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WEEKEND LADDER

A summary of the week’s results

09.06.2017

Week Ending 09.06.2017

Eco Blog

- UK election consequences will take time to evolve.

- Australian GDP growth is too low for comfort and corporate investment spending is key for a lift.

- Asian and Japanese growth trends remain intact and broad-spread across sectors.

- The labour market’s changes in structure are the likely cause of low inflation.

The primary news of the week is unquestionably the UK election. At this early stage, the economic and financial repercussions are far from clear. Inevitably, the GBP has fallen and the FTSE likely to follow suite, but in other such similar ‘shocks’ the medium term judgement is different to that in the first few days.

The air of tension amongst economists was palpable as sector data rolled in prior to the release of Q1 GDP for Australia. A potential negative print was redeemed by business profits providing the relief, jumping 7.8% in the quarter and ensuring the record of growth was sustained.

There are two unpredictable swing factors in GDP that can’t be assessed prior to the final release. The first is inventory movement and the second is the savings rate. Inventory contributed 0.4% to GDP, but this was attributed to the decrease in export volumes which should unwind in forthcoming quarters. More concerning was the fall in household savings and while this measure is sometimes judged as nebulous given it’s a residual (deducting consumption from income), the trend is quite clear and logical; income growth is too weak to support spending and saving.

Household saving rate

Source: ABS, ANZ Research
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The household sector is unable to have a positive impact on growth absent a recovery in the labour market. In the past, a sharp improvement in the terms of trade such as we have recently experienced, flows into income.

 

Average earnings growth and the terms of trade

Source: Deutsche Bank, ABS
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This time the disconnect is large, with real household income growth at a skinny 0.5% over the year. Wages share of income has fallen from 54% a year ago to 51.5%, while corporate share has taken up the slack. A hearty expansion in business investment will be required to reach the RBA’s view of 3% growth in the medium term. Yet, there is no incentive for corporates to pay up in wages given labour market conditions and weak productivity.

Encouragingly Asia remains on a growth path. The combined PMIs across Asia show a good mix of business expansion, with the index over 50. The measure is derived from surveys where companies are asked to provide a qualitative assessment of variables such as new orders, backlog in work, input prices, inventory, employment growth and product prices.

The weak areas are real estate, a somewhat welcome trend given the persistent risks in that industry sector, and basic industries. The growth components are well represented in equity markets across the region and underpin the strong performance from Asia Pac in the past six months.

Asia Sector PMI index, May 2017

Source: Markit
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Paralleling this pattern is the Japan PMI, also showing a sharply better May, and importantly, broadly based across both manufacturing and service sectors.

The other notable feature across both Asia and Japan is the absence of inflation which would typically tick up on such strength.  The quandary of low inflation is a worldwide phenomenon. A host of issues are frequently thrown into the discussion. High earning baby boomers are leaving the workplace, service industry pay scales are lower than construction and factory jobs and job insecurity diminishes employee bargaining power. Another is the significant move in working arrangements, with contract and informal practises increasingly common.

Alternative Working Arrangements (US % of total employment)

Source: Capital Economics
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Fixed Income Update

- The Fed looks set to raise rates next week, while the pathway beyond that looks less certain.

- The RBA kept rates on hold, although it is possible the next move could be down.

- Term deposits struggle to outperform the CPI.

It is highly anticipated that the US Fed will raise rates at their forthcoming meeting on June 14. Beyond that, the pathway for rates looks less certain, with only 27% of market participants expecting rates to rise again in September and 37% by year end.

Following the US election, rates rose on the back of the anticipation for growth driven from expansionary fiscal policies to be implemented by the new president. However, in the months that followed, the rates market has swung around, albeit, with a downward trajectory.

The yield on the 10 year US Treasury bond in the last 6 months

Sourece: IRESS, Escala Partners
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The Australian curve has followed suit, with rates on the Australian 5 and 10 year government bonds 35-40 bp lower than where they were 6 months ago. The more subdued economic data, especially inflation, out of the US and Australia has softened enthusiasm for a strong growth story in the former, while domestic growth has indeed been weak. The extent of the rates move has caught many of the portfolio managers off guard, with the consensus trade over the last few months being one of short duration (reducing risk to rate rises). The result is that performance of many funds has been below that of the benchmark in the last month.

The RBA kept rates on hold. The accompanying statement noted that the pickup in the global economy is continuing, as is inflation, reflecting higher commodity prices. They commented that further US rate rises are anticipated with little prospect of monetary easing in the major economies.

On the domestic front, they noted that GDP growth slowed in March, although still expect economic growth to move above 3% in the next couple of years. The RBA also noted that the housing market is showing signs of easing and labour market data remains mixed.

While the statement did not give a lot of forward guidance, the market consensus is that rates will be on hold throughout 2017. Highlighting the divergence in monetary policies between Australia with the US and Europe (where rates are likely to be raised), there are still some suggesting that the RBA maintain an easing bias and cut rates in Australia if the economy deteriorates further. The domestic futures market is currently pricing in a 14% probability of a rate cut by December, with no calls for a rate rise.

Source: Bloomberg, Escala Partners
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Term deposits have, until recently, had special rates on offer that have been higher than the CPI. However, in the last two years, the differential has narrowed considerably and it is conceivable deposit rates will do no more than match inflation. Further, banks are increasingly differentiating between household, SMSF’ and smaller balances, while reducing the rate for large deposits and corporate entities. They are also reducing the short term rates offered in favour of medium term maturity. See chart showing historic TD rates vs CPI.

Banks Special TD rate versus headline CPI

Source: RBA, Escala Partners
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Corporate Comments

- Bendigo and Adelaide Bank’s (BEN) accounting change to its Homesafe product has no impact on underlying cash flows, however is another indicator of a peaking housing market.

- Vocus Group (VOC) has received an opportunistic takeover proposal from private equity and the company will have the chance to outline its strategy at an investor day next week.

- Qantas (QAN) shares are flying at high altitude this year, although challenges remain on the horizon.

- Wesfarmers strategy day.

It is not often that a change in accounting policy triggers a 7% selloff in a stock, but that was what occurred this week when Bendigo and Adelaide Bank (BEN) announced that it would now exclude unrealised income and/or losses and associated funding costs from its Homesafe product.

Homesafe is a home equity release product (i.e. a partial sale product as opposed to a reverse mortgage, which is essentially a loan against the property) which BEN offers to retirees in Sydney and Melbourne.

BEN’s prevailing accounting policy had booked unrealised gains or losses in each reporting period based on BEN’s effective home equity ownership in these properties, which was driven by changes in house prices in these two capital cities. With house price growth very strong over this time, this had typically led to a strong contribution to the bank’s overall earnings over several years, as illustrated in the EPS chart below.

Bendigo and Adelaide Bank EPS (c)

Source: Bendigo & Adelaide Bank, Escala Partners
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It is hard to disagree with the cynical assessment that the change in policy reflects a view by BEN that the housing price cycle has peaked. Under its historic policy, this would have led to future losses through its profit and loss statement. Gains and losses will now only be recognised when the house is sold. For BEN, the accounting change effectively means that that its dividend payout ratio has lifted to close to the top of its 60-80% range and thus its current dividend could be under pressure should earnings be challenged by several possible factors, particularly a normalisation of bad debts.

While BEN received a free kick from the government through avoiding the recently proposed new liability tax on the majors, its capital position is weaker than its larger peers; a significant disadvantage in an environment where regulatory capital requirements are rising.

The broader banking sector has sold off materially in the past five weeks following a relatively soft half yearly reporting season and the aforementioned new liabilities tax. The selloff has been in excess of the forecast earnings impact. However, it had previously been bid up on the reflationary and yield curve steepening theme that has lifted global banks, despite what is only an incrementally positive earnings translation for the domestic market. While the banks may be due for a short term bounce following recent share price moves, longer term we remain cautious given the several headwinds that the sector faces.

After a tumultuous nine-month period, telecom Vocus Group (VOC) this week received a takeover approach from private equity company KKR. The proposal, offering $3.50 per VOC share, follows the playbook of other private equity bids for Tatts (TTS) and Fairfax (FXJ), with a long list of conditions, including VOC board approval (the company is yet to respond to the proposal) and no further deterioration in VOC’s earnings forecasts.

After two earnings downgrades since late last year and a subsequent sharp share price fall, it is fair to surmise that KKR’s approach is highly opportunistic in nature. As we have previously noted, the valuation of VOC is underpinned by a relatively strong asset base, although the company’s issues have been primarily attributed to poor integration of acquisitions and the loss of senior management from bringing the M2/Vocus/Amcom businesses together.

With the stock now trading at a slight premium to the proposal price, the market is implying that not only may the bid be successful, but that a higher price will be required to get the deal done, whether it be from KKR or from another party. The high level of consolidation in the telecoms industry in Australia would likely rule out Telstra, Optus or TPG from the process, however another private equity group may yet emerge. With the balance of probabilities pointing towards further activity, we recommend shareholders retain their holding for the time being. Further detail from VOC should be revealed at the company’s investor day next week.

In what might be surprising to many, Qantas (QAN) shares have taken flight this calendar year, with the stock the best performing equity in the ASX 200, adding ~60% since the start of the year. While analysts have been taking a more positive view on the outlook for the company, this has not been reflected in earnings estimates and the rally has instead been driven by a sharp P/E rerate. QAN has followed many of its international competitors through this time, with the industry benefiting from the equity rotation into cyclicals through the coordinated upswing in economic activity.

Qantas Forward P/E

Source: Bloomberg, Escala Partners
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Several factors have been in the airline’s favour through recent times, including an increasingly rational domestic market (whereby capacity has been managed more tightly and increases in fares have been achieved) and the realisation of cost ‘transformation’ benefits (with $2bn in savings already made).

The list of challenges for QAN and its competitors, however, remain. The oil price has recovered off a cyclical low early in 2016; the domestic consumer appears to be relatively fragile; and QAN’s international business is highly competitive and faces the structural threat of the rise of low cost carriers. QAN may still appear to be relatively cheap at below 10X earnings, but historically its earnings base has been highly variable and it has rarely achieved an adequate return on equity for an extended period of time. Its discount to the broader industrials index is thus warranted and should be viewed as an opportunistic trading stock at best.

Judgment on Wesfarmers (WES) strategy day came quickly with the share price down 4.5% in the week. The main issue is the heightened tension in the supermarket sector as Coles product price structure continues to adjust to competition. Profit margins fell 50bp in the first half and are likely to be about 125pb lower in the second half. This is been exacerbated by slower sales and therefore operating leverage, a reverse of the years of profit recovery for the group. While many believe the supermarket sector is ‘rational’ given the small number of participants, there is inevitably a loser at any time and the cycle is slow in transition. Margins of around 4% (from the mid to high 5%) are the probable outcome with major consequences for cash flow.

Managements optimistic assessment of the Kmart and Target business runs counter to global trend and the challenge of low consumer spending, excess store space and the impending entry of Amazon. Bunnings remains the high point. Slower housing activity may level off the rate of growth but refurbishments and a broader product suite may stay off any deterioration in trend.

For investors the risks are still skewed to the downside. The chances of upside earnings surprise are low and the dividend many well come under pressure given the payout ratio of 90%.

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