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WEEKEND LADDER

A summary of the week’s results

12.05.2017

Week Ending 12.05.2017

Eco Blog

- The balancing factors for the budget will rest on labour conditions and commodity prices. It is hard to make a case for improved employment outcomes and therefore household spending.

- Infrastructure and business investment is now the key to lifting momentum.

- Global growth is intact. Household incomes and inflation remain critical to the outlook.

With the bulk of the budget news swamped by the bank levy debate, some of the structural issues facing the economy got little airplay.

From a growth point of view, the two biggest swing factors are likely to be wage growth and the terms of trade.  Successive governments do not have a great track record in their assumptions for wage price inflation (WPI), consistently expecting this to pick up against the outcomes of the past five years.

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The budget projections are for labour inflation to rise from 2.5% in the coming year to 3.75% by 2020. The significant shift in the structure of the labour market, from high wage mining and construction, above average public sector increases and lower part time and service jobs, is likely to have had a deep-seated influence on wage expectations for quite some time.

Australia has a high reliance on personal income taxes compared to other OECD countries, which tend to source more from consumption taxes. Therefore, the labour market has a disproportionate influence on our fiscal budget.

Commodity prices, and specifically iron ore, is the other big variable. The budget assumes an iron ore price of US$50/ton, a metallurgical coal price of US$120/ton and a thermal coal price of US$85/ton through the forward estimates.

The secondary impact from the budget is also perhaps underestimated. Households, already under pressure from rising debt and low wage growth, are now set to make a meaningful contribution to government revenue. If the banks find a way to push some of the levy to consumers, either via lower deposit rates or higher lending rates, this too falls onto the household sector.

Source: CBA
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It is a hard case to point to any change in the subdued trend in domestic consumption until there is a decent lift in employment or wages. March retail sales growth was particularly weak and while one should not focus unduly on this one month, the downward trend in retail spending has been in place for some time.

There are other unknowns. The sharp fall in housing approvals may take another step back if it is assumed that higher investor lending rates restrain this segment of the market. A fall in house prices could then have a negative feedback loop into household spending. All told, the RBA is now even more likely to remain unmoved on interest rates. In turn, this could increasingly sit in contrast to global trends where tightening financial conditions is evident.

The glimmer of hope for a better outcome for Australia comes from global growth, rising business confidence and planned infrastructure spending. The mix of politics, judgement from Infrastructure Australia and cost has likely resulted in the list below receiving the tick of approval. States will have to decide if the others can be funded from their own revenues or possibly through private partnerships.

Source: Budget papers, Infrastructure Australia
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Globally, the momentum is ticking along. The US household sector appears to be in a good shape, with tax receipts indicating that total income from all sources is growing at around 6%. One less commonly noted factor is the contribution from ‘unincorporated enterprises’ and small businesses to household cash flow. These include farming income and the rising tide of contractor and sole proprietor businesses.

The two key measures that are in focus are wage growth and its bigger relative, the CPI, with the US to report its inflation rate overnight. US wage growth is sitting at a solid 3.5% and many companies highlight rising labour costs in the recent quarter reporting period.

Import costs as a proportion of US CPI is relatively modest, yet it does indicate where the trends lie. Putting aside the volatile petroleum component, industrial supplies and material prices are up 7.9% over the year, complements of higher commodity prices. Conversely, capital equipment and motor vehicle prices are flat year on year. The relative strength of the USD, spare capacity, competition and corporate cost programmes all collude to keep a lid on these goods. Consumer goods prices continue to fall and there is little to suggest this trend will ease. Getting inflation up is hard work and it looks likely the ultimate level in this cycle is going to be subdued. Unless services costs, pulled by wages, take up the slack, changing practices and technology will persistently lower price rises.

Fixed Income Update

- The Federal Budget is expected to leave Australia’s credit rating unchanged, while there is an impact to hybrids securities listed overseas.

- Global yields have traded higher, factoring in stability in Europe and US monetary tightening.

- Credit spreads have continued to contract, helping to lift corporate credit.

- Short dated term deposits offer better relative value to longer dates.

Following the Federal Budget announcement this week, ratings agencies Moody’s and Fitch confirmed Australia’s AAA credit rating, while S&P is expected to follow suit. This keeps Australia’s sovereign at the highest credit rating available (which only 12 countries worldwide enjoy) and assists in keeping the government’s funding costs low.  Australia has had the AAA rating for over 10 years. It also firms up the major banks’ AA- credit ratings, which are largely derived from the sovereign rating.

Australian Credit Rating

Source: CBA
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Another impact on fixed income markets was the announcement that the government will tighten the tax treatment of prospective hybrids issued by Australian banks foreign branches. ANZ had previously issued a bank hybrid in the US, while CBA transacted the PERLS deal out of a NZ entity. These outstanding securities have been granted transitional relief and will not be affected by the change, but it will now limit the banks to issuing within Australia.

In markets, there has been a reasonable sell off in bonds over the last week as the French election helped lift yields across the curve in the US and Australia, with both markets hitting their highest levels in six weeks on Wednesday. In addition, a Federal Reserve member stated that they would be comfortable with the Fed reducing its balance sheet this year, and reiterated the need to be “very vigilant against a fall behind” in raising rates. The price weakness comes as further supply is entering the Treasury market this week, also weighing on valuations.

Credit markets spreads have continued to contract, with the Aussie iTraxx trading down to 80bp, the tightest that the index has been since September 2014. The net result since the beginning of May has been that investment grade corporate credit has had little price movement, with spread contraction helping to offset rate movements. The corollary is that government bonds are trading lower, as they don’t have this credit spread to aid valuations. 

Five Year Australian Government Bond Yield

Source: Escala Partners, IRESS
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In a normal market environment, one would expect to receive a higher rate of return for investing in a long-dated security, given the extension in interest rate and credit risk. As an example, with floating rate bonds, which have limited interest rate risk, the credit spread increases with the term. For example, a four year NAB bond will pay a higher credit spread versus a two year NAB bond. This is reflective of the increased credit risk over time.

By contrast, the term deposit (TD) market is currently offering more favourable terms for shorter term compared to longer term rates. TD rates of 1-6 months offered by the major banks is at a higher spread than the 6-12 month part of the curve, according to a report by the RBA. The chart below shows current spread premiums, for a given bank, split into these two maturity buckets. While the overall rate offered on longer dated term deposits will still be higher, this rate is reflective of where interest rates are priced, as opposed to the ‘spread premium’ that the bank is offering. It implies investors are of the view that interest rates will track higher in Australia, following the lead of offshore markets. Those of this view would be advised to keep their term deposits to a shorter time frame (within six months), as this part of the curve offers the most value from a credit risk perspective, whilst opening up the opportunity to lock in higher rates when the time comes.

Term Deposit Spread Premiums

Source: Bondadviser, RBA
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Corporate Comments

- Westpac’ (WBC) half year result and Commonwealth Bank’s (CBA) update were consistent with the trends across the banking industry, however, the biggest surprise for the industry was revealed in the budget this week, with a new tax on the liabilities of the majors.

- Fairfax Media (FXJ) shares rose marginally after an opportunistic proposal for its most valuable assets was reported.

- Incitec Pivot’s (IPL) half year result showed a lift in earnings, but the composition was viewed as weak.

First half bank reporting season wrapped up this week with Westpac’s (WBC) half year result and a quarterly update from Commonwealth Bank (CBA). WBC’s result was judged to be in line with expectations, with a 3% rise in underlying profit and an unchanged dividend. With revenue growth supported by cyclical elements, such as trading income, the composition of the result could be viewed as weak. Relative to the other major banks reporting, WBC fared worse on margins (with a 7bp decline in net interest margins), but better on bad debts (with a 6bp fall). CBA also highlighted margin pressure in its quarterly update.

WBC’s result was consistent with the trends evident from ANZ and National Bank’s (NAB) results from last week and CBA’s half year in February, as detailed in the table below, including:

- low revenue growth (driven by credit growth) was evident across the sector;

- net interest margins have been flat to slightly down, reflecting funding pressures, including higher deposit rates;

- balance sheets are being managed conservatively ahead of further impositions forced by APRA;

- dividend growth has been capped by this same issue, a lack of profit growth and prevailing high payout ratios;

- bad debts have again provided a slight tailwind for the sector after rising on a number of large individual corporate loans this time last year; and

- Expense growth has been a key focus of the sector in this current environment.

Major Banks: 1H17 Underlying Results Summary

Source: Bloomberg, Company Reports
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With a convergence of strategies across the sector, cost containment is likely to emerge as a potential key differentiating factor in separating the performance of the majors. ANZ was the most impressive on this front through the first half, although it should be noted that it has been rationalising its operations and reducing its exposure to its institutional business. The two key medium term risks for the sector remain in place; being a normalisation of bad debts (which would almost certainly result in declining earnings and dividend cuts) and further regulatory pressure.

With banks largely meeting consensus expectations through this reporting season, the more significant news this week emerged from the Federal Budget, with a new tax to be charged against the liabilities of banks in excess of $100bn – being ANZ, CBA, NAB, WBC and Macquarie (MQG). The proposed 6bp charge is forecast to raise $1.5bn annually for the Government and equates to an approximate 5% hit to earnings across the five banks. The regional banks (Bendigo and Adelaide (BEN) and Bank of Queensland (BOQ)) have escaped the new tax, improving their relative competitiveness.

It is highly unlikely, however, that the banks will fully absorb the new tax without passing on a large part of this to their customers. Recent evidence would support this view, with increases in regulatory capital requirements leading to a lift in mortgage rates across the sector. In this case, it has been estimated that a lift of 20bp on variable mortgage rates would be sufficient to neutralise the cost. An ACCC residential pricing inquiry announced this week may, however, limit some of this pass-through. All in all, it adds to the increasingly difficult regulatory environment that the sector faces, whether it be through lending restrictions, increased taxes or higher capital requirements.

Fairfax Media (FXJ) was the subject of an indicative proposal to acquire some of its key assets from a consortium which includes private equity group TPG and Ontario Teachers’ Pension Plan. Under the proposal, Fairfax shareholders would receive a cash consideration of $0.95 per share for assets including the property media asset, Domain, and its flagship metro newspaper mastheads, while the residual would be bundled up into a separate listed entity.

This separate listed entity has been valued by the consortium at 25c – 30c per share, to give a combined FXJ value of up $1.25. The proposal consideration is similar in structure to the proposal put forward for Tatts Group (TTS) last year by a separate private equity consortium, which offered cash for TTS’s lotteries business and had planned to list the remaining businesses.

The estimated value of the remaining FXJ businesses was viewed as overly optimistic, and judging from the market’s reaction this week (with FXJ’s shares only appreciating slightly), a similar conclusion can be drawn.

We would highlight that FXJ has already announced earlier this year that it is investigating the option of separating Domain into a new listed entity, which would help it to realise its full value. With Domain the most valuable businesses with FXJ, it has been thought for some time that the implied discount to market leader REA Group (REA) has been too large. However, with strong share price performance since FXJ’s February announcement, it would appear that the window to participate in this opportunity has diminished considerably.

Incitec Pivot (IPL) reported an 11% increase in underlying profit for the first half, although it was noted that this included a sizeable contribution from a one-off damages payment from the builder of its recently completed ammonia plant in Louisiana in the US. With the first earnings realised from this project (illustrated in the ‘Industrial Chemicals’ division in the chart below), this masked the somewhat softer performance from the group’s core fertilisers and explosives divisions. Earnings from IPL’s fertiliser business fell in the half on the back of weaker pricing, while explosives gained, predominantly on the group’s cost-out program.

Incitec Pivot: Group EBIT Movements

NoSource: Incitec Pivot
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The outlook for IPL appears somewhat challenging, and following the completion of the Louisiana project, the company is again likely to be beholden to swings in commodity prices (particularly fertilisers). IPL does have some exposure to the positive environment in quarry and construction markets in the US, however this is only providing an offset to commodity production declines, most notably in coal.

While IPL’s cash flows should pick up from here given its lower capex profile and the cost savings that it has realised through its productivity improvement program, its longer term strategic direction is somewhat clouded. A new CEO is yet to be appointed after the retirement of its current CEO, James Fazzino. Having experienced a material re-rate since mid-2016, IPL’s performance has parallels with other perceived value stocks in the market, however, this now does not appear to compensate investors for the potential downside risks going forward.

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