Week Ending 10.04.2015
Given the recent relentless commentary on monetary policy, we will restrict this week to the headlines. The RBA held rates, yet the consensus is overwhelmingly in favour of a rate cut in May. The ‘ayes’ in favour remain the same – weak growth, flat employment, low inflation, pressure on the currency. The ‘nays’ against are the housing market and the seemingly minimal impact of rate cuts.
Sightly improved retail sales for February came with a fall in consumer confidence in March; arguably an indication that more recent retail data will not be as good in coming months. Similarly the last official employment release, with a better than expected outcome, has been followed by falling job ads.
In the US, the FOMC meeting tilted bearish compared to past months, causing economists to squabble over the timing of the long anticipated rate rise. The JOLTS, or job opening survey, points to strong prospective growth with the reading the highest in 14 years. This is in contrast to the weak employment release of a couple of weeks ago. The early evidence from a low initial jobless claim indicates this will indeed be the case.
The conclusion of one rate rise some time later this year is all that should matter for most investors who take more than a trading orientation to markets and it therefore make sense for portfolios to position in anticipation.
Other economies, specifically the emerging world, only seem to get attention when problems arise. Recently the fall in commodity prices, geopolitical events in Eastern Europe/Middle East (EEMEA) and structural issues in Latin America, has seen growth for these regions fall sharply. Conversely, the collective Asian outcome has been remarkably stable
Emerging Market GDP Growth
Taking a snapshot on some of their current features, the question of debt is almost always foremost in mind.
The chart shows the change in overall gross debt levels from 2009 to the last common data point for Asian economies.
Change in Government Debt Levels since 2009
Much is made of the rise in debt in China (CHN) at local government level and this is clearly having an impact on growth, with the central authorities restricting credit growth that was being ploughed into investments with questionable returns.
It also pays to be aware of individual country circumstances. Many may be surprised to see Singapore (SGP), notionally a conservatively managed state, with high debt levels. The net government debt is negative due to its asset investments.
Low household, and to some extent corporate debt, in India (IND), Indonesia (IDN) and the Philippines (PHL) are mostly due to the unsophisticated banking sector rather than restraint by households, but opens up the potential for growth through better access to credit markets.
Most Asian economies have eased monetary policy in the past six months and have proven responsive to the inter-balance between the need to maintain foreign flows while encouraging growth through lower interest rates. The second trend has been lower inflation and therefore lower central bank rates.
Clearly the fall in commodity prices, especially oil, has had a substantial impact. Importantly, however, is that inflation expectations have also fallen sharply, which holds the promise that the trend will not simply revert were commodity prices to rise again. In the meantime, structural reforms are easier to achieve and Indonesia is expected to reduce electricity subsidies which eat up 5.5% of the fiscal budget while ploughing the proceeds into infrastructure.
Structural change and reform is the key to building an investment case, particularly in emerging economies. Many would argue, however, they are even more essential in some developed regions, not least Australia. Elsewhere in emerging economies, the momentum is patchy. Mexico and Chile are generally considered to be on the right track, while Brazil looks likely to slide into a recession this year, perhaps itself a trigger for change. Turkey has not lived up to hopes of a few years ago, having been exposed with large fiscal and current account deficits. Were these relatively large and potentially dynamic countries to turn, they would represent great investment opportunities.
It is Europe that is proving to be the surprise package for the moment. While much attention has been on Greece, other Eurozone countries have been making good headway. The best indicator is the PMI with the reading this week showing steady progress against the previous two reading and consensus expectations.
Italy has moved into a solid expansionary phase with even a hint of labour market reform from the recently approved Jobs Act. It is now up to France to join the other major economies and Europe’s momentum would pick up even further.
Atlas Iron (AGO) this week entered a trading halt as it undertook a review of its operations, financial outlook, capital structure and potential asset sales in the wake of the tumbling iron ore price. AGO is one of many smaller Pilbara iron ore miners that would be under considerable cash flow pressure in the current pricing environment. Much like the majority of its peers, AGO has done a great job in taking costs out of its business over the last 18 months (see chart below), however the benchmark iron ore price has been falling at an even faster rate. With AGO requiring a benchmark prices of approximately US$65/t to break even from a cash perspective (inclusive of all costs, e.g. royalties, overheads, interest, capital expenditure, freight), the company would have likely been loss-making for at least the last month.
Atlas Iron: All-in Cash Costs (A$/WMT)
Asset sales may well be part of the overall plan for AGO to survive, although the price environment is far from ideal to achieve a satisfactory outcome. Given the extreme leverage of these smaller iron ore stocks to small movements in price, their share prices are presently behaving more akin to options. We remain of the view that the only safe and prudent way to participate in the iron ore sector is via the large diversified miners.
Merger and acquisition activity again helped the domestic equities market this week. Shell’s takeover bid for BG Group (formerly British Gas) was relevant for our market given the interest that the companies have in various projects around the country. The offer may demonstrate some confidence in an oil market recovery by Shell, opportunistically taking advantage of the current sharp downturn in energy markets. For companies that have the financial capacity, buying existing assets may make more sense than developing their own. Shell’s motivation for the deal could also have been to plug a potential production hole from its higher cost operations should the oil price fail to reach its previous levels.
Given the aforementioned Australian presence of Shell and BG, there are a number of implications for our listed energy sector. BG’s primary Australian asset is the QCLNG project in Queensland, one of three large-scale LNG operations that have been under construction over the last several years at Gladstone. BG is the majority owner and operator of the project, which commenced operations late last year. Shell also has an interest in coal seam gas acreage in Queensland through its stake in Arrow Energy (jointly owned with PetroChina). Arrow had previously explored the development of a stand-alone LNG project itself, however with these plans off the table, the natural destination for this gas would now be as an additional source of supply for QCLNG. This would rule out this gas source for Santos’s GLNG project, which has the weakest resource position of the three.
Woodside Petroleum could also be indirectly affected by a Shell/BG tie-up, with Shell retaining a 13.6% shareholding after its partial sell down last year. Shell’s current strategy involves increasing its divestment program of non-core assets which will help fund a targeted US$25bn buyback between 2017 and 2020. The additional funds required for the BG acquisition would lead to the obvious conclusion that a further block sale of these shares could happen sooner than expected. While we do not recommend investing in stocks based on the speculation or hope that they will become a takeover target, we believe that Oil Search (OSH), with its interest in PNG LNG and strong resource base, would be the most likely large-capitalisation candidate in the Australian listed energy sector.
Other corporate activity news continued over the past two weeks in the Australian market, with offers/proposals for Bradken (BKN), PanAust (PNA) and Emeco (EHL). BKN and PNA received takeover proposals last year which ultimately were not completed. In BKN’s case, a private equity consortium (which included Pacific Equity Partners) ceased discussions early this year on a $5.10 per share proposal after citing difficulty in achieving satisfactory funding terms. Pacific Equity Partners is back with a different investor this time and a much lower offer price ($2.50 per share).
BKN’s experience has parallels with that of PNA, which last year received a $2.30 per share offer to acquire the company from its largest shareholder, Guangdong Rising Assets Management. After walking away from the potential deal and in light of the lower current copper price, Guangdong has since come back with a lower offer of $1.71 per share (a reduction of 26%). These experiences highlight a few things. For one, acquirers can in certain situations exercise patience when looking at their targets (sometimes to the detriment of these shareholders), particularly if either the company or industry is facing pressure. Secondly, the attraction of Australian assets has perhaps increased in light of the recent depreciation in the $A, which could result in a spike in international interest in our companies.
Another company that was the subject of a recent takeover offer is iiNet (IIN), which we hold in our model portfolios (but are now likely to exit). IIN is currently trading at a price ($8.93) in excess of the $8.60 per share offer from TPG Telecom (TPM). While the IIN board has recommended the offer to shareholders (in the absence of a superior proposal), a few large IIN shareholders have publically questioned the pricing and structure of the deal (i.e. there will be no opportunity for shareholders to roll their investment into TPM shares without incurring capital gains), introducing an element of risk for the deal. Apart from gaining the necessary regulatory approvals (highly likely,
but not necessarily a formality), the next step in completing the deal will be the release of the scheme document in the next month or so before a shareholder vote, scheduled for late June.
IIN’s share price is currently implying that either another bidder will emerge (a possibility, with Optus seen as the most likely) or that TPM will have to sweeten the deal to appease some investors. With board approval secured, it would seem that the latter option is rather remote. In light of these potential risks, we believe the best course of action for investors is to take advantage of the premium currently built into IIN share price by taking profits.
TPM’s offer for IIN is coming at a time when signs of increasing competitive behaviour is emerging in the telecommunications space. Optus, which had last year offered promotional “unlimited download” plans for fixed line broadband, has now extended its discounts to the mobile phone market. Its post-paid mobile plans now come with unlimited voice calls and text messages, with pricing dependent on the data component. Data has been increased on all but the cheapest of its plans, which should pressure the other key players in the sector to improve their offering. While consumers are the ultimate winners from this pricing tension, shareholders of companies in the sector (including Telstra) are the likely losers given what is a fairly mature market.