Week Ending 09.09.2016
• Australian GDP data surprised on the upside this week, but has had little impact on markets. The terms of trade (price of exports versus price of imports) remains the key swing factor in national income growth.
• European monetary policy was unchanged. The debate on the effectiveness of these global central bank strategies and possible next moves is an ongoing topic.
An air of suspended disbelief hung around the release of the Australian GDP June quarter data. The promising headline of 3.3% annualised growth is contradictory to general sentiment and trajectory of profit momentum for many listed companies. Nonetheless, it would be churlish to ignore the long period of economic growth we have enjoyed, though, as always, that is not predictive.
Public demand was particularly strong in the quarter, mostly from a big jump in spending in the final quarter of the year. It would appear state-based infrastructure may be making an outsized contribution, though general expenditure on services is also rising. The swing away from the mining states is stark. NSW and VIC have had the bulk of the run in apartment building, complemented by commercial construction in NSW and in VIC by public projects – rail underpasses and the like. The handful of equities which participate in this segment have had support in recent months, but the main benefit may be the broader implications if this pattern is sustained.
Corporate profitability, as measured by national accounts, also improved overall in the quarter, a likely consequence of cost savings over the past year. Private investment spending, however, will be constrained by global excess capacity in many industries.
The household sector was relatively subdued, with service spending continuing to dominate. Financial, real estate and health are, unsurprisingly, growing more rapidly than others. Only accommodation spending, transport and administrative services experienced a small decline in the quarter, which may well be seasonal. While the listed discretionary retail sector has done well in the recent results season, we are reluctant to back a fully-fledged spending cycle. The drag from low growth in compensation per employee was all too obvious, with annual growth of only 1.1% and a barely-positive 0.2% in the June quarter. Households are now eating into saving to sustain spending, a path that cannot last.
Exports did most of the heavy lifting, comprising 2.2% within the 3.3% GDP number as commodity prices recovered off their lows and volume growth continued. This terms of trade effect has been the critical feature of the past decade and a constant reminder of the dependence on the emerging world.
The key metrics for the Australian economy sit in an awkward position. Inflation is too low for the RBA, employment dynamics are acceptable but lacking vigour, household debt is at its highest ever and private investment spending is possibly showing signs of picking up. This is mixed with uncertain policy outcomes and all-time low interest rates. The GDP data would suggest that the RBA should remain on hold, yet the majority of economists are still holding out for another rate cut. A new data point will have to emerge to support that contention.
This week the ECB was firmly on hold, with Draghi expressing confidence the transmission mechanism of Euro-style QE was working. Evidence is the upturn in bank lending and reduction in ‘fragmentation’ or the relative position across financial instruments within Europe. Two points of interest were, firstly, the recognition that the ECB bond buying programme had stretched the limits of what bonds were available, with specific reference to German Bunds where the ECB is effectively buying any new issue. The second issue was to acknowledge that zero or negative interest rates hampered the banking system and implied there would be no further changes to the deposit rate. That said, many commentators expect further easing or at least, the extension of the existing programme.
The absence of inflation is now at the heart of monetary policy. This task may become even harder if food prices are influenced by what looks likely to be grain surpluses in many regions. The US CPI is out late next week and will be once again perused for any hint of higher cost in any segment.
While most indictors have been relatively benign post the mid-year Brexit rattle, the trends are not, on aggregate, pointing to a pickup in activity. What is just as notable is the absence of any particular theme. The US housing recovery has been underway for some time, yet consumption spending is subdued. The European recovery from its self-induced sovereign debt crisis has come through, as evidenced by growth in regions such as Spain and, even more recently, some traction in Italy and France. Emerging economies have partially regrouped and coped with the external influences of falling commodity prices, problematic current accounts or volatile currencies.
It begs the question of what could come next, aside from politics. Eventually the probability of modest economic growth, low inflation and low interest rates may just become accepted as the norm. The obvious corollary is that the financial world will then, too, accept lower long-term investment returns. There are, however, other consequences, such as the real cost of pension liabilities, currently still allowing for some normalised rate of return rather than a low one. Fixed asset prices, including housing, will also have to reflect their appropriate utility value rather than be bond proxies or any assumption of long term capital gains.
Fixed Income Update
In this week’s publication we will discuss:
• Performance results for fixed income markets in the month of August, including the main drivers; and
• The changing face of issuance in emerging markets and the implications for investors.
Fixed income markets performed well in August, with the Bloomberg Composite Bond Index returning 0.44%. Over the last few months the main driver of performance has been the ‘duration’ trade, where bonds have benefitted from the fall in interest rates. The duration trade is where the fall in yields (caused by an actual cut in the official interest rate or sentiment) results in a fixed rate bond becoming more attractive on a comparable basis. While the official cut in rates by the RBA occurred in the month of August, the decision to do so was already priced in by markets and therefore the gains from duration were modest in August. Instead, the tightening of credit spreads was the main driver of performance.
The contraction in credit spreads was a continuation of the tightening trajectory which began in mid-February. The Australian iTraxx index, which is the best measure of spread performance for a basket of 5 year investment grade synthetic bonds, is illustrated below.
Australian iTraxx Index
As corporate bonds are priced off interest rates plus a spread premium, this downward movement in spreads results in a lower overall yield for bonds, pushing up the price. This was favorable for the credit market (corporate bonds, high yield, bank hybrids etc), with a return of 0.89% for the non-bank corporate index, 0.72% for financials in August compared with government bonds (which have no credit spread but do have duration) at 0.34%. The price moves of the indices for these different sectors is depicted below.
Bond Indices in August
Glossary: ACGB’s=Australian Commonwealth Government bonds, SSA’s = Supranational, Sub-sovereign and Agency sector, Semi’s= semi government bonds ie States and Territories, non-financials = corporates and financials = banks etc)
Elsewhere, the global high yield sector was a standout, with a 2.23% return (BofA Merril Lynch US High Yield index), bank hybrids gained 1.53% and subordinated notes 0.74%, all driven by the contraction in spreads.
While European and US markets remained basically closed for new bond deals during their summer holidays, domestically, issuance by the Australian major banks reached $4.3bn - the second largest month for the year - with ANZ and CBA active.
In this publication we have previously discussed the strong performance of emerging market (EM) debt securities. The low interest rate environment has increased demand for high yielding products, resulting in record inflows into this sector since the beginning of the year.
As the spreads on these bonds have contracted, this has attracted more issuance due to the falling cost of borrowing. Asian and South American countries have been leading the charge on increased volumes of outstanding debt. In addition, new entrants have been lured into the market, with Saudi Arabia issuing an inaugural bond into the global market just a few weeks ago. JPMorgan (which runs one of the EM indices) expect sales of debt by emerging markets in “hard” currencies such as dollars and euros to reach more than $125bn by the end of the year, surpassing the previous record in 2014 of $95 bn. The growing amount of new issues in this sector is illustrated below.Enlarge
While this elevated level of supply helps keep equilibrium in this sector, if the current level of inflows was to continue, the demand side will still outweigh supply. The concern for investors, therefore, is that unless there is a change in view on emerging economies, the reverse is clearly likely.
With a component of EM bonds denominated in USD, movements by the Federal Reserve Bank will also impact this sector. While the path for US interest rates is a moving target, EM fund managers will be hoping for further delays in a rate hike to keep the market buoyant. The chart below shows the changes in the market sentiment and the probability of a rate hike priced into the market over the last 6 weeks.
Fed Rate Hike Probabilities
The aged care sector (Regis Healthcare, Japara Healthcare and Estia Health) had another setback this week after the Department of Health (DoH) late last week clarified the rules regarding the charging of residents for additional fees. Specifically, the DoH stated that ‘capital refurbishment’ fees (or similar) would not be supported by current legislation where the fee does not provide a direct benefit to the individual or the resident cannot take up or make use of the services. The fees had been levied on residents to cover the cost of capital improvements to rooms, although this will now have to be borne by the operators.
These ‘capital refurbishment’ fees had been one of a number of measures that the operators had recently introduced in order to combat the margin headwind from previously announced government funding cuts. Other avenues that the listed operators are expected to pursue include increases in room prices and improving the take up by their residents for extra value-added services.
Investors have been left somewhat in the dark on quantifying the impact of the government’s proposed funding changes to the sector (which are yet to pass as official legislation), however all three operators have noted that there would be minimal impact in FY17, with a greater effect to be felt across FY18 and FY19.
There is a possibility that the operators will get some relief if a compromise is achieved, with the changes yet to receive support from both sides of politics. Nonetheless, it is clear that margins across the industry will likely be lower in coming years, a factor that not even the efficient for-profit operators can avoid. The fact that there is significant variability in the profitability of aged care operators in Australia would point towards a cap on the extent of further funding cuts, given it could threaten the viability of some.
We remain positive on the long term investment thematic of the sector, driven by the growth in Australia’s older demographic. The short term outlook, however, is expected to remain clouded until further certainty is revealed on the future profitability path of the industry.
Reporting Season Wrap
August’s FY16 reporting season was viewed as relatively respectable on aggregate, with more companies than not meeting either consensus expectations or their own earnings guidance to the market. Earnings forecasts, however, were relatively low leading into the reporting period, indicating that while the bar was achieved, it was set at a low level. Below we discuss some of the key themes to emerge during the month.
Decline in overall earnings
FY16 earnings were expected to be lower, primarily driven by what is typically the most volatile sector from a profitability perspective, resources. As a result, the market’s aggregate underlying (i.e. excluding one-off writedowns etc.) earnings fell by approximately 10%, with resources falling by close to 50%. Earnings in the industrials sector and banks, however, were also lower, indicating a fairly broad-based trend across the market. The chart below illustrates the half-yearly pattern of earnings across these segments of the market.
Half-Yearly Net Profits
The average company performed better than the market
While FY16 was a weak year for the market from an earnings perspective, the poor performance of large cap stocks was particularly notable. Outside of the resources sector, earnings pressure was evident in the key supermarket stocks (Woolworths and Wesfarmers), insurers, across the major banks and Telstra. Even CSL, typically a reliable generator of year-on-year earnings growth, underwhelmed with its result. The large weighting of these companies in the benchmark index meant that total earnings growth across the market was going to be difficult to achieve.
Operating margins also fell in FY16, reflective of a number of factors. With top line growth restrained, competitive pressures were high among most of the key sectors highlighted above (supermarkets, banking, insurance and telecommunications) as companies sought to drive market share through more aggressive pricing. Cost cutting has been a source of margin improvement across the market over the last few years, however many of these multi-year programs are beginning to run their course.
Amidst the overall tougher environment, there were still pockets of strength. Ongoing robust housing activity has translated into a solid backdrop of support for companies directly involved in housing construction (Stockland, Lend Lease, Fletcher Building etc.). This has also translated into a sales tailwind for a number of retailers, such as Harvey Norman and JB Hi-Fi.
Inbound tourism is another area that is enjoying good conditions. This was reflected in the profit announcements of Sydney Airport and the two large casino operators, Star Entertainment and Crown Resorts.
Finally, offshore cyclicals as a group printed respectable earnings. While a currency tailwind helped (the AUD on average was lower against most key currencies in FY16 compared with FY15), the market-leading positions of many of these companies in their respective sectors held them in good stead. This group includes Amcor, Brambles, James Hardie, Aristocrat Leisure, Orora and Treasury Wine Estates.
Dividends and Capital Management
Aggregate dividend payments fell for the first time since the onset of the global financial crisis. The primary driver of this outcome was the long-overdue rebasing of dividend payments from the resources sector, with high payout ratios in recent years persistent in the hope that commodity prices would stage a remarkable recovery. While BHP Billiton and Rio Tinto abandoned their progressive dividend policies in favour of a more sustainable payout ratio, dividends from the energy sector were also slashed and in some cases, reduced to zero (in the case of Santos and Origin Energy)
Elsewhere, dividend growth from industrials was limited by the rising payout ratios of recent years and the slight decline in earnings, with capex cuts often supporting payouts. While Commonwealth Bank was the only major trading bank to report during August, dividends from the banks were lower over the year. This was the result of flat earnings spread over a larger share base following recent equity raisings.
Capital management featured again for a small number of companies, with buybacks conducted (or continuing) with CSL, Telstra, James Hardie, JB Hi-Fi, IAG and Qantas, among others.
Value outperformed growth
Growth-orientated stocks have outperformed their value counterparts over the last few years, as investors have placed an ever-increasing premium on the small group of companies exhibiting double-digit earnings growth. Some of the best performing companies through reporting season, however, included those that are more at the value end of the spectrum, as they were rewarded for providing no negative surprises. These included Flight Centre, Downer EDI, Computershare and Ansell. Conversely, several high P/E stocks that had high earnings expectations were sold off sharply after missing expectations, including REA Group, Blackmores, CSL and Medibank Private.
Guidance, outlook statements and trading updates
The majority of listed companies provided fairly cautious guidance or outlook statements for FY17 and a large number failed to put a figure on what investors can expect for the next 12 months, preferring instead to leave this to the upcoming AGM season. Of note, was the number of companies that reported a weaker trend in the June quarter, with the lead up to the Federal election cited as a break on activity.
Current market valuation
The following table presents the current earnings expectations for the market, split into three broad sectors (financials, resources and industrials) with a possible scenario to determine a valuation from a top-down perspective. The scenario described below suggests that the market has little upside from the current level.
Financials: Both key sub-sectors of financials (banks and REITs) are in a low-growth environment. For the banks, the headwind of higher capital requirements will abate somewhat in the next 12 months, although the challenges of low credit growth, falling margins and higher bad debts remain. REITs have been one of the greater beneficiaries of the falling yield environment, although rental growth is subdued across most industries. Left behind in the most recent ‘yield’ rally and trading on a larger discount that typical to industrials, the banks could possibly re-rate higher in the absence of other viable options in the market.
Resources: Are expected to be the big improver in FY17 as the sector cycles low commodity prices from FY16, many of which have recovered in the first half of this calendar year. The longer spot pricing persists, the more likely the sector will see upgrades, and ongoing cost cutting could result in additional leverage to earnings. For the domestic investor, the recent strength in the $A complicates the earnings outlook.
Industrials: Industrial companies have been the most consistent source of earnings growth for the market, although an 11% bottom-up consensus forecast does appear somewhat optimistic, particularly with the ongoing challenges of some large-cap stocks and less of a currency tailwind going forward. The P/E of the industrials sector also looks relatively high at this point and thus could see some contraction over the next year.
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