Week Ending 08.04.2016
There was little meaningful economic news out this week, leaving forecasters to reflect on the weak first quarter of the year and contemplate what could come next. Indications from the combined PMI surveys suggest global growth will be only slightly above 1% in Q1, well below the long-term average of 2.3%.
With the Yen reaching a 17-month high this week, the status of Japan’s economy and the ineffectiveness of monetary policy is in the spotlight. Part of the problem lies with soft global conditions, particularly export trade in Asia, which has been sliding for some time. Internally, policy uncertainty on a consumption tax is unlikely to have engendered confidence and efforts to get wages up appear to have gained little traction.
While unemployment in Japan is low, the headline disguises the structure of the labour force with many in so-called ‘non-regular’ positions.Enlarge
The ‘job for life’ embedded in permanent positions is skewed to the older population and has resulted in a growing number of younger employees stuck with temporary work at lower wages.
Further, low interest rates are arguably a negative, as Japanese are savers rather than borrowers. There has not been the outflow of capital that may have been expected following monetary policy decisions and where it has taken place, the currency has often been hedged, partly supporting the stronger exchange rate. The Yen has therefore surprised on the upside, though some is a function of the universally weaker US$. Yen strength is also attributed to a widespread suggestion that at the G10 meeting earlier in the year there was a tacit agreement by members not to fuel ‘currency wars’. As such, the BoJ has stated that it would not sell Yen to weaken the currency as it has done before.
While today Japan is far less important to global economics than previously, the above issues are similar to those faced by most other developed nations. Labour markets are much better than a few years ago, yet there is a strong undertone of the ‘working poor’ in many regions. Job security is considered low and implicitly consumption is more restrained than expected.
Weak currencies cannot be the solution for all and excess efforts to drag cross rates down are likely to be hugely distorting. As one pundit put it, “markets are watching the Yen, Euro and US exchange rate interaction closely for signs of intervention, and exchange officials are watching markets closely”.
Monetary policy has to change its path. Rather than being supportive, negative interest rates now make no sense as a tool given they now cause anxiety instead of confidence. Central banks instead are proving that they can no longer influence the direction of inflation or growth. For financial markets, the risk of increasing distortion is rising.
The most likely data point to break this impasse is inflation. Two regions bear watching. Firstly, it is likely that China’s CPI will see a step up from a low ebb, driven by food prices. Fiscal and wage support may arise and give confidence to consumers and an incentive to spend.
US inflation, however, holds the key, as it sets in train the rate cycle and possibly the turning point on the wages share in the economy. The combination of widespread increases in minimum wages, rising rental and healthcare costs make a credible case that US CPI will edge up sufficiently in the second half of the year and take the Fed with it.
Attracting much of the attention in global financial market this week is the US Treasury’s decision to deny the Pfizer/Allergan merger the tax inversion benefits essential to the transaction and the possible Justice Department block of the Halliburton/Baker Hughes deal on competition grounds. The consequences are likely to be some reversion to capital investment and pursuit of internal growth options rather than mergers, lower credit issuance to partly fund these deals and possibly, alongside a host of other issues, a rise in corporate tax payments.
The impact on global investment markets is likely to be mixed. Investment spending is welcomed, though takes time to achieve returns. The arbitrage in merger activity will require very careful assessment of the possible intervention by authorities, companies may choose to use cash balances rather than await what might be forced upon them, and higher tax rates for some companies encourage a rotation in equity sectors that are focused on their domestic market.
Fixed Income Update
Commonwealth Bank’s new hybrid security, PERLS VIII (CBAPE) began trading on the ASX last week. The first trading day saw relatively heavy volume at 23% of total hybrid turnover and 6% on the second day. The bonds are now priced above par, with their margin over BBSW tightening in approximately 40bp from issuance. This is in line with the spread tightening that has occurred across the secondary market.
We are now starting to see steepness across the maturity curve of hybrids. For the last few years, the spread curve was generally quite flat in terms of the trading margin offered on four year maturities (for the majors) and beyond. A re-adjustment in pricing in the last two months has occurred, with investors now being compensated for taking on longer-term maturities.
Theoretically, a higher premium for a longer tenor (maturity) should be the case for floating rate credit bonds. The exception is when spreads are wide and the market’s expectation is that this won’t be sustained, creating re-investment risk for shorter dated maturities. This newly formed steepness in the curve is therefore a reversion to the ‘normal’ behaviour of credit bonds.
Shorter-dated bank hybrids have rallied significantly of late, as has the middle part of the curve. The longer end has remained broadly unchanged, creating this steepness beyond four years. The chart below illustrates the movement in trading margins for bank hybrids from February 15 through to April 1.
The outlook for spreads on bank hybrids is unclear. Our understanding is that up to 60% of holders of PERLS III did not roll into the new PERLS VIII deal and have received the proceeds of the maturing bond this week. Therefore, potentially up to $870m of funds has been returned to investors and may be re-deployed back into the hybrid market, which would be supportive for bond prices. On the flip side, Westpac is looking to announce a new issue to replace maturing Westpac Preferred Securities (WCTPA) and are expected to raise more capital than that of its predecessor. This in turn may weigh on spreads as supply increases.
Bank of Queensland’s (BOQ) result was a slight disappointment, having recovered much of the ground previously lost after it provided the market with a cautious outlook back in February. For the six months, BOQ reported earnings growth of 7%; a figure at the high end of the broader banking sector, although the bank benefited from lower ‘one-off’ costs in the half. Underlying cost growth of 4% matched that of the top line, a function of the relatively tough environment that the banks are currently facing. BOQ has continued to diversify its lending away from its core Queensland market, although the state still accounts for half of its portfolio.
Bank of Queensland: 1H16 Total Lending by Geography
Compared to the majors, the regional banks have had a comparatively supportive regulatory background over the last 12 months, avoiding the increased capital requirements that APRA has imposed on the majors, which have forced them to hold additional capital against their residential mortgage books. The banks have responded to this pressure by re-pricing mortgage rates, which was seen to be an offsetting move to the falling returns profile for this category of lending. However, with the costs of funding increasing (bank credit spreads have increased in international markets), net interest margins have instead been flat over this time and so the benefit to the regionals has been negligible.
BOQ has looked to combat this further by announcing interest rate hikes across residential investor and owner-occupier mortgages alongside its results. While BOQ has traditionally followed the majors when it comes to out-of-cycle mortgage rate increases, in this instance it has been proactive in its decision and it remains to be seen whether the majors also reprice. We remain underweight the banking sector in our model portfolios.
Nine Entertainment (NEC) was sold off heavily after downgrading its revenue guidance for the financial year with soft ratings for the network in the March quarter. The company blamed the poor standard of international sporting competition over the Australian summer (not helped by a below-par West Indies team) as well as the cycling of last year’s cricket World Cup and the early timing of Easter.
NEC is an example of traditional ‘old media’ that is currently battling disruption from new forms of video and content delivery, with a weak cyclical outcome exacerbating a challenging structural trend. Short term trading opportunities can thus arise when a network has a string of successful programs and a subsequent increase in ratings (and thus take market share from its competitors), although longer term the investment case is far from clear.
The loss of revenue for the free to air is deteriorating at a much slower pace compared to what print media has experienced over the last decade (see chart below). Yet it appears inevitable that audiences and hence advertising dollars will continue to migrate to more ‘on-demand’ video streaming services, whether it be Netflix or other streaming video services. This creates a substantial headwind for an industry that is exposed to a high fixed cost base, with margins thus falling at a faster rate. The balancing act is that reducing costs may simply compromise viewer numbers.
Share of Advertising Spending in Australia
While NEC is looking to combat this change with its own streaming initiative (Stan), costly quality content is what will differentiate the winners from the losers in this new environment and the domestic players are up against international competitors with deep pockets. Changes to media ownership laws in Australia provide an opportunity for consolidation among several listed companies and short term realisation of value through synergies, although the structural change in each advertising medium is the key longer term trend that should dictate the respective performance of these companies.
Downer EDI (DOW) shares lost ground after Fortescue Metals (FMG) announced that it would bring its mining operations back in-house at its Christmas Creek mine in the Pilbara. The contract was thought to be the company’s largest in the mining sector, providing close to $500m a year in revenue (compared to the company’s annual revenues of approximately $7bn) after initially being awarded nearly six years ago.
DOW has had some appeal in recent times as a value stock among ASX 200 stocks, with the stock trading down to a single-digit P/E despite having a much more diversified exposure compared with its pure mining services peers. This sector, however, now represents less than 15% of its forward order book. Yet in a continued weak commodity price environment, it is difficult to see this P/E discount being lifted in the medium term with the risk remaining over these revenues.
The sentiment for resources was not helped this week when steel company Arrium (ARI) appointed voluntary administrators. The company had attained a level of vertical integration in its business when it begun mining its own iron ore. The business, however, has unravelled following the drop in the iron ore price, exposing the high cost base of its mining operations, the low-margin, highly competitive steel market and a balance sheet under considerable stress.
A number of investment conferences this week gave listed companies the chance to present to institutional investors. Vocus (VOC) was at one of these, reiterating the benefits from the company’s recent merger with M2, as well as illustrating the broader opportunity. While VOC has historically been more associated with corporate customers with its extensive fibre network, the M2 brands are predominantly focused on the consumer market.
The table below details a scenario put forward by VOC if it were to attain a 10% market share of the consumer broadband market by FY18 (which it labels a “generational churn event”), with NBN-connected premises expected to significantly ramp up over this time. We believe that investors can get better exposure to the trends in telecoms markets through these challenger companies as opposed to Telstra (TLS).
Vocus: Services in Operation (SIOs) as NBN Rolls Out