Week Ending 11.03.2016
The ECB both delivered and disappointed financial markets. The general view is that the announced package would do as much as could be expected to support credit conditions within the Euro zone. On the other hand, Draghi made it clear that this was likely to be the last gasp of interest rate movements, though expanding and adapting asset purchases could not be ruled out. In summary, the refinance rates, deposit rate (at -0.4%) and marginal lending rates were all set to incentivise lending banks to limit their short term cash holdings. There is much debate about the effectiveness of negative rates as they reduce bank margins (which perversely pushes banks to raise lending rates), reduces investment income for insurance companies and annuity streams and sends a signal all is not well within the economy.
The increased asset purchase programme, from €60bn/month to €80bn/month, and the inclusion of non-financial investment grade (IG) bonds got a warmer reception. There is approximately €650bn in outstanding IG bonds in the Eurozone with around €20bn issued monthly and each central bank in Europe can select its mix of bond or credit purchases. Overall, this is supportive of spread compression in Euro bonds, though the lack of carry and low coupon yield still limit the attraction of these securities for most fund managers.
The other component was the catchy ‘Targeted Longer Term Financing Operation’ (T-LTRO) which has been extended to a four year maturity. In simple terms, this gives the lending banks security in terms of funding sources. The actual rate will depend on the liability mix of each bank and its capital structure.
The RBNZ surprised with an interest rate cut of 25bp to 2.25%. The trigger was low inflation and falling inflation expectations. The rise in the NZ$, low dairy prices (with current milk fat prices implying a 10-15% default in dairy loans), sluggish global growth and moderating house prices in Auckland (though not elsewhere) provided additional ammunition. Though the low headline inflation forecast by the RBNZ of 1.1% would be taken as the key data point, there is little doubt that inducing a fall in the NZ$ was essential to their thinking.
In the forthcoming weeks, central banks in the US, Japan and England will also get a chance to make their mark. But it is increasingly clear that easing monetary policy is no longer an effective tool and could possibly do more harm than good.
After a few quiet months, China is once again under the spotlight. The annual People’s Congress has set the growth objective for the coming year at 6.5-7.0%. While there is already scepticism on credibility of the published GDP growth rates, few believe China can maintain growth without fuelling accelerating credit expansion from the current high levels. The targets paint a benign picture, with aggressive expectations for an uplift in CPI as well as monetary expansion. Notable was the underperformance of the trade component and absence of target for this year.
China Economic Data and Targets
Some commentators highlighted the large investment on railways and highways as a sign infrastructure spending was to pick up, but these in fact merely reiterated what had been announced before. Where there is new fixed investment, it is to improve existing assets such as modernising agriculture, the ‘innovation’ agenda, and clean energy.
Financial sector reconstruction is to be upheld. While it does not gain headlines, the development of a local bond market, akin to the semi-government segment here, is an important issue as it requires local authorities to be accountable for their spending, as well as offer an opportunity for Chinese households to invest in a broader array of instruments.
The other components of the current five year plan are based around societal outcomes – urbanisation through reform of ‘hukou’, health insurance, childcare to support the two child policy, worker training for the right skills etc. Many of these are to maintain the support of the populous at large; a key dimension for the central authorities.
Historically, the trend in money supply (M2 growth) in China has been a good indicator of GDP. The recent uptick in credit would suggest growth can improve in coming quarters.
It may, however, be misleading, as there have been large flows out of the capital account. Simply making funds available does also not mean it will be invested. State owned enterprises have relatively high liquidity, but as there are now required return hurdles to achieve, they are in no hurry to deploy that capital. The worst outcome would be another bout of property investment. Not only is this likely to imbalance the demand/supply dynamics again, but it adds to a sense that property investment will be saved by government support.
Trade data out of China was well below expectations. While there is substantial distortion around the timing of the Lunar New Year, it is clear that exports have been deteriorating for a number of months. This is far from a China phenomenon, with global trade clearly on the wane for some time. The question is: why?
Global trade in goods rose from 13.8% of world GDP in 1986 to 26.6% of GDP on the eve of the financial crisis 2008. GDP growth itself was rock solid, with major factors including the democratisation in Eastern Europe followed by the entry of China into the World Trade Organisation. Post a sharp bounce in 2009/10, world trade has been much more sluggish, declining to 24.6% of GDP (as at latest data, end of 2014).
All segments show a deterioration in product values. Low commodity prices (as can be seen in processed and raw materials goods) are a big part, but the there is more to it than that. Intermediate goods, such as chemical products, paper, communication and electronic equipment, steel and textiles, have all fallen in value as well. Finished goods are a mixed bag, with good momentum in segments such as aircraft parts, motor vehicles and pharmaceutical inputs. The declines are in products such as computers, electrical equipment and heavy machinery. In part, this reflects a slowdown in investment spending but also falling product prices.
The detail from China’s trade data provides further colour. Based on three months to the end of January, exports to the US are up, so too for Singapore and Vietnam. Conversely, the rest of Asia and most of Europe are importing less in value from China. It is likely that as a significant amount of Chinese exports are traditionally US$ denominated, these countries have turned to other lower cost sources of imports, or that China has lowered the transaction values to reflect the higher US$ received. From a product perspective, the trends indicate that the ‘automatic data processing machine segment’ i.e. computers and electronic components are facing the inevitable fall in value versus volume. In terms of the traditional sectors of apparel, Chinese exports have maintained their growth into the US, but have seen declines to Europe and Japan. Once again, the currency is the likely culprit, with many European apparel manufacturers willing to switch to eastern Europe or northern Africa on a total cost and timeliness perspective. Further, with Vietnam and Bangladesh appearing as prolific importers of textile from China, it is more than likely these are taking advantage of trade agreements and that these products are re-exported.
A final comment is that Australia is in China’s top five destination for two categories, paper and furniture.
Global export services are growing at faster than GDP, but as the majority of these are local, the global component is relatively small compared to goods.
Absent in the trade data is a broader measure of intangible product. The movement of digital information has grown exponentially and shows no signs of slowing down. The trend is not based only on Facebook but increasingly in corporate services such as accounting platforms, cybersecurity, customer relationship management and data analytics. Where these services are transacted from the corporation in one country to a client in another, there may be some data captured. However, not only does the corporation often establish a sales office in many of its client domains, recently there has been plenty of evidence that sales and profit of services are frequently accounted for in regions with advantageous tax statuses. Tracking global trade is going to become all the more challenging.
The pictorial below shows the explosion of data from a small base, largely within a region to a massive scale and cross-region.
Change in Global Dataflows
Behind this level of detail is the suggestion the slowdown in industrial production and global trade would inevitably result in a recession, as it has often in the past. The troublesome issues of high global debt, demographics and deflation paint a somewhat gloomy outlook, yet some of the interpretation from standard indicators of economic activity may miss a rosier potential outcome.
Fixed Income Update
Australia’s 10 year Government bond yield fell to 2.35% on 3 March, which was very close to the all-time record low of 2.25% in February 2015, bouncing back to over 2.5% as risk assets rallied.
Nonetheless, higher nominal rates of our government bonds, together with the AAA credit rating, sustains the attraction for global investors.
The surprise interest rate cut by the RBNZ didn’t move the local bond markets, but it will perhaps give the RBA something to think about, especially in light of the strengthening AUD. With the next meeting not until April, there is plenty of time for markets to retest lows as we wait for interest rate cuts on the front end.
Australian 10 Year Government Bond Yield
Over the last week, the media has been covering the unfolding rate rigging saga by the major banks of the Bank Bill Swap Rate (BBSW). While there is no indication, at this time, of whether the BBSW rate was more likely to be artificially inflated or lowered, it would have had return implications for those investors holding fixed income assets. This swap rate is the most widely referenced interest rate in the Australian market. Securities including corporate FRN’s (fixed rate notes), mortgage backed securities, term deposits and hybrids have their coupons calculated off the BBSW base rate. Of comfort to current investors is that the BBSW has been calculated electronically from market data by AFMA since September 2013, so any manipulation was prior to this time.
US High Yield (HY) securities (bonds from issuers that are below investment grade) are back in favour after a challenging few months of widening credit spread and fund withdrawals. HY was heavily impacted by the falling oil prices due to the significant number of energy issuers in this sector (~15%), which had contagion affects across the market as a whole. Some stabilisation in the oil market has seen credit risk appetite return in March, with performance on high yield becoming positive (+1.4% YTD) after being down to as much as -5.1% when it hit its lows a month ago.
It is reported that $5 billion flowed into the high yield market in the first week of March, which was the largest weekly total ever. With new issuance volumes down in 2016 and continued inflows for over three weeks now, yields have compressed significantly. However, to put this into context, high yield funds have had $44 billion of outflows since June 2014, therefore credit spreads still remain at around 3% higher than where they were a year ago. The chart below depicts the trend in the average effective yield as measured by the index.
A divergence in spreads between energy companies and non-energy issuers remains, with the average yield on speculative companies (CCC rated) being 19%. With defaults expected to continue to filter through from the lower quality names, fund managers remain averse to exposures in energy and only invest in the higher rated and better quality segment of this market.
Iron ore and steel were back in the news this week as the iron ore price recorded its largest single day percentage gain this decade, providing a boost to the beaten-up sector. Increasing financial market participation in iron ore has led to traders reacting to the current bout of positive sentiment. Several factors have caused the rebound in the iron ore price, which is one of the best performing commodities year-to-date, although the overwhelming consensus is that the rally is likely to be short-lived.
News from China has been gradually less negative over the last few months, helping the iron ore rally. Steel prices have risen in the early part of 2016, with an improvement in steel mill margins (many of which have operated at a loss) required to support increased production before the seasonal pick-up in demand; the effect has been amplified by low steel inventories ahead of the peak period. Higher steel prices have thus allowed room for iron ore (a key input) prices to expand in this time.
Policy announcements from China’s government have also been positive in recent months. In February, support was provided to the property market, with property purchasing taxes cut and down-payments for property purchases reduced. Last weekend’s National People’s Congress was also well received by investors; the economic target growth rate for 2016 was higher than anticipated, and coupled with a higher targeted fiscal deficit, the prospect of commodity-intensive investment stimulus has been raised. However, any stimulus may yet target the country’s growing services sector (this would be more capital-light), which may dampen the expected pick-up in iron ore demand.
Steel Production (mt, 12 month trailing) and Growth Rate
The question of whether the rally will be sustained will ultimately come back to the fundamental supply-demand equation, which remains weak for the miners. China and global steel demand has been falling over the past year, and without an improvement, the expectation is that the price recovery will be short-lived. The factors that we noted above are typically quite short-term in nature (inventory levels, seasonal demand etc.) and the longer term view of investment stimulus from China is yet to be backed up by evidence. Noted bull BHP Billiton (BHP) also provided a relatively sombre outlook at a conference this week, noting that the short term outlook remains “challenging”, that the current downturn is driven by an oversupplied Chinese property market and that there will be a “prolonged period of market rebalancing”.
The iron ore price has now also pushed above many on the global cost curve (which has taken several steps down as the industry has taken out costs), making previously uneconomic miners profitable again. Some of this supply would likely return to the market should the current rally be sustained.
A deal between Fortescue (FMG) and Brazil’s Vale also added to the news for iron ore, with the two miners agreeing to a joint venture to blend their respective product and allowing for a potential investment by Vale in FMG. The blending of iron ore makes sense; Vale has historically struggled to achieve an adequate premium for its high grade iron ore, while FMG has received a discount to the market price for its lower grade iron ore. It is hoped by investors that this partnership may lead to more rational supply growth from the major iron ore exporters. Despite the seaborne iron ore market having oligopolistic characteristics (see chart below), the main participants have still prioritised volume over profits and thus it would be unreasonable to expect this would change materially post this deal. Our preference for participation in the mining sector is through the major diversified miners, which are still enjoy healthy margins in iron ore despite the sharp decline in price over the last four years.
Seaborne Iron Ore Market Share
Stock Focus: Mantra Group (MTR)
Mantra Group is Australia’s second largest accommodation services provider, with over 19,500 rooms across 125 properties. Mantra’s diversified network includes hotels, resorts and serviced apartment properties, and the company also has a presence in New Zealand and Indonesia. The group operates under three brands (Mantra, Peppers and BreakFree), which cater for business and leisure customers, as well as for varying budget levels. In the December half, Mantra’s CBD properties accounted for 56% of the group’s exposure, with the balance from resorts.
Mantra operates an attractive, capital-light model whereby it does not own the underlying real estate property and generates a strong level of free cash flow conversion. Mantra’s model reduces its level of recurring maintenance capital expenditure requirements, which are shared with the underlying property owners. The company typically entrenches itself in its properties through long-dated agreements to manage the centralised services, such as reception, restaurants and bars, and entertainment and function areas. The various operating structures which Mantra employs takes into account the different levels of risk from the cyclicality of demand. The group’s CBD properties have a relatively stable demand profile in which Mantra uses operating leases. Mantra reduces the risk from its resorts properties through the use of management letting rights, which provide a more variable cost and revenue share with the underlying property owner.
The key drivers of Mantra’s profitability (and the broader accommodation sector) are growth in number of rooms, the average room rates across its portfolio and occupancy levels. The latter two of these measures combine to measure revenue per available room (or RevPAR); growth in RevPAR is important in growing the company’s overall margins. Mantra’s recent trends across these indicators have been positive. In the recent half year, Mantra expanded its available rooms, via acquisitions and organically; occupancy levels increased by 1.8% to 79.9%; and average room rates across its portfolio increased by 3.6%, with a strong tailwind from its resorts properties. The balance between supply and demand is also an important factor in growing RevPAR. While supply has begun to pick up again in response to the strengthening demand conditions, demand growth has been ahead of supply for most of the past decade.
Following the decline in the AUD over the last few years, the outlook for the domestic tourism industry is robust, and we believe that Mantra is well positioned to benefit from this cyclical trend. With a weaker AUD, Australians have less incentive to travel overseas, which should thus provide a boost to the domestic industry. Inbound tourism should also improve as Australia becomes a cheaper destination for international travellers, and this is already beginning to show in data points. A longer term structural growth driver for Australia’s tourism industry is the growth from consumers from China and other emerging Asian economies.
After making a significant investment over a number of years, Mantra has made good progress in increasing the proportion of bookings through its centralised reservation system. These bookings generate higher margins for Mantra as they remove third party commissions paid to travel agents and other parties.
At Mantra’s December half year result the company upgraded its full year profit guidance, underlying the robust conditions in the accommodation and tourism industry. Earnings from its resorts segment were particularly strong and the company’s expansion in this area sees the company well placed to benefit in coming periods. With its balance sheet in good shape, Mantra should be able to take advantage of the environment through further acquisitive growth. We recently added the stock as a smaller position in our extended guided portfolio.