke, it is the bank’s cocos (the name used in Europe for bank hybrid securities) that remind us of the close relationship that exists between these securities and equity during times of stress. Deutsche Bank cocos have fallen by 25%, compared with a share price fall of more than 50% over the same period. While the bank hybrid price decline is less dramatic than that of equity, it is still worrying, and is reflective of the truly ‘hybrid’ characteristics of these securities.

Deutsche Bank Equity and Hybrid/Coco Bond Price Movements

Source: Bloomberg, Escala Partners
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Despite the Deutsche Bank events, there appears to be no contagion in our domestic tier 1 bank hybrid market.  The listed debt market has had strong gains in the last week as credit spreads have narrowed. The new ANZ tier 1 issue (ANZPG securities) has begun trading and are already priced at a premium. At a price of $101, this equates to a trading margin of BBSW +4.54%, some 15 basis points narrower than its issue spread of BBSW +4.70%.

With uncertainty in the European banking sector, a flight to quality has seen Finnish bonds join Germany and the Netherlands with government bond yields in negative territory out to 10 years. Notwithstanding this, criticism over central banks’ negative interest rate policies continues and many market participants are of the view that global yield curves will need to steepen further to support the profitability of the banking sector.

Domestically, Fitch confirmed Australia's AAA rating this week, citing “strong institutions, effective governance and high income” as supporting the rating. While Moody’s and S&P ratings tend to hold more weight, the validation by Fitch is no doubt welcomed by the Australian Government as it looks to come to market with an inaugural 30 year bond issue. Our government has been extending maturities in the last few years, and this new deal will become its longest, some five years beyond its next longest tenor, which was a 25 year bond issued in August last year.

Corporate Comments

•  The Bank of Queensland’s (BOQ) full year earnings report was slightly below consensus and reflected some banking industry headwinds 

•  Henderson Group (HGG) has announced a merger with Janus Capital with significant cost synergies to be realised 

•  BHP Billiton’s (BHP) petroleum division should show improved earnings from the recent rebound in the oil price, however its US shale energy assets face a more difficult task to generate significant cash flow for the broader group 

The Bank of Queensland (BOQ) reports out of cycle compared to the majors, however this often gives a window as to what to expect in the upcoming major bank earnings season. For FY16, the BOQ result was slightly below par, as it managed to eke out earnings growth of 1%, although earnings per share fell slightly on a higher share count. The highlight of the result was in the asset quality in the business. Bad debts expense fell for the 12 months to 16bp, while solid trends were evident in housing and commercial loans.

The key negatives from the result related to the weak top line figure and margin pressure, despite the efforts of the industry to reprice mortgage books over the last 12 months. Expense growth of 4% outpaced revenue growth (although BOQ is forecasting expenses to moderate in FY17), resulting in a tick up in the cost to income ratio.

One of the key issues was in BOQ’s net interest margin, which fell 7bp in the half. Record low interest rates (particularly negative rates) has created a problem for banks around the world, leading to weaker net interest margins. Margins have fallen as banks have not cut deposit rates (a key source of funding) to the same extent as cuts to the cash rate for fear of customers taking their capital elsewhere in search of higher returns. Australian banks have not been hurt has much as their international peers (where some benchmark rates are negative), however BOQ’s result shows that this is nonetheless a headwind for the time being.

Bank of Queensland: Half Yearly Lending Growth ($m)

Source: Bank of Queensland
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As a result of the margin pressure, BOQ decided to be less aggressive in its pursuit of lending growth in the half, and this was evident in the sharp drop in the half yearly trend.

On a price/book valuation measure, BOQ currently trades on a discount to its larger major peers, although this can be attributed to a lower return on equity. Like the sector, dividend support is likely to remain for BOQ (on a yield of nearly 7%) in the short term given that the banks have been left out of the yield rally in the last 18 months, although there still remains the possibility of dividend cuts in coming reporting periods.

Fund manager Henderson Group (HGG) this week announced a merger with Janus Capital (the home of ex-Pimco manager Bill Gross) in a deal that would create a top 50 global asset management company. The merger has been put forward as an all script offer, with the combined entity to be listed in New York and on the ASX.

There are two clear motives for the deal. The most obvious of these is the high level of cost synergies from economies of scale that are expected to be realised soon after the deal is completed. These are forecast at US$110m on an annual basis, which equates to more than 15% of the combined operating EBITDA of the businesses. Secondly, the deal would partly be a reflection of some of the structural challenges facing the funds management industry, particularly with pressure on fees and the increasing use of low-cost passive index funds. The combined entity will be in a better position to confront these.

The deal also makes sense given the FUM bases of the two managers are geographically complementary. Janus is predominantly a US fund manager (77% of its FUM) while Henderson is primarily focused on European markets (71% of its FUM), although more recently has been expanding into new markets. The blended FUM mix will now also be better spread across various asset classes, as illustrated below.

Henderson and Janus Capital AUM

Source: Henderson Group
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From a timing perspective, the merger is good and bad from Henderson’s point of view. It is positive in the sense that it will de-risk Henderson from the flow on effects following the Brexit vote, including potential fund outflows. However, the timing is poor from a valuation perspective (for an Australian investor) given the fall in the pound since the vote, which would have improved the relative terms for Janus.

As some investors may be aware, we recommend investment in the Kapstream Absolute Return Income Fund, which is owned by Janus, as well as the local Henderson Fixed Income Fund. There should be no impact to the underlying funds following this transaction as they are locally managed in Australia.

BHP Billiton (BHP) held an investor day this week focusing on its petroleum division. BHP’s energy business generally does not attract as much attention as others, given the diversification of the group, but if it were a stand-alone entity it would be the largest oil and gas company on the ASX, with production more than twice the size of Woodside Petroleum.

While BHP is well placed to report better earnings in this division in FY17-18 on the back of a recovering oil price, the company’s challenge will be in its production profile. Several years ago, the company staked its energy growth on the US shale industry to help offset the natural oil field decline in its conventional assets through a number of acquisitions. Unfortunately, these were poorly timed given the dive in the oil price since then, forcing BHP to cut its activity, write down assets and focus on cash generation in recent years.

The chart below illustrates cash flow scenario analysis for BHP’s US shale business under various oil and gas pricing assumptions, with a breakeven outcome the most likely in the short to medium term. The optimistic view would be that other US shale operators face a similar cash generation outlook, leaving little incentive to invest and thus likely leading to some oil price support in coming years.

BHP Billiton: US Onshore Pre-Tax Cash Flow Scenarios

Source: BHP Billiton
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