Week Ending 08.05.2015
Europe has perked up again after a soft patch. Spain is now powering ahead based on the PMI release this week and confirmed by fund managers who have noted the much better tone in that country. Italy is also showing some early signs of improvement and, among the major economies, only France has yet to make an effort.
In common with global trends, services is the key to recovery and manufacturing trends remain sluggish.
European Services and Manufacturing PMI
The incumbent UK government will inherit an economy also with a buoyant services sector. While not wanting to read too much into a few months, UK corporates note the rise in input prices versus the weak output prices. Wage rises are the major contributor to inputs, as yet it appears companies have not wanted, or been able to, adjust their selling prices. This may cause some contraction in margin but eventually result in the inflation rate picking up from the current low levels.
US indicators suggest a similar outcome, with manufacturing employment relatively weak; unsurprisingly concentrated in the oil and gas sector. Services, with over 80% of private employment, remains solid. We have commented on the likely rise in labour costs in the US due to high profile corporations lifting the bottom end of wages. Once again, whether this translates into slightly higher inflation, given the weight of the service sector, will be keenly watched. We view this feature as arguably the most important issue for investment markets over the coming 12 months.
The RBA rate cut was not a surprise, but the market reaction was probably not what the board was looking for. Whether this rate cut has any marginal impact on activity outside housing would appear unlikely, yet the RBA would certainly have preferred a downward move in the $A. The dollar popped up as the decision was accompanied by guidance that this was likely the last cut along with generally appeasing comments on the economic momentum.
Retail sales for March supported the RBA contention that there was some life in the economy, with nominal growth for the quarter of 4.5%. While there may be some seasonal enhancement of the numbers, the overall pattern seems to have stabilised.
These trends are corroborated by comments from some retailers and property trusts.
The labour market has also reached an apparent equilibrium with the unemployment rate sitting at the 6.1% - 6.2% mark. Job growth in residential construction and services has offset the losses in mining and manufacturing. The Victorian budget also allowed for growth in public service employees, suggesting support from the fiscal side may compensate for some of the hit from commodity prices on real incomes.
The excitement of the week in financial markets, however, came from the movement in bond yields. In recent weeks the negative rates in parts of Europe had become the topic of the day with some justifying these on the basis of ECB buying and very low inflation. Now things have changed again.
The icon for the European Bond market is German Bunds, which has moved up from zero to over 60bps in 10 days, catching many by surprise. On Friday, the intraday moves reached a fixed interest frenzy, with 10 year yields starting the day at 66bps, reaching 76bps, before buyers drove them back down to 60bps.
German Bund 10 Year Yield: Past 12 Months
There are a host of reasons for this shift. The extremely low rates were probably an anomaly, driven by trader positions rather than any fundamental buyers. Then, the rise in oil prices caused inflationary expectations to reverse and the generally benign, almost encouraging, economic data put the bears on the backfoot. We doubt this is much more than a messy unwinding of extended positions, but does highlight that financial markets, given the broad-based rally of recent years, are likely to become increasingly sensitive to any apparent anomalies.
Australian bonds reacted to this and local conditions with 10 year government bonds now 40bps higher than the lows of only a month ago. The $A has therefore rallied, along with the RBA comments that rate cuts are less likely. That said, it is the $US which has weakened somewhat against other major currencies as well. Most believe these trends will be temporary, albeit that the general direction of a weaker $A, euro and yen versus the $US has largely run its course.
Fixed Income Commentary
Few parts of private investor fixed income portfolios escaped some impact this week. Firstly, the RBA cut rates, then a selloff of some bank hybrids, and finally the movement in bond rates (which impact on fixed rate securities). The hybrid market appears to have taken heed of the regulatory capital requirements for the banks, though the capital raising and dividend reinvestment plans are, on the margin, a good outcome for hybrids. Nonetheless, it is a timely reminder that these securities are vulnerable to sentiment shifts and frequently can be mispriced. Investors should not be afraid to take advantage of these circumstances given they are relatively easy to trade on market. We note that volumes at times can be patchy and that discipline should be exercised in both buying and selling.
Bank Hybrids: Performance over Last Week
Global credit has generally tracked the movement in bonds and invariably given up some of the gains of this year. US investment grade yields, for example, edged up 11bps in the month to date, though total returns for the year to date are still positive.
We have pointed out that recent above average returns from fixed income is highly unlikely this year and we guide to an average of 4-5% based on holding a number of funds, as well as selected listed bonds and hybrids. The recommended funds have as wide as possible mandates to allow for potential dislocation in some sectors as well as opportunistic reweighting when appropriate.
This year, for example, high yield and emerging market debt have been the two better performing subsectors. Both are coming off a specific issues of 2014; high yield was tainted by the relatively high weight of energy companies, which were considered more risky as oil prices fell. Indiscriminate selling across the sector saw some funds buy back into issuers with no oil relationship. Similarly, the universal view that a US rate rise would be problematic to emerging markets due to their current account weakness gave way to a considered approach to which countries were indeed vulnerable. The fall in the oil price is generally beneficial for emerging country trade balances and once again, buying when ‘others are fearful’ paid for those funds with exposure to these sectors.
Three of the four major banks reported their half yearly results this week and a quarterly trading update was provided by Commonwealth Bank (CBA). Rather than focus on trends in the sector, at the forefront of the attention was their respective capital positions and how they will deal with an increasing regulatory capital burden.
To refresh, the banks were put on notice late last year with the release of the Financial System Inquiry (FSI) or Murray Inquiry. The report recommended that Australian banks improve their capital ratios to be in the top quartile of all international banks. A further recommendation was to reduce the difference in average risk weights for mortgages across the various authorised deposit-taking institutions in Australia. This could see a potential doubling of the current approximate 16% weighting implemented by the four majors. (A 16% risk weight indicates that an institution is required to only hold 16% of its targeted capital requirements; i.e. the lower this value, the higher the actual leverage in the bank). Overall, it has been estimated that $25-30bn in additional equity would be required to be raised in order to satisfy the proposed recommendations. The issue built up further last week when APRA chairman Wayne Byres declared that the banking regulator may accelerate the implementation of some of these recommendations, including the increased risk weighting of mortgages.
With this backdrop, the banks took differing approaches to address the problem as they reported their results. Westpac (WBC) was first up on Monday, announcing that through its dividend reinvestment plan and the partial underwriting of this, it would raise approximately $2bn. ANZ, however, was more dismissive of any urgent need to raise further capital, pointing to the fact that it was not in shareholders’ interests to do so ahead of any requirement due to the dilutionary impact of additional shares. The bank’s capital position was improved somewhat after it announced the sale of its Esanda vehicle financing division.
National Australia Bank (NAB) instead accompanied its results with the announcement that it would raise $5.5bn from a 2 for 25 rights issue. While NAB faces the same domestic regulatory capital requirements as the other majors, the raising in this instance is more closely related to a problem that is unique to the company, being its exposure to the UK and its desire to exit the market to focus on its domestic business. NAB outlined its plans to proceed with this plan, which will involve a demerger of the business with a partial IPO to institutional investors.
One of the key legacy issues relating to its UK bank, however, has been forced on NAB by the UK’s banking regulator. The regulator has asked for a £1.7bn provision be set aside to cover future potential legacy costs. NAB has noted that the figure is “substantially in excess” of its own stress test scenario and ultimately may be returned to shareholders, although only an optimistic investor would make this same leap of faith. After taking this into account, the ‘net’ capital raise for NAB is approximately $2.2bn, or a similar amount to WBC; additional capital will clearly still be needed over time to meet the new requirements of APRA.
Of the results, a number of observations can be made. Firstly, the tailwind from bad and doubtful debts has now clearly run its course. While each of the majors again showed marginal improvement in their bad debts expense, this has not had the same benefit to overall earnings growth that has been experienced over recent years. Few are predicting bad debts to cycle back to more ‘normal’ levels in the medium term, however, this will be a source of downside risk should the employment market or domestic economy deteriorate, or if we see interest rates rise again.
Major Banks: 1H15 Results Summary
Secondly, while credit growth has shown some improvement over the last 12 months (particularly in business credit), this has been off a low base, with total system growth now just over 5%. We note that a high proportion of mortgage lending has been for investors and that APRA has indicated that they are monitoring institutions who are showing excessive growth in this area. Competition in lending has also increased, leading to a fall in interest margins and impacting overall profitability. Expense growth has generally been high, as the banks battle with growing regulatory and compliance costs.
All of this adds up to a fairly benign 4-5% p.a. expected earnings growth outlook across the sector over the next few years. While CBA and WBC both have a domestic focus (and have generated higher ROEs compared with the sectors), ANZ’s larger Asian operations remains its key differentiator compared to its peers. This much was evident in its half year result, with this remaining a higher-growth opportunity but on the flipside, reducing the bank’s ROE. NAB’s divestment of its UK bank should be a positive for the company, however it remains to be seen whether this will expose any underperformance of its domestic operations.
The pullback in bank equities over the last two weeks has again pushed up dividend yields above 5% (and greater than 7% on a gross basis including franking credits) and while they remain attractive from this yield perspective we believe that valuations are still fairly elevated accounting for this more difficult outlook for the sector.
Macquarie Group (MQG) also announced results, beating expectations with a 27% rise in net profit to $1.6bn. The result was particularly strong considering that the FY14 result had included a contribution from the sale of the company’s stake in Sydney Airport (SYD). While the market conditions in its transactional-based capital markets-facing businesses were better over the last 12 month period, pleasingly it was its annuity-style businesses (asset management, corporate and asset finance, and banking and financial services) that were the foundation for the group’s profit growth, with these divisions showing a 33% increase in net profit. These divisions are a more sustainable source of earnings for the bank and thus should be valued at a higher multiple by the market. They now combine to account for over two-thirds of MQG’s earnings, up from approximately a third less than a decade ago; a clear demonstration of the evolution of the company over this time. The return on equity from these combined businesses is also higher, reflecting a higher quality growth source for the company.
Macquarie Group: Capital and Return on Equity
For the year ahead, MQG expects that its FY16 operating profit will be broadly in line with that of FY15, although subject to a lower overall tax rate. While this outlook may be slightly disappointing to some investors, we note that MQG has been quite conservative in its recent guidance to the market and has tended to update investors on its progress throughout the year. We have MQG in our model portfolios.
The ongoing battle for iiNet (IIN) continued this week when TPG Telecom (TPM) effectively matched the offer put forward by M2 Group (MTU) and secured the IIN board’s approval for the deal. While TPM’s initial offer was cash only, it has now added some flexibility to its new proposal through a cash or scrip option (subject to an equity cap) for IIN shareholders. A further counter-offer from MTU cannot be ruled out, although the probability of this occurring does not appear to be high. MTU has less capacity to raise its offer courtesy of its smaller size and a relatively stretched balance sheet. What is also notable is the possibility that TPM is now free to build a blocking stake in IIN to prevent a competing bid; a strategy which it has achieved in its battle to control Amcom (AMM). Optus may yet also decide to enter the bidding war for what we believe to be highly strategic assets.
An equity conference held in Sydney this week provided one of the last remaining opportunities for listed companies to provide trading updates before the end of the financial year. While some merely present the same story from February reporting season, a number provided further colour on their current operating environment. The risk of earnings downgrades or profit warnings from listed companies is particularly high at this time of the year. Pleasingly, the majority of companies presenting at the conference confirmed their guidance for the full year. Stocks in our model portfolios to confirm their guidance included Asciano Group (AIO), FlexiGroup (FXL) and Transurban (TCL).
Oil Search (OSH), Santos (STO) and Origin Energy (ORG) all demonstrated how they are managing the current weakness in oil prices, while expressing confidence in the future profitability of key LNG operations. For STO and ORG, given the ramp up period of LNG projects, prices over the next 12 months don’t necessarily matter as much as those beyond this period (although cashflows clearly need to be managed carefully as the construction period is finalised).
ORG expects that its share of cash flows from APLNG will approximate $900m p.a. from FY17, based on an oil price of A$100/barrel. Forward curves (see chart below) still suggest that this target may be met, which also illustrates the buffer provided by a weaker domestic currency. ORG believes that every A$10/barrel movement in the oil price will result in an approximate A$200m change in cashflow from the project for ORG, with a cash breakeven of A$55/barrel (which incidentally is well below the current ~A$80/barrel price). ORG is also concentrating its other capital spend on projects with the highest returns and shortest payback periods and is open to the idea of asset divestment if required.
Brent Forward and Spot Curves (A$/barrel)
STO also highlighted that when the oil price falls, operating costs often do as well, providing some protection to its margins. The group’s production costs have fallen 12% in the first quarter compared with its average for the 2014 full year. OSH, which is in a more comfortable position than its peers and is our preferred stock in the sector, is also targeting reduced costs. The company is looking to cut its contracting costs by up to 25% while also adapting through reducing its exploration spend. Importantly, longer-term production growth still remains on the table. Following the step-up of production through PNG LNG initial two-train development, OSH believes that the potential is still there to double its existing production levels by 2021/22.
Unsurprisingly, BHP Billiton (BHP) shareholders voted in favour of the demerger of South32. A detailed summary of South32’s operations and outlook can be found in last week’s Weekend Ladder. BHP shareholders will now receive one South32 share for every BHP share currently held and the shares will commence trading on the ASX on a deferred settlement basis on Monday week (18th May). While those with an optimistic view of a recovery in commodity prices will find better leverage in an entity such as South32, BHP remains our preferred exposure to the mining sector with its low-cost, long-life operations.
Woolworths (WOW) held a much anticipated strategy day accompanying the release of its Q3 sales with the core supermarket division showing a well below-par 0.2% comparable store growth. Big W sales fell 7% on a comparable basis and the Masters’ sales per store are still about half of what is required to make them profitable.
The strategy day was therefore an inevitable mea culpa, with most analysts commenting on management’s willingness to acknowledge failings. Reviving supermarket growth will be challenging. Recent store rollouts for the sector and intentions by Aldi to increase its footprint have resulted in an easier choice for consumers to shift their spending around. Woolworths has to attack from all sides – lower private label prices to match Aldi, invest in promotions to offset Coles, add staff to improve store standards, while also aiming to cut costs. The chart shows the type of customer – price sensitive as well as ‘premium’ i.e. looking for product differentiation and service. To date supermarkets have been frustratingly poor at distinctly servicing each of these subsets, particularly given the rich data they have through their loyalty programmes.
Australian Food Spend by Customer Segment
Both Big W and Masters are making changes to their product assortments which they hope will lift sales, yet their position is precarious in the longer term.
The stock price has fallen sharply over the past year from its high of $38/share. While some will want to bet on improved sales in coming quarters, we are of the view that the medium term outlook is very challenging. Woolworths will not be able to claw back sales without a likely reaction from others in the sector and the possible margin deterioration may take time to play out. The optimists will hope that the duopoly nature of the industry prevents a UK-style outcome where the restructuring is causing some businesses into losses. We are of the view the consumer will increasingly drive the agenda rather than just industry structure.
JB Hi-Fi’s (JBH) sales update was relatively upbeat, with comparable sales growth of 6.6% in the past quarter, in line with the strength in household goods sales released by the ABS. Some will have come from repricing due to the fall in the $A, but clearly is also from the buoyant housing market and a gadget-attached consumer. The business remains one of the best retail options in listed equity, however we prefer Super Retail Group (SUL), as it has a range of business rather than the single focus of JBH. SUL experienced a rough patch in 2014, but we note over a longer time horizon it has comfortably outperformed JBH.
Super Retail Group and JB Hi-Fi: 5 Year Performance (Re-based)
Scentre Group (SCG), the Westfield manager of 47 centres across Australia and New Zealand, provided more colour on the retail sector. Specialty store sales growth improved in the past 3 months to hit 5.8% for the March quarter, with Victoria and NSW particularly robust. The shift in sales growth however is notable with homewares once again, very strong, followed by telco and cinemas.
Scentre Group: Comparable Sales by Category (Australia)