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WEEKEND LADDER

A summary of the week’s results

11.01.2019

Week Ending 11.01.2019

Eco Blog

- Economic data early into 2019 has not been encouraging. The forward indicators such as PMI surveys uniformly suggest that manufacturing activity slowed towards the end of 2018.  This may see interest rate moves stabilise, a supportive factor for equity markets.

The softer pace in the US may surprise, yet the economy appears to have hit a series of bottlenecks. Labour shortages are one and higher rates have troubled consumers in the big-ticket segment, reflecting in weaker trends for housing. Notably, the small business sector (National Federation of Independent Business) has lost faith in a strong expansion. In turn, that lines up with consensus forecasts for the US economy, which expect GDP growth to ease back from 2.9% in 2018 to 2.5% this year.

Source: National Federation of Independent Business/Haver Analytics
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The current government shutdown is likely to feature across January data and it will take another month or two to get a further update. Lower Treasury rates have already seen mortgage demand recover from its lows, setting up a potential improvement in consumption spending into 2019.

Employment conditions have sustained their upward trends, but elsewhere Europe continues to be hit by factors that detract from growth. The French ‘yellow vest’ protests and Italian financial conditions was joined by German manufacturing data that was weaker than expected. The last mentioned should be partially resolved, as some is due to the prolonged resetting of the auto industry to new emission standards and the impact of the summer drought which, amongst other issues, has limited cargo movements on the Rhine. A degree of fiscal easing is on the cards, already underway in France and Italy, and likely to follow in Germany.

China has already hit the expansion button with a reduction in the bank reserve requirement (akin to a capital retention ratio), tax cuts and rail road spending. It may take a few months for any evidence of a transition, while some form of agreement on trade would clearly also be helpful.

Recent pointers suggest Australia had joined the general trend with weak consumer confidence, an inevitable fall in housing activity, partly offset by ongoing construction activity.

  • Directionally, global economies are expected to move into the same trend in 2019. Slower growth can set up better conditions for equities. Rates are likely to be stable and central banks take a cautious view on guidance, inflationary pressure has abated and fiscal spending is set to hit the sweet spot. The hurdle is the reduction in central bank balance sheets alongside the issuance of bonds, particularly US Treasuries. The clearing price for bonds remains uncertain.

Weekly data of note:

  • China’s CPI at 1.9% and PPI at 0.9% for 2018 will limit the capacity of companies to service their debts give their incapacity to raise prices. In turn, it is likely to further weaken private sector investment. As an offset, the release coincided with tax cuts for small business.
  • US CPI will be out overnight (11th January). Reported sales from large retailers have been soft and airlines have announced profit warnings.
  • Locally, residential building approvals fell sharply in November to -33% yoy, though coming off an usually strong comparable period. Conversely, non-residential approvals recovered somewhat in November, but are still running 8% below last year. Without state-based spending, the construction sector would be in a much more difficult position and will be key to sustaining acceptable growth in 2019.
  • Australian November retail sales rose by 3.3% in nominal terms. Food, alcohol and tobacco spending is growing at 3.9% (in part due to tax rises on tobacco), while clothing stores are also enjoying a good period. Conversely, big ticket household items are sluggish and department stores moribund. Overall annualised revenue growth of 3.3% over the past three months is in a stable range, albeit relatively low compared to history and in the context of population growth and inflation.

Fixed Income Update

- Australian fixed income takes the gong for the best performing asset class in 2018 as bond yields take a slide.

- We analyse the drivers of the Australian market and whether this performance is likely to be repeated in 2019.

The strong 2018 annual returns in Australian fixed income was a surprise to many. The return for the Ausbond Composite Bond Index was 4.5%, mainly due to its high weighting to government bonds (~80%). The government-only treasury index returned over 5%, in what was possibly the best performing liquid asset class for many portfolios, not to mention being the highest quality. The robust return was roughly half coupon income and half capital appreciation. The capital appreciation was picked up as yields on the 10-year government bond fell ~30bp (attributing a ~2.55% price increase), while the 5-year government bond yield retreated ~40bp (adding ~1.8%) over the year.

Several ‘risk off’ factors have driven the yield compression. Falling equity markets and the expectation that the US Fed will take a pause on raising interest rates in 2019 were the biggest drivers. Domestically, a falling housing market has stoked the sell-off in risk assets, benefitting safe-haven Government bonds.

While bond yields have been falling, the RBA cash rate has remained unchanged since August 2016. Given the central bank was in a cutting cycle back then, the shape of the yield curve was very flat throughout that period. The spread between the cash rate and the 10 year bond yield had slipped to a low of 12bp in July 2016, which reflected the view that the RBA would lower rates again. The recent fall in bond yields has seen the spread between the cash rate (1.5%) and the 10 year bond narrow to 82bp, its lowest since the end of 2016.

Spread between the RBA cash rate and the 10-year Govt bond yield

Source: RBA, IRESS, Escala Partners
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For outperformance of domestic bonds this year, one must make a judgement on the likelihood of the RBA lowering the cash rate. The governor has given mixed rhetoric, with comments on the likely path of rates being up, while stating they have the ability to cut rates further if warranted by economic conditions. We suggest that the most desired course for the central bank will be to keep rates on hold, with a decent capitulation in economic conditions required to lower the rate again. However, tighter lending standards from APRA regulatory changes and out of cycle rate hikes by the banks (BOQ raised rates on mortgages by 0.18% this week) are effectively tightening monetary conditions. This may force the RBA to cut the cash rate as an offset, although the central bank has little room to move with the cash rate sitting at 1.5%. The futures market is leaning to this scenario, with a 23% probability of a rate cut priced in by October. Yet, a negative interest rate policy like that of Europe would not be a favoured outcome given the squeeze it puts on the banks’ net interest margins.

In the absence of a rate cut or any rapid deterioration in the Australian economy, offshore markets (particularly the US) will continue to influence the long end of the Australian yield curve. In our view, valuations of domestic bonds look expensive and yields are likely to drift higher. Even with a slowdown in rate hikes by the Fed, other factors such as a resolution to the trade wars, unwinding of central banks’ balance sheets and US treasury supply/demand dynamics are likely to elevate bond yields. The probable lesson of the recent bond rally is that the ceiling on the US 10-year bond rate is lower than once thought (just above 3%), with bond yields set to trade in a 50bp trading range for now.

  • It is doubtful that 2019 will be as favourable for bond returns in the absence of strong recessionary indicators. For those that are overweight domestic, long-duration style funds, taking profits now and moving to an underweight position is advised. Maintaining some allocation would be on the premise of insurance against a recession, insurance within a higher risk portfolio and income generation from a high-quality asset. Our current view would be to add to offshore duration if the US 10 year rate trades back above 3%.

Corporate Comments

- Costa Group’s (CGC) earnings downgrade saw the stock de-rate to a more appropriate multiple for the business. Discipline on valuation is a persistent risk in growth companies.

- Magellan Financial Group (MFG) has performance and flows on its side, compared with Platinum Asset Management (PTM). An emerging markets turnaround would be in the latter’s favour.

- Investors have rotated back into higher growth stocks again over the last three weeks.

Fruit and vegetables company Costa Group (CGC) has been somewhat of a market darling since listing 3½ years ago and a favoured pick among small cap fund managers. CGC had developed a short but admirable history of earnings upgrades through this time, with investors attracted to a story of growing demand met by CGC’s investment in new production and via acquisitions.

A ‘trading update’ this week ended this run, with the company issuing a sizeable downgrade to its FY19 guidance from ‘low double digit’ earnings growth to ‘flat’ (consensus estimates had sat at ~12%), blaming subdued trading in a number of categories, including tomatoes, berries and avocados. Somewhat heroically, CGC stated that it believes this weak trading is a short-term cyclical issue and that an ‘annual double digit CAGR in profit over the 2017-18 calendar years is achievable. Investors were much more skeptical, selling down the stock by more than a third of its value.

While this may prove to be a short-term cyclical hiccup for the company, the key observation is that the stock was previously trading at an excessive P/E in the high 20’s, a measure that had drifted higher since its listing; we believe a retracement back into the high teens is closer to a more appropriate valuation for the stock’s characteristics.

Costa Group: Forward P/E and EPS

Source: Bloomberg, Escala Partners
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Updates from asset managers Magellan Financial Group (MFG) and Platinum Asset Management (PTM) illustrated their contrasting fortunes over 2018. For PTM, a heavy bias towards emerging markets (EM) equities (which lagged through the year) have been a headwind for performance and investment flows, along with the news of Kerr Neilson’s resignation from his position as CEO and Portfolio Manager. Meanwhile, MFG’s performance has recovered (particularly in the December half), helped by a large-cap US-centric approach and cash weight, resulting in a return to solid performance fees for the half.

While one should be careful in capitalising these performance fees for MFG, the stock presently screens as the more attractive of two in the short term given the superior momentum in its business and the similar valuation. On a longer term view, an EM recovery would clearly be in PTM’s favour, although the timing of this is currently complicated by noise around trade and China’s growth.

The turnaround in the domestic equity market over the last three weeks has been marked by rotation back into higher growth segments of the market. As illustrated in the chart, defensive sectors such as REITs, utilities and infrastructure (we have used TCL/SYD/AIA as representative) materially outperformed the benchmark through the downturn between September and late December. Over the last three weeks, this has begun to reverse amid a more ‘risk-on’ phase. Consumer discretionary is a sector that has bucked this trend, with some caution towards retailers after a downgrade from Kathmandu.

Relative Performance (to ASX 200 Accumulation) of Selective Sectors

Source: Thomson Reuters, Escala Partners
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Selecting portfolios appropriate to an investor’s requirements inevitably will result in periodic under or outperformance, given it is unreasonable to expect above index returns in all conditions, especially on a short-term basis.

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