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WEEKEND LADDER

A summary of the week’s results

07.12.2018

Week Ending 07.12.2018

Eco Blog

- Hopes of stability post a tariff raincheck faded quickly. US investment spending is crucial into 2019.

- The good news is that people are employed more than before. How they spend is dependent on their financial conditions.

- The Australian household sector is, based on Q3 GDP data, tightly constrained. It will take some years to regroup.

As the year closes, the outlook is increasingly hazy. Hopes that the G20 summit could rebuild confidence faded given the potential that everything could change again in coming months. Communication from the US president on the merits of tariffs did not help sentiment. Many suggest that one should ignore this as banter, yet it is unhelpful to businesses that would prefer to know where things stand in the medium to longer term.

At this stage the US economy is clearly strong, yet the debate on what 2019 could look like preys on investment markets. Based on a survey (IHS Markit, the provider of the widely followed PMI data), 800 US businesses expect to raise prices rather than undertake other measures in response to the tariff impost.

Source: IHS Markit
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This lack of new investment growth, potential for a modest rise in prices or fall in profit margin and the weaker housing market (though showing some signs of stablisation) are called out as the key distracting trends. Most importantly, the tightening financial conditions from the rise in interest rates, bond supply and stronger dollar weigh into the view 2019 could be more challenging than the current pace would suggest.

The escape clause comes from a goldilocks scenario of just enough wage growth to support a rise in consumer spending, not too much in the way of rate rises (1-2 more next year instead of 2-4) and a belated investment spending spree. The key is confidence from both consumer and the business sector.

  • No longer can the S&P 500 rely on tech/internet stocks to mould its performance; growth from local businesses will be required to prove that the US’s economic prowess is broader.

This sits within evidence that unemployment is at decade-long lows. Depending on the measure (for example, based on standardised data of how many hours a week are required to be judged employed) global unemployment is at decade long lows. This is in good part due to the rise in female participation (mostly in part time jobs), alternative employment through consultancy or gig-based services and low wage growth that has allowed for the low-cost service sector to expand.

How this eventually unfolds into household spending is a big determinant of longer-term growth. A significant subsector of younger households rely or expect their parents to offer some form of support. A recent study in the UK showed that parental home ownership and BoMaD (bank of mum and dad) were, for most, necessary conditions to buy a current home in the UK. If those under 30 were solely dependent on saving their non-discretionary income for a deposit, it would take 18 years to get there.  This trend and low wage growth is likely to change the course of household spending in the coming decades.

Europe looks increasingly messy, with growing risk that the US will turn its tariff issues towards the auto sector. The region is not in a good spot. Local warlords in Germany, France and Italy are involved in a battle that does little for the unity sought by the union in the first place. Brexit does not add to the party. This makes the likely outcome for Europe to disappoint against the hope that growth will stabilise into 2019.

The upside is the household sector. Wage growth has been decent, savings are relatively high, and, outside a few regions, housing is affordable relative to income. This year, Germany has taken the back seat in growth, a combination of an unsettled election, change in emissions regulation for the auto sector and repercussions from global trends. However, the household sector is in a good spot. Wage growth is well above inflation and pensions are rock solid, offering secure income to the large number of retires to spend.

Even with a large migration intake, the unemployment rate is only a touch over 3%, and vacancies are at decade-long highs due to lack of skills or regional shortages.

German wage and price inflation (seasonally adjusted)

Source: OECD
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  • There is no free lunch in Europe. Increasingly, fund managers are turning cautious on internal and external matters. Households are the potential green light.

The contrast with Australia is becoming more evident over time. Q3 GDP was softer than expected, mostly due to the tone from the household sector. A combination of falling savings, now at 2.4% of income from 10% post the 2009 downturn, low wage growth and housing spending, has left the consumer in a weak position. There is no easy escape clause; ahead is either a long period of rebuilding saving or accepting lower or flat house prices and potential wage rises. None give credit to a growth rate ahead of the global develop economy average.

Australia household spedning and income

Source: ANZ
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  • There is no escape clause for Australian households. Nonetheless, most are in a reasonable spot; employed, in a home with a serviceable mortgage and flexibility in discretionary spending. This latter sector is likely to be the pressure point.

Focus on ETFs

- Expensive growth stocks have come under pressure in recent months and a switch to cheaper value stocks appears to be a logical option. However, with heightened volatility in recent months should investors consider styles beyond growth and value.

In the first half of 2018, any investment style factor that was overweight technology outperformed broader-based indexes. Given the bull market that we have experienced, momentum factors have fared the best, followed by quality. The quality style factor focuses on three metrics: high return on equity; steady year-on-year earnings growth and low financial leverage. During times of economic slow downs or heighted volatility, companies that score highly on this style factor usually have defensive characteristics, as they have low leverage and the ability to maintain their competitive advantage and earnings. As such, quality-focused ETFs have generally been outperforming other factors over the past few months.

3-year cumulatie performance of MSCI ACWI indexes

Source: Morningstar, Escala Partners
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The only ETF listed on the ASX that focuses purely on the quality factor is the VanEck Vectors MSCI World ex Australia Quality ETF (QUAL), which replicates the MSCI World ex Australia Quality index. The ETF’s largest overweight is in technology, which is largely due to Microsoft and Apple accounting for nearly 10%.

Whilst QUAL may be the only ETF that only that focuses on quality, wide moat ETFs incorporate both quality and value in their stock selection. Economic moat ratings aim to focus on a company’s sustainable competitive advantage. Again, VanEck provides the only ASX-listed offering in this space, the VanEck Vectors Morningstar Wide Moat ETF (MOAT), which offers exposure to 40-80 US companies through a rules-based assessment on quality and value. Morningstar’s assessment of quality is aimed at determining the economic moat and the intrinsic value calculations utilises a discounted cash flow methodology.

  • Singe factor ETFs inherently have cyclicality in their performance. One of the main reasons for this is due to the sector bias that occurs in each factor. As such, no individual factor outperforms the market all of the time. These ETFs could therefore be used for enhancing short term performance, however, timing the market for these tilts is difficult.

Fixed Income Update

- A part of the US yield curve turns negative as long end bonds rally.

- Australian fixed income is on track to be the best performing asset class this calendar year.

- Equity and bond correlations turn negative on a 1year time horizon.

Rhetoric this week focused on the shape of the US yield curve, as a risk off sentiment has lowered bond yields on the long end (prices up) resulting in an inversion in the curve between the 2year and 5year maturities. As a reminder, a yield curve is a line on a graph that plots the interest rates of bonds (that have equal credit quality) against the bonds' different maturities, from shortest term to longest. In the case of a normal yield curve it is a positive upward slope whereby short-term debt yields are lower than long-term debt. It is considered normal, because longer term bond holders get greater compensation for unknown risks that may occur over the longer time period. This may include changes to interest rates, inflation and counterparty defaults, in addition to compensation for the time value of money.

In the case of an inversion in the curve, short term debt instruments have a higher yield than long term debt instruments. Lower rates on the long end indicate the market is expecting interest rates to trend lower as the economy heads into a recession and central banks will cut interest rates to stimulate growth. A yield curve inversion between the 2year and 10year bonds has preceded every economic recession in the US since world war two, however, it has also inverted with no recession eventuating such as in the 1960’s. On average the inversion occurs 18months to 2 years prior to the downturn.

Bond yields have fallen further this week, and while there is no inversion between the 2 and 10year part of the curve only a further flattening, the 2 to 5year curve has inverted. While it is one to watch, it is distorted by the lack of trading volumes in 5year bonds compared to 2 and 10year bonds which also have futures contracts driving price.

US Yield Curve

Source: Bloomberg, Escala Partners
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  • Most market economists agree that an inversion in the 2 and 10year part of the US curve would be the one to note, not the 2-5 year. While growth remains positive in the US a recession may still be years away, with many researchers forecasting it is not likely until 2020.

The rates rally in the last month has the yield on the US 10 year back down to 2.88%, which is 0.34% off its highs a month ago, but still 0.44% up from the beginning of the year. This is not surprising as the Fed has raised rates 3 times this year, with a 4th rate hike still likely for December. Coupled with credit spread widening on investment grade bonds throughout this year, the Barclays global aggregate bond index’s performance has been an underwhelming 0.62%. Higher bond yields and wider credit spreads have weighed on returns.

In contrast the Australian fixed income market has performed well this year, with the Bloomberg Ausbond index posting +3.7% this calendar year. Perhaps the biggest surprise is the break from the upward trend in US yields as Australian rates have fallen with the 10year sitting at 2.46%, after starting the year at 2.63%. Given the Ausbond index has a high weighting to long dated fixed rate government bonds which are not affected by widening credit spreads, duration has been a significant contributor to performance.

Over the last few years the once negative correlation between equities and bonds turned positive over a 3year time frame, while long dated correlations remained negative. This recent bond rally and equity sell off has correlations once again turning negative on a 1year time frame and strengthens the argument for bonds to remain in portfolios for diversification.

Asset class correlations over a 1-year timeframe

Source: Morningstar, Escala Partners
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  • The positive performance from duration strategies in the Australian fixed income market has offered investors some reprieve from the falling equity market. This is not the case for credit, which often follows the lead of equity. For true diversification within portfolios duration should be included, noting that we recommend on an underweight tactical basis. 

Corporate Comments

- The Telstra (TLS) investment thesis is dependent upon cost out and capitalising on the 5G opportunity, although there is high uncertainty with the latter.

- Origin (ORG) faces the dual challenges of a weaker oil price and political intervention. A clearer picture may emerge following next year’s federal election.

Among large-cap ASX 20 stocks, Telstra (TLS) continues to face the most change in its business and environment, which has led to a challenging period over the last few years. This week the company hosted an investor day to give an update on the progress on its mobile 5G network and the opportunities that this will create. While the session was light on in terms of financial details, the company did reaffirm its full year guidance, despite noting that competitive intensity had increased.

The 5G network will progressively be rolled out over the next couple of years and is expected to result in a ten times uplift in speed and capacity, with latency at 1/30th of the current 4G network. The full usage of 5G is dependent on several factors, including the availability of 5G-enabled handsets, the network build and the availability of new spectrum, the latter which may be up to two years away.

TLS, and other telcos, are banking on two factors to drive revenue growth for the industry from the investment in 5G, although both are far from certain. The first is the expectation that customers will be willing to pay more to access this new technology. While this has occurred in previous network upgrade cycles, the uplift in the all-important ARPU (average revenue per user) measure has historically been short lived, before declining again as competition builds, and the current trend is down.

The second is new revenue opportunities, a range of which are illustrated below. The applications are more business than consumer-driven and the size of each market would be difficult to forecast given many involve technologies that are continuing to evolve.

Telstra: 5G Revenue Opportunities

Source: Telstra
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There is also the possibility that following the rollout of 5G, some households will opt to go mobile-only given the potential speed and capability of the new network. TLS and other telcos may pursue this strategy given the high wholesale access costs imposed by the nbn, which has left skinny retail broadband margins, although there is also the risk of the cannibalisation of its own revenue base. With ongoing nbn-related earnings headwinds, high competition levels, a dividend supported by one-off nbn payments and an unknown return on this current capex spend, we are happy to remain on the sidelines with Telstra.

Also holding an investor day this week was Origin Energy (ORG) which has been viewed as a turnaround story among large caps. ORG’s primary issue had been its debt levels, which in hindsight, were too high as the APLNG project in Queensland was completed. This led to cashflows that were below expectations as the oil price corrected sharply over 2014/15. Equity raisings since followed and dividends suspended, with cost out and debt reduction the focus of management. Meanwhile, the company’s operating environment was improving all along; LNG prices (which are linked to oil) had recovered well over the last two years and wholesale electricity prices had also spiked, accelerating the self-help initiatives.

Developments over the last six months have become more difficult on two fronts – political/regulatory risk and the oil price. An increased level of government intervention designed to cap energy prices has been proposed, from greater retail pricing transparency to forced divestiture of assets to new government-underwritten generation. While legislation is yet to be passed (and may change following next year’s federal election), the threats have already led to a change in behavior; for instance, ORG has decided to absorb an expected 3% price rise in NSW for FY19, equating to an $80m pre-tax impact. Ultimately, the longer-term impact of regulatory uncertainty is less investment in new generation and higher prices as the market becomes short supply.

While the political situation has garnered most of the attention, ORG’s earnings base is much more sensitive to the fluctuation in LNG revenues (illustrated in the following chart). Higher well productivity and oil hedges limit the downside for the company, while a stronger balance sheet sees it better placed following the recent oil price correction. Nonetheless, the earnings recovery will be much more muted if the oil price fails to rebound.

Origin: Free Cash Flow and Yield (Continuing Operations)

Source: Origin Energy
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Despite these emerging issues, the key positive to arise from the investor day was ORG’s unchanged guidance (although earnings guidance is only given to its integrated energy markets business), and importantly, a return to dividends from the first half result in February. Trading on a forward multiple of less than 10X and with its balance sheet problems largely resolved, ORG screens as value, although any P/E multiple re-rate will likely be dependent upon a clearer regulatory outlook, possible following the next election.

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