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WEEKEND LADDER

A summary of the week’s results

10.03.2017

Week Ending 10.03.2017

Eco Blog

The local housing debate is valid, given the economic risks.

- US economic decisions are vastly complex and it is worthwhile being mindful of the at-times conflicting and challenging decisions. It is unlikely to be a smooth path. 

- The impact of a delayed move in US rates should be factored into portfolios as a possible risk.

The discussion on Australian house prices holds a tenacious grip on the headlines. The concept of a ‘bubble’ is perhaps unproductive, though there is near uniform agreement housing affordability is an issue. Given the nature of the our mortgage market and obligation (compared to, for example, the capacity to walk away from a mortgage in the US), the pressure from mortgage payments due to elevated prices means that disposable income is compromised, with cuts in discretionary spending and the risk of creeping credit card debt.

Judging the extent of the issue is always hard. Some suggest simply that flatlining house prices for some years will alleviate the issue as it did in the 2000’s. However, that was at a time of stronger income growth, not the case now. 

A further telling indicator is the rent to price ratio. The chart shows the historic average for few countries based to 100 and where we are now. The only good news is that there are others with greater differentials. In Sweden, and the other Scandinavian countries, the local regulator is increasingly tightening the market down through a raft of measures such as banning interest free mortgages, raising deposit requirements and limiting the lending to income ratio.

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Many other countries, including Australia, are travelling down the same path with these macroprudential measures battling with loose monetary policy. Similar to Australia, Scandinavia, New Zealand and Canada don’t want to raise interest rates given the likely impact on currencies and business investment. History would suggest monetary policy must play a role. In short, there will be a pain factor, either house prices fall and the wealth effect kicks in, lowering consumer spending, or rates rise and hurt disposable income.

One-way options are a false premise for the US too, with decisions on tax rates, budget deficits, tariff plans and cash repatriation interlinked. The diagram demonstrates the major choices facing the administration. It reinforces the probability any change will be piecemeal.

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Add to the mix the coming change in leadership and composition at the Fed and then the guess as to whether the consensus will be hawkish or dovish on rates. It is then easier to understand that there is a growing view that the rally in financial assets has priced in the potential good news, while ignoring the risks on the other side.

As we have noted for some time, inflation is expected to rise, but remain subdued without a bigger lift in wages. Yet most view that the Fed is already 

behind the curve, given the rate of recovery in the labour market and other activity levels. A dovish tilt will then exacerbate this issue and possibly require a much harder hit by 2018/19. Many recall the 1994 rate hikes, and even though they were widely anticipated, the dislocation was significant. This time, with debt much higher, it would not take anything like the 300bp in hikes of 1994 to cause a much bigger impact.

We have even heard a lateral argument that rate rises will be good for the corporate sector, as it will force capacity out of industries and cause poor operators, which have been able to stay in business due to low interest rates, to fold.

All these issues are probabilities, not expected events. But they reinforce that portfolios cannot just follow momentum into high performing assets, such as equity, without taking on undue risk. As we often note, if a part of the portfolio is marking time while another component is doing the heavy lifting, that is not an opportunity foregone but rather an appropriate degree of vigilance for the unexpected.

There is of course another path too. Economic growth remains acceptable, but range bound due to all the usual culprits – low productivity growth, demographics and debt. Everyone is all too well aware of the impact of higher rates and therefore the expectations of a lid on bond yields. In turn, as long as equities can show earnings growth, their relatively high valuations are possibly acceptable. The caveat is earnings growth. After operating cost cutting, interest cost reduction and buybacks, real headline improvement is now required. And that is expected to be selective, with the refrain of disruptive change from the internet, consumer behaviour and new technologies likely to be repeated in setting up stock selections and active strategies to once again find favour.

Fixed Income Update

The likely path for interest rates in Australia has changed over the last six months. The market is now looking for stability in 2017, as opposed to further rate cuts. 

- The US is gearing up for further rate hikes as early as next week.

- We list the key differences between subordinated bonds and bank hybrids.

- Crown Resorts is looking to buy back their CWNHA subordinated bonds.

- There has been an increase in the number of less liquid fixed income funds in the US.

As expected, the RBA kept interest rates on hold this week and the market was unchanged following the announcement. The tone from the governor was more upbeat given the short term boost to the terms of trade and the income side of the economy. The Board believes that the cash rate at 1.5% is “consistent with sustainable growth in the economy and achieving the inflation target over time”. The RBA notes that “conditions in the global economy have continued to improve” and that “business and consumer confidence have both picked up”.

Expectations on interest rate movements by the RBA have changed considerably over the last six months. Following a fall in the cash rate from 2% to 1.5% last year (a reduction of 0.25% in both May and August), the futures market was previously forecasting further rate cuts into 2017. Six months ago, there was a firm easing bias imbedded into the rates curve, which has been reversed in today’s pricing. Rate hikes are currently priced in for 2018.

Further Interest Rates as Implied by Futures Market

Source: Bloomberg, Escala Partners
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In the US, the most likely outcome is for the Fed to raise rates next week. The futures market is pricing in a 96% chance of this eventuality. While the decision itself should not move markets, the commentary regarding the path and pace of future rises will be the one to watch.

With the recent new issuance that has been taking place in the domestic listed debt market, it is perhaps a good time to refresh on the differences in the structure of bank hybrids and subordinated bonds. In the last month, NAB printed its 6.5 year NABPE subordinated bond with a price of BBSW +2.2%, while CBA opted to issue further down the capital structure with a 5-year (CBAPF) bank hybrid paying BBSW +3.9%. The difference in the spread on these two bonds is due to the structure of these two types of securities. The table below highlights these and helps explain why the CBA deal pays an extra 1.7% over NAB for a shorter dated security.

Differences Between Hybrids and Subordinated Bonds

Source: Escala Partners
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Staying in the listed market, Crown Resorts announced this week that it intends to buy back all outstanding CWNHA subordinated notes. Holders of these securities should seek a recommendation from their adviser.  

Of note in the press this week was the increase in the number of ‘interval funds’ being launched in the US. Concerns around bond market liquidity have been topical in the last few years, given the reduction in balance sheet lending for trading activity by the banks. These types of funds seek to limit redemption risk by only allowing quarterly withdrawal of money, up to a maximum of 5% of the fund. This then allows the portfolio manager to purchase less liquid assets, locking in the illiquidity premium. Further, large cash balances that are often held to meet redemptions can be a drag on performance given the current low interest rate environment.

Australian Equities Reporting Season Wrap

Australian first half reporting season was relatively solid, particularly compared to the disappointments of recent years. Earnings growth for the market for the six months was close to 20%, a good rebound after the decline in earnings experienced in FY16. On a positive note, more companies than not reported ahead of expectations. Despite this, the ASX 200 underperformed several other developed equity markets during the month, including the US and Europe. Below we comment on some of the key takeaways and observations from results.

Earnings Growth Composition

While the headline earnings growth rate for the market was solid, the underlying drivers of growth paint a less positive picture. The earnings rebound of the market was very narrow and was driven by a select few large-cap companies. Outside of the major resources companies, this included a ‘less bad’ outcome for the major banks (their large combined weight can mean that small changes in earnings are disproportionally reflected in the aggregated earnings of the market), and a turnaround in the fortunes of a number of other companies, including Woolworths, Coca-Cola Amatil and QBE, coming off a low base.

This was also illustrated by underlying earnings figures. Earnings growth excluding resources was a more tepid 6%, while the median (i.e. the ‘middle’ result as opposed to the average) company delivered subdued 4% earnings growth.

Resources

Following the sharp rebound in commodities prices over the last 12 months, the resources sector, unsurprisingly, generated the strongest earnings growth of the key sectors of the market. After a multi-year decline (including a 40% fall in FY16), profits across the sector are now expected to more than double in this financial year.

Aside from the benefit of a better pricing environment, resources companies have also continued to cut costs, providing a further boost to margins. Overall, they reported ahead of expectations, with earnings upgrades during the month (helped by commodity price revisions). The sector, however, underperformed the index over the course of the month, with investors looking ahead to an expected tapering in commodity prices into the second half of the year.

Balance sheets are now largely repaired and given a reluctance to step up capex budgets again, investors stand ready to see an increase in shareholder returns, with capital returns on the table. While Rio Tinto was the first to proceed with a buyback, others may be dependent upon the sustainability of the recent rally, of which there is a healthy degree of scepticism. 

Banks

CBA was the only one of the four majors to report during the month, though trading updates from ANZ and NAB also gave an indication of broader sector trends. Overall, earnings have been an improvement on the declining EPS experienced across the majors following the round of capital raisings that dragged on the sector for most of 2015-16.

The key takeaway for the month was a return of the improving bad debt tailwind that helped to lift the sector prior to the introduction of tougher capital requirements. Earnings forecasts for the banks have thus gone from flat to low single-digit growth, driven by cyclical factors. Notably, this is the first time in approximately three years that the banks have been in an earnings upgrade cycle, however modest it may be.

Industrials

The primary concern of weak sales growth among industrial companies was confirmed in this reporting season, with better earnings supported by expanding margins. Cost out programs (or cost containment in general) was an important influence in higher profits across these sectors.

Retailers reported mixed results, with some categories doing well; a number of companies began to recover on stock-specific issues (e.g. Woolworths); and several cyclical companies somewhat justified the rally in their share prices over the last months. Mining services companies looked to have turned the corner, however with low capex plans by their customers, the recovery is expected to be capped.

Capital Management/Dividends

Dividend payouts across the market were ahead of expectations. Overall, the market payout ratio has remained relatively high, although it has fallen following the reset of dividend levels in resources over the last 12 to 18 months. Dividend increases from the banking sector have also slowed over recent periods, as they digest a higher share count, while ANZ’s restructure resulted in a 12% dividend cut over the last year.

Management reluctance to reinvest in their business is not overly surprising given the signals from investors. As interest rates trended lower over the last several years, it has been high dividend/high payout ratio companies that have experienced the greatest P/E re-rate, although this group of stocks has faced more challenging market conditions in the last six months as this rate cycle ends.

With balance sheets in reasonable shape, share buybacks have also returned. In the month, new buybacks were announced by AMP, Rio Tinto, QBE, BlueScope Steel, Coca-Cola Amatil and Crown Resorts.

ASX 200 EPS, DPS and Payout Ratio

Source: Bloomberg, Escala Partners
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Abating Tailwinds

Several tailwinds that have supported profits in recent periods are now starting to fade. Among these is the weaker AUD, which has now been relatively range-bound against both the USD and the Euro over the last two years, after depreciating over the three years prior. The key stocks affected here are much of the healthcare sector, large industrials such as Brambles and Amcor, and a number of financials, such as Macquarie Group and QBE. Countering this, there is better underlying economic momentum in these countries.

Falling interest rates have been another trend that was well established before the uptick in the second half of 2016. Companies and sectors with high debt levels have benefited from this development, although conversely are likely to face a tougher environment as they refinance at a higher cost in coming years. To protect against future rate rises, many companies have extended their debt maturity profile at a slightly higher cost.

Finally, housing-related stocks (both the builders and retailers leveraged to this theme) performed well again, although the consensus view is that the sector will receive less support from activity in the coming year.

Current market valuation

The following table gives an indication of the current market valuation from a top down view by looking at the three key sectors of financials, resources and financials. Compared to our most recent assessment, the rebound in resources has meant that the most recent share price rally has been based on an improving earnings environment, albeit narrow in nature (as described above) and hence the market remains relatively fully valued.

Financials: The major banks have already experienced a PE re-rate over the last six months on the back of a lift in global bond yields and an easing of a number of pressures, including capital and rising bad debts. Earnings growth is, however, still relatively subdued and thus it is becoming harder to justify further price appreciation without a pickup in credit growth. REITs are challenged by low rental growth across most sectors and rising debt costs.

Resources: Resources are expected to show a sharp rebound in FY17 earnings, although beyond this, the picture is less clear. Several of the factors that led to the rebound in commodity prices may start to fade in coming months. On the plus side, positive global economic momentum, stronger balance sheets and the prospect of additional shareholder returns provide some counterview for retaining exposure. Nonetheless, share prices are likely to peak ahead of any pullback in commodity prices, which could see stocks in the sector de-rate.

Industrials: Industrials have been the most consistent source of earnings growth for the market. However, a consensus 13% forward growth is more optimistic versus what is typically realised. PEs of industrial companies also remain elevated and thus it could be reasonably expected that these would reduce over the coming year. 

S&P/ASX 200: P/E, EPS Growth and Scenario Analysis

Source: Bloomberg, Escala Partners
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