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WEEKEND LADDER

A summary of the week’s results

08.07.2016

Week Ending 08.07.2016

Eco Blog

Have central banks run out of options? The role of quantitative easing was to stabilise and lower interest rates so that business and households would be encouraged to make spending decisions, knowing their cost of debt capital would be managed by the central banks. A repercussion of such an outcome would be from the basic tenant of economics. Rising demand would increase prices and take inflation to the desired level.

That has not happened and the question is therefore, what other options are there? Unlike the central bank bond purchases to influence the direction of rates, money printing would be intended for spending purposes; for example, infrastructure or cash payments to households. This is essentially a fiscal decision, but by co-opting the Treasury function. Some are speculating that Japan may capitulate to such an outcome, an experiment that when tried before, has had unattractive consequences.

Italy is the new problem in Europe. Few would be unaware of the source of its malaise. Unhelpful labour relations, sloppy tax collection, fiscal ill-discipline and largely dysfunctional politics are only some of the issues raised. Without the Euro, the currency may have borne much of the brunt, but it is debatable whether it would have dealt with the structural challenges.

The banking problems in Italy did not, unlike most others, emanate from a housing bubble. If they had, it is possible some of the issues would have been addressed earlier. Much of the lending is to the corporate sector, dying manufacturing industries and often driven by political interests. The banks, in turn, sold risky debt to the general public, who have been lulled into the belief these were safe, tax-effective investments. Any suggestion that they may lose some of their capital is unlikely to pass muster.

The concept of a ‘bad bank’, or a structure that can take on bad loans and work through them, has been helpful in many other circumstances. In Italy, however, bankruptcy drags on for an average of seven years, compared to three for the EU. A state rescue is unpalatable to the rest of Europe. That said, the rules may well adapt. At this stage it looks like the European Commission may allow some state support, while requiring institutional investors to be bailed in (in other words lose some, or even all, face value of the bank debt they hold). Retail investors may, up to a limit, be protected.

While this is the current headache in European financial markets, Italy will vote on a referendum in October intended to curtail the power of the Senate. If it does not pass, the current Prime Minister, Renzi, has stated he would resign and likely plunge Italy into a problematic period given the rise of alternative style parties.

Many European banks remain under intense pressure. The US banking units of Deutsche Bank and Banco Santander failed most recent review of US bank stress tests and the IMF noted that Deutsche posed a threat to the global financial system; mostly a function of its size and risk management.

Why does this matter for Australian based investors? The obvious is that any global instability is not good for economic growth and the corporate sector. Specifically, the ongoing risks in the financial sector are likely to push up the cost of funding for banks and other institutions reliant on wholesale investors.

Ironically, many indicators to date have been positive for the Eurozone. Unemployment has been moving down uniformly across the region, retail spending has been solid and manufacturing activity picked up in Q2. With Brexit and now Italy, it is more than likely these trends will reverse in coming months and global growth will depend more on the US and emerging economies. Helpfully, the US composite index of non-manufacturing activity recovered in June, a good sign for forthcoming employment data. What trends evolve in coming months, given the degree of potential political instability, is going to have a marked impact on financial markets.

Australian retail spending for May was weak, registering 2.4% year on year, its lowest growth rate in three years. Food retail was only up 1.1% compared to the same month last year, verifying the deflationary trend that is impacting on profit margins. Seasonally adjusted data suggests the slump is more of a slide and May’s very poor outcome is likely due to the number of weekends (5 in 2015 versus 4 in 2016). Nonetheless, consumers are at best paddling along, enjoying the lower food costs but disinclined to spend elsewhere.

Australian Retail Sales: Year on Year Growth

Source: ABS, Escala Partners
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The trade deficit widened in May, now recording its 25th monthly deficit in a row. While resource exports have bounced back somewhat given the recovery in commodity prices, imports have persistently risen. All manner of capital goods and intermediate capital (parts and industrial supplies) reflect the fall in the local manufacturing base as well as the capital intensity of the LNG projects. In the current climate, the debate on what kind of manufacturing can be sustained in Australia has again come to the fore.  Inevitably, the persistence of the strong AUD until the past few years was an important factor. On the other hand, scale was never going to be a competitive advantage and while the demand for mining-related equipment is high, the relatively low degree of complexity and higher costs here disadvantaged local production.

Can service exports plug the gap? Prior to the sharp rise in the AUD associated with the commodity boom, the service impact on the trade data was largely in balance. Services prices tend to be sticky and the currency is the basis for the bulk of the movement.

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The ABS categorises service exports into three components. The largest is travel services (which excludes the transport component) comprising tourism, business travel and education. Education is the biggest of the three, and along with tourism, is growing strongly, a function of the lower AUD and underlying trends. China is key to both these services, with demand still in its infancy. The trade surplus in travel is therefore likely to rise.

The second component is business services – consulting, financial and technical. While the growth has been good, imports of these services have also grown and there is an overall deficit in this area. 

Transport (essentially airline travel) runs at a trade deficit, unsurprising given the number of foreign airlines.

Service trade may give some breathing space to the trade deficit, but is highly unlikely to close the gap. LNG exports will help, but at the end it is the goods sector that will have to make a larger contribution. This means less imports, a lower AUD and/or more value added exports; all a tough assignment.

Fixed Income Update

The RBA disappointed markets somewhat this week by not including an explicit easing bias at their July meeting, however, a slight softening of language has kept an August rate cut ‘live’, with any moves by the RBA likely to remain data dependent. The front end of the futures curve remains inverted, highlighting the market’s expectation of further rate cuts this year. However, interestingly, the rates curve on term deposits is positive meaning that banks are paying up for this type of funding, seeking out longer maturities despite the fact that rates may be lowered within that time frame. The spread offered over the forward curve increases with the term. This is indicative of the competition amongst banks to attract a strong deposit base, and reflects the increase in funding costs this sector is facing as bank credit spreads have increased this year. The table below highlights the disparity in the futures market pricing and the rates on offer for term deposits by the major banks.

Source: Bloomberg, Escala Partners
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There has been more ‘risk off’ sentiment in global markets in the last week. Following the Brexit vote, the latest issue to arise has been a freeze on redemptions for retail investors in some UK property funds. This has spooked markets, despite the core problem arising from offering a high level of liquidity from an illiquid asset class. Out of Europe, anxiety has also arisen over debt problems that the Italian banking sector is facing, which has resulted in a large sell off in Italian bank bonds across the capital structure.

The effect has been a clamour for safe haven government bonds as markets look to central banks to ease monetary policy further. Switzerland’s 50-year bond yield fell below zero for the first time, German and Japanese government bonds traded in negative territory out to maturies of ten years, while the US 10-year Treasury yield fell below 1.36%, the lowest rate on record.

Domestically, the rating agency Standard and Poors has downgraded Australia’s credit rating to ‘AAA outlook negative’ from AAA stable. This followed the election uncertainty and concerns on the ability to manage the budget with an expectation that the debt to GDP ratio will increase.  Despite this, our government bonds remain at low levels. At the time of writing, the Australian 5 year government bond is trading at a yield of 1.60% and the 10 year at 1.88%. A depiction of our yield curve is illustrated below

Australian Yield Curve

Source: Iress, Escala Partners
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Government bonds are posting strong gains as yields fall and prices rise, however, credit spreads have also remained relatively stable recently, also aiding the performance of corporate bonds. Domestically, increases in credit spreads was evident following the Brexit vote and the failed election result, however on both occasions the market quickly recovered with spreads back to levels of two weeks ago. In addition to the revision of our sovereign rating, S&P placed the Australian banks on negative outlook. As a result, we may see some credit spread widening in the coming days. Funding costs for the banks will rise if our sovereign rating gets downgraded as they receive an implicit support from the government’s AAA rating, and the loss of it will also lead to a downgrade in the banks’ rating.

The new Westpac Bank hybrid has had a good start to trading, posting gains in its first week. The 5.5 year, tier 1 security has traded above $100 (par) every day since it launched last Friday. The new NAB 6 year, tier 1 bank hybrid commenced trading on the ASX today. With bonds and credit both performing well in June, the following table highlights the performance of key indices over this period.

Source: Bloomberg, Escala Partners
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Corporate Comments

Treasury Wines (TWE) provided confirmation of its FY16 EBITS (‘S’ is self generating and regenerating assets, intended to accommodate agricultural assets) would meet investor expectations. It also announced the sale of some brands from its acquisition of Diageo assets at book value and stated that the fall in the GBP would not impact through to FY17 as it had hedging in place.

After a troubled time a few years ago, TWE management focused on cost reduction while consolidating their product into higher end pricing (A$15+). The successful strategy has been followed by the Diageo acquisition along with strong demand growth from China. In turn, the stock has soared, and is now sitting on a near 30X forward multiple, too rich in the view of most analysts.

The NSW Government’s decision to ban greyhound racing from July next year has hurt the outlook for Tabcorp (TAH), although the overall impact is not overly material. NSW greyhound racing represents approximately 5% of TAH’s total wagering turnover, however it is unlikely that all of this revenue will be lost. The most probable scenario is that the lost wagering expenditure will partially migrate to other betting options, whether it be thoroughbreads, harness or other sports, limiting the earnings drag in future years. Tatts Group (TTS) will also be affected by this decision, although wagering is relatively a smaller part of the group’s overall business.

At this stage, other states, including Victoria, Queensland and South Australia, have all stated that they will not seek to ban greyhound racing in the future, although this regulatory risk would be expected to remain over the industry. Regulatory and political outcomes remain the key source of potential risk to stocks across the wagering and gaming industry.

In our model portfolios we have had a holding in TTS with its high quality, defensive growth characteristics. TAH, while enjoying a strong tailwind of increasing wagering turnover through the growth in sports and the migration to mobile phone based betting, is faced with a greater level of competition from online-only operators. A potential merger between TAH and TTS could also be revisited in the near future, with the parties walking away from discussions late last year. The synergies from a tie-up are viewed as significant by most analysts.

AGL also disappointed investors with an update this week on its earnings guidance for FY16 and FY17. Despite noting that it expects to take a $100m hit to pre-tax margins (approximately 10%) in FY17, the stock closed just 2% lower. The reaction reflected the relatively short-term or one-off nature of the issues that AGL highlighted, which revolve around the company’s short gas position in Queensland as a result of some problems at a key supplier project. Some margin compression was already forecast to occur in the next couple of years as AGL’s low cost legacy gas portfolio position rolls off.

The key driver for AGL in the next few years is expected to be the step up in prices that has occurred in the wholesale electricity market. With hedges typically employed by AGL, the benefits from an increase in wholesale electricity prices will likely flow through with some delay. A stabilisation in residential electricity demand is another factor and a challenge that AGL and Origin have faced for a number of years.

The group’s cost out program adds an element with a higher degree of certainty in a market that is typically quite volatile in nature from a price perspective. As a result, despite this week’s announcement, AGL is still guiding to earnings growth in FY17, which would follow a double-digit growth rate in FY16. Trading on a forward P/E of 16X, AGL screens as reasonable value compared with other large cap stocks that currently offer limited earnings growth.

Change in Residential Electricity Demand per Customer

Source: AGL
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Australian Equities: FY16 Review and the Year Ahead

While equity returns in FY16 were relatively disappointing, the returns of the benchmark ASX 200 Index were dragged down by two key sectors – resources and financials (excluding property trusts).

The four major banks (which collectively account for nearly a quarter of the index) have been restricted by several issues over the last year, including higher capital requirements and rising bad debts. Resources have led the rally in equities in recent months, although have only clawed back part of the losses prior to this.

The tougher environment that the two largest sectors have faced is similar to many large-cap stocks that form the core of the ASX 200. Other blue chips (which are well represented in funds and investor portfolios) which this description could apply to would also include Telstra and the two major supermarket companies, Woolworths and Wesfarmers. Investors would have been better rewarded seeking opportunities in the small and mid-space of the market, and this would appear to again be the case in the medium term.

Health care was again among the strongest sectors, driven by a mix of earnings growth, the increasing premium attached to these companies and a weaker $A. CSL is a core component of this index and hence the rally in this stock’s share price has driven overall returns. Consumer discretionary also had a large number of individual stocks that generated strong returns, including several retailers and gaming stocks.

S&P/ASX 200 Sector Total Returns in FY16

Source: Iress, Escala Partners
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So what were the themes that drove investment returns for the year? A number can be identified:

- high, defensive yield sectors (such as property trusts, utilities and infrastructure) and stocks again produced solid returns. While underlying earnings growth across several of these sectors has been low (e.g. listed property trusts), earnings multiples have continued to expand. Key infrastructure companies have shown a greater capacity to lift distributions, helping these stocks to outperform even further.

- there was a noticeable shift from quality higher growth stocks, which generated strong performance in the second half of 2015, to a rebound in value, which staged a recovery since February.

- despite participating in the value recovery to a large degree, resources still failed to produce positive returns for the financial year.

- housing-related companies generally fared well, such as James Hardie, Fletcher Building and Stockland.

- the $A, while now essentially flat year-on-year, was again a tailwind for reported earnings for many large industrial companies which were cycling a tougher currency environment. Many of these companies have also reported stronger earnings growth relative to the broader market, adding to investment returns.

Looking ahead, it is harder to identify clear themes for FY17, with many of the drivers listed above maturing. Of note:

- the $A, while volatile over the last 12 months, is now trading at a similar level to July last year. A case can be made for our currency to fall further in the medium term if inflation remained benign, commodity prices cooled and the Federal Reserve starting lifting rates again. The most likely scenario, however, would see the $A continuing to be range-bound and no longer provide the uplift to international earners.

- the yield trade could extend further, particularly if interest rates were to decline further. The consensus here is that these sectors have already re-rated to a large degree and stocks will need to be supported by earnings and/or dividend growth. At some point in time, rising interest rates will become a headwind for the large number of companies exposed to this theme, however it would appear unlikely that a swing in the near term is imminent. The yield gap between interest rates and equities should provide somewhat of a buffer.

- the domestic housing cycle has been particularly strong and is likely to have peaked in terms of activity. Companies exposed to this sector should find it harder to achieve the rate of recent earnings growth.

- while commodity prices have bounced off recent lows, the key commodity markets typically remain in a low-growth/well-supplied situation and therefore sustained positive performance across the sector is unlikely. Key commodities include oil, iron ore, coal and copper.

Outside of long term structural themes that are present, what could provide some upside to overall equity returns? The following factors generally have a low overall exposure for the Australian equity market, although the prospect for better earnings growth is a positive for a number of companies from a cyclical perspective:

- with the $A now settled in a lower trading range, inbound tourism should be robust and there is some disincentive for Australian consumers to travel abroad instead of within Australia. Airports, accommodation providers and gaming and entertainment stocks have a supportive backdrop.

- some select commodity markets have better fundamentals than the core commodities listed above. Gold is one such commodity, benefiting from the Fed’s inaction and general uncertainty across investment markets. While valuations across the sector appear relatively stretched, the sector has momentum and positive sentiment. The lithium market has progressed rapidly in the last 12 months and the theme of electric cars and household energy storage has some merit.


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