A summary of the week’s results


Week Ending 09.11.2018

Eco Blog

- The long-awaited improvement in US wages appears to be being realised. That would compensate for rising mortgage costs, potentially increase consumption into 2019 and provide some upside to the expected slowdown in GDP growth.

- With the AUD judged to be slightly below fair value, the currency may prove to be a less effectual hedge against any weakness in equity markets into 2019.

With tricks, treats, races and midterms behind us, economists suggest that nothing much has changed.

The US economy is motoring along, though the persistent signs of a weakening housing market are worthy of note. The Mortgage Bankers Association reports that applications are at their lowest level since 2014, reflecting the effective rise in the 15-year mortgage rate to 4.68% from its low of 3.01% in July 2016 and the long-term average of 5.48%. The sensitivity to rates is likely to be repeated in other parts of the world. In the US, house prices are holding up relatively well, though there have been high profile pockets, such as New York, where values have fallen sharply.

US mortgage and house price trends

Source: FRED, Freddie Mac, S&P Dow Jones Indices

Similarly, outstanding consumer credit growth has eased to 4.8% after running at 5-7% over the past three years.

The slow, but clear trend in wages growth will prove helpful to households, as average hourly earnings are now rising at above 3%. Every indicator points to further tightening in the labour market. The National Federation of Independent Business reports on plans to raise worker compensation and a major deficit in the quality of labour. In turn, job switchers are able to gain a 1% rise in pay. It currently takes 31 days to fill a vacancy in the US, the highest time recorded since the data was collected in 2000.

The only likely cap on wage growth may be from the participation rate. Taking a long-term view, the proportion of civilians in the workforce grew steadily through the 1970s and 1980s as women increased their participation. After holding steady at 67% for the 1990s, it eased off and then took a more meaningful step downwards after the 2009 recession. The rationale at the time was that older workers did not return to the labour market given that their skills were ill-suited to the tech type world or low wage service sector. Further, it is suggested that many chose to participate informally through contract work or via Uber and its related cohort.

Civilian labour force participation rate

Source: FRED, US Bureau of Labour Statistics

  • These trends may be good for the economy, but rising wages imply either lower profit margins or higher prices (and therefore interest rates). Neither of these suggest strong investment returns.

The USD has been relatively weak in the wake of the falls in financial asset values in October. This would be counter intuitive to its usual role as a haven of security, and even more so given the political issues troubling Europe and the slow growth in Japan.

Foreign exchange markets have largely priced in the expected rise in US rates and have now turned their focus onto the potential slowdown in US GDP growth into 2019, while also the possibility that Europe and other regions do slightly better than expected. A moderation of the trade dispute would help and if the ECB does lift the deposit rate it would add another leg to the argument. This scenario is likely to evolve into 2019, with the rider that US events and policy could become recurringly disruptive.

Emerging market currencies are likely to lag. The consensus is that the China CNY rate has downside due to the likely movement to a current account deficit and a slump in growth post the pull-forward of export orders.

In turn, this would have implications for the AUD.  The currency stabilised in the low 70c range, held up by stronger commodity prices, an improving GDP and low deficits. Were the RBA to hint at a rate rise, the AUD should strengthen.

The downside could come from higher than expected US rates or pressure from China. The tied link to the economy of China is now expressed in the exchange rate.

Another factor is capital flows, which have been modest in recent times. The mining and LNG sectors have moved past their respective large spending programmes that required foreign capital inflow and the banking sector continues to see foreign demand for bonds. Conversely, short term deposits and commercial paper has reduced demand, attributed to the repatriation of US cash holdings.

The CBA provides a range of forecasts for the AUD/USD based on several scenarios. On balance, the expectation is that the exchange rate will drift towards the mid 70c range, which would align with the RBA’s view of the fair value for the currency.

AUD/USD outlook (CBA forecast profile)

Source: CBA

  • Unhedged global investments have traditionally proven to be a buffer to sell downs as the AUD is vulnerable to risk off sentiment. This is less likely to be the case now, given the valuation of the currency. A much stronger AUD could emerge on the back of a growth recovery in China; likely to be mid to late 2019. Correlation in currencies and equity markets may add to portfolio volatility, but not impact on the longer-term return potential.

Focus on ETFs

- The resources sector has been one of the top performers in the ASX200 over the past 12 months. Investors can gain access to this sector through sector-based ETFs.

This index includes the energy, metals and mining industries, making up nearly 25% of the ASX200. As the sector has a substantial reliance on the price of commodities it is inherently has a higher volatility.

There is a high concentration to BHP, Rio Tinto and Woodside Petroleum, which combine to account for over 50% with BHP alone contributing 33% of the index. Therefore, due to these heavy weights there are close ties between the performance of BHP, RIO and the index, as demonstrated in the below chart.

Monthly Returns – BHP, RIO and ASX 200 Resources Sector

Source: Morningstar, Escala Partners

Both SPDR® S&P/ASX 200 Resources ETF (OZR) and BetaShares S&P/ASX 200 Resources Sector ETF (QRE) replicate the performance of the ASX 200 Resources Index. OZR and QRE have similar MERs of 0.40%pa and 0.39%pa, respectively, while QRE has a maringally lower Bid/Ask spread of 0.11% compared to that of OZR’s 0.16%.

VanEck Vectors Australian Resources ETF (MVR) tracks the performance of the MVIS Australia Resources Index. This index differs from the traditional market cap weighted index as it has a rule of a maximum 8% single stock weight and must have a minimum of 20 companies. This is designed to avoid the concentration risk of the market cap index dominated by BHP and RIO. Therefore, this ETF will outperform OZR and QRE when the iron ore price is weaker and is overweight mid-companies, typically in base and precious metals. The index includes companies that generate at least 50% of their revenues from energy and mining and include could include companies that are not considered a ‘pure play’ on resources such as Aurizon (AZJ). The MER is 0.35%, the lowest in its peer group.

MVR relative weights versus S&P/ASX 200 Resources Sector

Source: Morningstar, Escala Partners

  • For those investors that are underweight resources, these sector-based ETFs provide a viable option to gain access to this sector. MVR is a respectable alternative for those investors who may want to have less of an exposure to BHP and RIO or additional exposure to smaller companies. 

Fixed Income Update

- APRA proposes an increase in capital requirements for the banks.

- Domestic and US interest rates stay on hold in November.

- Italian bonds sell off on budget concerns.

- We highlight why the same credit rating does not mean the same probability of default.

APRA released a paper this week proposing that ADI’s (Authorised Deposit-taking Institute) increase their loss absorbing capacities, with the suggestion that they issue around $75bn subordinated bonds (Additional Tier 2) in the next 4 years. The aim is to ensure that the banks have sufficient capital in the event of a failure without needing taxpayer support.  Credit spreads on existing subordinated bonds drifted slightly wider, although very little bonds traded.

This week marked the 7th year in a row that the RBA has kept the cash rate on hold on Melbourne Cup Day, after changing rates for 6 consecutive years from 2008 till 2011. While the decision was expected, the central bank did surprise with an upbeat outlook on the domestic economy. In this it revised growth forecasts and inflation while lowering expected unemployment. The futures market responded by increasing the likelihood of a rate rise by the end of next year.

The FOMC also met this week and kept US rates on hold.  From the accompanying statement the outlook remains largely unchanged, with a December rate hike still anticipated. As such, there was little movement in US bonds following the release.

Italian bonds however, responded to warnings from the European Union that Italy’s budget deficit was moving close to the bloc’s deficit target of 3%, resulting in a significant spike in bond yields. 

Italian 10-year bond yield

Source: IRESS, Escala Partners

  • While our base case is that the RBA won’t raise rates for at least a year, the likelihood of them acting sooner remains a tail risk for long duration domestic style funds. We remain underweight to this sector of fixed income. US duration has emerging value, while investing in Italian bonds will be a volatile ride.

A rating of BB+ or below is considered sub-investment grade by the ratings agency, S&P.  Ratings are assigned to an issuer of the debt (at a senior level) and then individual debt pieces are also rated according to where they fall on the capital structure. For example, ANZ (and the other majors) has an issuer rating of AA-, which is applied to its outstanding senior debt. However, debt issued lower in the capital structure, such as subordinated bonds and bank hybrids, are assessed to have a higher risk of loss given a default and are therefore rated accordingly. ANZ bank hybrids are rated below investment grade at BB+ (although we note this may change in the near term as it is under review with S&P).

Current ratings of the four major Australian banks.

Source: S&P, Moody’s, Escala Partners

The ‘high yield’ market consists of any debt that is rated below investment grade. This includes senior ranked debt components from lower rated companies that have an issuer rating of BB+ or below, as well as bank hybrids, even though the issuer is above investment grade at a senior level. Mezzanine or subordinated tranches of structured deals such as RMBS (Residential Mortgage Backed Securities) are also included.

While all are high risk/high yielding securities it is important to consider the differences. Companies that have weaker financial metrics, resulting in the company rated below investment grade at a senior issuer level, clearly have a relatively high probability of becoming non-viable and defaulting on outstanding debt, with investors realising an absolute loss.  By contrast, similarly rated bank hybrids from an investment grade issuer (eg ANZ, CBA, Westpac, NAB) have a lower chance of an investor loss as the probability of the company defaulting is low.  However, in the event of a default, the likely recovery rate of the lower rated bank hybrids is extremely low, especially given APRA’s capital trigger which will convert the hybrids to equity if the regulator deems the bank non-viable.

  • Investment decisions should not be based only on credit ratings. In the example above, one must distinguish between the likelihood of a loss from a company default versus the amount of the loss given a default.

Corporate Comments

- Westpac’s (WBC) flat profit was the best of the major banks this reporting season. Potential medium-term risks to earnings include bad debt normalisation and further customer remediation costs.

- Costs hurt James Hardie’s (JHX) quarterly profit margins, which has translated into a ~6% downgrade to its full year guidance. The stock now screens as value for investors who can look through the short-term noise.

- Lendlease (LLC) has suffered further losses in its engineering division, leading to a share price decline much larger than this ‘one-off’ event would imply.

Westpac (WBC) rounded out a benign set of results for the banks (summarised in the following table), with a full year profit inline with expectations (flat year-on-year). There were parallels with the trends reported from its peers last week, including record low bad debts (9bp for WBC) and sound credit quality, margin pressure from high levels of competition in mortgage lending and a rise in funding costs, a slowing in credit and hence revenue growth, client remediation costs arising from the Royal Commission (impacting both the retail bank and BT wealth profit) and another year of flat dividends.

Major Banks: FY18 Results Summary

Source: Company reports, Escala Partners

Relative to the three other major banks, there are two points of difference worth highlighting. The first is in its higher proportion of interest only lending in its mortgage book, which is gradually being unwound given the push by APRA, the drop off in investor lending and the tighter lending standards that are now being implemented. WBC still has 35% of its total mortgage book on an interest-only basis and as this reduces towards principal and interest, there is a greater margin headwind for the bank compared to the other majors.

The second distinction is on the cost side, which is the focus of the sector given weak lending growth. Westpac has set a cost target which would equate to around 2% growth on an underlying basis, less ambitious than the other major banks. A factor which remains unknown for WBC and the broader sector is the level of additional remediation costs in FY19, which are again expected to hinder the possible return to profit growth over the next 12 months.

A return to a normal credit environment has the potential to also constrain earnings and hence dividends into the future (a normalisation in bad debts would cut earnings by up to 10%), although little of this is factored into the medium term. Despite attractive valuations and healthy forecast dividends, we remain wary of the sector given the ongoing headwinds.

James Hardie (JHX) has been a particularly volatile stock around its quarterly profit announcements, which can often lead to an extrapolation of shorter-term trends in its business. This was the case again this week as it published its second quarter report. The focus of investors was on its outlook statement, which was likely to attract attention given the recent weak share market performance of US stocks exposed to home building.

The company downgraded its full year profit guidance by 6% at its mid-point, which led to a share price decline of twice this quantum. This appeared to be a fairly significant reaction given that a) the majority of this related to rising input costs (key costs such as pulp and freight were up more than 20% year on year) and hence a reduction in margins; b) management’s assumed forecast of new housing construction in the US was unchanged (while noting that “market conditions remain somewhat uncertain”) and c) there has been quite considerable variability in the past in JHX’s margins, which had already been trending down over the last three quarters.

James Hardie: Quarterly EBIT and EBIT Margin


The rise in input costs should be cyclical rather than structural in nature and therefore it is safe to say that it is the wrong approach to capitalise this factor into perpetuity. Nonetheless, margin risks can be expected to be to the downside in the short to medium term, along with the additional uncertainty caused by a softening (though not collapsing) US housing market, which may also slow efforts to recover costs via price increaes.

For investors who are willing to look through the short term noise, there is value starting to emerge in the stock. JHX’s forward P/E has now fallen to ~16X, well below the premium it has historically traded relative to the broader industrials index given its quality characteristics and track record of earnings growth.

Also feeling the wrath of investors this week was Lendlease Group (LLC) after it revealed an additional $350m provision in its engineering division, relating to cost blowouts on a small number of large projects. While these have occurred in the past and are rarely forecast by sell side analsyts, the risk of provision was somewhat elevated in this year after the same projects led to a writedown in the company’s FY18 result. Once these regular ‘one-offs’ are included in LLC’s earnings, the thin margins that LLC generates on these projects are generally wiped out, significantly diluting the through-the-cycle returns of the business.

Considering that the provision equates to ~60c (or just more than 3%) per share, LLC’s 18% share price decline today looks somewhat overdone, although there are obviously some resdiual risks that there will be more to follow as these projects (including NorthConnex) are completed in coming periods. A case could be made for the spin-off or sale of this division given its higher risk and lower return profile, which has detracted by the much better performing core business units that would argubably attract a higher earnings multiple on their own.