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WEEKEND LADDER

A summary of the week’s results

08.09.2017

Week Ending 08.09.2017

Eco Blog

Japan is proving a different set of lessons than many had envisaged. The structural challenges have, at least for the moment, given way to a growth path that may be more sustaining.

US uncertainty will linger with a 3-month extension to the debt ceiling and further Fed member changes.

Canada once again tightened monetary policy citing global growth.

Industrial companies may yet see another leg to their earning cycle.

GDP growth improves but not enough to change monetary policy.

- Consumers to constrain growth going forward but infrastructure and trade are bright spots. 

International Eco News

There has been much comment on the strength of the European recovery and the movement in the Euro, which is up 13% against the USD this year to date. But the prize for economic growth in the second quarter went to Japan, occupying the top spot in the G7 economies. The magnitude is even more notable in that the quarter alone represents about the annual average of Japan since 2010.

For a long time, the cynics have pointed to Japan’s demographics - high debt, low wage growth and lack of inflation - as an economy on its way to oblivion. There were even articles (‘are we all Japanese now’) implying that its fate was so dark that we all should be concerned on heading in the same direction.

The other side of Japan has now put that to rest. Japan saw a startling 28m tourists in the year to June (annualised and seasonalised), equal to 22% of its population. Capital spending was up 6% in the second quarter, reflecting improving demand for its goods and an acceleration in automation, a sector where Japan excels. What is missing is a stronger Yen, which should have followed the Euro path. Short positions in the Yen remain in place. Some of this may be from those betting the trends cannot last, it may be a judgment on geopolitical risk in the region, but also may be a ‘risk on’ bet and the Yen is a textbook currency in risk averse times as a safe haven.

For an economy with a falling labour force, wage growth is subdued, reinforced in data this week with full time total income up less than 1%, while part-time hourly wages rose 2.9%. One of the cited reasons for low wage momentum is the return of older workers. A survey shows that this is due to a desire to participate in work rather than a shortage of income. In turn, these workers are willing to work part time and are holding back the wage growth for full time employees. 

Annual Change in Employment by Age (12mth ma)

Source: Statistics Bureau, April 2017
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The big problems have not gone away. Japan’s debt is unsustainable, though as the central bank is holding much of it, it is effectively monetised with no discernible impact on the economy. Yet for the moment some of the business sector is being revived by better management as the intriguingly constrained, but also imaginative, corporate ethos finds a productive outlet.

In the US, short term events had a modest impact on markets. The debt ceiling was extended for 3 months to allow for funding for the Hurricane, but that means the debate will return later in the year. The resignation of Stan Fisher from the Fed, who was widely seen as close to Yellen, adds another layer of uncertainty. Over the coming year the Fed will be dominated by new members and with a view the current administration will be dovish, bond markets many find it difficult to establish a fundamental framework. The interaction of low inflation, solid labour markets and cyclical recovery in growth sends mixed messages about the likely path of rates.

North of the US border, Canada surprised markets again by lifting the overnight cash rate to 1%, coming after a rise in the official rate only a few months ago. Most believe Canada is now on a tightening cycle, in contrast to the reticence of other developed world central banks. The rationale was stated as the ‘synchronised global expansion’ following a more traditional playbook on rates than elsewhere. The evidence for this growth is consistently reinforced in the data, with manufacturing activity at its highest point since 2011.

Manufacturing PMIs

Source: Nordea Markets & Macrobond
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While central banks are equivocating on economic health, the activity levels are at least somewhat supportive of equity markets and potential profit momentum as these sectors gain leverage to the trend.

Local Eco News

It was a big week in terms of domestic economic news with second quarter GDP, balance of payments, operating company profits, July retail sales, trade balance numbers and August PMI data released to the market. Second quarter GDP grew at +0.8%, much better than the weather-impacted first quarter (+0.3%), but a tick below expectations of 0.9%. This resulted in annual growth of +1.8% (unchanged from the previous quarter). Below is a summary of the main GDP components and their impact on growth. 

Australian Second Quarter GDP Breakdown

Source: Australian Bureau of Statistics
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As you can see, public capital investment and consumer spending were the two drivers of GDP over the quarter, while trade, dwelling investment and private investment in machinery and equipment also made positive contributions. Offsetting growth were a fall in non-dwelling construction and changes in inventories (driven by a run-down in grain). On the surface, this was a reasonable result. If repeated in the third quarter, annual growth will move up to 3% (noting that third quarter 2016 activity showed a contraction).

Looking forward, contributions from the consumer sector, the largest component of GDP, and dwelling construction are expected to moderate.  The consumer expenditure figure was unsurprising, given strong retail sales data in April (+1.0%) and May (+0.6%).  This is encouraging as it indicates confidence, but given low wage growth, consumers had to dig into savings to maintain this level of consumption. (Note that the household saving rate fell again from 5.3% to 4.6%.)  In other words, wage growth will need to rise for the rate of consumption to continue at the current pace and it is difficult to see wage pressures in the near term. 

Recent retail sales data have been more subdued, with June rising 0.3% and July showing no growth at all.  Building approvals also suggest dwelling construction will moderate over the next year and the August PMI Construction Index indicated that future orders for apartments are contracting. On the bright side, infrastructure is expected to continue to contribute to GDP growth with engineering construction registering continued strength within the PMI Construction Index and the pipeline of projects (as we have highlighted in previous issues) looking strong.  We note, however, that despite infrastructure helping to offset the slack from housing construction, infrastructure projects are less labour intensive and therefore unlikely to have a positive impact on wages and jobs growth.  On balance, the GDP figures provide nothing to suggest a change in monetary policy in the near future.

The balance of payments (which measures the value of transactions between Australia and the rest of the world) worsened during the second quarter to a deficit of $9.4 billion (from a revised deficit of $4.8bn in the first quarter). The primary reason for the deficit deterioration was international trade, where our key commodity exports (iron ore, coal and natural gas) all experienced price weakness over the quarter. The result was essentially ignored by the market, given a strong rally in commodity prices post-quarter end, with iron ore, for example, rallying 27% from June to August. The fall in commodity prices also impacted operating company profits, which were down 4.5% over the June quarter, in contrast to +5.8% in the March quarter.  We expect the September quarter to be a stronger month for trade (export value less import value) and company profits.

Fixed Income Update 

European bonds rally and the EUR currency strengthens on the back of the ECB September meeting.

Large inflows into US treasuries push prices higher as yields reach their lowest level since before the US election.

A flattening of the US yield curve threatens the profitability of the US banking sector.

- Emerging market and frontier sovereigns take advantage of favourable debt issuing conditions. 

The European Central Bank (ECB) made no change to monetary policy settings at the September meeting this week, keeping the deposit rate at -0.4% and the bank’s refinancing rate at zero. President Draghi said in his accompanying statement that the governing council had a “very preliminary discussion” about how to unwind its Quantitative Easing Program in which the central bank purchases €60 billion of bonds a month. It is expected that the ECB will outline details for the unwind in the October meeting, as improvements in the European economy and lack of eligible bonds to purchase will be catalysts for the tapering.

Also in the statement:

• Draghi stated that low interest rates would remain in place beyond QE, indicating that a rate rise was unlikely before 2019.

• The central bank lowered its projections for inflation, although Draghi stated that he expected it to hit above the central banks 2% target by 2020           

• Concerns were expressed regarding the rise of the Euro currency which could dampen the Eurozone’s economic growth as exports become more expensive.

Post the meeting, European bonds rallied across the board with the peripheral countries of Spain and Italy outpacing that of Germany and France. The bond rally was fuelled by the central bank’s concerns regarding the continued strength of the Euro which caused bond markets to price in a prolonged QE unwind. Immediately following the meeting, the EUR strengthened to a near 3 year high against the USD and an 8 year high against the British pound.

EUR Currency Appreciation Against the USD

Source: Thompson Reuters
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Perhaps one of the biggest surprises for rates this year has been the movement in the US treasuries in recent months. With three interest rate hikes by the US Federal reserve bank in the last year and talk of a reduction in its balance sheet, one would expect US rates to be higher than where they currently reside. Low inflation has perhaps been the most dominant cause of rates not pushing ahead, but in the last two weeks rates have fallen further. Hurricane Harvey hitting landfall in Texas, the imminent Hurricane Irma approaching Florida and the escalating tensions with North Korea have weighed heavily on yields in the last week pushing treasury prices higher. The yield on the 5 and 10 year US treasuries are trading at their lowest levels since November 2016 which was before the last 3 rate hikes. 

The recent moves have led to a flattening in the yield curve. The spread differential between the 2 year and 10 year treasury bonds is at its lowest level in a year. This impacts the profitability of banks who profit from borrowing in the short end of the curve and lending at longer term rates. The borrowing and lending rates are benchmarked off the treasury curve, and while this will play out as an equity story, it highlights the relationship between the bond market and the performance of the banking sector.

Spread Differential Between 2 Year and 10 Year US Treasury

Source: IRESS, Escala Partners
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Emerging market sovereigns have been the recipients of strong investor demand for high yielding assets in the last 12 months, pushing spreads lower and opening up markets for new entrants. This week, Tajikstan raised $500m in an inaugural 10 year international bond at a fixed rate of 7.125%. This follows on from Belarus issuing a 10 year deal at 7.625% and Iraq raising $1billion for 5 years at 6.75%. Market talk is that the Ukraine is also preparing to issue its first USD denominated bond in 4 years. Moody’s has just upgraded the sovereign from to Caa2 from Caa3, with a positive outlook. In making its decision the rating’s agency noted Ukraine’s “structural reforms that, if sustained, are expected to improve government debt dynamics”.

Corporate Comments

On a total return basis, the ASX200 performed broadly in line with its major global peers, however, August’s full year reporting was relatively underwhelming.

Results from the resources sector was the highlight of the reporting season, with most companies reporting solid cash flows, strengthened balance sheets and higher dividends.

Dividends across the market generally held up quite well, with the payout ratio higher than analysts’ forecasts.

- A reasonably weak reporting season was partly due to weak guidance provided by companies for FY18.

August’s full year reporting season for the Australian market was, on balance, relatively underwhelming. Despite this being the case, any negative investor reaction to results was relatively muted; on a total return basis, the ASX 200 performed broadly in line with its major global peers. Below we discuss some of the key takeaways for the month.

Strong Earnings Growth for the Market

At face value, the aggregate earnings growth for the market at approximately 20% would appear to be a relatively strong figure, which was largely in line with expectations leading into August. The number of companies meeting or beating expectations was marginally below the average of recent reporting seasons.

Total earnings growth, however, was boosted by a sharp rebound in resources earnings, which more than doubled and were cycling what turned out to be a low point across most commodity prices in early 2016. The results from the resources sector was undoubtedly the highlight of the reporting season, with most reporting solid cash flows, strengthened balance sheets and higher dividends. An additional pickup in commodity prices through the month provided a further tailwind for the sector, although many remain cautious as to the extent of the rally into FY18.

Earnings from industrials were more mixed, although on aggregate, it was a further year of benign mid to low single digit earnings growth. Revenue growth for industrial stocks was better than in FY15-16 at around 4%. Offshore companies had to rely less on a depreciating exchange rate which had aided profit growth of recent years, while there was an absence of the mining services-related drag and large one-off declines (such as Woolworths in FY16) on overall earnings. Companies with leverage to the housing sector again generally reported quite well, although there is broad consensus now of a maturity of this theme.

Financials had their pockets of strength, although the insurance sector was a key disappointment for investors. The banks largely showed better trends, although this was perhaps of poor quality, with low revenue growth and earnings driven primarily by even lower bad debts. While Commonwealth Bank’s result was consistent with this trend, its performance over the month was overshadowed by allegations that it had breached anti-money laundering laws.

Dividends and Capital Management

Dividends across the market generally held up quite well, with the payout ratio higher than was forecast by analysts. As with earnings, the major sector to lift the market’s dividends was resources. Notably, however, in many cases the rise in resources dividends failed to lift dividends above levels of FY15 after a significant rebasing occurred in FY16 after the large diversified miners abandoned their progressive dividend policies. Despite a more supportive energy market, Origin Energy and Santos both elected for further balance sheet repair over the reintroduction of dividend payments.

Telstra was the latest and most high-profile company to cut its dividend as it faces a large earnings gap to cover in coming years as the NBN transition continues. While a dividend cut was viewed as inevitable by most at some point in the future, the surprise for some was how soon this will take place.

Share buybacks remain a priority for many companies over investing for growth. Buybacks that were either announced or extended through the month included from QBE Insurance, Coca-Cola Amatil and Treasury Wines. Companies that fell short of expectations on capital management, however, included CSL and AGL Energy.

ASX200 Payout Ratio

Source: Datastream, Deutsche Bank
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Guidance Weak

The major reason that reporting season has been viewed as weak is due to the guidance that companies have provided for FY18, which, in many cases led to downgrades. The trend was most notable across a range of industrial stocks, with earnings for the next 12 months downgraded by approximately 2%. In some cases, the share price reaction was quite severe, from cyclical turnaround companies like BlueScope Steel to the derating of high-growth stocks, such as Domino’s. Several companies also posted guidance that was below expectations, although managed to maintain their market valuation premium, CSL being a prime example.

The overall disappointing guidance for FY18 has been somewhat surprising given that it stands in contrast to improving business conditions surveys of recent months. The negative revisions to FY18 earnings was, however, contained by resources and banks; the former on the back of a renewed uplift in commodity prices in the month, and the latter on better trends in bad debts.

The Energy Conundrum: from Coal to Lithium (and in between)

Electricity prices have been on most household’s minds of late. The issue has had more airplay than ever since the SA blackouts, with energy costs related to both gas and electricity having increased dramatically since 2015.

Average Electricity Prices 

Source: AEMO
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The critical problem with electricity pricing has been the lack of new base-load generation capacity coming on stream into the Australian market. In fact, generation capacity from traditional sources (coal and gas) has reduced – the main culprit being the closure of the Hazelwood plant in Victoria (5% of the nation’s baseload power capacity, and 25% of Victorian demand). The closure was signalled late last year for a March 2017 close date.

While other sources of electricity generation have come online, they are not baseload (e.g. accessible at all hours of the day at an efficient price cost). As an investor, how do you benefit from this thematic?

AGL Energy is currently best positioned, with excess electricity generation capacity (relative to its internal needs). Origin Energy also has good generation capacity but this is mostly utilised by its internal needs (but at the above market prices). Hence, the price hikes (50% on pre Hazelwood closure prices) would benefit both these companies in terms of generating strong returns on these generator assets.

While the cost of generating electricity has gone up, the cost to a household is also made up of transmission, distribution and retail costs as follows:

Schematics of Cost Components

Source: AEMO; Origin Energy;
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Prior to the jump in the generation prices, generation cost made up 24% of the total cost of an electricity bill, and transmission/distribution made up 55% of total cost.

The transmission/distribution cost has been an area of contention as well because the asset base for pricing purposes has increased due to a requirement to “bullet proof” the networks. The main consequence of this has been distribution charges have jumped by 6% and 4% respectively over the past two years.

Transmission/Distribution The key beneficiary of these jumps has been SKI (Spark) and AST (Ausnet), whose share price performance has been +54% and +46% respectively over the two-year period.

The key beneficiaries from an increase in generator prices has been AGL +61% of over the two-year period and ORG +20% however, we note their APLNG project issues have been a detractor. We watch with interest what the interaction will be between the government and AGL on the Liddell Coal fired power station which is scheduled to close in 2022.

Lithium – how to transform green energy into baseload.

The biggest issue for the Australian electricity market is a lack of baseload capacity, not so much additional non-baseload carbon efficient capacity such as solar or wind. While these two forms of generation have obvious CO2 benefits, they are intermittent and cannot meet certain 

demand periods. One solution that has been proposed is to store the excess capacity and utilise it when needed.  This leads us to battery technology which is starting to gain traction via a proposed SA solution for its blackout issues. While it will not solve the loss of 1600MW (Hazelwood) and 2000MW (Liddell), it is a start with the proposed Lyon Battery Solar farm generating 100MW.

This brings us to a potential new way of thinking in terms of the electricity grid and one key component for such batteries is Lithium. While the above SA solution suggests the potential future path for green baseload generation, the investment cycle has already taken a view with two factors driving an interest in Lithium:

• Storage of green electricity and
• Electric cars

Therefore, the second part of the energy conundrum is more about the raw material Lithium (hence our journey from Coal to Lithium).

In this respect, Australia is well placed with estimated Lithium reserves of around 1.6m tonnes (or 12% of global reserves), with Chile’s (being the largest) has Lithium reserves at 7.5million tonnes. As an investor, this battery evolution has been given further momentum with China and Europe playing lead roles in focussing on electric cars.

While Tesla has been a key promotor of this sector we see many of the mainstream manufacturers also taking strong lead e.g. Toyota, BMW etc.

In Australia, our key focus on the Lithium revolution has been via the exposure to new mining developments and we mention key names such as Mineral Resources (MIN: Lithium, iron ore, and mining services), Pilbara Minerals (PLS), Galaxy Resources (GXY) and Orocobre (ORE), which has operations in Chile that are focussed on extracting Lithium from Lithium brine deposits.

The main thrust of this article has been the changing nature of electricity energy landscape and its impact on how investment portfolios need to be active. For instance, from Coal to Lithium, or is it AGL for now but later should the focus turn to companies that are setting up solar-battery farms?


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