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WEEKEND LADDER

A summary of the week’s results

11.08.2017

Week Ending 11.08.2017

Eco Blog

- Geopolitical tensions weigh on markets, but there also have been other issues that are shifting the pattern and emphasis.

- Tax take in the US is relatively benign compared to perceptions of growth, and it’s the household sector that does most of the heavy lifting.

- The theme of housing and inflation is a global one. The rise of wealth above nominal GDP growth is too.

Before commenting on economic news, we have reflected on the flare up in geopolitical tensions. We have no insight into the situation beyond what is available for all to read and limit our discussion to investment markets.

Factoring in political issues sits awkwardly in financial markets, beyond the obvious that such risks can result in a sharply cautious stance and inevitably a rally in gold, bonds and fiat currencies. Without putting aside the seriousness of these events, history shows that investment markets typically react and then returned to where they left off. This was the case for the Kuwait invasion, 9/11, the problems in Ukraine and the Arab spring.

If the North Korean situation does not escalate into an extreme case, investment portfolios are likely to revert to form relatively quickly. Nonetheless, it raises a few other issues. Until the last quarter, equity markets have been strong and valuations have been expanding; therefore, a pullback was increasingly probable, driven by short term traders and ’profit taking’. Further, what colluded before and resulted in very low volatility (supporting selected sectors and regions) is now fragmenting. The dominant themes that have driven equities since late last year are in three broad categories.

Lofty expectations of a cyclical rally and emerging inflation resulted in a substantial uplift in energy, material and financial stocks in the final quarter of 2016. This dissipated with sluggish inflation and the shift back to growth stocks, specifically IT. Now those valuations are coming into question, along with a degree of discomfort that there will be losers within the disruptive theme as well.

Europe has been a consensus call this year. Valuations were below other markets and economic growth surprised. Yet, with some of the relief rally post the French election fading to reality and the impact of the higher Euro limiting the export sector, the returns have, for the moment, eased back. Investors have therefore turned to domestic conditions in Europe and away from export-led sectors.

Conversely, the predominating concern that a stronger US$ would hold back emerging markets (EM) not only proved incorrect in its base assumption, but there was also evidence that current account imbalances are no longer as problematic as in the past. Within a yield-focused world, the potential returns from fixed income from higher yields available in EM flowed into equity markets. Those with a longer-term eye on growth believe that much of EM is in a position to produce good data for some time.

In the hope the tensions in the Korean Peninsula ease, investment markets should improve, but will also reflect these changing conditions and expectations.

The US budget deficit makes for interesting reading, given the signalling on tax payments and implicitly how well sectors are doing. With the looming debt ceiling, it takes even more importance. For all the noise about US spending, outlays have been relatively flat since 2010. Receipts recovered out of 2009, but the rate of growth has since faded.

Source: US Treasury/Haver Analytics
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Social security taxes are the most stable source of income, tracking between 3-4% growth and contributing circa 35% to the tax take. Individual tax income is surprisingly variable, not due to paid employment, but because of other sources of income that are taxed, and currently comprises 45% of the total. It is up 3.2% in this financial year. Companies are only contributing 9% to the pile, though that is up 2.4% in the year after a fall in 2016 caused by the slump in the energy sector. The relatively subdued rate of increase in the tax take that reflects economic conditions implies that the spread of US momentum is far from as exuberant as some might suggest.

An issue that refuses to leave the headlines is housing. US house prices are currently at median of $263k, barely a beach shed in Australian terms, up 6% over the year. Along with the rise in mortgage rates, a new homeowner is facing a circa 11% rise in housing related costs. Nonetheless, the housing CPI at 42% of the US index, via the owner equivalent rent, is up only 2.8%. This metric assumes that the cost of home ownership will, in the longer run, reflect rental growth, assuming they are traded off in financial merit by each household. Australia is also about to see housing CPI adjusted to include building costs, even though that has little to do with those that occupy an existing building.

These issues consistently come back to two problems. Household behaviour is at odds with the apparent stable or growing employment and wealth effect while enjoying low inflation. The reality for most households is that the CPI is a poor measure of their living costs. The second is that central banks and regulators are managing monetary policy for the economy at large which inevitably pushes one segment into excess leverage.

On cue, the RBA governor noted the tension between our low wage growth and inflation against the heated housing market and high household debt. In the coming week, the release of the Wage Price Index is expected to show little movement, but the next reading in November will include the 3.3% rise in the minimum wage. Along with the inevitable impact of utility costs, the CPI may take a step up, but not in a way that adds to confidence to economic growth.

From the adage that all roads lead to Rome, the question most investment managers are asking is whether all these questions on inflation, wages or housing will not come down to one issue. When central banks step off the monetary accelerator, will household wealth representing property and investment assets revert to trend?

Source: Federal Reserve, TS Lombard
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Fixed Income Update

- The struggling retail sector is a concern for the Commercial Mortgage Backed Securities (CMBS) market

- Divergence in central bank monetary policies globally continues, particularly from the emerging markets

- ANZ are expected to announce a new bank hybrid deal as early as next week

- Tesla test the market for a new bond offering

The global commercial mortgage backed market (CMBS) has experienced some spread widening over the last 12 months. The catalyst has come from concerns relating to the retail sector as the ongoing shift away from traditional stores in favour of online continues, resulting in shop closures and vacancies. While retail exposure only makes up a part of the CMBS market, there has been widespread contagion. As fund managers loose appetite for retail exposure in their CMBS holdings, there has been a drop in the number of retail loans that are making it to the securitised market. This has been a downward trend over the last 7 years.

Retails loans in CMBS* declining

Source: Trepp, Financial Times
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Many US shopping malls have been struggling for years. The CMBS market had one of its largest commercial defaults in 2016 when a shopping mall in the US (Hudson Valley) defaulted last October generating an 86% loss. This low recovery rate puts the spotlight on the challenge of valuing these commercial buildings for collateral purposes in CMBS vehicles. An untenanted building has a very different value to one that is fully occupied and usually required considerable reworking.

While the markets spend much time focused on the pathway of interest rates in the US and Europe, a divergence in central bank policies is playing out across the globe. In the developed world, only the US Federal Reserve bank has lifted rates alongside Canada, while the ECB, Bank of England and others are yet to act. By contrast, in the emerging markets there have been a few central banks that have raised rates, but more that have lowered the cash rate. The number of EM central banks still with accommodative monetary policies outweighs the number that are tightening.

Selected Policy Rate Changes Since End-April (bp)

Source: Capital Economics
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Locally, talk of the RBA raising rates alongside the other developed nations has subsided as bank representatives have done their best to dampen expectations of an imminent rate rises after the market reacted to the July statement where comments on a nominal neutral cash rate of 3.5% got attention. Big hurdles face the RBA to move rates higher, notably being the recent strength of the AUD, which has increased 15% against the USD since its low in 2016. In addition, the pressure has been alleviated as APRA’s macro-prudential changes and out of cycle rate hikes by the banks have effectively already tightened domestic monetary policy. While most are of the view rates will be on hold well into 2018, and possibly beyond, the notion that the RBA would eventually want to see something closer to 3% will mean market can be expected to react to any signal that indicates the time might be getting closer. 

It is expected that ANZ will come to market next week to announce a new ASX-listed bank hybrid with a reported size of ~$1bn. ANZ suggested at the end of last month that it was considering a buy-back on  ANZPC securities (which have a call date in September this year) in conjunction with a new hybrid capital note offer. A formal announcement from the bank is yet to be made, but in the event of fruition, participants will welcome the new deal. Lack of supply has been a contributor to tighter credit spreads in the ASX listed hybrid market this year, making valuations on many securities expensive.  

In global markets, despite Tesla burning through $2bn-$3bn a year in capital as it spends on building battery and assembly plants for its electric cars, it is close to launching a new $US1.5bn bond. Marketing is still continuing, but suggestions are that it should be able to issue an 8 year bond below 5%, slightly lower than the current high yield sector average. Tesla’s credit rating is below investment grade at B- from Standard and Poor’s. Credit from high profile companies with charismatic leaders appears to be in demand. Without the public profile, other companies are moving to the private lending market where investors willing to do the work are turning their attention, as banks remain restrained by their balance sheets.  

Corporate Comments

- Commonwealth Bank (CBA) got a pass mark for its result in a soft market.

- AGL Energy (AGL) has tailwinds from rising electricity prices. Regulatory risk remains key.

- Transurban (TCL) again reported distribution growth which is among the best among large-cap companies. Rising rates are its biggest challenge.

- James Hardie (JHX) disappointed on its quarterly result. Investors are now looking for evidence of future margin improvement.

- Asset managers have received a strong boost in the last year from rising investment markets. Janus Henderson is a differentiated exposure in the sector from the perspective of geography and earnings growth driven by synergies.

Commonwealth Bank (CBA) reported a satisfactory result given current market conditions for the banking sector, although this was overshadowed by the allegations that it has breached anti-money laundering laws.

The result itself was a marginal beat on the market’s expectations, although a 3% lift in underlying cash earnings per share did little to trigger much investor enthusiasm. The dividend also surprised on the upside, with a 2% increase, while return on equity again edged down as increasing regulatory capital requirements contined to provide a headwind. For a fourth consecutive year, CBA was able to control expense growth below that of its top line, leading to margin expansion (or positive ‘jaws’ as the banking sector refers to). Notably, revenue growth was softer again in FY17 compared to previous years, with home lending growth of 7% the key highlight.

Commonwealth Bank: Income and Expense Growth

Source: Commonwealth Bank
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Other factors were relatively mixed. Net interest margins were flat over the year, a function of higher funding costs and mortgage repricing. After a slight rise in FY16, impairment expenses dropped to their lowest level since the financial crisis, at just 15bp. Some form of impairment normalisation is an ongoing risk for the sector, and an area to watch in coming periods will be WA, where home loan arrears are now running at more than twice that of the rest of Australia.

CBA has traded on P/E premium to its major peers, based on its superior ROE and earnings consistency off the back of a predominant exposure to Australian mortgage lending, which has remained a steady source of credit growth for the banks. Its ROE gap on its competitors has though recently fallen, given the higher capital that all banks are required to hold against their mortgage books. Further, it perhaps warrants less of a premium rating given the reputational damage it has suffered following the emergence of a second significant scandal in recent times. We believe an underweight weighting to the sector is appropriate for most investors.

AGL Energy surpassed its own earnings guidance with 14% profit growth and 34% jump in dividends, an outcome of the company’s new dividend policy set at a higher payout ratio target of 75%. Given a strong position in electricity generation, the key driver of the result was well anticipated – a rising wholesale electricity price – while the drag from reduced margins in its gas business had also been flagged to the market.

The reasons for the price spike have been well documented this year, with government policy uncertainty leading to reduced investment in new capacity over several years, coupled with the closure of several large coal power plants. In AGL’s view, the current pricing environment is largely reflective of that required to incentivise new supply to the market, as illustrated in the chart below.

Electricity Market: Pricing and Cost of New Generation

Source: AGL Energy
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AGL provided a positive outlook for FY18, with the mid point of its guidance implying a further 23% profit increase on FY17. Supportive conditions in wholesale electricity is again expected to be key over the next year. However, the delayed pass through of pricing to the various segments of the market will lead to a more gradual stepped impact in AGL’s earnings. Large business customer sales typically have contracts that last two to three years, rises are phased for retail customers subject to competition and affordability considerations (many would be yet to absorb the price increases that were passed through from July 1), while wholesale customer contracts can be much longer in length.

AGL’s share price weakness post its result was most likely an outcome of a capital allocation outlook that has lifted the priority of growth capex (the company highlighted more than $2bn of projects in development), at a time whereby investors may have been hoping for an extension of the buyback that the company had in place.

While the medium term outlook for AGL remains robust and its valuation doesn’t look overly stretched if its expected earnings materialise, the key overarching risk is regulatory/political in nature, particularly given the sensitive nature of the issue. Quantifying the downside from this risk is more difficult, although this has typically been something that has been underappreciated across a range of industries by investors over some time.

Transurban’s (TCL) full year result was typically solid, if uneventful, with 10% growth in EBITDA and a 13% increase in distributions over the year. It achieved average traffic growth of 4.0% across its portfolio, with annual price escalation leading to a 11% rise in revenue. The key drag in FY17 was the disruption caused by its project to widen the Tullamarine Freeway in Melbourne, which is expected to be complete in the next six months.

TCL outlined an expected 56c distribution for FY18, which would represent 9% growth. We note that its initial distribution guidance has been conservative over the last four years, with actual distributions ahead of these forecasts. A significant development pipeline remains, with the most significant of these being the proposed West Gate Tunnel Project (WGTP). Many of its projects are simply upgrades of its existing network and it expects to be able to fund these from its existing balance sheet. A green light for WGTP, however, is more than likely to trigger an equity raise for funding.

A large tailwind for TCL and other infrastructure owners over the last several years has been a falling cost of debt. It is likely that this has bottomed, and, coupled with a higher level of debt, should turn into somewhat of a headwind over the next few years. TCL has mitigated this to a degree through extending the average maturity out to nine years.

From a relative perspective, TCL looks to be valued fair, with the stock now trading on a yield premium to the broader market and underpinned by a good distribution growth profile. The key risk remains, however, that interest rates normalise at a faster pace than anticipated, which would surely overwhelm any positive operating performance.

Transurban Development Profile

Source: Transurban
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James Hardie (JHX) disappointed for a third consecutive quarter with its earnings result, although it has been more self-inflicted issues hurting the company, as opposed to a soft market environment. Despite pushing through price increases in its core North American business in April, earnings were again affected by the poor operational performance on its manufacturing plants as it adjusts to an improved demand environment. As such, margins in the business have dropped to the bottom end of its targeted 20-25% range, which it has consistently achieved over the last four years. A rise in input costs through the quarter also contributed to the outcome.

James Hardie: North America Fibre Cement EBIT and Margin

Source: James Hardie
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JHX management expressed confidence that an improvement will come through over the rest of FY18, although some may be wary until this is evident in coming quarters, putting a cap on the earnings premium that the company has traded at for some time. A more constructive view of the stock would note that the current opportunity exists to invest in a company that has expected margin improvement, with positive leverage to a gradually recovering US housing market, and at a time when the $A has enjoyed a strong cyclical rally.

Several fund mangers reported this week, with varying degrees of market response. AMP and Magellan Financial Group (MFG) both fell short of expectations, while results from IOOF (IFL) and Janus Henderson Group (JHG) were cheered. While the focus of each company is different, there are similar factors at play that determine profitabilty and share price performance: FUM flows, base fee rates, variable performance fees, fx movements (for managers of interational assets) and broader industry trends, such as the rise of passive vs active management, all play a part. While FUM flows are the most important factor for a less established asset manager, the primary driver of earnings in any given year for the majority of managers is typically market movements (particularly for equity managers), while flows will generally determine the longer term success or otherwise of the manager.

JHG was a case in point with its quarterly result. While the merged company has experienced net outflows following the Brexit vote last year, totalling US$13bn over this time. Market and currency movements, however, provided a US$41bn tailwind to FUM levels. The net FUM outflow was, of course, mitigated by the merger between the two entities (which was completed in late May); as a stand-alone entity, Henderson was based in the UK and thus exposed to Brexit-driven flows, while Janus is more aligned with US investors.

Janus Henderson: AUM Flows and Market/FX Movements ($USbn)

Source: Janus Henderson Group
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Overall, the trends from JHG’s result were positive. Fund outflows have now moderated, a greater proportion of its funds are again outperforming their respective benchmarks (a good leading indicator for future flows), performance fee generation in the quarter was strong and excellent progress has been made on the synergies that it will realise from the merger via a reduction in headcount. The company is currently running at a US$57m run rate in savings and is thus well on the way to achieving the US$110m pre-tax target that it has forecast. JHG retains some appeal among diversified financials atlhough arguably now has less upside following a sharp share price rally since early February.

The next two weeks are the two busiest of reporting season. Companies scheduled to release results next week include:

Monday: Ansell, Aurizon, Bendigo and Adelaide Bank

Tuesday: ANZ, Challenger, FlexiGroup, GPT

Wednesday: CSL, Computershare, Dexus Property, Fairfax Media, Invocare, Origin Energy, Pact Group, Seek, Stockland, Sonic Healthcare, Vicinity Centres, Westfield, Woodside Petroleum

Thursday: Adelaide Brighton, ASX, Cochlear, Link Administration, Mirvac, QBE Insurance, Telstra, Tatts Group, Wesfarmers

Friday: Mantra, Primary Health Care, Spark Infrastructure

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