Week Ending 11.12.2015
Hot on the heels of an encouraging NAB Business Survey came the labour report, suggesting that in the past two months some 125,000 new jobs have been filled, taking the unemployment rate down to 5.8%. The ABS does note that ‘sample rotation’ has played a part (probably accounting for around 70% of the jobs growth), yet it would appear that unemployment is trending down.
NSW has proven the key, accounting for the majority of the job recovery; unsurprising given the strength in the housing sector and supporting services in the state.
Employment Growth by State: Past 6 MonthsEnlarge
Both the business and labour data are clear on the current impact of the services sector in supporting economic growth. While the financial and property services sectors have eased, retail has staged a decent recovery. Consumer confidence has rebound in recent month, though is still low in an historic context.
The Westpac-Melbourne Institute Consumer Sentiment Survey shows the responses to a set of questions posed to households. The table below should be read from the long term average in the first column. Two years ago, consumers viewed their world with a moderately optimistic tone, though they were already concerned about employment conditions. One year later, in December 2014, the outlook was deteriorating across the board.
The most recent data now illustrates a milder tone. Even with the apparent improvement in the labour market, households are not confident about employment which may reflect the lower security and wages in service jobs. Personal financial and comfort with economic conditions are within the average range. Household wealth should be in acceptable shape – over the past three years investment assets and housing have clearly done well, while many households also maintain a buffer through savings. The reading on economic conditions may be reflecting a realistic view on the circumstances rather than necessarily being optimistic.
Westpac-Melbourne Institute Consumer Sentiment - December 2015
These divergent trends muddy the water for the RBA. The apparent recovery in labour markets and confidence indicators sit somewhat uneasily with weak domestic demand, falling investment spending intentions and low inflation. This likely points to a wait and see attitude with respect to interest rates. It would be far from surprising to see the RBA stay on hold for all of 2016.
Next week, the Mid-Year Economic and Fiscal Outlook (MYEFO) will be released, which is likely to escalate the discussion on the budget. Indications are that the deficit is within forecasts and possibly even a little smaller than in May. This is due to the fall in the AUD (reducing the severity of the impact from commodity prices) and the apparently benign labour market. That said, the extended period of deficits has been the feature of these times. The inevitable pressures from an aging population, infrastructure requirements and a host of social programmes will maintain pressure on the budget. The chart shows the trend through the current cycle with a surplus pencilled in at the turn of the decade.
In New Zealand, another cut took their official rate to 2.5%. As the kiwi has recovered some 5% of its Trade Weighted Index (TWI) move of the past year, the NZ Reserve Bank is out to keep a lid on the currency, as drought conditions in New Zealand are expected to have a notable impact on economic growth in the short term. The emphasis on currencies in monetary policy looks likely be remain a predominant feature into 2016.
All indications are that seven years of ZIRP (zero interest rate policy) in the US will come to an end this week. We are all looking forward to moving the debate to other issues, though in the near term the attention will be on the path of US rates.
Loss of growth momentum in many countries is the major concern into 2016. The UK, for example, appeared to be on a sustained trajectory earlier this year and the assumption was that interest rates would follow the footsteps of the US. The strength in the labour market has been key and the chart on the following page illustrates an interesting feature of self-employment. This may be the ‘new economy’ of startups and consulting. If sustained, it can be expected to have ripple effects elsewhere; for example in demand for office space, travel patterns and income security.
UK Employment Trends
However, wages growth has not followed through and any inflationary pressures have ebbed away. Further, investment growth has tapered, taking consumption growth in its path. Overnight, the Bank of England therefore held the official interest rate to 0.5% and indicated that this could be the case through to 2017 given a low inflation rate of around 1%.
The debate on why wages are not ticking up perplexes many. As can be seen from the chart below, surveys in the UK are indicating higher wage growth than the official figures. The misalignment of these trends may see an unexpected upward move in labour costs in 2016 and be a game changer for interest rates.
UK Pay Indicators
Fixed Income Update
A number of topical fixed income themes and points of note have been discussed in the media of late.
In response to liquidity concerns that have been plaguing global bond markets, research by the Federal Reserve Bank of New York suggests there is no liquidity crisis in the US Treasury bond market. The Fed researchers argue that dealers’ holdings are well within the historical range of the past 25 years, and the reason that the world’s biggest bond traders are holding fewer bonds is that they don’t expect sufficient returns.
This research is in contrast to reports from Goldman Sachs and JP Morgan that there is a drop in corporate-bond inventories causing illiquidity. However, the lack of profitability argument certainly makes sense, especially now that the Fed is on the brink of starting its normalisation policy and many expect the yield curve to flatten further.
According to the Bank for International Settlements, issuance by emerging market borrowers slumped to a net $US1.5bn in the third quarter of this year, a drop of 98 per cent from the second quarter. This was the biggest downtrend since the 2008 financial crisis. The BIS stated, "growing concerns over emerging market fundamentals, falling commodity prices and rising debt burdens probably played a role. Additionally, an increasing focus on local markets may also have been a factor."
In our domestic government bond market, foreign holdings of outstanding Federal debt slid to 63.6% in the September quarter, the lowest since 2009. Domestic investors are presumably picking up the slack as the amount of debt outstanding here continues to grow. The face value of government securities on issue swelled to a record $403bn this month up from about $55.4bn on 30 June 2008.
Based on budget forecasts, debt is projected to rise to about $415bn by 30 June next year and reach about $521bn by the end of the 2019 fiscal year. The fall in foreign ownership is attributed to the expectation of higher global yields, led by the start of the US policy normalisation cycle, and suggests that capital is already shifting in search of better returns.
A fall in foreign ownership has potential repercussions for the AUD, as there will be less offshore buyers purchasing our dollar for these investments and may reduce liquidity for both new issuance and secondary bonds given there will be less investors in this market.
Spotless (SPO) provided some further clarity following its unexpected downgrade last week, shedding light on the issues that saw the company revise its expectations, just weeks after reiterating guidance at its AGM.
As we noted last week, a large part of the downgrade was related to the poor integration of a number of recent acquisitions, with its laundries division accounting for the largest part. At this stage, management is of the belief that these issues are temporary in nature and will not impact the eventual realised synergies from these businesses. However, the time taken for this to materialise has been slower, and hence the profit contribution will be lower in FY16.
The company also made some detailed commentary on the rest of its business. Importantly, while there has been evidence of margin pressure in certain sectors, this has not been widespread across the whole industry.
Spotless made note of its current win rate (for potential new contracts) and contract renewal rates (i.e. the renegotiation of contracts that have expired). In short, the company has experienced better success in this financial year in terms of the number of contracts in both of these categories, although it has fallen short on the potential revenue opportunity; it has thus has had a better strike rate with smaller contracts and missed out on some larger bids.
Spotless: Win and Renewal Rates
While Spotless has downgraded its earnings by around 10%, the share price reaction has been much more significant. The stock now trades on a material discount (of around 50% on a P/E basis) to its international peers, albeit with question marks over its ability to execute on its strategy. After the last two weeks, it is likely that this discount will persist until it can demonstrate an ability to address the issues in its business and thus its next few earnings results will be important.
Woodside Petroleum (WPL) withdrew its takeover offer for Oil Search (OSH) this week in a move that, while anticipated by many, came sooner than expected. Woodside had approached Oil Search with a takeover proposal (one Woodside share for every four Oil Search shares) in early September that was subsequently rejected by the target company as inadequate on the grounds that it “grossly” undervalued the company.
The consensus view in the market was that a deal between the two companies was unlikely for several reasons, not least the PNG Government’s stake in Oil Search, but also because of the lack of synergies between the companies. The latter issue would have been an important factor in Woodside’s ability to improve its offer to Oil Search shareholders. The likelihood of this occurring was contained by the disciplined investment approach that Woodside’s management have been keen to project.
We have previously highlighted the key differences between what are now Australia’s two largest listed pure oil and gas companies. Woodside enjoys strong margins from a portfolio of assets that are maturing yet lacks meaningful growth options, while Oil Search has participated in the growth in LNG in PNG and has the prospect of additional investment in the region that should continue to generate solid returns for the company and its joint venture partners.
The market release from Woodside came amidst another difficult week for the energy sector as the oil price dropped again (although not as dramatically as 12 months ago) after OPEC’s meeting last Friday. OPEC decided to persist with the current strategy of maintaining production levels in an effort to push higher cost oil operators out of the market.
The strategy has been successful in terms of sharply reducing investment in the energy industry globally, however is yet to show through in terms of supply cuts. Several headwinds remain for the expected re-balance of the market, including the return of Iranian production following the lifting of sanctions and the high current level of inventories. The adjustment in the oil market thus may not occur until well into 2016 leading to another challenging year for stocks in the sector.
The leveraged large cap options in the sector are Santos and Origin Energy and both of their large Queensland LNG operations would be barely cash break-even at current spot prices and currency exchange rates. Our preference remains with Oil Search for the reasons noted above.
Staying on the resources sector, the current perilous state of global miners was brought to attention of investors again with one of the more spectacular responses to the current environment. Anglo American, a large diversified mining company outlined a substantial restructure of its business.
The company’s plan included a proposed rationalisation of its asset portfolio from 55 operations down to 20; disposing, closing or placing on care and maintenance assets that are currently cash flow negative; reducing its employee count from 135,000 to less than 50,000; suspending its dividend and moving to a payout ratio policy; and reducing its capital expenditure guidance further.
A challenge for the company will be finding buyers for assets that it puts up for sale, particularly those which are unprofitable at current commodity prices. Based on Anglo American’s forecast for free cash flow by asset in 2016, a sizeable part of its portfolio would fall under this category.
Anglo American: Forecast Operating Free Cash Flow by Asset in 2016
Anglo American’s actions follow that of Glencore a few months ago. While both are comparable peers to BHP Billiton (BHP) and Rio Tinto (RIO), their margins are lower than that of the two ASX-listed companies and they thus have a greater imperative to address their stretched balance sheets.
On a positive note for the sector, the drastic measures taken by these companies may finally be the beginning of a more significant supply-side response across the industry (something which has been limited to date) and potentially halt the ongoing fall in commodity prices.