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WEEKEND LADDER

A summary of the week’s results

09.12.2016

Week Ending 09.12.2016

Eco Blog

-  The headline of negative third quarter Australian GDP was largely dismissed as an anomaly given the boost to come from higher commodity prices into 2017. Housing is one key area to watch for risk.

-  Evidence of a modest acceleration in global growth is widespread. However, seasonal influences may see a weak first quarter in the US.

-  The ECB has extended its bond purchasing programme for a further nine months, albeit at a slower pace.

A weaker than expected third quarter GDP outcome had economists scurrying back to their models to work out why. The summary finding was a view that the weakness was overstated, but that there were some trouble spots previously not identified. Dwelling investment declined in the quarter, undermining the ‘crane count’ that some use to assess activity in the housing sector. The fall is attributed to adverse weather conditions over the month, which also flowed into retail sales (already evident from the ABS data for apparel and department stores). The drag from a fall in small business profit and a slump in productivity are both somewhat worrying features. 

On the other hand, nominal GDP is growing at 3% year on year due in part to a rebound in employee compensation. Indisputable evidence of the change in the terms of trade is also obvious, which should expand rapidly into 2017.

The annual and quarterly growth in industry sectors paint the picture of the current status of the economy. Construction, manufacturing and transport all remain a drag on growth (in terms of gross value add), while the finance sector, information, communications and telco are robust, along with other services.

Source: NAB
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These industry contributions are not picked up in the usual data releases, with the bulk of monthly trends picking up only activity in physical retail, construction and mining. Picking the GDP indicators from services is near impossible, bar anecdotal evidence from indirect indicators. 

Data for the forthcoming quarters now becomes much more critical to prove or disprove the resilience of the longstanding positive growth in the Australian economy. By the second quarter of the coming year, the kick from the terms of trade should be well imbedded, given the basing effect of commodity prices against the very weak period in February/March 2016. The impact on national income, as we have noted before, is not that obvious and takes time but, if it does eventuate, will likely support a meaningfully better headline GDP growth rate over the course of 2017.

The housing market will also remain in focus. Residential investors don’t appear to have heard the siren song from higher mortgage rates or a weakish economy and have once again upped their exposure to debt. A solid rise in October has taken investor lending to 12% annual growth after a decline earlier in the year. Owner occupiers are more conservative and lending is down 7.7% on an annualised basis. One of risk to stability in in the Australian economy is the sharp rise in household debt; most of its recent growth has supported high leverage in investment housing. Low rates and tax breaks are ingrained in the system and any change at a marginal level may create a headache for those whose expectations lie with capital gains.

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The potential for an improvement in global growth into 2017 is gaining traction. Broadly-based data such as PMIs, interest rates, local consumption trends and inflation suggest a rising pattern across much of the developed world. Inevitably the US data will be closely observed.  To muddy the water, US first quarter growth is developing a habit of underperformance relative to the rest of the year. The government agency, Bureau of Economic Analysis, this year found that the measures used to determine growth were not fully adjusting for seasonal fluctuations.  The problem appears to stem from so called residual effects, in short, where a component of economic activity has an impact on other quarters. In 2015 for example, Q1 GDP first came in at a low 0.6%, only to be revised to 2%, while Q2 was lowered from 3.9% to 2.6%. For the first half, the growth rate was therefore stable, rather than a slump followed by a rally.

Presuming this pattern repeats in 2017, bond yields may well take a breather in the first quarter. This will coincide with the anniversary of the bottom of the oil price in February 2016, which has an unusually large impact on US inflation and inflation expectations.

In the meantime, the ECB committed to extend their monetary policies for nine months, longer than expected, though the programme was adjusted to a slower pace of bond purchase to €60bn from €80bn per month. The debate will turn to expected conditions in September 2017, the next date that will require a decision. Inflation is edging up, but European growth needs to be confirmed amongst unusually difficult political conditions. The experience from 2016 would suggest that business activity can brush off any discomfort. UK recruitment trends suggest the labour market will tighten, notwithstanding the uncertainty surrounding Brexit. In all the noise, few have focused on the unemployment level in the UK, the lowest in 11 years at 4.8%. At this point, the US, UK and Germany all have lower unemployment than Australia.

Fixed Income Update

-  Italian bond markets overshot leading into last Sunday’s referendum.

-  The RBA kept rates on hold and has anchored the short end yields on domestic bonds.

-  The investment grade universe of corporates is shrinking. 

Despite the overwhelming ‘no vote’ from the Italian referendum last Sunday,  global fixed income markets appeared unaffected, with the moves being contained to the Italian market. In what is typical of financial markets, and their ability to overshoot, the rumour was worse than the fact. Holders had been selling down Italian government securities in prior weeks, pricing in expectations of a ‘no’ result, with yields rising 1% over two months (a significant rise considering the low starting base of 1.15%). However, in the subsequent days, bond yields eased (prices higher). 

Italian 10 Year Government Bond Yield

Source: Escala Partners, Iress
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Interest rates were left on hold at 1.5% by the RBA this week. The commentary stated that the board believes this is “consistent with sustainable growth in the economy and achieving the inflation target over time”. Further to this, it made note on below-trend inflation which is expected to remain range bound in the near term. While domestic yields on long bonds have risen in line with global markets over the last few months, our short end remains firmly anchored to decisions by the RBA.

Weak economic data in Australia (including a negative GDP print this week) will keep rates low, with the consensus being that our central bank can still hold an easing bias. The chart illustrates the shift upwards in yields for longer dated bonds, while the short end moves have been limited. This highlights the impact of global factors driving the long end, while the short end remains tied to the RBA interest rate setting.

Change in Australian Yield Curve in Last Month

Source: Escala Partners, Bloomberg
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Fixed income markets regularly rely on rating agencies to assess the credit worthiness of an issuer. The highest rating that can be achieved by Standard and Poor’s rating agency is AAA and anything above BBB- is considered to be investment grade.

Since the financial crisis, US companies have amassed 2.4x median debt to EBITDA, the highest level since 2002. This boom in debt issuance has dragged credit ratings lower. By comparison, 20 years ago, 66% of companies were investment grade; today it is 45%. At present, there are only two companies in the US (Microsoft and Johnson and Johnson) that hold a AAA rating compared to 60 companies in the US 30 years ago. The other side of the coin is that interest rates are low with a very limited likelihood of the double digit rates of that past era. Credit analysis shows that, as such,  a change in business circumstances or strategy is a better indication of potential default than debt levels.

Corporate Comments

-  IAG’s strategy update placed greater emphasis on the cost out opportunity ahead, although the benefits are unlikely to flow through to earnings in the next two years. 

-  Origin’s (ORG) decision to IPO its conventional oil and gas assets could be the first step in an eventual demerger of the company’s utilities division and stake in APLNG. 

-  Santos (STO) has make excellent progress this year in reducing costs as it has faced a high debt burden. Its current situation is more comfortable, however its operations still remain relatively marginal. 

-  DUET Group (DUE) has received a takeover offer, although there remain a few hurdles before a deal is completed.

As with many companies that have struggled in a competitive, low-growth environment in recent years, IAG’s strategy update placed a greater weight on the opportunity to improve earnings by taking costs out of its business. The group’s new CEO outlined a strategy that expects a medium term top line growth (in line with the market) of 3-5%, while reducing pre-tax operating costs by at least 10% (~$250m p.a.) by the end of FY19. The key drivers of these savings are expected to arise from the consolidation of its core systems (from 32 down to two) and realising benefits from rationalising its supplier base.

For shareholders, however, the profile of the realisation is expected to be slow, with the related costs expected to be greater than the benefits in this financial year, broadly neutral in FY18, before ramping up the following year. The company could be commended for its intention to absorb the costs ‘above the line’ although it will therefore still be the broader market conditions which dictate earnings over the next two years, including factors such as claims inflation, volumes, premium growth and investment earnings. Volume and premium growth is still evidently difficult in the current market, with IAG guiding towards a flat outcome for FY17.

Within our recently updated concentrated guided portfolio, we have QBE within the insurance sector. QBE is also operating in a competitive global insurance market and has been taking out considerable costs out of its own business, although has the additional tailwind of the expected lift in short term interest rates in the US, which will boost the earnings from its investment portfolio.

Origin Energy (ORG) announced the planned IPO of its conventional oil and gas businesses (with a listing targeted for 2017) to instead focus on its core energy markets division and integrated gas (primarily APLNG). The decision was not entirely unexpected given that ORG had previously noted to the market its intention to pursue the sale of some of these assets after also selling its stake in Contact Energy last year. It also fits with one of the group’s primary shorter term objectives in reducing its net debt below $9bn this financial year to help protect its investment grade credit rating.

Origin Energy: Assets to be Included in IPO

Source: Origin Energy
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With a range of historic transaction earnings multiples across the sector over time, estimates for the value of the assets vary quite widely across the market. An additional complication is the relatively high cost and short asset life based on existing reserves. Most analysts, however, expect net proceeds of between $1bn - $1.5bn for ORG.

While the timing of the transaction makes some sense in that it capitalises on the recent recovery in the oil price (particularly post OPEC’s decision to cut production), following the deal, ORG will effectively reduce the vertical integration of its gas retailing business, subjecting the company to the same risks that saw AGL downgrade its outlook back in July. We also note that ORG does not have the same positive leverage to rising wholesale electricity prices as AGL, which is long generation.

A possible question to arise from ORG’s decision is why the company did not also include its APLNG stake in the IPO. This does not appear likely to be considered until at least the APLNG debt becomes non-recourse to ORG sometime in the second half of next year, the project is further de-risked through the ramp up of production and operating costs are reduced. After surviving the worst of the oil downturn in part due to an equity raising late last year, ORG is in a better position today, although following a sharp rally in the group’s share price since early February, the value in the stock is now perhaps more limited.

Origin’s decision had some parallels with Santos’ (STO) new strategy announced at an investor day this week, with the company now simplifying its business to focus on its five core natural gas assets, with the residual to be run as a standalone business with the potential to be exited through a sale process. STO’s immediate focus also remains on its debt burden, with the company targeting a US$1.5bn reduction in net debt to less than US$3bn by the end of 2019. While achieving this goal will largely depend on the progression of the oil price over this time, STO has reduced some commodity price volatility through a partial hedge that it has in place for 2017 that limits the downside to prices but putting a ceiling on the upside.

STO also provided updated guidance on its Gladstone LNG project, with a slower ramp up to capacity than previously expected. The company has done an excellent job through this year by reducing the free cash flow breakeven oil price on its operations from US$47/bl to US$39/bl. The fact remains, however, that its core assets are still relatively high cost and, as illustrated in the following chart, did not begin to generate positive free cash until May this year. Asset sales and natural field decline are expected to lead to a drop in the company’s production levels over the next two years.

Of major listed oil stocks, Santos has the most leverage to a better oil price environment, although our preference remains with Oil Search, which also has a stronger portfolio of growth opportunities.

Santos: 2016 YTD Free Cash Flow (Before Asset Sales)

Source: Santos
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The utilities sector, which has borne the brunt of the sharp rise in bond yields over the last few months, rebounded this week following confirmation by DUET Group (DUE) that it had received an “unsolicited, indicative, incomplete, non-binding and conditional proposal” from Cheung Kong Infrastructure (CKI) to acquire the company for $3 per stapled security. DUE is yet to respond to the deal, which is expected to face some scrutiny from the Foreign Investment Review Board (FIRB). FIRB had already rejected a combined bid from CKI and State Grid (owned by the Chinese government) for NSW ‘poles and wires’ operator AusGrid in recent months.

The uncertainty of the deal being completed has left DUE trading at an approximate 7% discount to the offer. What appears to be a full price (at 1.6x DUE’s regulated asset base, at the upper end of recent transactions) has also reduced the possibility of a rival bid emerging. The more surprising element may be in the timing, with current upward pressure on interest rates likely to put a lid on valuations across the utilities sector for the near future. Evidently, CKI would appear to be not buying into the current reflationary view that has been gaining greater traction since the US election.





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