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WEEKEND LADDER

A summary of the week’s results

10.02.2017

Week Ending 10.02.2017

Eco Blog

We have summarised a useful paper on why the Australian cash rate will be lower than before and considered the investment implications.

Asian export growth has picked up considerably, with the benefits into their domestic economies still to come. Australia is somewhat sidelined from this welcome momentum.

The term ‘new normal’ has been used to describe what could be stable growth, inflation and interest rates in the coming years. Locally, the CBA economics team have worked on what the ‘normal’ RBA cash rate should be. Establishing the likely level of interest rates will determine a substantial amount of investment options and return. Back in 2001, the then governor of the RBA, Macfarlane, stated that the normal interest rate was 6% (3.5% real with inflation at 2.5%). Ten years later, Governor Stevens put the neutral rate at 4.5%, reflecting the post financial crisis environment. The current governor, Lowe, has indicated that it is ‘lower’ than that. CBA think 3%. The point of determining what this rate should be tells us a lot about the potential growth in the domestic economy and how monetary policy is being used to support or dampen direction.

During the 1990s our high economic growth was a function of a rise in hours worked (mostly due to the growth in female participation in the labour market), a solid increase in productivity and growth in capital stock (i.e. investment spending). Post 2000, the commodity cycle masked the trends. Productivity has been declining and hours worked has softened considerably. Now output per capita is declining, which means there is a lower rate of return on capital and labour, which then dampens investment given the expected return will be lower than before, and therefore interest rates remain low.

Awkwardly, the size of the Australian household sector debt makes the management of interest rates ever more complex.  Given the importance of household spending in the economic equation, and that most debt is floating rate, the sensitivity to rates is extreme. The fall in interest rates over the past 7-8 years therefore was another buffer to growth.

But the growth in housing debt, in particular, has had another impact. Prior to 2008, the difference between the cash rate and lending rates was low; risk pricing was, with hindsight, clearly too low. That would have changed in any event and the impost of regulatory capital measures has taken that even one step further. Housing debt however has escaped much of this movement and small business has worn the biggest step up. Essentially, housing has crowded out business.

Source: RBA, Commonwealth Bank
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Add to this fiscal expansion or contraction. Once again, the economic support from rising government debt is (apparently) to diminish which would reduce the requirement to run interest rates at a higher level.

Finally, the currency comes into play. A rising AUD tightens monetary policy and the CBA team judge the currency to be slightly above fair value at the moment; hence it currently acts as a brake on growth.

After putting its assumptions on several models, the team comes up with a ‘neutral’ cash rate of between 2.5-3.5%, with a mid-point of 3%. The movements around this rate will have a skewed impact if the structure of our debt obligations remains with the household sector. A small rise in rates will result in a greater tightening than before, whereas easing policy needs bigger cuts to achieve the same economic outcome. This is due to the fact that household spending has a lower level of impact than business investment.

All this sets up for a low growth, low rate outcome for Australia in coming years. Of course, there are scenarios that would paint a different picture - a commodity boom or bust, an inflation spike, a large influx of immigrants or a productive investment spending programme, but these are lower probability.

The investment implications are far-reaching. Fixed income returns will be within the lower interest rate parameters, and the risks in higher rate securities or products should never be ignored. Equity valuations have already assumed a lower discount rate, and that may be of some comfort that a valuation sell off is less likely. But what is not incorporated is the lower growth rate (or terminal growth rate) in the case of a discounted cash flow projection. Naturally the capital growth potential from equities is therefore more limited than before. Dividends have formed the bulk of investment returns in the past decade. While at present, dividends for the market on aggregate look relatively secure, though it will mean that dividend growth will fall and in some cases nominal payouts will level off.

The RBA has been suggesting that the corporate sector has not fully adjusted to accepting a lower level of return on investment than they were able to achieve in the past. The same applies to most investors. But on the other hand, lower inflation than before may mean that real returns are less affected.

For all the noise out of the US, it is the economic developments in Asia that, in good part, set the scene for Australia. In the past week, China has raised its interest rates across the board. China watchers suggest this is more of a signal than a shift in policy and intended to reign in private sector credit growth, which was showing the usual signs in property market exuberance. The secondary effects were on the currency, with the renminbi for once rising against the USD, though at a time of general weakness in the USD. Nonetheless, it was a useful outcome, as the claims of ‘currency manipulator’ hang over exchange rates.

At the time of the US election, the fear that a stronger USD would affect the financial strength of emerging economies (to the extent they have USD debt) and that export trade would face barriers and tariffs. While these issues remain real, the current momentum is working in Asia’s favour. Global growth was already picking up into the end of 2016 and therefore Asian export sectors are benefitting. This week, China data shows a 16% jump in exports. The Lunar New Year would have brought forward some of this trade, but other indicators suggest there is more to come.

A way of assessing the voracity of this improvement is in the data from high export countries such as Taiwan and Vietnam. The trend has gained ground over some months and heralds a significant turnaround from last year.

Taiwan Exports (LHS) and Vietnam Exports (RHS)

Source: Deutsche Bank
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The risk to these countries’ debt from a higher USD is also overstated. Firstly, they have large foreign exchange balances, complements of years of trade. Secondly, the borrowings are largely in the form of bonds held by pension funds and the like, rather than bank lending, which will be subject to structural changes such as occurred after 2008/9 when most developed country banks withdrew from these markets. Most emerging economies have been at pains to protect themselves from these external financial changes in pattern, including the USD. They won’t escape the impact, but the outcome is unlikely to be as difficult as it has been in the past.

For the Australian economy, the recovery in Asian exports has already come through the commodity market. Further upside could be through services flow – predominantly tourism and education. But otherwise a stronger integration of economic benefits appears elusive, and the corporate sector has relatively little to show in terms of direct interaction with Asian economies.

Fixed Income Update

The RBA kept interest rates unchanged this week.

- The probability of further rate rises by the US Federal Reserve Bank at their next policy meeting has been scaled back.

- National Australia Bank has brought to the market a subordinated bond to replace NABHB securities, which have a call date in June 2017.

As anticipated, the RBA kept rates on hold at 1.5% this week, with no significant moves in the bond market following the announcement. The accompanying statement noted that conditions had improved in the global economy in recent months, with a pick-up in business and consumer confidence. The outlook for the Australian economy was broadly unchanged, with comments that the negative Q3 GDP print reflected ‘temporary factors’ and it expect headline inflation to pick up above 2% in 2017.

The consensus from market participants is that interest rates will remain on hold domestically, with only a small number of financial institutions predicting further rate cuts. The domestic futures market is only pricing in a slight easing bias throughout 2017, with the first sign of a rate rise priced in at the start of 2018.

In offshore markets, US treasuries have continued the recent upward trend, as market sentiment is of the view that subdued inflation will prevent the Federal Reserve Bank from raising rates in coming months. The futures market is showing the probability of a rate hike by the Fed at the March meeting has fallen to 24%, down from 34% a month ago.

Fed Rate Hike Probabilities (As Reflected in Futures Market)

Source: Bloomberg, Escala Partners
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Financial media publications have reported that asset managers have been the main buyers of these futures, causing the shift as they look to lengthen duration within portfolios. Volumes are said to be at record levels. As a reminder, the US central bank lifted interest rates in December last year and released somewhat hawkish commentary, indicating that more rate hikes were to be expected. Nonetheless, fund managers will jump on any opportunity to trade in and out of bonds if they believe yields are moving ahead or behind their judgement of where rates should be.

As discussed in last week’s publication, there has been a huge amount of new issuance in the US markets already this year.  This new supply has been well received, with $2.7bn flowing into US investment-grade corporate bond funds in the last week and inflows of $12.4bn year to date. Amongst the $185bln raised by investment grade issuers this year, Apple and AT&T each issued $10bn of debt, and Microsoft issued a $17bn bond, which is the largest offering so far this year. These deals have been well oversubscribed and have been issued at tight margins.

In the domestic market, this week National Australia Bank announced a new listed subordinated bond. This new deal replaces the NABHB securities, which will be called by the issuer in June this year. The terms of the deal include a 11 ½ year final maturity, with the issuer having the right (but not the obligation) to call the bond at a call date in 6 ½ years.  The coupon on this bond is BBSW +2.20%. Subordinated bank bonds rank above bank hybrids and equity on the capital structure, but below senior debt and term deposits, and non-payment of coupons is a default by the issuer (as opposed to hybrids which have discretionary coupon payments).

One metric to assess fair value on these types of securities is to look to the secondary market and do a price comparison on similar type bonds. In this case, there hasn’t been a subordinated bond issued in the ASX listed market in three years; therefore bonds in the Over-The-Counter (OTC) market are used. All current outstanding subordinated bonds by our major banks have a shorter maturity (under five years) and a projection of a term premium needs to be factored in ensure investors are compensated for the additional time to maturity (credit risk increases the longer the bond).

The issuer’s credit quality, the maturity of bond, position on the capital structure, liquidity of instrument, and issue size are considered in relation to the bond’s re-offer price. Price comparisons to other listed bonds (albeit corporates with different credit profiles) is also undertaken. The position of this new NAB bond compared to other subordinated listed debt securities is illustrated below.

Source: Escala Partners
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Corporate Comments

Carsales.com (CAR) reported excellent results in its core operations, while its smaller divisions were mixed.

- Rio Tinto (RIO) switched from capital preservation to capital returns with a better full year result.

- Transurban (TCL) provided a positive distribution surprise with its half year report. The risk lies with rising interest rates.

- AGL is in the early stages of capitalising on rising wholesale electricity prices, although the stock has re-rated ahead of the event.

- Henderson Group (HGG) has a short term issue in stemming fund outflows. Attention will soon turn to its merger with Janus Capital.

- Suncorp (SUN) showed some early progress in restoring its general insurance margins; this remains a work in process.

Carsales.com (CAR) had a positive reaction to its half year numbers with excellent top line growth, somewhat defying the notion that its domestic operations are maturing. The company generated 13% online advertising growth, with expansion across each of its key categories.

The principal criticisms of the result would be that it was lower-margin elements of its business that were key in the group’s solid revenue number, its international investments reported mixed results and the acquired Stratton Finance division suffered an earnings hit after a large volume reduction from one its major lenders. At this point in time, CAR’s international operations are still yet to contribute materially to overall group earnings, accounting for less than 10%.

CAR has managed to navigate some rising domestic competition and pushback from car dealers in recent years, demonstrating the strength of its competitive position. With the stock offering a respectable 10% medium term earnings growth rate, it screens as reasonable value given the limited options in the market with this outlook.

The transition from capital preservation to capital returns continued for Rio Tinto (RIO) as it lifted its final dividend and announced a $US500m share buyback (to be transacted on the company’s UK-listed stock). While the buyback was lower than some analysts and investors in the market had been anticipating, it still completed a remarkable turnaround from this time last year, where the company had abandoned its progressive dividend policy. The decision has been permitted due to further strengthening the company’s balance sheet on higher earnings and asset sales, with gearing at 17%, below the 20-30% target range.

While the year was characterised by a sharp rebound in a number of commodity prices, some prices were still lower than that achieved in 2015 (a function of the high starting base at the beginning of this year), as illustrated in the following chart. As a result, the primary driver of the improvement in profit was RIO’s ongoing commitment to reduce its cost base, with US$1.6bn in pre-tax savings achieved in the year.

Rio Tinto Key Commodity Prices: Averages Lower in 2016

Source: Rio Tinto
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While the commodity recovery has been broad, particularly in the second half of 2016, iron ore remains pivotal to the profitability of Rio Tinto, accounting for more than three quarters of the group’s earnings. Its pricing path through 2017 will thus have a large influence on further capital management over the next 12 months and expectations will increase the longer current spot prices hold, particularly given a low appetite for large capex.

Several factors point towards some sustainability of the recent rebound, including China’s focus on reducing high-pollution steel production, favouring the high-quality iron ore product of the Pilbara producers. Nonetheless, with some tapering in stimulus and additional seaborne supply growth, the widespread expectation remains that iron ore will be softer over the next 12-18 months. With earnings momentum likely to continue in the short term (as analysts upgrade commodity prices to match realised pricing), we believe that some exposure to the sector for most investors remains appropriate.

Transurban (TCL) again provided a positive distribution surprise with its result, with a slight upgrade to its full year guidance. The group achieved 12% EBITDA growth on the back of a 5% increase in traffic numbers, with contracted toll increases adding to the top line. Margin improvement from operational leverage has also continued to play a part. Approximately half of this earnings growth was from the company’s existing asset base, while half was from the  AirportlinkM7 assets acquired from the Queensland Government in late 2015. The result was achieved despite the disruption involved with the Tullamarine freeway widening project, which has had an adverse impact on traffic flow on the road.

Outside of ongoing organic growth in its existing portfolio, TCL has retained a large optionality value with existing upgrades and/or the prospect of participation in new projects that will often feed traffic flow to its network. Among these are the Western Distributor project in Melbourne and the possible sell down of WestConnex in Sydney by the NSW Government. The former is expected to require a call on additional equity capital, which may occur in the second half of this year.

Transurban Development Pipeline

Source: Transurban
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While TCL has continued to perform well operationally, realising the benefits of its core integrated network, the key risk for the company remains one of valuation and the direction of interest rates. The second half of 2016 reflects this transition as the stock dropped by almost 25% as yields reversed a multi-year decline. We believe that TCL is better placed than many of the other ‘bond proxies’ in the market due to its inflation-linked revenues. An extension of its debt maturity profile beyond nine years also protects the company to a degree. Nonetheless, we believe that a lower allocation to these sectors of the market is recommended in the current environment.

AGL Energy required a good result after a strong share price rally since mid-September and the company didn’t disappoint. Earnings growth was just 4% for the half, yet the company said that it expected its full year profit to come in at the high end of its forecast range. Reflecting the new adopted dividend policy of a higher payout ratio at approximately 75%, the half year dividend was increased by 25% to 40c per share.

Presently, there are two key drivers to the AGL investment thesis and one principle drag. The first of these, which has now been largely realised, is its cost reduction program, aiming for $170m in savings by the end of this financial year. A further program is anticipated, although is yet to be announced.

A second driver, which is still yet to be reflected in the company’s earnings, is a better outlook for wholesale electricity prices following some rationalisation of supply and an improving demand outlook. Two recent developments have supported this outlook; the announcement of the closure of Hazelwood power station next month and the decision by Alcoa to keep its aluminium smelter in Portland open (which represents approximately 10% of Victoria’s electricity demand).

AGL’s acquisition of Macquarie Generation just over two years ago appears to have been relatively well-timed to capitalise on this theme, with a considerable earnings lift expected. Benefits will largely flow through over FY18/FY19 and are phased over different time periods according to the segment of the market. What may slow this transition is continuing high competition in the retail market and the threat of political intervention, particularly given the sensitive topic of power prices.

AGL: Pass Through of Electricity Prices by Segment

Source: AGL Energy
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Finally, balancing these positives is the increased costs for AGL’s gas supply as the company’s low cost legacy contracts are renewed. This is expected to result in a $100m impact on EBIT for this financial year.

The rally in AGL’s share price over the last few months has reflected this improving outlook for the company, with earnings upgrades alongside a healthy P/E re-rating. To the extent that the changes in AGL’s earnings base are structural as opposed to cyclical, the lift in valuation for the stock would appear to be warranted, with strong earnings growth now expected over the next few years.

Henderson Group (HGG) reported a full year result that was in line with expectations, although contained some concerning trends. Of greatest significance was the ongoing net outflow of funds from its business in the fourth quarter, reversing the trend of more recent years. The rate of outflows accelerated after the initial spike in the lead up to and following the Brexit vote followed by the UK’s push for a ‘hard Brexit’ option would lead to the conclusion that this may be an ongoing headwind into 2017. US retail flow show the impact of the fall in sterling and the next quarter will show if that is a one off. On a brighter note, HGG has been winning more institutional mandates, however the fees from this source of FUM are materially lower. 

Henderson Net Fund Flows

Source: Henderson Group
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Performance fees on HGG’s funds were also below that of 2015 (as was anticipated), however the company was able to absorb this partially through a lower employee compensation ratio. While the relative performance of HGG’s funds is an important driver of the company’s share price, market movements should arguably attract greater attention. Currency movements and robust equity performance led to a 10% increase in FUM (as measured in £) over the course of the year, despite a 4% drag from outflows.

The two factors that appear most likely to dictate the performance of HGG in the short to medium term are the impending merger with Janus Capital (with large associated synergies) and the direction of the pound, which some view as oversold. The current share price provides a degree of safety from the risk, with the stock now trading at a reasonable discount to its funds management peers.

Suncorp’s (SUN) result was broadly as expected, with the focus on the turnaround in its core insurance business (which accounts for around 60% of group earnings). To refresh, SUN first highlighted problems in its general insurance division in late 2015, primarily due to a higher rate of claims inflation than expected. This had the effect of reducing SUN’s underlying insurance margin from 14-15% to 10%. For the recent half, SUN has improved this margin to 11%; a better outcome, although below the 12% target that management has set. Steady progress is now expected in the second half of the year, with SUN’s better control on costs and some benefits from premium repricing flowing through to earnings.

Of some concern was the fact that SUN exceeded its natural hazards allowance again, with storms in South Australia and Victoria the biggest contributors to the breach. With this having occurred now in 12 of the last 14 half year reports, this is now an expected outcome for the company.

SUN’s banking business was supported by a very low bad debts charge for the half (less than 1 basis point!), with profit growth of 5%. Net interest margins contracted, while there was little growth in its loan book. The trends in this division are not dissimilar to the broader market. After rebasing its dividend in FY16, SUN has lost some of its appeal as a yield stock, although its forward yield is still comparable to the major banks, with the possibility of special dividends next year due its strong capital position.

Reporting season becomes much busier next week, with the following companies scheduled to release results:

Monday: Newcrest Mining, Ansell, Bendigo and Adelaide Bank, Cochlear, JB Hi-Fi, Aurizon

Tuesday: GPT Group, Challenger

Wednesday: Amcor, Commonwealth Bank, Sims Metal Management, Wesfarmers, Sonic Healthcare, CSL, Computershare, Seven West Media, Boral, IOOF, Dexus Property, Domino’s Pizza, Vicinity Centres

Thursday: Sydney Airport, Telstra, Origin Energy, Tatts Group, Mirvac, InvoCare, Magellan Financial, Goodman, Star Entertainment, Orora, South32

Friday: Santos, Ardent Leisure, ASX, Primary Health Care, a2 Milk, Medibank, Link Administration, Mantra Group

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