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WEEKEND LADDER

A summary of the week’s results

08.02.2019

Week Ending 08.02.2019

Eco Blog

- The trend in global industrial production currently looks bleak. There are a number of one-off factors that should result in a rebound as the year progresses. These are important as, while services account for 70-80% of employment in developed nations, the manufacturing sector creates most of the volatility.

- Recent returns, along with low correlation to other equity segments and low beta could see an allocation to REITs providing benefits to a portfolio. 

A gloomy cloud sits over much of the recent data releases. Germany’s industrial sector has now experienced a contraction for two quarters, inducing calls for more effort on the fiscal front. The contributors to this malaise are obvious; the auto industry with production disrupted by changed emission standards and a drop-in demand from China (resulting a deep slump in Q3), then the drought and subsequent low water levels in the Rhine, which gridlocked the movement of chemicals along this distribution channel in Q4.

German industrial growth

Source: Bundesbank, Citi
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A rebound is being undermined by weak business sentiment, which has now moved to the consumer.

The dependence on specific industrial sectors in each country is much higher than one often assumes. But it is also correct that data releases are skewed to this part of the economy rather than services.

In round numbers, the labour force in the US is split between 2% in primary industry (agriculture, mining, forestry etc.), 18% in manufacturing and the remaining 80% in services. While the US is on the high side of the service equation, the pattern repeats across all developed countries.

Nonetheless, the impact of the industrial sector is larger than its labour force, as it has the largest multiplier effect (i.e. it supports jobs outside the industrial employee) and tends to have the greatest variation.

The US non-residential cycle has become more sensitive to oil prices than other factors as it ramped up its activity in the shale sector. The correlation between changes in total non-residential investment is now at 0.75 to the oil price, from zero in 2000.

Contribution of oil assets to change in non-residential investment

Source: Penn Wharton
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The relatively buoyant oil price post the slump in 2016 is estimated to be responsible for the bulk of the growth in non-residential investment in 2017/8. It also parallels the current softer pattern in US investment spending, given oil prices are off circa 15% in the past quarter.

Unsurprisingly, the Texas-based Dallas Federal Reserve surveys the energy sector and based on current prices, investment may pick up modestly this coming year. 

What are your expectations for your firm’s capital spending in 2019 v 2018

Source: Federal Reserve Bank of Dallas Energy Survey
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If this proves to be the case, it supports the contention that the US economy is likely to achieve GDP growth in the mid 2% in 2019.

Locally, the full repercussions of the downturn in housing is yet to be determined. It is easy to identify the companies in building materials that will be directly affected, but the broader impact is harder to judge as other factors come into play. For example, when house prices eased in 2012, the mining investment cycle was still running at pace.

Economic interdependency is a complex assessment. The level of reliance on any sector has to be understood in the degree it impacts other industries and the cause of variation.

  • The same applies to equities with fund managers commenting on work to understand the interaction between companies and unintended consequences across their portfolios. Single name limits are usually imposed, yet the links can mean any trend (good or bad) is a much greater risk than apparent.

The global REIT outperformed the rising market in January, putting in the strongest monthly performance since October 2011. At the start of last year, REITs lagged other equities due to fears of rising interest rates and an uncertainty in real estate markets.  However, the sector has now produced a return of greater than 10% over the past 12 months, while the MSCI ACWI is in negative territory. The changing stance on interest rate rises could have both positive and negative ramifications. Investors may shift some allocations from fixed income towards REITs given the fall in yields. Conversely, the Fed’s stance is as a result of waning macroeconomic conditions which may reduce tenant demand.

A positive valuation sign for REITs typically is when the dividend yield is attractive relative to the yields on other income-oriented assets, such as corporate bonds. The spread between REIT dividend yields and Baa-rated corporate bond yields has nearly halved from 112bp in December to 62bp in January. The chart suggests further positive returns.

Yield spread as a valaution signal in rising-rate periods

Source: NAREIT
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One of the main objectives of a REITs allocation is the diversification benefits it provide within equities.  The low correlation between REITs and equities is a consequence of its yield and the real estate market cycle, whereas broader equities are large driven by business cycle.  During 2018 the correlation between US REITs and the S&P was 45%, which is below its long-term average of 59% even with an increase from the volatility spike in the second half of last year.

REIT-Equities correlation (LHS) and beta (RHS)

Source: NAREIT
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Fixed Income Update

- The RBA meeting, quarterly monetary policy statement and a presentation by the governor drove yields lower over the week, notwithstanding unchanged official interest rates.

- We discuss the potential that a European AT1 (hybrid) security will not get called and possible cause.   

The RBA kept the cash rate unchanged at 1.5%. In the accompanying statement it revised down growth forecasts and commented on a softer housing market, which could impact household spending. It noted downside risks have increased domestically and globally, reinforced in its quarterly statement. Weak retail sales figures also didn’t help the economic outlook and consequently yields shifted lower with a rally in bond prices. The governor was unwilling to commit on the likely direction of interest rates, indicating that it was contingent on employment levels with a scope for this to influence the decision either way.

Rates have moved dramatically since the beginning of the financial year as the market switches from the prior likely uplift in interest rates to a cut. Seven months ago, there was a 60% probability of a rate hike by March this year. Now, the yield curve is leaning towards rate cuts, with a 62% probability priced in by year end. The change of sentiment over the period demonstrates how the yield curve is often not the best predictor of future rates. In the short term, lower yields will give a price lift to long duration bonds, which will need to be unwound if the central bank fails to deliver another rate cut.

  • Our view is that the RBA will be reluctant to cut rates, preferring to remain on hold for this year, but acknowledging the data may become biased to further rate cuts. Easier monetary policy is arguably going to have limited effect on supporting the falling housing market given banks are raising interest rates out of cycle and tighter lending standards are driving the squeeze. The RBA will need to respond if economic data capitulates, driven by a rise in unemployment.

The shift downward in the Australian yield curve

Source: Bloomberg, Escala Partners
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Bank hybrids (AT1s) are structured with a call date and a final maturity. As the call date approaches, the issuer has the option to redeem the security, convert to equity or extend, as is the case of a perpetual note. Similar to bonds, they intend to pay a coupon until maturity date, but this payment is not mandatory and is at the discretion of the issuer. The discretionary flexibility that the issuer has and the positioning of hybrids on the capital structure are compensated via a higher rate of return for the investor.

In the Australian market, many assign a low risk probability to a bank not calling their hybrids at the first available call date. Reputational risk is cited, with the view that if not called, the bank in question (with potential contagion) would have difficulty accessing the market when next required. While this may be true domestically (at least for now), one can look to the European bank hybrid market (named Contingent Convertibles or CoCos) in which the potential to not call is a very viable option. 

In Europe, the decision to call the hybrid rather than extend must also be approved by the regulator, with the decision based on whether it is economical for the issuer to do so. While there are no known enforcements, the regulator will consider which is the cheapest form of funding for the banks (replacement or extension), and what is in the best interest of shareholders. In a current scenario, Spanish bank, Banco Santander, has commented that it may not call an upcoming €1.5bn Coco with a call date in March as it is cheaper to extend the note. The market has repriced the security as a perpetual while awaiting a decision on redemption, which is due in the next week.

  • While we see no immediate threat to an Australian hybrid not being called, investors need to be cognisant of potential regulatory changes that can quickly affect pricing. These risks need to be considered upon purchase.

Corporate Comments

- The recommendations from the financial services Royal Commission provided some relief for most listed companies, although cultural change and adjustments to business models will impact earnings in 2019.

- Commonwealth Bank’s (CBA) result highlighted the challenges in retail banking at present.

- CYBG provided a positive update, although the stock’s direction is Brexit-dependent in the short term.

- IAG’s benefits from quota sharing and cost out are evident, while premium increases are now flowing through in general insurance.

- Political and regulatory uncertainty make for an unfavourable environment for AGL.

For the large majority of Australian listed financial services companies, the recommendations contained in the final report of the Royal Commission (RC) were not as bad as feared, leading to a positive share price reaction and the claw back from the (vast) underperformance experienced over the last 12 months.

For the banks, the primary risk was around responsible lending laws, which would have reduced the borrowing capacity of mortgage applicants. The RC opted not to change the existing law, rather a tightening how it is applied. There was a recognition that the banks have already undertaken changes to their processes to enforce a more careful assessment of a borrower’s expenditure, which is supported by anecdotal evidence and a broad slowing in industry credit growth.

Vertical integration was the focus for the likes of AMP and IOOF. The report did not ban this model, as was widely expected, which could have forced structural separation of these companies. Nonetheless, various recommendations will require changes to their operations, including the banning of advice fees for MySuper accounts, an end of trailing commissions (addressing ‘fees or no service’ issues) and rules that would make the cross selling of products more difficult. The above also applies to Westpac, the only one of the majors that is retaining its wealth management arm.

Mortgage broking faces the biggest shake up in the wake of the RC. The most significant recommendation is that brokers be paid by borrowers and not the lenders to remove conflicts of interest, which would end the current upfront and trailing commission model. This has been endorsed by the federal opposition, although the current government is more cautious about banning upfront commissions, noting the potential harmful effects that this may have on competition in the industry as consumers will be much less likely to seek advice they had previously received for ‘nothing’. This shift would see the major banks in a stronger position given existing networks, lower distribution costs and a potential to regain the margin paid to brokers, which currently sell more than half of loans in the market.

Overall, while market participants may have escaped most of the worst-case scenarios put forward, the period of adjustment (including necessary cultural changes) is already well underway. The high level of uncertainty has now lifted and the broad negative impacts to future earnings will increasingly be captured in analyst numbers.

  • The benign outlook for the banks is consistent with the new environment in which they operate post the RC, in particular, weak credit growth. Client remediation costs are likely to persist in the medium term, while a higher regulatory burden is also expected. The impact to the wealth management sector has been greater, although this is likely reflected in fall in share price over the last year. Within financial services, insurers have been the least affected by the RC.

This aforementioned environment was reflected in Commonwealth Bank’s (CBA) half year result, the only major bank to report in February. Earnings rose slightly year-on-year, although the comparison was assisted by high one-off costs in 1H18 and the dividend was steady. The changing narrative of CBA was a point of interest. With the core retail banking business experiencing an 8% decline in profit (amid low loan growth and contracting margins on fund costs and competition), the focus has turned to the levers in which it can pull on its costs and a new 40% cost to income ratio target.

The key positives were bad debts that remain well behaved (15bp) and an improved capital position (CET1 ratio of 10.8%), which will be topped up by the sale of its wealth management business. This opens up the possibility of capital returns to shareholders, although there is some uncertainty over what will need to be set aside for higher regulatory capital requirements in New Zealand.

Of the major banks, CBA currently screens as relatively expensive. Despite converging ROEs and benign profit growth across the sector, the stock’s forward P/E premium to the other three majors has expanded materially over the last few months.

CBA P/E Premium to Other Majors

Source: Bloomberg, Escala Partners
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One listed bank that has avoided the RC-driven domestic selldown has been UK-based CYBG, although its backdrop is arguably worse given the lack of clarity on Brexit. A first quarter report provided some respite for shareholders after a disappointing update late last year. CYBG increased its synergy target for its large acquisition of Virgin Money, lifted its net interest margin guidance to the top of its range and grew its mortgage book above system. Progress continues to be made on its cost-out targets and a strong balance sheet provide optionality for capital management (further information is should be revealed at a capital markets day scheduled for June). Trading at a large discount to book value, the stock continues to represent good value, although this will not be realised until the form of Brexit is resolved, creating a short term binary scenario.

Insurance has been a hiding place for managers aiming to avoid the higher risk areas related to the RC. A reasonable general insurance backdrop was reflected in IAG’s result, with its underlying insurance margin again rising on the back of additional quota sharing arrangements and cost out initiatives, with premium growth on rate increases. Headline profitability was weaker following higher catastrophe claims in the half, predominantly linked to the Sydney hailstorm in late December.

Among the domestic insurers, IAG retains its position for investors who prioritise quality, while SUN is the value option of the two.

AGL Energy’s result was slightly disappointing, despite reiterating guidance, with the negative share price reaction attributed to a lack of capital management and lower forecast cost savings. Rising wholesale electricity prices (which have again rebounded recently) underpinned the result, offset by the margin contraction that is flowing through on the retail side of the business as political and regulatory pressures continue to hurt. With wholesale electricity prices elevated, the forward curve is anticipating declines in coming years as new renewables supply is added to the market, although industry investment continues to be hindered by political uncertainty. The stock has a solid dividend yield of 5.5%, although dividend growth in the medium time will likely be capped by the challenging outlook ahead.

Reporting season schedule for next week:

Monday: Amcor, GPT, Bendigo and Adelaide Bank, Aurizon, JB Hi-Fi, Healthscope, Cochlear

Tuesday: Transurban, Challenger

Wednesday: SkyCity, Orora, Tabcorp, CSL, Bapcor, Computershare, carsales.com

Thursday: Unibail Rodamco Westfield, Treasury Wine, Newcrest, Goodman Group, South32, AMP, Magellan Financial, ASX, Telstra, Woodside, Suncorp, Super Retail, Cleanaway Waste Management

Friday: Healius, Medibank Private, Link Administration, Vicinity Centres

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