Week Ending 12.04.2019
- Currencies are one of the most difficult segments of financial markets, as they are always relative and prone to sharp swings. Yet, exchange rates do make a big difference to portfolio returns when they are the at the upper or lower end of valuations.
There are a number of discontinuities in financial trends so far this year. Equity markets have rallied strongly, notwithstanding deteriorating economic data and falling bond yields that are symptomatic of a bearish opinion. The oil price is up 21%, yet energy stocks have seen a sharp downward revision to earnings and have lagged this cycle. Using credit markets as an indicator, high yield (i.e. riskier) energy names have an EBITDA margin well in excess of that of the rest of the high yield universe, but this has not been rewarded in equity performance.
The foreign exchange pattern, however, has been notably dull. Most currencies have ambled around without any particular sense of direction. Typically, a negative outlook comes with a strengthening USD and Yen, with both seen as safe havens. Conversely, positive global growth is associated with support for emerging market currencies.
The predominant influences on exchange rates are purchasing power parity (PPP), interest rate differentials, current account positions and terms of trade. These wax and wane in terms of their assessed importance, while other factors invariably come into play as well.
By most assessments, the USD strength had run its course through 2018 and factored in the relative yield and growth outlook. On the negative side was the persistent current account deficit and growing trade gap. The change in the Fed stance on rates has added to the potential for a weaker USD. Based on a broad currency mix, the USD index has been tracking sideways in a narrow band for much of the past six months, exhibiting only a short-term response to data and news.
US Dollar Index
The Euro is judged to be undervalued by approximately 10% against the USD, with forecasts expecting it to trade up to 1.2-1.3 EUR/USD from the current 1.13 by 2020. This is based on PPP, with Europe now relatively competitive in pricing and labour costs. Its high current account surplus has been sustained and Europe accrues more in global investment income than it pays out. As the net proceeds flow back into Europe, the currency should appreciate.
Emerging market currencies have also not rebounded even though the flows into equity and bond markets has been robust this quarter. As the charts demonstrate, Asian FX movement versus the USD has edged up, but is disproportionately outweighed by the support in other financial markets.
The unresponsiveness in other parts of EM is even more pronounced, with LatAm and central Europe currencies particularly undervalued. Central European currencies are inevitably tied to Europe while LatAm exchange rates are influenced by a mix of local and US factors.
As is the case with other financial assets, fair value is purely conceptual as a guide to where there may be dislocations. It can take years for assets to mean revert to their appropriate level and, in the meantime, other data and factors will change the valuation.
Yet, there is a good case for USD weakness in coming years, particularly if the Fed’s dovish stance remains. Based on an improvement in China’s growth by mid-year and a mild recovery in Europe, EM and the Euro could strengthen against the USD, weighed down by the large budget and trade deficit. Investment flows into the US have declined, in part due to the petering out of repatriation of foreign held cash folloing the tax changes of 2018, and foreign buying of Treasuries have also fallen given the cost of currency hedging.
- We have held a bias towards unhedged global equities. Currently, given a relatively high degree of risk in equities, unhedged holdings can buffer downside. Nonetheless, it will be challenging to protect against a prolonged period of USD weakness.
Focus on ETFs
- Value and growth are two distinct factors in equity markets. Expensive growth stocks came under pressure towards the end of last year and a switch to cheaper value stocks appeared in the making. This is not clear-cut and other style factors are under consideration.
For most of the past few years any investment style factor overweight technology-based stocks outperformed broader based indexes. Momentum (buying what is going up already) fared the best, with quality the next best performing factor. The quality style factor focuses on three metrics: high return on equity, steady year-on-year earnings growth and low financial leverage. Quality indices differ from value indices due to their defensive nature as value tends to have cyclical and higher leveraged companies.
During times of economic slowdown or heighted volatility, companies that score highly on the defensive style factor are favoured. Conversely, growth indices will outperform during periods of expansion, which was the case until the end of last year.
MSCI ACWI Quality, Growth indexes - cumulative peformance since Dec 15
The only ETF listed on the ASX that focuses purely on the quality factor is the VanEck Vectors MSCI World ex Australia Quality ETF (QUAL). The ETF’s largest overweight is in technology, as Microsoft and Apple account for nearly 10%.
- Single factor ETFs inherently have cyclical performance given the sector bias in their construction and no individual factor consistently outperforms. Therefore, these ETFs could be used for short term performance or to complement the bias in active management.
Fixed Income Update
- Woolworths issues the world’s first supermarket ‘green’ bond as it deploys capital into environmental initiatives.
- A Saudi Arabian oil company hits the record books with the largest order book for an emerging market bond. In doing so, investors uncover the profitability of this company and we discuss why it decided to raise capital in the bond market.
In recent years there has been a growing global trend towards ESG (environmental, social and governance) investing. This has resulted in the issuance of ‘green’ bonds, in which companies issue a bond to allocate the proceeds to projects that deliver positive environmental and climate outcomes. This week, Woolworths announced the issue of a green bond, making it the first supermarket globally to do so.
The company (rated BBB by S&P) is aiming to raise $400m through a fixed and floating rate 5-year bond, with price talk in line with where it would issue a standard bond of this maturity (BBSW +130-135). The proceeds are intended for installation of solar panels on supermarket roofs, energy-efficient LED lighting, adding doors to all fridges and to trial a TESLA solar battery system.
Since 2007, the global green bond market has grown to $US521 billion, with the US leading the way at $US118.6 billion, followed by China ($US77.5 billion) and France ($US56.7 billion). Australia now ranks 11th in the world, despite only issuing its first bond in 2014.
Green bonds issuers by countries since 2007 (LHS) and in 2018 (RHS)
- Investor appetite for ESG solutions is on the rise. While there are a few fixed income funds on offer, a complete portfolio outcome is a challenge. We continue to monitor developments in this space and undertake due diligence on available offerings.
For several reasons, there was another interesting new bond that came to market this week. The state-backed oil producing company Saudi Arabian Oil Company (‘Saudi Aramco’) issued a series of bonds into the US market with maturities ranging from 3 to 30 years. In doing so, the company opened its accounts to the public for the first time in 86 years, revealing itself as the world’s most profitable company. The company generated $111.1bn in net income last year, double that of Apple and outstripping the comparable oil producer Royal Dutch Shell five times over.
Given the huge cashflow, one questions why it would need to raise debt in the bond market. The rationale is part of Saudi Crown Prince Mohammed bin Salman’s vision to open Saudi Arabia to the global markets and public investors.
The credit metrics of Aramco are exceptionally strong, with Moody’s noting the ‘minimal debt relative to cash flows, large-scale production, market leadership and access in Saudi Arabia to one of the world’s largest hydrocarbon reserves.’ Despite this, the company’s close linkage to the Saudi government, where it relies on the oil producer to fund its budget, capped its creditworthiness. This prevented the rating agency from assigning it a AAA rating, instead giving it an A1 rating.
Demand for the rare bond was immense, with orders in excess of $100bn for a $12bn issue size. This makes it the largest order book for an emerging market bond, coming close to the largest ever, held by US pharmaceutical company CVS Health’s $120bn in orders. While the high demand is a given, the actual order amount is likely to be inflated as investors often over-state their actual demand on popular deals as they know that they will get scaled down during the allocation process. Indeed, in the first trading day, the Aramco bond traded slightly below par, indicating that investors likely got as much as they intended.
The conclusions we take from this deal are:
- The higher the expected demand, the more inflated the order book will become. As the book build grows, it is difficult to ascertain the actual ‘real’ demand from investors.
- Bonds are not always issued as a means of raising required capital; other objectives may be at play.
- In a challenged banking sector, Bank of Queensland’s (BOQ) results were still below par. Dividend sustainability is a key criteria at present.
- Crown Resorts (CWN) had a takeover proposal quickly withdrawn, however the expectation of a deal in the future may help to keep a short term floor on the share price.
Bank of Queensland’s (BOQ) financial year is out of sync with the major banks, and even a preannounced result (after a trading update in February) couldn’t prevent further negative sentiment following its half yearly announcement this week. For the six months, profit fell 8%, while earnings per share dropped at a double-digit rate due to equity dilution.
The issues affecting BOQ are not dissimilar to the majors, albeit with a few additional challenges. Total income showed a decline in the period, primarily driven by a 5% top line fall in its core retail bank. Growth in the retail side of BOQ’s business has been problematic for some time as its branch network has continued to contract, with below-system growth in an already soft market.
The bank acknowledged limitations in turning this trend around quickly, where its “existing lending processes, digital platforms and inability to attract new owner managers” have hurt its profile.
Bank of Queensland: Half Yearly Loan Growth ($m)
Further, cost growth has remained high, particularly in meeting new regulatory and compliance expectations following the Royal Commission, leading to margin contraction and a rise in the bank’s cost to income ratio. Little relief is expected in the second half (BOQ forecasts a 2-3% underlying increase, with an additional 4% regulatory impost) and hence the short-term earnings profile will remain constrained.
Any long-term action to address the problems faced by BOQ is unlikely to be put in place until it resolves the outstanding vacancy of its CEO position. The fallback for investors is a strong capital position and a forward yield of 7.7%, however this is also likely to be subject to negative revisions following this result. After holding its dividend steady for several periods, BOQ announced a 10% dividend cut in the half, yet its payout ratio remains about 80%, leaving little margin for error. As we noted in our recent asset allocation report, we believe that the banks now represent reasonable value for an income-focused investor. Dividend sustainability is key on an individual stock basis.
Crown Resorts (CWN) was also in the headlines, with a share price spike that followed confirmation that it had received an indicative takeover proposal (which was a 50/50 mix of cash and scrip) from US gaming group Wynn Resorts. While the proposal was quickly withdrawn after the news was leaked to the public, CWN shares only gave back some of the gains made in the prior session indicating that a deal is likely to be revisited.
The offer for CWN could be viewed as opportunistic following its poor recent results. Compared to much of the rest of the market, the share price had not participated in the domestic equity recovery in the first quarter of this year.
Some of CWN’s problems are likely cyclical in nature (including weaker revenue growth in a more variable economy), while other issues could be more difficult to turn around. In particular, the performance of its high roller, or VIP business, has been depressed since difficulties experienced in China more than two years ago. The Barangaroo development in Sydney (slated to open next year) was designed to cater for this market and this has added to the uncertain return profile of this investment.
Wynn would likely extract cost synergies in the event that it was successful in bidding for CWN, however it would also have its eye on lifting this high roller side of the business with its less-tainted brand in Asia.
From a valuation point of view, the proposed implied offer price of $14.75 would represent a forward EV/EBITA multiple of almost 13x, some 30% above international competitors and well in excess of the closest domestic peer, being Star Entertainment. M&A may return as a theme to the market (particularly for companies with strong assets such as CWN) given a weaker organic growth environment and cheap funding costs, while the low AUD could provide opportunities for overseas groups.
Crown and Star Entertainment: EV/EBITDA