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WEEKEND LADDER

A summary of the week’s results

10.10.2014

Week Ending 10.10.2014

Mixed signals from the US saw investment markets rotate on a daily basis through the week. While the focus is on equity indexes, the bond market was more telling.

The US and Australian bond movements maintained their close relationship over the past few weeks, even though economic data was far from correlated. US 10 year bond yields initially rose on the back of strong labour data and then gave up all those gains with the FOMC reinforcing its cautious language on the timing of the expected official rate rise. 

Source: IRESS
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The nuance to these trends has been the relative performance of shorter dated bonds, with the curve having flattened as the 2 year eased back less than the 10 year. The rationale for this would be that markets still anticipate tightening next year (as implied by short rates) but are increasingly pricing in suboptimal long term growth (therefore longer-dated rates will remain below par).

Rising bond yields caused a sell-off in equities and the Australian dollar, but the follow through from the fall in bond yields has been less convincing.  

Source: IRESS
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The case can therefore be made that the majority of market participants still expect a US rate rise in mid-2015 and are therefore reluctant to price in the recent movement towards lower yields into equity markets.

The influence of economic data is becoming more accentuated in the behaviour of financial markets, with expectations of US tightening, Eurozone easing and Australia somewhere in between.

The missing link, however, is a higher degree of conviction on economic growth. While there has been a pickup in housing, other areas of asset investment have been weak across most regions. Even the well-heralded US energy boom has sagged away with falling oil prices. Capital investment, including infrastructure, has not been the panacea for which some had hoped.

Locally, the RBA maintained its ‘steady as we go’ stance. Its monetary policy statement had references to uneven global growth, its now well-known view on the housing market and that the Australian dollar, to date, had not moved substantially against its trade weighted index, with most only focusing on the US dollar cross rate.

In the circuit of speeches from the RBA the head of financial stability, Luci Ellis, commented on the frustratingly low level of economic activity from monetary policy compared to asset prices. She further referenced the aggregate risk in the financial sector from mortgages in contrast to individual organisations; once again a flag that the RBA was expecting banks to self-regulate their mortgage exposure or face intervention. The central bank would therefore have welcomed the moderation of housing finance data, with owner occupied down 0.9% - continuing the trend of the past six months - while the value of investor loans edged back 1.5%, the first fall since early this year.

The trade weighted index is recast by the RBS/ABS based on trade data. The most recent reweighting was in December 2013 and shows the incremental change from the previous weight. The US is marginally under 9% of the index. 

$A: Trade Weighted Index

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The labour market data released by the ABS attracted attention due to the revisions of the past months, which had shown a sharp rise in unemployment followed by a big jump in employment. The implication is that the unemployment rate is likely to have been relatively steady in recent months and other job series data would substantiate that outcome. The offset has been a significant slowing in average wage growth, suggesting most jobs are being created in low wage service industries.

The RBA is faced with an unenviable task on this important metric. It has to place a low reliance on the official series and has to contemplate the balance of borderline-acceptable employment growth with the low wage outcome. The conclusion is easily drawn that this would even further entrench the current official stance of ‘ no change for some time’.

European economic growth has faltered in recent months. Most importantly the contribution from Germany has been notably weak with the industrial production and export data out this week adding to the concern. There were some structural reasons for the big decline. These have included factory holidays, a sharp decline in auto production with new models on the way and the overflow from lower demand out of Russia, and to some extent, China.  But these cyclical issues do not override the reality that momentum in Europe has stalled and the call for further monetary accommodation is near universal.  

The chart below shows the August fall of over 4%, but also that three month moving average in production and new orders are now at near zero growth.

German Industrial Production

Source: Deutsche Bank
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Company Comments

Before reflecting on company news out of Australia, it is worth touching on the expectations from the US Q3 reporting period. For some time now, the quarterly profit has sufficiently exceeded expectations to keep the S&P 500 moving upward. This quarter is likely to be more challenging. The rise in the $US against most other currencies, while known, tends to take time to factor into forecasts. Non-US revenues average 33% of the S&P 500, with IT topping the list at 60% of sales. The ongoing softness in demand in Europe and Asia is also likely to impact earnings and outlook statements. Falling energy prices, which are good for longer term personal consumption, will impact the profits from the sector. Total capex across the market could possibly be restrained, with the energy sector accounting for 27% of listed company capex in previous quarters. Finally, buybacks may not find favour as there is increasing concern some companies are leveraging up to fund buybacks and that buybacks simply disguises a lack of underlying growth.

In summary, while there are reasons to believe the response to the US quarterly season will be unhelpful to equity markets, it is not a reason for a systemic sell off.

With news coverage on the iron ore market reaching near-saturation point, BHP Billiton (BHP) added to the noise this week when it conducted a site tour of its Pilbara operations. The iron ore price has declined from US$134/t at the start of the year to its current level of around US$80/t, largely due to the vast supply added to the market over this time. BHP acknowledged this in its presentation, estimating that seaborne supply growth between 2013 and 2016 will outpace demand growth by more than 200 Mt, as illustrated in the chart below.

Iron Ore: BHP's Estimates of Supply and Demand Growth

Source: BHP Billiton
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BHP’s response to this situation is to accelerate its own expansion plans, as it looks to grow its Pilbara operations from a production level of 225 Mt in FY14 to a run rate of 290 Mt within the next three years. Many would question the motive for adding to the supply problem in the market, given the impact that this is having on the profitability of all iron ore miners. When viewed in isolation, however, it is clear why BHP is pushing ahead; the company expects the additional 65 Mt of capacity will be added at a capital cost of just US$30/t (compared to the company’s previous estimate of US$50/t), which should result in very attractive returns and a quick payback on its investment, even under bearish forecasts.

The company is able to expand production at a much lower cost than most of its competitors because it expects to deliver the extra tonnes using the existing rail and port infrastructure that it has in place, a luxury that companies undertaking greenfield projects do not have. BHP could also be looking to use this opportunity to push more marginal producers out of the market, many of which would be struggling in the current environment.

The other key takeaway from its presentation was the company’s plans to reduce its unit cash costs to below US$20/t, which would represent a 23% reduction on its average costs in the second half of FY14 and would make it the lowest cost producer in the market (currently held by Rio Tinto). This is expected to be achieved from scale efficiencies through higher production levels, reduced overhead expenses, more efficient use of raw materials and consumables, and savings through further insourcing. There is some longer term optionality through the increased use of autonomous (i.e. driverless) vehicles, which could further reduce labour costs. A weaker $A would also clearly make these targeted savings more achievable. If the savings are achieved they will protect BHP’s margins to a degree, however they won’t nearly make up for the loss in profitability that has resulted from a lower iron ore price. Given this, the net impact of lower capital and ongoing production costs may well be a net zero outcome on the value of the company in the medium term. However, it should strengthen its position in the market if it is able to take market share away from higher cost producers.

Rio Tinto (RIO) reiterated its commitment to iron ore expansion this week, with the company also revealing that it had rejected a takeover approach from Glencore in August. This outcome is unsurprising given that RIO’s share price has been weighed down by the weakness in iron ore, and that it appears to have been pitched as a nil-premium offer. Nonetheless, the rationale of a deal appears to be sound. The deal would then overtake BHP as the world’s largest mining company; it would provide a more diversified exposure for RIO given its concentrated earnings exposure (and a possible re-rating of its earnings base); and it would open up some synergies, particularly in the Australian coal businesses. Glencore has walked away for the time being and cannot launch a hostile bid in the next six months. Its interest in RIO should, however, provide somewhat of a floor underneath RIO’s share price in the short term.

Lend Lease (LLC) held an investor day, showing consistency in the group’s strategy that has delivered solid returns in recent years. LLC has received a tailwind from the strong residential market in Australia, and its long-dated urban regeneration projects such as Barangaroo in Sydney and Elephant and Castle in London are well known. What is now beginning to emerge is a solid pipeline of work in road construction in Australia. LLC has had success in winning work on Melbourne’s East West Link, one of several projects to be completed in the medium term. The chart below illustrates how major road spend is expected to grow over the next few years, broken down into the individual projects:

Australian Major Road Projects

Source: Lend Lease
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LLC has performed remarkably over the last two months in a market that has trended down over this time. The stock’s earnings multiple discount to the market has contracted somewhat over this year and, as a result, perhaps offers less upside (in a relative sense) compared to some other stocks that have recently been sold off. The outcome of the upcoming Victorian state election is a near term risk for the group, with the Labor opposition planning to cancel the East West Link contracts if it wins power.

New National Australia Bank (NAB) CEO, Andrew Thorburn, has undertaken a classic clearing of the decks this week, owning up to $1.3bn of impairment charges which will be taken when the bank reports its FY14 result later this month. At the core of these writedowns was the provisions relating to its UK business. While clearly not a good outcome for NAB, the announcement does have a silver lining in two respects; it reduces the prospect of a capital raising to address losses from the UK business (although NAB will be undertaking a DRP to shore up its capital position), and it puts the division in a better position for an eventual sale.

The task ahead of Thorburn is significant given NAB’s long term underperformance compared to the other major banks. Ridding the company of the troubled UK business would be welcomed by investors, and remains a potential catalyst for the group to close the valuation gap on its peers. In the interim the lower full year dividend (compared with what analysts were previously expecting) as a result of the impact of this on the group’s capital position may also reflect a more cautious stance given the risk of more onerous capital requirements in the near future.

Bank of Queensland’s (BOQ) result was well received, with a 20% uplift in cash earnings. In a benign lending growth environment the bank’s profit uplift came from two primary sources; a reduced bad debts expense and an improvement in its net interest margin, largely driven by lower funding costs (wholesale and retail deposits). BOQ has been performing well in business lending, however the growth in its retail book has lagged that of its peers. This is a function of a lower overall growth in the Queensland market.

On a relative basis, compared to the majors, the regional banks could gain some ground from the upcoming Financial System Inquiry. The interim report focused on the big four with proposals that would likely see them required to hold higher capital levels as well as increasing the risk weightings that the majors currently apply to their respective mortgage books (see comparison provided by BOQ below). We are underweight the sector in our portfolios, taking into account the weak top line growth forecast and with bad debts at cyclical lows.

Residential Mortgages: Capital Held Across Australian Banks

Source: Bank of Queensland
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Market Focus: Upcoming Dividends

Earlier this year we highlighted the consistent outperformance of banking stocks in the period leading up to their ex-dividend dates. Our analysis showed that since 2000 the banks had outperformed the S&P/ASX 200 Index in the 45 days leading up to their ex-dividend date (to incorporate the holding rule period to qualify for franking credits) on average by 2.6%. Of all periods analysed, the outperformance occurred nearly two-thirds of the time.

With three of the four major banks reporting their half year results in around three weeks’ time, these stocks have again done relatively well over the last fortnight. There could be several reasons why this may be the case. These would include a recovery following their poor performance in the first half of September, where they appeared to be one of the primary sectors affected by selling by foreign investors as the $A fell.

Nonetheless, with bonds rallying further this year, resulting in lower yields again from fixed interest investments, the motivation (rightly or wrongly) for investors to seek higher income through participation in equity markets could persist for a while yet. Investors have received their dividends from the August reporting season over the last month and, in coming weeks, those who are looking to maximise their income, will likely reinvest this into stocks that have a September or March year end. Below we have listed ASX 200 companies (by date of earnings release) that are scheduled to report their results between now and the end of the year. We have excluded from the list stocks that are not expected to pay a dividend. Obviously, one of the key risks in investing in these stocks would be the possibility of earnings disappointment, or missing earnings expectations. Stocks that would appear to be most at risk here would include IPL, ORI, GNC and ALQ.

S&P/ASX 200: Upcoming Results

Source: Bloomberg, Escala Partners
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