A summary of the week’s results


Week Ending 08.03.2019

Eco Blog

- After nearly a decade of focusing on central banks and interest rates, the attention is shifting to fiscal policy and wages.

- We have added a REITs-focused fund to our global equities allocations.

The prospect for fiscal spending is based on current fiscal deficits, now well off their ten-year peak, and as a response to populist politics and low wage growth.

Government deficits as a % of GDP

Source: IMF, Capital Economics

The alternative to deficit funding is ‘helicopter’ money. The terminology comes from the economist Milton Friedman, where he proposes the option for a government (the helicopter) to drop money from the sky which is collected by the community under the impression this was a unique event. The concept is based on the Treasury of a country issuing a bond to the central bank, theoretically therefore resulting in no increase in the balance sheet.

The difference to quantitative easing is that the money goes directly to households rather than into the financial system. It is achieved through a tax rebate or a dedicated programme (a local example was the baby bonus; globally, China is currently subsidising the purchase of household appliances).

There have been other instances of this policy measure. The notorious example is the Weimar Republic, which lead to hyperinflation. But there is also a long history of benign outcomes. For many years the Bank of England had a ‘Ways and Means Advance’ to fund spending when required and various US administrations have issued rebate cheques as one-offs. These did not have a direct impact on inflation. The idea is not new in this cycle.  The soft economic trends in early 2016 brought up the concept, but by year end growth had resumed.

This time it is more likely not only for political expediency, but as monetary policy is viewed as exhausted. Low rates are no longer associated with having much effect and there is a reluctance to encourage credit growth (particularly given debt levels in, for example, US and China corporates and Australian households). Further, zero and negative rates end up handicapping banks given their capital requirements.

Can it succeed? To boost aggregate demand, household confidence needs to be reasonable or otherwise it has been shown that they prefer to save or pay down debt. It must be widely enough distributed so that it is not simply a transfer of money but a permanent increase in the money base.

The detractors point to two problems. At the extreme, it is self-defeating if it sets in train a cycle of inflation and real incomes fall. Others view that it should only be used in the case of real recession events rather than to manage GDP weakness.

In practise, we are likely to see a combination of straight forward fiscal spending combined with directed handouts over the coming year or two.

The wages topic has boiled over into a plethora of analysis on why it remains so subdued. Governor Lowe weighed into the debate this week, citing global trends and perceived technology impacts, a common refrain. In the US, the discussion is ongoing with frequent reference to the Phillips Curve, a linear relationship between unemployment and inflation. Given an unemployment rate of 3.8% and persistent growth in job openings, there is clearly relatively little slack in the US economy. A study by the San Francisco Fed views low wage growth as anchored by low inflation expectations – if an employee believes inflation to be low, say 2%, a 3% wage rise is possibly seen as adequate. This view of inflation is, ironically, a consequence of the central bank’s success in containing inflation such that the bulk of employees believe that it will be range bound.

The following chart demonstrates the contributors to this unemployment/inflation trade-off. The slope of the curve has had little impact. In the decade up to 2007, the persistence of either unemployment or inflation was the primary influence, whereas after the recession, it is expectations that determines wage growth.

Contributors to Phillips curve changes before, after recession

Source: San Franciso Fed

Unless corporates willingly decide to pay more, the chances of wage growth creating a meaningfully higher level of inflation appears to be unfounded. Even the expectation that a rise in the US minimum wage for many states and businesses would lift all boats has come to naught.

A final word, or rather chart, from the well-followed Atlanta Fed wage tracker. The recent uptick in wages is entirely in the highest income quartile; other segments have been flatlining for the better part of 2 years.

Wage growth tracker by wage level

Source: Current Population Survey, Bureau of Labour Statistics & author’s calculations

We believe a similar pattern is evolving in many economies, not least Australia. The corporate sector appears willing to forego growth rather than increase wage rates. Whether regulated wage growth can make a difference remains to be seen. Germany’s one million public sector employees have secured a 3.2% wage rise for this year and next. We may well see a change in government take the same path here later this year.

  • Corporate profit growth is inevitably tied to household demand. Without the capacity to spend, growth will remain constrained, absent a rise in debt. Australian households, given debt levels and ten year lows in the savings rate, are in a relatively weak position compared to many other countries. The potential for very weak domestic demand should not be taken lightly, as it has direct implications for investment portfolios. Our bias remains to global equities. Within the mix, companies that may benefit from fiscal largesse to mid and lower income groups could be a direct beneficiary.

We have recently added Quay Global Real Estate Fund as part of our international equity allocation. Although the fund has a CPI + 5% p.a. target and is index agnostic, the reference benchmark for most funds in the sector is the FTSE EPRA/NAREIT Developed Index. This index represents the performance of global listed real estate companies where the predominant activities are the ownership, disposal and development of income-producing real estate. Many funds chose to exclude those that have a high level of operational activity such as Lend Lease in AREITs. Similar to broader global equity indices, the US makes up over half of the overall market cap with retail and office space the two biggest sectors. Currently, Quay has a zero weighting to office and is nearly 50% underweight retail.

The level of concentration is the main differentiator between global and Australian listed property indices. The S&P/ASX 300 A-REIT Index comprises 29 stocks, whereas The FTSE EPRA/NAREIT Developed Index has nearly 10 times at 337. The Australian sector is dominated by two stocks, Scentre Group and Goodman Group, which makes up nearly 35% of the index. and will inevitably skew the index performance to these two. The largest exposure for GREITs is retail giant Simon Property Group, which only makes up 3.7% of the index.

The further noteworthy difference is the how the total returns are achieved. Global Listed Property is expected to offer a lower yield offset by a larger capital growth component. AREITs characteristically deliver a yield of around 4.5%-5%, whereas their global counterparts are around 3.8%.

Fixed Income Update

- Macquarie launch a new listed hybrid. We view the value of this security.

- We examine the Australian RMBS market following an article in the Australian that the sector is in trouble.

After the successful issuance of two long dated new hybrids from Westpac and NAB, Macquarie came to market last week. This hybrid (MQGPD) was done to raise new capital and is not a rollover of a maturing deal. On face value, the margin on offer appears tight, especially if compared to another higher yielding Macquarie AT1 security which is higher rated and trades in the US dollar OTC market. However, it does offer the benefit of a high cash coupon and lower franked component (at 45%), benefitting investors that do not value franking credits as much compared to hybrids issued by the major banks which are 100% franked. 

In terms of the margin on offer, at BBSW 4.15-4.35% it is above the median for hybrids currently listed on the ASX at 3.6%. While it is priced at the top of the range of new issues done in the last 2 years, it is below where new issues came at in late 2015 through till early 2017.

New Issue margins for hybrids in the last 10 years

Source: Yield report

  • While this security may be attractive for those preferring a larger cash coupon, we don’t view the margin on offer enough for the credit risk of a 7.5-year Macquarie hybrid. As this new issue does not coincide with a maturity, the question is why Macquarie has decided to raise capital. Is it because it is of the view that the cost of capital will be higher in the future (especially given the potential change of government and subsequent policy change)? Or is it capitalising on the strong demand from the other recent deals? Both potentially play a part.

The Residential Mortgage Backed Securities (RMBS) market in Australia remains in the spotlight as housing prices decline across the country. Fund managers that invest in RMBS will counter this with the robust structure of these bonds (protecting investor capital), relatively low arrears rates (likely because of the recourse nature of mortgages), and benign unemployment levels. However, a recent article in The Australian “Suncorp mortgage bond failure ‘a canary’” added to concerns that the $1.7 trillion RMBS market was under pressure.

This publication explains that “Suncorp has unexpectedly declared a residential mortgage bond worth $120 million may not repay all investors after the share of borrowers in arrears rose to a trigger point, putting the distributions in doubt.” Understandably many picked up on the article with Westpac’s head of securitisation swiftly responding with a note which included “This is not unprecedented, it is erroneous for some media reports to claim that this transaction is the first local mortgage bond to encounter difficulty since the global financial crisis.”

What this all means is hidden in the detail of these bonds. The payment structure of RMBS transactions are sequential to begin with, i.e. top tranches (AAA rated bonds) get repaid principal before bottom tranches and will switch to being pro rata when certain arrears and time triggers are met (for example, arrears below 3% for at least 18 months). This can be reversed if triggers are no longer satisfied, switching back to a sequential payment ( AAA’s get paid principal and interest whereas the other tranches just receive interest), as was the case in this transaction. This is not unusual with some transactions (such as the Sapphire 2016-2) changing the payment structure on a monthly basis.

In the case of Suncorp, the pool is very small with only 12% remaining and arrears rose to 3.7%. It is not uncommon to see high levels of arrears in smaller pools because the loans left behind are often of poorer quality and have difficulty refinancing (or they may be concentrated to a certain area that have been adversely affected by floods etc). For this reason, transactions have a clean-up call once the pool of mortgages shrinks to 10%, which is expected to be utilised by Suncorp once it falls to that level.

This transaction was originated in 2010. The remaining mortgages in the pool have an ~50% LVR (Loan to value ratio), which implies that if Suncorp was to foreclose on the mortgages in arrears, it is expected to recoup the outstanding loans. Further, this transaction has 100% mortgage insurance coverage (LMI) from QBE, which supports noteholders in the event of mortgage default. It is also expected that Suncorp will pay bondholders out in full by executing the clean-up call, of which they noted in an ASX announcement following the Australian article.  

  • As far as we are aware, none of the funds that we recommend have exposure to this Suncorp RMBS bond. Notwithstanding, we are not as concerned as it highlights the robustness of the structures. Historically, no rated tranche of an RMBS in Australia has ever incurred a loss, and our sources point to this article being sensationalised, with no defaults imminent. Aquasia credit fund are our largest holders of Australian RMBS, with ~57% exposure.

Corporate Comments

- Metcash’s (MTS) strategy has shifted to include a focus on growing its top line, with a large increase in capital expenditure.

- Myer’s (MYR) new management got a tick for the company’s first half result, although a lack of dividend highlighted the large task still ahead.

Metcash (MTS) held a strategy day with a changing narrative to one that strikes a balance between cost out and growth. The former has been the focus of the company over the last three years, having successfully defended a declining sales profile with cost savings, helping to stabilise the earnings of its core food division.

Metcash Food Sales and EBIT

Source: Metcash

In order to implement the new strategy, a step up in capex will be required, a factor which was absent across many companies from this reporting season. For each of the next five years, capex is expected to be double the current level of $60m p.a., with spend across each of MTS’s three divisions of food, liquor and hardware. The bulk is on the core grocery division, with the key initiative being the acceleration of a store refurbishment program in which MTS will support retailers with loans and joint investment.

While a return to top line growth would be welcomed, the downside is that prospective capital management options are now likely to be limited given the reduction in free cash flow after investing. Additionally, the success of the program will be challenged by an unsupportive operating environment amid high levels of price competition and low inflation in groceries. Additionally, the declining housing market is a substantial headwind for its hardware division, trends which were reflected in its trading update. From a stock point of view, MTS has moved from a ‘deep value’ mid-single digit P/E a few years ago to low double digits, which is more closely aligned with the current risk/reward profile.

Myer (MYR) is another company in the retail sector that has faced a declining sales profile. The company’s first half result this week showed an improvement on this prior pattern, although an uphill battle remains for the new management team.

Profit growth of 3% for the half was better than expected and was primarily driven by the company stepping away from the normal level of discounting that is prevalent across department stores, with gross margins rising almost 100bp. The sustainability of this strategy is somewhat dependent on competitor behavior. Other positives were a lower cost of doing business, solid growth in online sales and an improvement in the headroom from the company’s renegotiated banking covenants, which has been of concern in recent periods.

Ultimately, MYR will need to show positive sales growth to return to a sustainable profit profile and comp sales growth in the second quarter remained negative at -0.9%. Achieving this in a weakening consumer environment is a significant hurdle for the company, while a short term reprieve could potentially come in the form of a fiscal boost given the improved budget position. Similar to MTS, MYR has found some appeal to value investors given the upside to earnings if it can turn current trends around.

Myer Quarterly Sales

Source: Myer