Week Ending 09.10.2015
The RBA released a paper ‘Modelling the Australian Dollar’ where its economists discuss the issue of some benchmark against which the equilibrium value for the AUD should be measured.
The conclusion is that the key long term factor is the terms of trade (price of exports versus price of imports). The RBA notes that while commodity prices had a substantial impact on the terms of trade, the goods market is in fact a better fit. In short, if the currency had followed the commodity cycle, the AUD would have had a much more extreme move in recent years.
Post Float Terms of Trade
Real Trade Weighted Index (TWI)
Interest rates (RIRD, or real interest rate differential) are the second most important factor. Within their model they use the 2 year and 10 year bond rates, noting that the two are highly correlated, but that at times they provide different signals.
However, in the short to medium term, there are a number of influences that will cause divergence from the equilibrium value, as the two variables above can only explain 50% of the quarterly variation. They note episodes of substantial divergence. For example, in 2000, at the height of the internet boom (in which Australia largely did not participate and therefore experienced little by way of financial flows). Similarly in ‘risk off’ events, such as in 2008, the flight to USD safety overrides any modelling. The central bank notes the influence of the VIX, therefore, as an expression of uncertainty, the S&P 500 as a growth signal and the broader commodity indexes as co-opted in the act rather than determining the underlying value.
And the answer therefore is? The RBA model suggests the currency is still slightly above its equilibrium point, but given that the deterioration of the terms of trade may be largely behind us, the rate of decline in the Trade Weighted Index should be expected to moderate.
Equilibrium Real TWI
The stimulatory effect of the weaker AUD is becoming a critical issue. Increasingly, there are signs the property sector, or specifically the housing industry, is past its peak and while activity will continue into 2016, approvals are likely to show a sharp deterioration.
The ANZ-Property Council Survey shows the marked fall in expectations for the residential sector. New South Wales continues to extend past the other states, with WA right at the bottom. Foreign interest is also changing pattern, as the emphasis on NSW moves to QLD and SA.
ANZ Property Council Confidence Servey (December Quarter)
Non-residential construction expectations are flat. A relatively healthy retail sector is now complemented by a growing interest in tourism construction; a welcome sign that this industry will continue its recent strong trend.
Turning away from persistent commentary on the US Fed deliberations, we have noted those from the UK (which was expected to raise rates in a US pattern) have now kicked into 2016. In April, the market had locked in a UK rate rise for September this year. Now some are allowing for 2017 as the first date.
An interesting change in emphasis is that global rather than domestic considerations are playing a big role in central bank language. Local labour markets, generally in line with expectations, are apparently secondary to inflation and global growth. Inflation is itself at present predominantly determined by commodity and global trade prices, with local services costs relatively stable.
The attention for the coming months therefore should arguably be on inflation, the policy settings in China, Japan (which is either on the cusp of an improved trend or reverting to its less than benign self) and the US, where the activity outside the household sector is going through a trough.
While the technicalities may be obtuse to many investors, the US ‘breakeven’ inflation rate in the longer term versus interest rates is a key market metric. A year ago, inflation was expected to be around 2%; mid-year 2015 it was at 1.87%; now it has taken a dive to 1.6%. In short, it appears that consumers have taken on board lower energy prices and poor traction in goods prices, relative to stable services and rising house prices, in setting their inflationary expectations.
This would worry central banks, and leave rates low for much longer. After all, if inflation is not a concern and labour markets are stable though unexciting, why raise rates?
Veda Group (VED) this week agreed to a revised takeover offer from Equifax. Veda had initially disclosed three weeks ago that Equifax had approached the company with an all-cash offer of $2.70 per share. This has subsequently been revised up by a skinny 4.6% to $2.825, a figure which the Veda board has agreed represents an appropriate takeover premium.
From a current investor’s perspective, the offer could be viewed as slightly disappointing for those who take a long term view of the business and the opportunities available to the company. While on a P/E multiple basis, the price appears to be fair, few valuations of the company would give much credit to the expected benefits that will be realised from the introduction of comprehensive credit reporting. Broadly speaking, this now allows for the collection of ‘positive’ data points for a credit report. In markets where this has previously been running, it has resulted in higher rates of credit growth as institutions are placed in a better position to assess credit worthiness with greater levels of information. At this stage, the rollout of comprehensive credit reporting in Australia is in its early stages and hence is given little value by brokers.
Secondly, as we previously highlighted, the deal could certainly be viewed as opportunistic given a decline in Veda’s share price from the beginning of August until the deal was announced; a function of weak equity markets as well as a poor market reaction to the group’s FY16 guidance which fell just short of expectations. Tied in with the fall in the Australian dollar over the last 12 months, Veda’s assets would have looked quite attractive for a US-based company, particularly given the time it would take to establish a database of records for a new entrant to the market.
Equifax will now conduct due diligence on Veda, and, if satisfied, the proposal will then move to a binding offer. We have held Veda in our model portfolios since early this year and following this takeover offer, we will look to replace this position.
Macquarie (MQG) announced the acquisition of Esanda dealer finance from ANZ for a price of $8.23bn. Esanda provides retail and wholesale dealer finance on motor vehicles and the acquisition will more than double Macquarie’s motor vehicle finance portfolio. The Esanda portfolio will add further to Macquarie’s growth in annuity-style revenues and the group expects it to be 10c accretive to earnings per share (an approximate 2% uplift) in its first full year, including benefits from the additional scale that it will provide. The capital to fund the acquisition will be partly sourced from an institutional placement (conducted this week at a premium to the previous traded price) as well as a share purchase plan.
Macquarie also announced another earnings upgrade for the first half of FY16, which comes just one month after it previously increased its guidance. The 11% increase on the previous guidance (with the first half profit now expected to be 55% higher than last year) appears to be largely attributable to the pull through of some performance fees from the maturity of its unlisted infrastructure funds (we have noted). The company also commented that trading conditions have been stronger than expected and it still expects all divisions to be either up, or in line, with the FY15 performance. With the group’s earnings momentum continuing and a relatively undemanding valuation, we hold Macquarie in our model portfolios.
For ANZ, the deal will allow the bank to deploy its capital more towards lending where it generates higher returns. With the major banks required to lift their capital ratios, the transaction makes sense for ANZ. Despite the recent lift in mortgage risk weights, the returns on capital from residential housing lending would remain higher compared to a business like Esanda. ANZ expects that the sale will further improve its tier 1 capital ratio by approximately 20 basis points.
Bank of Queensland’s (BOQ) financial year is out of step with the other banks and gives an early indication of what could be expected from upcoming full year results from the majors, albeit with a bias towards BOQ’s home state. The underlying profit growth for the year was 5%, with this driven by a decline in its bad debts expense. The bank’s overall profit growth of 19% was boosted by last year’s acquisition of a professional finance business from Investec Bank (now known as “BOQ Specialist”).
BOQ has shown an improving trend in its lending growth, which grew by 7% over the last year, although remained below the broader system growth. The shift towards owner-occupier mortgage lending was evident; a necessity given APRA’s focus on this part of the market. Much came from the BOQ Specialist division, indicating some early success with this acquisition.
The regional banks have been given a competitive free kick from APRA in that the recent requirement to lift mortgage risk weights only applied to the four major banks. Nonetheless, BOQ is still exposed to a number of other industry trends that will impact profit growth in the medium term, including weak credit growth, flat interest margins and an inability to make much progress on the cost front. While not evident in this result, the potential for resources-related weakness may also yet emerge, with just under half of the group’s total loans still in the Queensland market, which has a high dependence on the mining industry. In our view, the regional banks do not offer enough differentiation compared to the major banks, particularly when compared with more niche operators in the financial sector.
These include fund managers, with two of the more successful Australian managers of international equities, Magellan (MFG) and Platinum (PTM) which reported their monthly funds under management (FUM) levels. Both showed that FUM growth for the month, despite the weakness in global equity markets.
Magellan’s inflows were particularly impressive; almost $1bn on a net basis thanks to a large increase in institutional FUM. This has been a fairly consistent theme for the manager over the last three years. It is likely that a falling $A (boosting the returns for an Australian investor) has played a part in this asset allocation decision for investors over this time, however this is now beginning to mature. The cash levels of the manager themselves also gives an indication of how attractive the asset class may be viewed; in this case, Magellan has been increasing its cash weighting. It also raises the issue of the differential costs MFG charges its institutional clients versus the so-called retail market; a point of contention that is likely to have longer term repercussions.
Crown (CWN) received a boost this week as Macau’s casino operators all rallied off what had become a low base. The catalyst was two-fold; China’s Golden Week holidays had been viewed as a success this year for Macau, while last week comments made by China’s government implied economic support for the region. With the pain experienced by Macau’s casinos largely a result of a structural policy response from China designed to reduce corruption, it would appear unlikely that these policies would be relaxed to such a degree to see a return to past buoyant conditions. Nonetheless, this week could be somewhat of an inflexion point in the sharp downward correction in gaming growth, although until this is reflected in released numbers, the risk would appear to remain on the downside.
Macau Gaming: Annualised Growth
The dust has now settled on last week’s capital raising by Origin Energy (ORG), with the stock rallying some 20% off its rights-adjusted price. A timely bounce in the oil price has also contributed to more positive sentiment for the stock, which has given the company headroom as it implements further cost out initiatives over the next few years. While the stock now looks to be reasonably good value in the energy sector (and with its balance sheet strengthened), it is unlikely that it will return to previous levels given the high equity dilution from the equity raising, as well as an increasing view that oil prices will be lower for longer. The profitability of the APLNG project is now much reduced in the current environment and our current preference in the sector is for the stronger asset base of Oil Search (OSH).
Santos (STO) remains in an exposed position compared to what ORG faced, given the same hit to its earnings from the declining oil price, but without the stable earnings that ORG receives from its utilities business. A sharp recovery in its share price this month may have given the company some options on how to address its balance sheet issues, however the most likely scenario that it will pursue is the sale of assets. As we have noted previously, asset sales or an equity raising at the bottom of the market would both result in a poor outcome for investors from a valuation perspective. Given the company’s high debt position, a combination of the two remains a distinct possibility.