A summary of the week’s results


Week Ending 08.06.2018

Eco Blog

- The Australian economy has worked its way out of the 2017 slump. Weakness in personal consumption is likely to persist given soft wages and fading housing prices.

- German industrial orders slide for the fourth month in a row. Waning economic momentum sits in contrast to the broad-spread uplift of 2017.

- The US consumer has dampened their enthusiasm for more debt to fund spending, in contrast to the sharp rise in the fiscal deficit.

Quarterly GDP releases combine much of what is already known via monthly economic releases, including retail spending, credit growth and investment data. Australian growth of 1% in the first quarter of this year was therefore not a great surprise. The weakest segment is now residential investment and consumer demand is soft, yet the combination of government spending, business investment and exports are maintaining the long-standing circa 3% annual growth rate for the economy. Recently, the now well-imbedded state-based spending sits alongside the healthcare as core to current activity levels. On the export side, LNG is making the most difference. Manufacturing was another area that showed some improvement based on food related investment.

The pace of the Australian economy appears relatively stable at around 3% per annum. This is notably above most other developed countries, but less special on a per capita basis. Without population growth and commodity exports, Australia would closely resemble the maligned nations within Europe.

GDP and national income growth

Source: NAB

The key to a change in pace rests with the household sector. Wage rates have bottomed, yet aggregate income is modest due to the mix in jobs. Savings have buffered the lack of income, with the saving rate now at 2.1%, the lowest since 2007. The other impact will be flow on effects of a housing cycle. If house prices fall more than expected, the perception of wealth fades and spending is often curtailed.

  • The investment implications are in rates, with the RBA still showing no signal that it will hurry to change its position. Within the equity market, structural and company specific factors are outweighing the economic fundamentals. Directly and indirectly, caution on household spending is reflected through many index sectors. Cost reduction and asset restructuring are required.

A further risk inevitably is with the commodity cycle. The relative resilience of resource pricing belies the growing dislocation in emerging economies and some signs the industrial investment trend is levelling off.

Reading the tea leaves of many economies challenges even the most experienced. German industrial orders have declined four months in a row. The weak spot is not from demand outside the Eurozone which is still positive, but rather from a sharp drop within the region. The blame could be laid at the uncertainty caused by political instability, trade talk (with the auto sector hard hit) or quite simply that Germany has such a backlog of orders (nearly six months) that demand has gone elsewhere. The trend, however, will feed back into lower GDP growth and reinforce the view that European momentum has peaked.

The ECB meets on June 14 and undoubtedly the outlook will be front of mind when contemplating its monetary decision. Italy and its political instability is unlikely to change its view, as the central bank would not want to be seen to be reacting to any country’s local issues. Only if there was an opinion that the monetary position was under threat would there be cause for alarm.

In nuancing its monetary policy, the ECB is expected to again reduce its ‘asset purchase programme’ or quantitative easing when the current programme ends in September. By early next year it is likely to pull that altogether and hint at its first rate rise.

US government debt is a dominant feature and will be so for some time given the fiscal deficit. The household sector is showing more constraint, with credit growth easing again in April. The data includes student loans, which now comprise 41% of non-revolving credit (excluding mortgages). This slightly cautious tone contrasts with the hype in confidence surveys and may reflect the understanding that there are three possible outcomes, none of which are attractive. Government largess will have to be pulled back at some point, interest rates rise more than expected or growth will be slower than preferred.

Source: FRB, BEA/Haver

  • Debt driven growth has proven unproductive in the longer run. The US risks adding to cyclicality if it persists down a path of financial stimulus rather than productivity gains.

Investment Market Comment

  • The Dow Jones, S&P500 and Nasdaq are widely followed and may be perceived interchangeable when used as indicators of the US stock market. However, there are major differences between the three index methodologies and weightings, as well as a variation in the performance figures.

The Dow Jones Industrial Average (the Dow) is the oldest of the three, with the first Dow Jones index made up of 9 railway companies, a steamship line stock and a communication company. It now represents 30 large-cap blue-chip companies, selected by a committee. The index is weighted by the prices of its constituents, therefore stocks with higher prices have a greater influence on the performance of the index. For example, this method does not reflect the fact that a $1 change in the $13.80 share price of General Electric is much more substantial that a $1 change in Boeing, which is trading at $368. Of the 30 companies, 10 make up over 50% of the index, which further highlights that the Dow is not an appropriate indicator of the trends within the US equity asset class. Currently the largest weighting is Boeing and its price move accounts for 10% of the index on any given day compared with less than 1% of the movement in the S&P500.

Changing the weights of the DOW from price-weighted to market capitalization significantly alters the composition. Technology would move from 18.6% to 37.5% and would clearly have had an outsized impact on the returns for the DOW.

Dow Jones Industrial Average: Actual Sector Weights, Market Cap Sector Weights and 1-Year Performance

Source: SPDR, Escala Partners

Despite these shortcomings, the Dow has recently outperformed the S&P500. Of the largest companies within the index (Boeing, UnitedHealth Group, Goldman Sachs, 3M and Apple) all except for 3M have outperformed over the past 12 months. These companies represent 35% of the DOW.

2-year growth of US equity market indexes

Source: IRESS, Escala Partners

Conversely, the S&P 500 and Nasdaq Composite are market capitalisation-weighted indexes with a significantly higher number of stocks and a broader range of sector representation. As the name suggests, the S&P 500 tracks 500 of the largest US companies, each with an unadjusted market cap of at least $5.3 billion. Meanwhile, the Nasdaq Composite tracks the roughly 4,000 companies that are traded on the Nasdaq Exchange. Due to the higher weighting in tech companies, the Nasdaq has becoming generally accepted as an indicator of how the technology sector is faring.

  • Since both the S&P 500 and Nasdaq are much more representative of the opportunity set in the US equity market, they should be viewed as the indices to follow, whether it be via an ETF or referencing performance of US equities.

Fixed Income Update

- Australian fixed income performs well in May, with the exception of hybrids

- Emerging market bond funds have large withdrawals, but with this comes opportunity.

- Italian bonds weaken further, as political uncertainty continues.

The political turmoil out of Italy favoured defensive assets such as Australian bonds, as a ‘risk-off’ tone lowered bond yields throughout May. ACGB’s were the best performing sector, with returns of 0.88%.  Corporate debt was also positive following the rates move, even as credit spreads widened somewhat. Floating rate notes returned 0.16% without the benefit of duration. These corporate bonds are set off the BBSW rate which eased back in May after reaching a seven year high in April versus the cash rate. However, the still elevated BBSW contributed to the outcome.

There is no formal benchmark to measure performance of listed bank hybrids and subordinated bonds, although CBA’s in-house index shows an underperformance in May of -0.20%. The fall out from the Royal Commission (weighing on AMP securities) and risk off sentiment emanating out of Europe have impacted on prices. Despite finishing the month lower, the market has been broadly range bound over May, with 5year bank hybrids moving between offering a spread of +3.75% to 4%. Shorter dated hybrids (less than 1 year) offer an opportunity to pick up a spread of +300bp with an expected maturity early 2019. In our view, these offer more value given the short time frame, however, we acknowledge the reinvestment risk this can pose.

Monthly change in Australian market indices

Source: CBA

  • Within our asset allocations we recommend a blend of fixed income funds and directly held hybrids, resulting in varied duration and credit exposures. Positive performance from the Australian fixed income funds offset the weakness in directly held hybrids over the month.

Recent global developments have not boded well for Emerging Market (EM) debt, with approximately $6 billion leaving EM bond funds in May. A combination of reasons are cited, including funding pressure in Argentina, inflationary concerns in Turkey, signs that South Africa’s economy shrank the most in 9 years, and government reform challenges in Brazil. Outside of the region, the strong USD, renewed talk of US tariff threats and political uncertainty in Italy have led to selling pressures on EM currencies. The higher nominal yield remains relatively attractive and flows can quickly reverse should conditions settle down.

Emerging Markets Investment Asset Flows

Source: Institute of International Finance

  • Opportunities potentially exist for this sector as all countries in EM tend to get sold off together. Goldman Sachs and Franklin Templeton are two participants that have identified value in countries such as India and South Africa where they are of the view that the market has indiscriminately sold them down as contagion takes hold.

Following on from last week’s focus on Italy, we note that Italian debt has fallen further in price with the yield on Italian 5year government bonds up ~0.40% and the 10year 0.30%. Surprisingly, pricing on credit default swaps, (the cost of insuring against a default on the 5year Italian govt bond) has edged down over the same period, with it costing 2.37% to insure versus 2.69% a week ago. This is perhaps an indication that the market is demanding a higher spread on the cash bonds given the volatility risk, but at the same time has scaled back the probability that the bonds will actually default. Last week we commented on the flight to US treasuries following these political issues in Italy. This trade has been reversed in recent days as yields on US treasuries have drifted higher, albeit, the 10 year is still sitting below 3%.

Corporate Comments

- The investment case for CYBG (CYB) is potentially changing from cost-out to accretive acquisition activity. The upside is greater, but so are the risks.

- Adelaide Brighton (ABC) has a fairly bright outlook over the next few years, driven by its east coast infrastructure exposure.

- Wesfarmers (WES) has dialled back any acquisition expectations following its foray into the UK home improvement market. There are several challenges across its range of businesses.

NAB’s UK banking spin-off CYBG (CYB) this week rallied on the news that the company had submitted a revised proposal for its challenger bank peer, Virgin Money. The new proposal similarly valued following weakness in CYB’s share price through most of May. The deal is significant in size; the all-script offer would leave Virgin Money shareholders with just over a third of the combined entity. Additionally, it would become the clear leader from a scale perspective compared with the big five national banks in the UK.

While a deal is yet to be formalised, CYB’s rise this week is likely on the back of the substantial synergies that could be realised following the integration of the two businesses. CYB have highlighted that savings should be achieved via removing duplication, optimising IT spend, rationalising the two banks’ operations and in central procurement and third-party outsourcing costs. Revenue synergies are a further possibility, although are more likely to be considered as optionality value by analysts.

There are clearly integration risks that would arise, however, the positive view taken by the market has been premised on the earnings per share upside from a successful takeover. Various estimates have put a figure of up to 30% EPS accretion and an improved ROE from a more efficient cost base.

The deal would also change the investment proposition of CYB, which has been primarily driven by the large cost out opportunity after being divested from NAB. CYB has been making solid progress on this front and reducing its cost to income ratio to the ballpark of its competitors would lead to a significant improvement in the bank’s profitability. There are other catalysts that could evolve over the next 12 months. This includes receiving accreditation for its mortgage portfolio, which would allow a sizeable capital release to shareholders, a factor which is not yet in most forecasts.

With the domestic banking sector facing numerous headwinds for earnings growth and greater regulatory and political scrutiny in the wake of the Royal Commission, we believe that CYB remains an attractive option for investors given the success it has had, and should continue to make, on its self-help initiatives. A lack of any dividends has a deterrent for some investors through its short history as a separate listed entity, however dividend payments are expected to commence within the next 12 months. The acquisition of Virgin Money could potentially enhance CYB’s earnings profile further, albeit with the introduction of a higher risk factor from M&A activity.

Adelaide Brighton (ABC) hosted an investor day, reiterating a fairly positive outlook for the company. The building and construction materials group, which has leading positions in cement, concrete and lime, is forecasting strong conditions across the east coast markets of Australia.

As we have highlighted before, the key factor underpinning the group’s outlook is the non-residential construction market, with a large pipeline of infrastructure projects. The peak of this investment is likely to be in 2020 given the multi-year build time and therefore there is a relatively high level of certainty in demand and pricing conditions over the medium term.

Adelaide Brighton Demand Environment

Source: Adelaide Brighton

The medium-term risk is a sharper than expected downturn in the Australian housing market. The base case consensus assumption is that housing starts will gradually decline over the next few years, supported by only modest increases in mortgage rates and ongoing migration growth. Additionally, like many manufacturing companies, ABC is dealing with high cost inflation (particularly with energy costs) although much of this is expected to be passed onto its customers.

On balance, ABC remains one of the better exposures to the growth in east coast infrastructure spend in Australia though much is factored into the company’s valuation, trading on a forward multiple of 20X. Compared to many other domestic stocks with a respectable earnings growth outlook, a forward yield of 4% provides appeal from an income perspective – we note the stock has been held in our Martin Currie SMA portfolio.

Another company that has some dependence on domestic housing activity is Wesfarmers (WES), which conducted its annual investor briefing this week. The key takeaway was the preference to return any excess capital generated to shareholders, rather than pursue M&A activity. The group’s capital management priorities should not come as any surprise, particularly given the recent disastrous entry into the UK home improvement market (via its acquisition of Homebase) and swift retreat once it was obvious that the expected profit was not materialising. While the exit may have saved shareholders from further potential losses into the future, it has no doubt impaired WES’s reputation as a superior allocator of capital across a range of different industries.

With acquisitions off the agenda, the attention will again turn to WES’s existing suite of assets. The stock has already had a positive bump from the decision to demerge Coles (WES is expected to retain a 20% minority shareholding) and while its more recent sales growth has been improving (assisted by the cycling of easier comps) there remain challenges ahead. Capex is expected to step up again in FY19, reflecting a declining rate of investment in the last few years, while its new 40% private label penetration target (over the next five years) could increasingly blur the lines between its offering and that of upcoming rivals such as Aldi.

Bunnings remains the one reliable generator of improving earnings and returns, although a peaking of the housing cycle is likely to see sales taper. Discount department stores are mixed; Kmart has been performing well, with plans to expand the store footprint, while Target is lagging and will see its network “optimised” (i.e. stores closed). The current standing is a reversal of the fortunes of the businesses from the previous cycle but does not acknowledge the key issue -  the oversupply of the format in Australia.

All of this, in aggregate, adds to a fairly benign growth profile; in the mid-single digit EPS p.a. over the next three years. Nonetheless, this tilt towards additional capital returns will be favoured by investors with a shorter term investment time horizon but possibly be to the detriment of longer term capital growth. The stock is trading back towards the top of its more recent P/E range, now on 18X forward earnings.