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WEEKEND LADDER

A summary of the week’s results

10.11.2017

Week Ending 10.11.2017

Eco Blog

- A fall in residential investor lending only moved the dial marginally given the longer term dominance of this segment of the market

- Japanese economic trends have caught many by surprise, not least wage growth. The shift to a services economy is also pronounced.

- China too, is moving down a different path engineered by the central authorities with major repercussions for global companies in the longer term.

It is a rare week where the Australian residential property market does not feature in the headlines. The housing finance data for September showed a notable drop in funding across all participants but the focus was on the investor segments where the 6.2% decline in the month pushed the annualised growth for these to -6%.  There is a sense of relief in the banking sector when investor lending falls given the macroscopic attention APRA and the RBA are paying to this segment. As the chart illustrates, this recent trend hardly registers against the longer term change and many interest only investors are still to face the roll into principal payments.

Mix of housing finance

Source: ABS, ANZ Research
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The combined effects of a hike in rates for investor loans, impact of land and municipal taxes on gross rental income, reduced depreciation allowances on used apartments, removal of travel deductions for ‘inspections’, a move to strengthen tenant rights and a possible change in government (with the ALP indicating changes to negative gearing and capital gains tax discount) suggest the fall in investor participation may accelerate.

Japan continues its position as the surprise economy of the year. Nominal aggregate wages rose by 3.7% yoy in September, comprising a 2.7% increase in employment and 0.9% in wages. Post the election, PM Abe expressed an expectation of a 3% wage rise from the base rate and seniority-based pay. It is likely the level will not quite reach this relatively large number, but indicates that the trend in income growth will accelerate.

There has been a major shift to part time employment, with the aging population moving to reduced hours as well as encouraging new entrants.

Employment by type                                     Scheduled Wage Index

Source: MHLW, DB Global Markets Research
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The influence of the service industry is also evident. Employment in the accommodation and food sector is up 5.9%, information services up 3.7%, education and learning support up 6.8%, while furniture manufacture, mining and quarrying, printing and information processing equipment all show long term declines.

The pattern is evident in manufacturing orders where the demand has weakened for domestic machinery, while export orders, non-residential construction investment and information-related equipment demand remains solid. Similarly, the long standing Tankan survey shows the degree of relative growth (based on indexing above 100) for manufacturing versus non-manufacturing.

Reuters Tankan: Manufacturers           Nonmanufacturers

Source: Thomson Reuters, METI
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The Japanese equity market has been on a tear this year, up nearly 40% in local currency year on year, pulling in the largest flows in Oct since statistics became available in 2005.  The economic environment remains supportive, but it would not be surprising for some profit taking to dampen returns in coming months.

Post China’s People’s Congress, views on the implications continue to roll in. On balance, the tone can be called ‘cautiously optimistic’. Many expect GDP growth to slow into 2018 as the legacy of the tightening of credit becomes evident. The efforts to restructure basic industries to limit pollution and excess capacity is another headwind to momentum. However, these largely cyclical trends are likely to be progressively overwhelmed by other industries.

The most prominent is the determination to develop advanced technology in a broad range of industries. The stated aim is for local companies to provide 70% of core components in ten key industries by 2025. The question is how this is achieved. Local development through start up enterprises is one way, but is likely to be slower than preferred. China could simply buy into international companies and transfer the IP to local manufacture. It could pull resources from the diaspora of Chinese that have studied and worked globally. It could allow global companies to set up in China or joint venture with a local. The probability is the first two paths will feature, but that all stops will be pulled to achieve the goal. In turn, it will not only mean China will import less advanced technology from elsewhere but in time become a competitor.

The social sector is also high on the agenda. China has achieved nominal universal healthcare, but the system is seen as underfunded and inadequate. The per capita spending on healthcare is low, even by emerging country standards. Private health insurance in urban dwellers is rising - first tier cities residents report 25.8% private cover. This is in the domain of the insurance sector, with these companies frequently appearing in China stock holdings.

Fixed Income Update

The RBA and RBNZ keep rates on hold at 1.5% and 1.75%, respectively.

- Apple issues again in offshore markets as new bond issuance levels hit record highs.

- ‘Green’ and ‘social’ bonds gain momentum.

- Figures show that Australian superannuation funds have the second lowest weighting to fixed income investments out of the OECD countries.

As expected, the RBA left rates on hold, and the bond markets were broadly unchanged following the announcement. There were six consecutive years between 2006 to 2011 whereby the RBA changed the level of interest rates on Melbourne Cup day. This week’s ‘no change’ marks six consecutive Cup days where the cash rate has been kept on hold. Across the pond, the Reserve Bank of New Zealand also kept rates on hold at 1.75%. Following a slightly hawkish rhetoric, rate hikes are now being priced in to the NZ market after the first quarter of next year, with 0.25% factored in by November 2018.

In offshore markets, technology giant Apple tapped the bond markets this week with its eighth bond sale of the year. The order book is said to have reached $US16bn, for a $US7billion issue size. Apple printed bonds across six maturities from 2 to 30 years, with demand heaviest for the 7 and 10-year debt. The 10-year notes priced at a yield of 72 basis points above benchmark Treasuries, or ~3.03%.

The money was raised to fund Apple’s $US300bn share buyback and dividend programme. The company holds significant cash reserves offshore, but if these funds were repatriated back to pay for this programme it would be subject to US taxes. As an alternative Apple is able to use funds sourced from debt markets.

New bonds in the US have grown at a record pace this year. This latest deal by Apple brings the amount of new issues by investment grade companies to more than $US1.2tn this year to date.

Biggest corporate borrowers of 2017, excluding financials ($bn)

Source: Dealogic, Financial Times
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Included in this trend is the growing number of green bonds, which reached record levels in the third quarter of this year. Green bonds are created to fund projects that have positive environmental and/or climate benefits. Nearly $US95bn of green bonds were issued globally in the first three-quarters of this year, with an expected $120 billion to be issued for the full year. This is up 49% on the previous year and satisfies the demand from many sovereign funds.

Social bonds, which raise funds for housing, clean water, education and healthcare projects have also grown in recent years. These bonds replace the traditional form of funding by governments’ aid budgets.

In the same vein, QBE this week tapped into the increased demand for ethical fixed income investments with the issue of a $400m USD tier 1 “gender equality” hybrid security.

A report out by the OECD shows that Australian superannuation funds have the second lowest direct weighting to bonds at just 10% of portfolios versus the average in the OECD countries at 43%. Unsurprisingly, Australian super funds have the second highest weighting to direct equities at 51% compared to the average at 10% (this excludes managed funds or collective investment schemes). Globally low weight to risk assets reflects the defined liability schemes that still predominate or capital guarantee. Low domestic corporate issuance is perhaps one of the reasons for limited bond holdings as the Ausbond Bloomberg index which is made up of 80% government debt. For those that are willing to do the credit work, there are many offshore fixed income funds (fully hedged) available to Australian investors with a growing number opening up offices on our shores.

The high weighting to bonds by other OECD countries has been a large driver of flows into bond funds this year. Investors added more than $US2bn to total return bond funds over the past week, which was the largest inflow in more than two years. The rise in the US equity market is said to have triggered move into bonds as investors seek to rebalance portfolios and increase their allocations in debt to compensate for the relative rise in equity values.

Corporate Comments

- Westpac’s (WBC) result was below consensus. The bank and its competitors face an ongoing difficult environment to generate respectable earnings growth.

- Commonwealth Bank’s (CBA) quarterly was better than the other majors, although the stock is likely to be discounted by many until a resolution is reached in its money laundering case.

- Orica (ORI) has, to date, not participated in the improved conditions in the mining sector.

- James Hardie (JHX) showed that it may be emerging from a challenging period where it had struggled to contain production costs.

Westpac (WBC) closed out a relatively benign reporting season for the major banks this week, with earnings growth of just 2% barely moving the needle and a slight miss on consensus expectations. The result was similar to the growth recorded by the other majors (all in the low single digit range), with the exception of ANZ, which was cycling several one-off charges from its messy FY16 result. As with its peers in the last few weeks, dividends were left unchanged in the year; in the current environment, the banks are no longer a reliable source of predictable dividend growth.

FY17 Banking Scorecard (Underlying Cash Earnings Basis)

Source: Company reports, Bloomberg, Escala Partners
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The key positives to be gleaned from the result were an improved net interest margin in the second half following industry-wide mortgage repricing and a sound capital position, which is now above APRA’s latest 10.5% CETI1 target for the banks. Bad debts were an additional positive, dropping to 13bp, and are now at or close to historically low levels. While credit quality remains sound for the time being, rising bad debt charges will be inevitable at some point in the future and turn into a drag on the profitability of the sector.

As with the other majors, markets and treasury income was weaker in the second half and growth into FY18 poses a number of hurdles, including the need to absorb the new banking levy. An additional challenge for WBC will be the margin headwind that will result from investor switching from interest only to principal and interest mortgages following the restrictions now in place on the former. Relative to its peers, WBC has a higher proportion of interest only loans (46% as at the September balance date) and is thus more at risk to a slowdown in investor lending.

The ability for the banks to reprice their mortgage books independently of any RBA moves further in the following 12 months may be restricted to a degree given the sharp political focus on the industry, particularly following the latest revelations on Commonwealth Bank (CBA). CBA’s own quarterly figures released during the week again showed the market-leading characteristics of the group, although potential fines that may emerge from money laundering allegations could hang over the stock for some time. Within our model equity portfolio, we remain underweight the majors.

The pullback in mining services group Orica’s (ORI) share price following its full year profit announcement was reflective of a stock that had run well in advance of a potential recovery in its earnings base. This had resulted in a significant expansion in its P/E multiple from ~11X to as high as 19X forward earnings in the last 18 months. As illustrated in the following chart, earnings were essentially flat for the year, with falling pricing and an increase in input costs marginally offset by a range of cost cutting measures. Volumes in its key explosives business increased by only 3% for the year, while its troubled Minova division finally managed to turn a slight profit.

Orica FY17 EBIT Waterfall

Source: Orica
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Investors were also disappointed with ORI’s guidance for FY18. Volumes are expected to flat in the next 12 months, indicating little participation in the recovery so far experienced in the mining sector. Investors hoping for an uplift from a better pricing environment may also have to be patient; the multi-year nature of ORI’s typical contracts means that lower prices will again pull earnings down by approximately $50m, while input costs will also be higher. Given the well supplied nature of ORI’s core markets and the delayed translation from a better pricing environment, there would appear to be better ways in the market to access the improved conditions for mining services.

James Hardie (JHX) put three poor quarters behind it with its half yearly result, which exceeded expectations. The focus has been on its core North American operations, which had experienced a margin contraction over the last 12 months on the back of poor operational performance. The primary issue had revolved around elevated costs as it ramped up its production capacity to adjust to an improved demand environment, causing margins to drop below its 20-25% targeted range. Adding further pressure on margins has been escalating costs, such as pulp, freight and gas, which were all up at a double-digit rate over 12 months.

JHX’s second quarter, however, showed a marked pickup in margins as a reduction in unit production costs and a realisation of price increases led to better earnings. The trend overshadowed weakness on volumes in the quarter, although some disruption was expected given the hurricane activity experienced in some states. Management expect further cost improvements in the second half, which, if achieved, point towards a good earnings recovery on the back of a reasonable demand. Success on this front should help the stock return to its traditional high multiple premium relative to the market.

James Hardie: North America Fibre Cement EBIT and Margins

Source: James Hardie
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