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WEEKEND LADDER

A summary of the week’s results

08.12.2017

Week Ending 08.12.2017

Eco Blog

- Australian GDP growth is hampered by a soft household sector with the outlook restrained by low income growth and high debt. State based infrastructure and exports are the redeeming features.

- The importance of services exports should not be underestimated.  We highlight South Korea as Australia’s fourth largest trading partner. It is also one of the more interesting investment options in the Asian region.

Third quarter GDP lifted to an annualised 2.8%, though the main impact was the very weak numbers of last year that are falling out of the year on year trend. The composition once again troubled economists with a dependence on project based investment offsetting the weak private consumption and the low savings rate of 3.2%. The October retail sales hints at a modest improvement in spending, though the revenue growth run rate is still only 1.6%, below inflation.

Retail sales – year on year growth

Source: ABS, Escala Partners
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Households are likely experiencing a cash flow squeeze, part self-induced as there appears to be an effort to get ahead in mortgage payments, but also a function of utility bills, the pickup in petrol prices and other ongoing daily increments that are not matched by wage rises.

The October trade balance showed a pickup in imports of consumption goods, which will either translate into higher retail values, or an inventory overhang. Conversely, resource exports fell, though this is likely to be a short-term factor and the year on year trend remains healthy. The outlook for commodity prices next year, specifically iron ore and LNG, looks relatively muted. Iron ore will feel the anticipated slowdown in China into 2018, offset by production cuts and healthy steel margin in the Chinese industrial sector. The consensus view is that iron ore will soften towards USD60/ton, but hold at around that level. LNG oversupply is expected to limit prices, though export volumes should make up for the differential.

Export sector growth

Source: ANZ
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The services sector lies at the heart of exports and cannot be taken for granted. Price does matter, as is evident during the period the AUD rallied. While the currency may no longer be the primary concern, the costs and the quality of delivery of these services will need attention.

The terms of trade has a meaningful impact on Australian incomes. This year it has been a large positive in an otherwise difficult economy. 2018 is likely to see less support, though still a net contributor.

Under the radar, South Korea is Australia’s third largest export market and fourth largest in two-way trade. It also vies with Australia in terms of unbroken GDP growth and will register 20 years of positive momentum in 2018, last handicapped in 1998 by the Asian banking crisis. In 2016 S&P raised its credit rating to AA stable, the highest in the region. The fiscal balance has been in surplus for nearly 10 years and government debt to GDP is a modest 41%.

With respect to the direct relevance of South Korea to Australia, the nature of the export trade between the two countries is a telling way to appreciate the risks in the Australian economy.

Australian good exports are essentially raw materials while Korea sends back a wide range of value added product.

Source: Australian Bureau of Statistics, NAB
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Similarly, in service exports where the Australian dependence on travel is again matched by Korea’s divergent sources (transport for Korea is shipping and freight).

Source: Australian Bureau of Statistics, NAB
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South Korea is widely regarded as a developed market even though it is classified as emerging by equity market indices such as the MSCI. With a minimum wage of circa AUD9/hour for 2018, and professional wage rate of AUD55k per annum, one cannot point to low cost labour as to how South Korea establishes an export sector within Australia. Rather it is the industrial strength in motor vehicles, integrated circuits, household products and shipping. Other smaller sectors have become prominent.  An example is the cosmetics industry where companies such as Amore Pacific and Kolmar make products for other global brand as well as under their own labels.

Asian and emerging market fund managers can have a relatively large allocation to South Korea. This is in part based on a view that the corporate structure is changing as the long standing ‘chaebols’ where tightly held family groups controlled companies and lent on the government of the day to return favours in exchange for donations to vested interest. The newly elected government is tackling this system head on with a Stewardship code designed in a similar vein to that of Japan where there has been a progressive shift towards dividend payments, elimination of cross shareholdings and focus on ROE.

  • South Korea is unlikely to be top of mind for equity investors, yet there are a number of large well-known companies (Hyundai, Samsung, LG, Kia) and a even larger selection of highly regarded stocks that are common in portfolio (NAVER, AmorePacific, Lotte Chemical, KB Financial). The country weight in Asia Pac ex Japan is a shade under 20% representing the second largest within that benchmark.

Fixed Income Update

- Reduced supply in the ASX listed debt market drives prices higher in 2017

- November posts a positive month for fixed income securities

- Proposed tax reforms in the US is already having an impact on the municipal bond market as governments rush to issue debt ahead of the changes. 

Credit spread contraction has been prevalent across most fixed income sectors this year, with low default rates and solid economic growth. The ASX listed hybrid market has followed the trend, although unlike the offshore credit markets where new issuance levels hit new highs, the supply of new listed securities has been falling. Combine the limited supply with low bond rates and spreads elsewhere, and it is little wonder that the higher yielding listed market has performed so well this year.

In the absence of a formal index, market analysts note the negative issuance, the first in the last 5 years, with redemptions exceeding new issues by $3,098m. Breaking this down, supply of hybrids has grown, but has been more than offset by redemptions in subordinated bonds. The reason cited is that issuers of subordinated bonds have largely moved to the wholesale markets as favourable pricing and rapid pricing of deals is preferred. This trend is expected to continue into 2018, as $2028m of maturing subordinated bonds are likely to be redeemed and rolled into the OTC market.

Source: Westpac, ASX
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Australian bond markets posted a positive month in November with ultra-long maturities and inflation bonds the best performers as the yield curve flattened, following the lead of the US. Credit spreads on investment grade securities did a v-shaped recovery, weakening in the first two weeks of the month before reversing this trend and finishing the month 1bp tighter (as per the AUD iTraxx). Returns on FRN’s (floating rate notes) were therefore broadly in line with the securities running yield.

Monthly change in Australian market indices

Source: CBA
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While we have previously cited some potential impact on fixed income from the US tax reforms, one that is already taking effect is that of the municipal bond market.  The $3.8tn municipal bond market is at the heart of US states and local governments to fund public works including capital expenditure for infrastructure. Governments are racing to issue more debt this month, ahead of potential changes in the tax reform. The most likely change is the elimination of “tax-exempt advance refunding bonds” that aide municipal governments by cutting their interest expenses, allowing them to lock in low borrowing costs before retiring previously sold bonds. The other change could be to “tax-exempt private activity bonds” which fund airports, hospitals and affordable housing at lower costs.

Increased supply in the last few weeks, as municipals front-run the reforms, has been met with strong demand from investors who are keen to buy up the bonds anticipating reduced supply into 2018. Borrowing is predicted to reach $45bn in December, up from $18bn a year ago. These securities can be in global fixed income funds. While the tax status is of no value to Australian investors, the change in the pricing can add to returns. It is an illustration that there are ways to participate in global fixed income that may not be apparent at headline level.

Corporate Comments

- Rio Tinto’s (RIO) ‘value over volume’ mantra was evident at its investor day this week, with productivity improvements central to its strategy.

- The ASX will proceed with the implementation of blockchain technology for share transactions. The benefits are potentially large, although will not be evident for some time.

- Metcash shareholders were rewarded by the improvement in the balance sheet. The operational outlook remains challenging, but the option of a capital return is likely to keep investors interested.

Rio Tinto (RIO) stayed on message in an investor day this week despite a recent chair transition, with an emphasis on cash generation, capital discipline and shareholder returns. Volume growth continues to take a back seat in RIO’s priorities, as evident in the long-term target of delivering just 2% over the decade to 2025. Capital expenditure is expected to pick up over 2018 and 2019, with an improving price environment allowing this progression. In an acknowledgement of the underinvestment that occurred at the bottom of the recent cycle, the allocation to ‘sustaining capex’ is expected to rise from US$2bn to US$2.5bn, although the total growth is growing off a much lower base. Some cost headwinds are also starting to bite, such as an expected US$320m increase in raw materials over 2017/18.

Rio Tinto Capital Expenditure Profile

Source: Rio Tinto
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Over the next five years, productivity improvement is a core plank of the strategy to improve returns, with an additional US$1.5bn annualised saving targeted in this time. Much of the productivity savings are driven by advances in technology, where RIO has been among the leaders in the industry; for instance, in iron ore, its Pilbara train system is expected to be fully autonomous by the end of next year.

A decline in the iron ore price remains the key risk for RIO through 2018, although the broad consensus is that the downside is limited to around US$50/t. A potentially weaker demand picture is a possibility as China continues to move from investment-led to consumption-led growth. This is balanced with reforms that have increased the demand for higher quality imported ore and improved the margins of steel mills, allowing them to afford higher raw material costs.

China Steel Mill Cash Margins

Source: Rio Tinto
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Nonetheless, with RIO’s strong balance sheet, investors can expect healthy dividends in the medium term, along with additional capital returned via buybacks. We have BHP in our model Australian equity portfolio, which has a slightly better commodity exposure balance and is embarking on a similar strategy.

The ASX share price was largely unmoved on its significant announcement that it would be proceeding with the implementation of blockchain technology to replace its legacy CHESS system, an indication that the decision was largely anticipated by the market. CHESS is the system that ASX uses to record shareholdings and manage the clearing and settlement of equity transactions.

A blockchain is a distributed ledger system that stores transactions on a decentralised list between participants instead of a central server (Bitcoin is perhaps the most well-known user of the technology). Employing a blockchain for transactions is expected to result in new revenue streams for the ASX and likely cost benefits for it and market participants, although it is unknown how these will be shared between the two.

Potential implications include faster settlement times (given the reduced requirement for the reconciliation of transactions), streamlined corporate action and AGM voting procedures, faster payment of dividends and higher trading volumes. The risks are also deemed to be quite substantial, however, particularly in implementation, as the ASX is ahead of other international exchanges in rolling out the technology and is essentially the test case for the industry. Other participants also be disrupted as it evolves, such as share register service providers Computershare (CPU) and Link Administration (LNK).

ASX: Blockchain Benefits

Source: ASX
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On balance, the decision to invest looks to be a sensible one, although it will be some time before the system is fully rolled out (possibly two years or greater) and the financial implications become more visible. Investors will need to be patient given the considerable capital cost that will be incurred in the interim and the current relatively benign environment of soft trading levels and IPO activity. Presently, ASX trades somewhat above its typical P/E over the last several years at 24X, indicating that some of these blockchain benefits are already built into its share price.

The focus in the Metcash (MTS) first half result was on the second syllable, cash.  The operating result was somewhat messy, with the core food distribution division suffering another loss in revenue offset by a slight improvement in the liquor division and a hearty lift in hardware, as the acquisition of HTH (Home Timber and Hardware) was incorporated. With the stated debt position low (despite some seasonality in working capital), the market responded with enthusiasm, predominantly on the expectation of capital returns, either via dividends or a share buyback. Given the modest valuation, a buyback would be incrementally meaningful to EPS growth, yet it comes barely two years after a capital raising at a much lower share price.

The soft outlook for the independent grocery sector is partly offset by an effort to reduce costs, with the company claiming $20m in savings.  Establishing the context of such savings is tricky, given the loss in revenue, changes in gross profit, offset by unavoidable underlying cost increases. This does challenge any forecast, given that the erosion of the revenue base is likely to continue. The base case is therefore that food distribution profit margins have bottomed, but that they are likely to flat line for the foreseeable future. The growth component is therefore hardware, where the competitive structure of the sector is quite different, given Bunnings’ dominance versus a fragmented set of independents.

Given the relatively modest PE of 13X and a respectable yield of 4.2% for this year, it is unsurprising to find MTS in some portfolios. Downside is limited by the valuation, with the upside skewed to a release of capital.

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