Week Ending 08.01.2016
The perception that China is a command economy does not resonate in its financial sector. A messy combination of attempted regulation and intervention in the equity market (CSI 300 Index), met with the culture of the participants in that index (where there is frequent trading by retail investors), explains some of the extreme swings. The China Security Regulatory Commission (CSRC) had imposed limits on the daily movement of the index, triggering a close for the day if the market moved by more than 7%. These had only been in place for days before being lifted at the end of the week. Restrictions on the sales of stock by large shareholders were to be lifted, however this has now been pushed out.
Adding fuel to the mix is the currency management. Along with the devaluation in August, the Peoples Bank of China changed the ‘fix’. Instead of tying the rate to the previous day, the central bank now sets the daily price wherever it wants and then manages the trading range. The chart shows the CNY/USD exchange rate over the past year. After a relatively stable first half of 2015, the August move been followed by accelerating depreciation.
Many commentators point out that as China held its USD currency trading range, it appreciated against its other trading partners. The fall against the USD since August 2015 is largely to realign these exchange rates and remain in a range with respect to its trade weighted index.
This currency movement and repercussions for capital flows is what is troubling markets, more so than the ever volatile CSI index.
Underneath this lies the problem for China and the rest of Asia. Trade, one of the two economic lifelines of the past decade, has been on a downward trajectory for the past year. The fall in imports is in part due to lower commodity prices, but also fading capital investment spending. The smaller south Asian countries are highly export-dependent and have all generally seen a deterioration in their trade data. Some industries have held up better, such as low value-add economic activity in Vietnam. Another trend had been Japanese companies undertaking a multinational strategy through investment in countries such as Thailand. China is clearly substantially larger, but must be perturbed by the prospect of intense competition exacerbated from the weak currencies in these countries.
Asia Trade Trends
Asia need two themes to emerge. The first is investment into education, health, waste and pollution control and other services; and the second is household consumption. By and large, consumption is doing fine, though not accelerating and therefore incapable of compensating for the fall in trade and investment spending.
The question then arises as to what can turn this cycle of negative momentum. Political will and a loosening of fiscal constraint is required for social investment. Greater confidence would be a helpful nudge to households.
Locally, November building approvals imply that the peak in housing activity will be in 2016 and fade into 2017. Multi-density has taken a big step down, with Victorian approvals declining by 63%. Given comment on excess supply, this is hardly surprising. Detached housing approvals have been flat for two years.
Residential Building Approvals
The trade deficit remained at $3bn in November, having increased a year ago, as commodity prices fell. Within the data there was a massive spike in exports of rural products, though small in the context of trade. Apparently, exports of fruit and veg rose by 146% in the month and oleaginous fruit by 103%. Inbound travel is otherwise showing up as the best sector, up 11% year on year. Import growth is centred on consumption goods, specifically electronic products and apparel, both up 24% year on year. This is largely due to the fall in the AUD and the price impact is likely to be more pronounced through 2016. Transport equipment was up 13%, with more sourced from countries where the exchange rate effect has been moderate. Finally, the fall in the AUD has not stopped outbound travel from a 6% rise through the year.
Retail sales data for November was unremarkable. Even within segments there was relatively little variation. We show the year-on-year change based on three month rolling data which removes some month-on-month effects.
Broadly speaking, the household sector around the world (after allowing for population chances) is spending in line with incomes. Given the high, albeit concentrated, debt levels in Australia, one would not want to see spending accelerate much. Weak manufacturing data in much of the world does leave the onus on consumers and the government to keep the GDP clock ticking along.
Fixed Income Update
We finished off 2015 with spread widening across the credit universe, led by the US high yield market. However, as expected, the Christmas break saw trading volumes drop off and new supply dry up. This resulted in a marginal correction from the weakness and a short reprieve leading into the new year. The fall in the Chinese stock market early this week gave reason for further price falls in credit bonds, although this was short lived. The high yield market in the US and Europe was the most volatile (15bp-20bp move on Monday), while the high grade market moves were moderate. The chart below illustrates the spread widening in the Australian market over the last three weeks as reflected by the Australian iTraxx index.
Australian iTraxx Index
Despite the spread widening in credit being quite exaggerated leading into the end of year, credit still (slightly!) outperformed government bonds in 2015.
Staying with credit, the Australian listed debt market had its share of woes in the last two weeks, with a broker report sighting concerns around a non-call event of Crown’s subordinated debt securities. Rumours of a private equity takeover of Crown Resorts, and the possibility of more leverage, posed the question mark of whether the company would call its subordinated debt. The result was a significant sell off in both CWNHA and CWNHB securities as the year closed out. A follow up report by the same broker this week, suggesting that the price action was over done on the downside, saw a slight rally in both securities. These securities will potentially stay range-bound until there is further clarification. The price movements of the CWNHAs is shown in the following chart.
Crown Subordinated Notes (CWNHA)
Things have been broadly positive for the rest of the listed debt market, with spread tightening across most securities over the holiday period. Volumes have been light, only picking up in the last couple of days given leads in the equity market. The newly issued AMPPA has performed well, with the price ticking up as high as $104.45 on Christmas Eve.
With more Fed hikes expected this year, the US futures market is now pricing in a 50% chance of a further rise by March this year, with the majority of participants expecting between 2 and 4 more hikes throughout the year. Despite this, the long end of the treasury curve is at odds with this theory as longer term rates have failed to rally; most likely more a reflection of ‘safe haven’ trades supporting the price as equity market volatility continues.
Australian Government bonds have started the year up (yields lower) as the RBA doesn’t look likely to cut rates any time soon given recent strong employment data. A halt in government bond auctions, restricting supply, would have also supported prices. However, the longevity of this price rally may be short lived, as the Australian Government announced in December that they have plans to increase bond issuance to about $86 billion this financial year, up from the $74 billion projected. In 2015, demand at Australian bond auctions dropped was the weakest since 2002. This will put upward pressure on yields if this trajectory continues.
This week’s depreciation of the Chinese Yuan has also been favorable for Australian Government bonds. Growth concerns in China, fueled by the PBOC’s policy action, has resulted in a flow of capital out of risk assets and into safe haven government bonds.
Early in January, market announcements have been typically quiet given the time of the year, and hence equities have been driven more by macro noise as opposed to fundamentals. Given our close links with China, it might be expected that the ASX 200 would have sold off more than other international markets, however the falls have been similar across the board.
One sector of the market that has enjoyed strong price appreciation over the last 12 months has been several smaller food companies. Vitamins maker Blackmores (BKL) was the best performing ASX 200 stock in 2015, gaining 525% over the 12 months to finish streets ahead of the second placed APN Outdoor (APO) with a 142% return. On a similar theme to Blackmores (although outside of the large-cap benchmark index), Bellamy’s (BAL), which produces baby formula, has also risen appreciably over this time, while A2 Milk (A2M) and Bega Cheese (BGA) have also done well.
Small Cap Food Stocks in 2015
There is a common link among each of these stocks. They have growth strategies which are linked to strong export growth to China and other Asian countries; the brokerage coverage among each is quite limited; and each trades on an elevated valuation (on a FY16 P/E basis, the range of the group is approximately 40X for BKL and BGA, up to around 60X for A2M).
While the export opportunity is no doubt large, at this point in time these stocks are more trading on the potential, rather than what they have achieved to date. Each still derives the large majority of its revenues and earnings from the domestic market, with Blackmores’ 18% revenue exposure to Asia the highest of the four.
In a slightly different category to the dairy companies, Domino’s Pizza (DMP) is perhaps the best example of an Australian food company that has achieved success in entering international markets. While again we struggle with DMP’s valuation, it is arguably more justified given its impressive track record of organic growth, acquisitions and innovation with its menu and digital ordering system.
Aurizon (AZJ) shares have fallen materially in the last few weeks after it announced in late December that its first half earnings were now going to be lower than previously expected given several factors, including a reduction in coal volumes and impairment charges relating to its investment in Aquila (iron ore) and its rolling stock and inventory.
Aurizon does have an infrastructure element to its business with its long term lease and operation of the Central Queensland Coal Network. An argument could be made that the company has not benefited from the tailwind of lower interest rates that other infrastructure stocks have enjoyed, such as Transurban (TCL) and Sydney Aiport (SYD).
However, we wouldn’t consider AZJ to be an alternative investment for these stocks for a number of reasons. Firstly, the volume component that should drive revenue growth, being coal, is less certain than that of TCL (traffic flow on its toll roads) and SYD (passengers through the airport). This is perhaps not the case on a short term basis (where weather can cause considerable variability), but is certainly true on a long-term basis given question marks over the sustainability of coal in an increasingly carbon-constrained world.
Secondly, the infrastructure assets of AZJ make up only around half of the total value of AZJ, with the remaining comprised of its above-rail coal and freight transport. Aside from the capital expansion of its network, much of the improvement has come from margin growth in this business as it has achieved cost out and various operational efficiencies over time. Its investment in a joint venture to develop an iron ore project in the Pilbara also would have to be unlikely to proceed in the current environment. Asciano Group (AIO), currently the subject of two takeover offers, was the most like-for-like comparison with AZJ, albeit with a lower exposure to resources through its stevedoring services at Australia’s largest container ports.
National Australia Bank (NAB) is in the final stages of its demerger of its UK Clydesdale Bank business, with a shareholder vote later this month ahead of the expected commencement of trading of the business in early February. Clydesdale has been a troubled investment for NAB and the divestment is expected to be below book value, reaslising a loss for NAB. Clydesdale has been loss-making in recent years, largely a result of conduct charges that it has occurred relating to the mis-selling of insurance products. While only a small part of NAB’s overall business, Clydesdale’s underlying return on equity (ROE) of approximately 5% has held back NAB’s overall ROE, with the bank indicating that this will rise to 14.6% once the demerger is complete, closing the gap on its domestic peers.
NAB: FY15 Cash Return on Equity
We recently downweighted NAB in our model portfolios given the headwinds that have been emerging in its domestic business, particularly in its business bank, which will attract greater attention following the Clydesdale demerger.
As a sector, the banks currently appear around fair value. The sector trades on a P/E that is close to its five and ten year averages, although at a slight discount relative to where it has traded against the industrials sector. The main attraction from an investor’s perspective is forward yields of 5.5% - 7.0% across the four majors, however the prospect of meaningful dividend growth is limited by benign credit growth and tighter regulatory capital requirements, which have forced equity raisings over the last 12 months.
We encourage investors to view their bank holdings in conjuction with their bank hybrid exposure as any event that affects the underlying bank will affect the pricing of both securities. Bank shares have a greater prospect of capital gains and losses and currently offer higher yields, while hybrids have a slightly higher level of capital security with lower yields.
The demise of Dick Smith (DSH), some 24 months after listing, was not entirely surprising after the downgrade at the AGM and asset writedown in late 2015. The saga contains the regrettable element of equity markets and management; a hasty private equity IPO; an aggressive growth strategy without a compelling point of difference; a grab for profit margin from self-sourcing, and consequently poor inventory management when this product suite failed to perform. Dick Smith was not alone in its outcome, the 38 store Australian operations of Laura Ashley have also gone into receivership post-Christmas.
The year-end retail period was, by all accounts, a reasonably good one and these failures are largely due to internal issues rather than the environment. Overall goods spending growth has been trending around 4.1% to November. JB Hi-Fi and Harvey Norman should pick up some of the Dick Smith sales over time and we consider JBH as our second pick amongst the major retailers.
Apparel sales are reported to have been selective with some store chains gaining significant share. Department store trading has also apparently been good. We are cautious on the sustainability of this trend. It may be coming from sales of written down inventory rather than a resurge in the new offer from the two major groups. Global trends in department store retailing are still unattractive.
It may be coincidence, yet remarkable, that male-oriented retail has performed well for some time. Auto parts, hardware stores and electronic product retailers have generally shown consistent positive momentum. While it is far from us to make any judgement on this pattern, it supports our recommended stocks Wesfarmers (WES) and Super Retail Group (SUL). For investors who have persisted with Woolworths, the catalysts to a possible recovery would clearly be a well-regarded CEO. The time taken to find a candidate suggests this is not proving to be an easy task.
Subsequently investors would be expecting a quick decision on Masters and possibly Big W, though we consider it unlikely that it can or will be sold. The key, however, is to fix the supermarket business. We believe trading into the year end has not improved. Store standards, weak price architecture and out of stocks contrast with Coles and the ever increasing presence of Aldi. A new CEO may follow the pattern of resetting the base lower before moving on.