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WEEKEND LADDER

A summary of the week’s results

10.06.2016

Week Ending 10.06.2016

Eco Blog

The RBA surprised no one by leaving the cash rate at a record low of 1.75% after last month’s cut, although the lack of an easing tone was unexpected. Instead, the central bank shifted to a neutral stance, noting that leaving rates unchanged “would be consistent with sustainable growth in the economy and inflation returning to target over time”.

While last week’s GDP figures were strong, the widely-held view is that inflation is the real focus. In this regard, the RBA’s stance this week makes more sense, with second quarter CPI not released until late July, which would give a better picture on inflation trends and even confirm its own recently downgraded inflation forecasts. This makes an August move the most likely in coming months. Further, it is rare to see a single rate cut implemented by the RBA, which typically will drop rates by two or more times over several months.

The RBA’s concerns, realised from the higher AUD, have also abated since mid-April when the currency hit US78c, although the dollar has again trended higher in the last few weeks, driven by a weak jobs report in the US. A paragraph of the RBA’s short statement was again dedicated to the housing market. At this stage, the RBA appears to be comfortable with the recent developments enforced by APRA that have slowed investor lending and led to slower price growth.

Domestic data released this week, while limited in number, also supported those calling for a rate cut. The Melbourne Institute Monthly Inflation Gauge (released more frequently than the ABS data) showed falling prices for May. The monthly index fell by 0.2% to bring annual inflation back to 1.0%, well below the RBA’s target. While the chart shows that it is not a perfect measure of the RBA’s statistics, the decline since the beginning of 2016 is noticeable and points towards further weakness in second quarter CPI.

Australian Inflation

Source: ABS, Melbourne Institute, Escala Partners
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Mortgage lending figures for April were also weaker than expected. The decline in investor loans continued, down 5.0% month-on-month and more than 20% over the year, providing further evidence that APRA’s investor restrictions are working . For the month, owner-occupied financing was flat, leading to an overall 1.8% fall in total dwellings. The mortgage lending data is in contrast to a recent further rally in house prices (particularly in the eastern states of Australia) and robust building approvals numbers.

In the US, it has been the employment market which has generated the headlines. Employment growth has been one of the more consistent indicators of the improving US economy in the post-financial crisis recovery, however there has been increasing evidence that the rate of jobs growth has slowed through the first half of 2016. It could reasonably be expected that employment growth would slow as the US approaches its natural rate of unemployment, though lower slack in the labour market is yet to translate into wages pressure.

The jobs report for May (released last Friday night) showed a marked deterioration from the first few months of the year. The US economy added 38,000 jobs for the month, well short of expectations of 160,000, and the lowest monthly increase in more than five years. A strike at telecommunications company Verizon was estimated to subtract more than 30,000 from the overall figure, which, if added back, would make the drop less dramatic. Unseasonably warm weather in February and March may have also pulled forward some hiring. However, while it is only a single data point that may eventually be dismissed as a one-off occurrence, at the very least it is expected to kill any chance of the Fed proceeding with a second rate hike next week.

Further clues about the employment market were provided by the Job Openings and Labor Turnover Survey (or JOLTS), a report favoured by Fed chair Janet Yellen. The report for April (which effectively lags the official employment data by a month) contained mixed signals about the strength of the market. Job openings remain strong, with the openings rate returning to its recent high of the current economic recovery. In addition, layoff numbers were low and were consistent with more recent figures for initial jobless claims.

Offsetting these points was the ‘hirings’ rate, which dropped to its lowest level in two years. The ‘quits’ rate also dropped slightly, although remains high (see following chart), having risen steadily since late 2009. This latter data series is a good indicator of the confidence that employees have in the economic outlook and their ability to find alternative employment – an employee is more likely to quit their job if they believe that they can secure another one.

US JOLTS Report

Source: US Bureau of Labor Statistics, Bloomberg, Escala Partners
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Fixed Income Update

Following the RBA’s meeting this week, there was little movement in bond prices, as the futures market was pricing in a 90% chance of ‘no change’. Despite the fact that there was no easing bias in their statement, the market is still looking for further rate cuts within the year. The futures market is currently pricing in a 50% probability of a 25bp fall in interest rates by September this year, with this cut fully priced in by February.

RBA Cash Rate and Forecasts

Source: Bloomberg, Escala Partners
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Similarly, the US Federal Reserve are also likely to keep their interest rates unchanged when they meet next week. Recent weakness in employment figures have pushed the prospect of a rate rise out to later in the year. A 58% probability of a hike is priced into the futures by December.

This week also marked a historic milestone for German government bonds, as the average yield fell below zero for the first time. The average rate across outstanding bonds, published once a day by Germany’s Bundesbank, hit a new low of -0.02% on Monday, surpassing its previous low of zero reached in April. The German 10 year bond also joined the party, rallying strongly, with the yield falling to 0.045%; also the lowest on record.

In fact, nine major sovereign bond markets hit yearly or all-time lows in yields on their 10 year bonds. This translated to record lows in the global developed market sovereign yield index. An illustration of this index is shown below.

Global Developed Market Sovereign Bond Index

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Despite this, corporate bond issuance remained buoyant this week. For the first time in 10 years, ANZ brought to market a tier 1 bond (bank hybrid) in the US market. This security, with a 10 year call date, was priced in USD at a coupon of 6.75%. The issuer was restricted (for regulatory reasons) to an issue size of $1bn. There was said to be over $15bn in demand.

The USD-denominated bond offering by ANZ brought with it some additional variance in the structure of the security compared to that of a domestic issuance. The main differences are highlighted below, where we compare this ANZ tier 1 security with the recent Westpac capital note done in the domestic market.

Source: ANZ, Westpac, Escala Partners
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The success of this ANZ USD tier 1 security is not surprising. A Bloomberg article this week sighted that Australian bond issuers are lapping up USD funding at the fastest pace in seven years, as the relative attractiveness of the European market wanes. USD-denominated debt issued by domestic companies is up 21% from last year.

The reverse is also true with many offshore companies issuing kangaroo bonds into our market. Apple and Coca-Cola are two examples of multi-tranche benchmark sized bonds that have priced recently.

Corporate Comments

Leading into the final stages of the financial year, it is not uncommon for companies to ‘update’ the market on their expectations for earnings in the upcoming reporting season. Amcor (AMC) was one such company this week as it released two separate statements on its trading performance as well as costs that it will incur to restructure its flexibles business, particularly in Europe.

Given that Amcor operates in over 40 countries it is not overly surprising that the economic conditions across each of these will simultaneously be strong and conducive to robust earnings growth. Emerging markets have been a core plank of Amcor’s growth over the last decade (representing nearly a third of the group’s sales), with the company tapping into the higher demand growth for packaged goods in many of these countries. Investing in these countries, however, can carry a higher level of economic and currency risk for the company, as illustrated by this week’s announcement. 

Amcor FY15 Sales

Source: Amcor
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In this instance, Amcor’s Venezuelan operations have caused the company to take a one-off impairment charge in FY16 and an approximate US$20m hit (or less than 3% of expected earnings) for FY17. The Venezuelan economy has been in the doldrums for some time, in part driven by the sharp decline in oil prices, with soaring inflation and a deep recession.

Venezuela also has a rather complex foreign exchange market, with an official fixed rate operating against the USD, which has been devalued materially on two occasions since it was fixed over a decade ago. The country also operates a secondary currency market, which is used for what are deemed less essential transactions and is floating in nature. The two exchange rates have diverged significantly over time as the country’s economic woes have deepened. As a result, Amcor has now taken a one-off foreign exchange charge as it has elected to shift to the floating exchange rate for reporting purposes.

Amcor also separately announced that it would be spending between US$120m and US$150m across the next two financial years to optimise its plant footprint, particularly in Europe. This type of restructuring spend used to be more common place in the company’s annual accounts, although the targeted return on the investment of 35% within three years should be viewed favourably, more so given its strong track record in this area.

Following these announcements, revisions to Amcor’s earnings by analysts have been modest, with Venezuela appearing to be an isolated drag on profits. However, the correction in Amcor’s share price (~11% over two days) confirms the view that many listed stocks are, to a certain degree, priced to perfection, with any hint of bad news punished by investors. Amcor has been an attractive investment for several years now on the back of the consistent and predictable earnings stream that it has generated, although no company is immune from setbacks along the way. Amcor now trades on a forward P/E of 17.8X, which is broadly in line with its local and global peer competitors, most of which has similarly benefited from a degree of P/E expansion in the last three years.

Amcor: Forward P/E of Local and Global Comps

Source: Bloomberg, Escala Partners
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