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WEEKEND LADDER

A summary of the week’s results

12.10.2018

Week Ending 12.10.2018

Eco Blog

- Expectations for relatively stable high growth in China have not changed much in recent months, but the complexity from potential shifts in manufacturing across Asia, domestic policy and exchange rates could result in a change in view.

- In more ways than one, the repercussions of change are becoming evident. Interest rates may be the most obvious, but on the other side of the coin is the voting public’s view of policy, which is likely to have long term economic implications.

The consequences of the tariff imposts on China will inevitably flow across others in Asia, some to the benefit of those countries. China’s competitive advantage in labour costs has largely dissipated. Myanmar, Bangladesh, Laos and Cambodia are meaningfully cheaper and production of low value-added product has drifted into these regions. This could take another big step to avoid the US imposed tariffs. For mid and high-end product, the choices are somewhat limited, but given that labour costs are a smaller proportion of the value add, these are less important. Where analysts have approached corporations on their intentions, the decision is based on the flexibility and work ethic of the labour force, supportive regulation and infrastructure. This tends to exclude countries such as India and to a lesser extent, Indonesia. Conversely, Vietnam, Malaysia, Thailand and even Taiwan are all likely to see incremental investment in electronic industries, in particular. The net outcome to the US trade deficit would then move location rather than decline.

China continues to tap on the accelerator. As we have noted, the full impact on export data is only likely towards the end of this year and into 2019, as orders were brought forward prior to the implementation of tariffs. To date, the services sector is holding up well, with growth of 7.6% in the first half of the year.

China: Services growth contribution to GDP

Source: CEIC, ANZ Research
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Measures such as tax cuts for low income groups, some support for property investment and infrastructure spending funded from local government bond issuance (which has been steadily rising in recent months) were reinforced by a cut in the reserve requirement ratio (RRR) of banks, this being the preferred monetary measure by regulating the volume (as opposed to the cost of capital). The bears construe this as another credit -fuelled stimulus, but it may rather be due to the regulation in the informal shadow banking system that tightened lending in the first place.

In the next few weeks, the US Treasury will release its regular report to Congress which comments on economic policies of its trading partners. Inevitably, the attention is on foreign exchange, specifically if China, Germany and possibly a few other countries are nominated as currency manipulators. The most likely outcome is that they remain on, or are added to, a monitoring list. The criteria used to designate a currency for inclusion are somewhat blunt and simplistic, such as a $20bn goods trade surplus over a rolling year (which ignores the size of the economy and excludes services), a current account surplus of 3% of GDP and net FX intervention over the past 12 months. Treasury then makes a subjective judgement on whether FX movements are to gain an unfair advantage.

The reality is that most of the weaker currencies this year are due to self-inflicted issues, or a repercussion of global dynamics. Oil importers have been hard hit, particularly where the country already has a current account deficit – for example, India, Indonesia and Turkey.

The prospect of slowing growth in China and the narrowing of its current account surplus, would be good reasons for the CNY to have weakened this year. If China is labelled as a manipulator, it politicises the stance as the Treasury criteria have not been met. The argument would have to hinge on the notion that China intentionally devalued to offset the tariffs.

There is a high degree of circularity in the policies and outcomes.  Given China is easing its monetary setting through the aforementioned reserve requirement and a weak trade balance, a falling exchange rate should be expected. The risk for China is capital flight (as in 2016). The other path is to stimulate growth through fiscal policy that will require some patience to be reflected in a stable exchange rate. The US administration can either add fuel to the CNY devaluation, or be willing to help China prevent any further dislocation.

  • Emerging markets and China stocks, in particular, have felt the full brunt of these issues for most of 2019. Things, however, change rapidly. Recently, equity performance in Mexico and Brazil has rebounded. The trade agreement helped the former, whilst a new government in Brazil is believed to be an improvement on the past.

In almost every region there has been a shift to some form of populist politics. These are expressed in various ways and Australia is no exception. The Committee for Economic Development of Australia (CEDA) commissioned a survey of households (weighted to be representative of the population). The result hone down on the reality or perception that households feel they have missed the benefits of economic growth.

Who has gained from 26 years of uninterrupted economic growth? (%)

Source: CEDA
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The results are remarkably uniform across employment, location (the ACT being the exception in willing to concede gains from the economy) and age and surprisingly only high-income groups believe they have had gains.  When asked what is important to them personally and to the community, healthcare is by far the most important, while essential services, affordable housing and regulation of foreign ownership also register above average. Ranking low on the scale are access to private schools/hospitals, business regulation and corporate tax and, interestingly, new entrants in consumer services and technology.

The gap between perception, reality and public policy is leading to decisions and attitudes that undermine the balance in long term economic growth in most parts of the world. As the tailwind of the growth from global trade post 1980, the demographic bonus and the structural changes such as the opening up of Eastern Europe run their course, many commentators reflect on the increasing uncertainty on what will determine successful economic growth into the next decade. In part, this can be viewed in the debate on long term interest rates, which suggest low growth is the most likely outcome.

  • Public policy aimed at the voter is clearly having an impact on equities. This trend is likely to become more widespread and be another factor fund managers will have to account for.

Focus on ETFs

- Momentum has been the top performer amongst factor investing, with a gain of nearly 15% over the past 12 months (using the benchmark MSCI USA Momentum index). It has done so largely thanks to the significant overweight in technology stocks.  

Momentum is one of the more widely followed investment factors with commensurate high inflows to related ETFs. Momentum trading aims to profit from the continuation of past returns by investing in securities have had high returns in recent times and selling those that have continued to underperform in the same period.

MSCI believes that high momentum companies tend to continue their uptrend in price performance over the near term, usually between 6-12 months. It has developed a quant-based index that includes the risk-adjusted 6 and 12 month relative strength of a stock to determine the momentum. Companies with higher volatility will be scored lower as it aims to avoid sharp rises and rather selects stocks that have continuous uptrends. Momentum, therefore, has a minimal amount to do with the fundamentals of a company.

The momentum index has a high concentration, with just over 120 stocks and a combined 52% in the technology and financial services sectors. Some of the index’s biggest holdings are Amazon, Microsoft, Visa Inc. Mastercard Inc and Boeing Co (which is the biggest overweight compared to the MSCI US index). In addition to this high concentration risk, the turnover is 3-4 times higher than that of the other factors and this can lead to tax inefficiencies and higher trading costs.

MCSI Momentum sector allocations over time

Source: Morningstar, Escala Partners
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As with any factors, momentum performance can be highly cyclical, as witnessed this week with Wednesday’s market fall resulting in the iShares Edge MSCI USA Momentum Factor (MTUM.US) plunging 4.5%. MTUM is now underperforming the S&P 500 over the last three months.

Relative performance of MTUM to S&P500

Source: Bloomberg, Escala Partners
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As the chart illustrates, momentum strategies are prone to setbacks, usually shortly after major risk-off events. A prime example came earlier this year with the spike in the VIX in February. The difference in volatility between MTUM and the S&P 500 is, therefore, more pronounced over the short-term.

Standard Deviation of US Momentum Index and S&P500

Source: Morningstar, Escala Partners
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  • There are still limited options available on the ASX for factor investing. Yet active managers have factor biases. Momentum has been favoured for some time and we blend investment styles to avoid the volatility and behavioural bias that is associated with this trend.

Fixed Income Update

- S&P release data pertaining to default rates for a given credit rating. Historically low defaults have kept credit spreads tight. However, a reversal in this trend may be looming as rates rise in the US. A higher number of BBB rated issuers in the investment grade universe may also lead to some downgrades.

- US, Australian and European bonds prices rise over the week, while Italian bonds weaken further.

- CBA assess the opportunity for another bank hybrid issuance before the end of the year.

Market reactions reflecting ‘risk-on’ and ‘risk-off’ sentiment, corporate profits, liquidity, supply levels and capital flows can move credit spreads. However, these changes are usually temporary, with the probability of default the main driver of long-term valuations in credit markets. Low default rates in recent years that have resulted in credit spreads tightening to the lowest levels in nearly ten years. It is therefore unsurprising that credit spread widening is directly correlated with a rise in default rates, with peaks in both during times of economic stress such as the financial crisis, 1991 recession and the tech bust in 2001.

Standard and Poor’s have just released the data for ‘global corporate average cumulative default rates by rating from 1981-2017’. While we note it is historic data, it does offer investors a good insight into the probability of default for a given credit rating. In line with tighter credit spreads in the last year, defaults rates for 2017 were down from the year prior, with 95 corporate issuers defaulting compared to 163 in 2016. In terms of rating changes, there were less downgrades and more upgrades than the year prior. 

Default rates for investment grade (IG) entities are extremely low in any given year (at 0.10%), and only rise to an average of 0.92% in a five year time horizon. This compares favourably to high yield debt (below IG), which has an average 15% default probability over five years. Within investment grade ratings, the uplift of defaults is negligible for a given notch down in ratings. However, within high yield, the probability of default oes become meaningful as credit ratings fall. For example, a BB+ rated entity has a default history of 3.86% over five years vs a CCC rated company at 46% over the same period. 

Historic default data for a given credit rating

Source: S&P Global Fixed Income
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While this table showing long-term data paints a picture of the risk of high yield (HY) debt, low default rates in the last year have been the driver of tighter credit spread valuations. The HY defaults in 2017 fell to 2.4% from 4.2%. This level is below the long-term average of 3.75% (in one year) for this segment.

Cheap funding costs have been a major contributor to falling default rates. As the Fed continues to raise rates it will translate to a higher cost of debt for US corporates that are more in debt now than ten years ago. Further, within investment grade, the number of BBB rated corporates in the index has grown from 25% ten years ago to 50% today. This reflects a deterioration in the quality and makes the IG index vulnerable to a higher number of downgrades (fallen angels) into high yield. It is therefore unlikely that this trend of low defaults will be sustained for too much longer. Higher default rates will translate to higher credit spreads. It will be the pace that will dictate the severity of the price reaction. A slow drift upward in defaults and ratings downgrades could be managed by the sector, but in the absence of this it does remain vulnerable to a more significant correction.

  • High yield is the most at risk from rising defaults. Credit selection is key, and we recommend better credits and short dated bonds. Investment grade bonds are unlikely to default, but downgrades could leave to some spread widening.   

Following on from the significant treasury sell off from last week, the US market pared back some of the recent losses. The lower than expected US CPI data, a risk-off sentiment in equity markets and comments by Trump blaming the Fed’s policy stance for falling markets have all lifted Treasuries as yields pulled back. Australian government bond prices are also higher over the week. Italian bonds are under pressure again on news that Parliament approved the plans for higher spending and deficits, with capital rotating out of Italian bonds in favour of other European sovereigns as a safe-haven bid.

Spread between Italian and German 5-year government bond yields

Source: IRESS, Escala Partners
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Domestically, there is market talk that CBA are looking to issue another bank hybrid in the coming weeks. It said to be a $1bn issue that will partially replace the PERLS VI offer which was issued in 2012. CBA has already funded some of this upcoming maturity with the issuance of PERLS X in April, which raised almost $1.4bn.

Corporate Comments

- Amcor’s (AMC) reiteration of its earnings guidance was a relief for investors given the number of headwinds that the company has faced in the last year. The upcoming catalyst for the stock is in its proposed acquisition of Bemis.

- Tougher conditions may be ahead for Nine Entertainment (NEC) and Domain (DHG), who have faced more difficult advertising and property markets respectively in early FY19. Earnings growth underpinned by merger synergies between NEC and Fairfax (FXJ) may come into sharper focus if conditions persist and the deal proceeds.

- The Coles demerger from Wesfarmers (WES) has taken another step forward. Caution is warranted.

While corporate governance issues such as executive remuneration typically capture the headlines of annual general meetings (AGMs), AGM season is also often an opportunity for analysts and investors to get a read on how companies are tracking operationally in the new financial year. This week, Amcor (AMC) was among the first large cap stocks to provide a trading update to the market for FY19.

The risks for AMC were likely to the downside, particularly given that one of the key issues that the company cited in its full year result, being raw material inflation, had continued to be problematic over recent months. Oil, in particular, is closely watched and has remained high (WTI crude is up 37% on a rolling year basis), given the flow through this has into the costs of packaging.

Despite this trend and some recent uncertainty around volume growth in certain markets, AMC was able to reiterate its FY19 outlook for ‘solid’ profit growth across both of its key divisions. While AMC’s outlook implied that earnings will be weighted towards the second half, the overall commentary was still relatively reassuring to investors. Notably, the company is making progress in recovering higher raw material costs, the North American beverage market has again returned to volume growth (with key customer Pepsi reporting better volumes), and emerging markets are a further positive.

While these issues will continue to be monitored, the primary catalyst in the next six months will be the completion of AMC’s proposed acquisition of Bemis, which was announced in early August and expected to close in the first quarter of 2019. The transaction was based on a fixed ratio of 5.1 AMC shares for every Bemis share, which has become less attractive for Bemis shareholders since announced. This is a result of the weakness in AMC’s share price as well in combination with the AUD and hence the takeover premium to the pre-bid Bemis share price has been cut from 24% to 8%.

Though potentially increasing the risk of the deal proceeding in its current form, this is somewhat mitigated by the fact that AMC’s global packaging peers have been under some pressure in the last few months on similar issues to which AMC has faced; hence the alternative for Bemis would likely be a fairly sharp share price correction. With AMC now trading at a discount to the industrials market (traditionally it has attracted a premium valuation on its strong management and relatively predictable earnings streams) despite a relatively sound track record over the last several years, the stock has again been rising on value screens for domestic fund managers.

Bemis: Implied Pre-Bid Takeover Premium

Source: Bloomberg, Escala Partners
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Also updating the market this week was Nine Entertainment (NEC), Fairfax Media (FXJ) and Domain Holdings (DHG) ahead of the release of the scheme documentation on the tie-up between NEC and FXJ. While DHG now has a separate ASX listing, FXJ still retains a 60% stake in the business (with this shareholding accounting for much of its market capitalisation), hence the performance of the real estate listings website is arguably more important than the core FXJ divisions. Weaker commentary from either party had the potential to complicate the merits of the merger from either company’s perspective, however, instead the blame could be pointed towards both companies, with softer outlooks in particular from NEC and DHG.

NEC has been a favoured trade among some small cap managers who have tracked market share gains, a high level of operating leverage and the ability of the free to air market to hold onto advertising dollars better than its old media peers. This financial year, the advertising market has been softer than expected, thus challenging the company’s ability to achieve its guidance to the market.

Domain, too, has faced pressure this year, amid lower property listings in its key markets of Sydney and Melbourne and the growing expectation that a range of factors will translate into a weakening real estate market in the medium term. This cyclical element of the business has the potential to overshadow the longer-term drivers of increased depth penetration (i.e. a higher proportion of premium listings) and possible market share gains.

The imperative for a NEC/FXJ merger may be somewhat accelerated given these recent trends and earnings growth underpinned by synergy benefits could evolve into a more appealing prospect for both sets of shareholders in this environment.

Wesfarmers’ (WES) progress to its demerger of Coles took another step forward with the release of the independent expert’s report and more details on the Coles business as a standalone entity.

At a headline level, current shareholders will own a pro forma structure as shown below.

Source: Wesfarmers
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The WES business is now predominantly based on Bunnings (the undisputed champion of the Australian obsession with housing), Kmart and Target (which is left lingering uneasily against changing consumer preferences), Officeworks (cemented in as the local champion for office supplies) and industrials (a self-described ‘diversified portfolio’ of energy, chemicals and safety products).

The majority of the information was on the Coles operations.  FY18 figures show that the direction of profit was heading lower across the supermarkets, convenience stores and liquor divisions. Gross margins have been largely flat to falling, while costs have edged up.

The proposed path forward is for a large investment into the supply chain (circa gross $1bn) to automate many of the processes. The other is to grow private label from 29% of sales to 40% (the high number is in recognition of the attribution of private label to fresh food as well as packaged items). In terms of cost structure, Australian supermarket retail struggles to differentiate on labour costs and leases, leaving it to the other major item, distribution, to gain an advantage. Woolworths (WOW) is long been recognised as ahead of Coles in this regard. Then there is the customer offer. Aldi has proven that consumers will buy private label if (a big if) they trust the corporation.

Post the ‘little shop’ promotion, it is reasonable to assume Coles’ sales momentum will dissipate back to its fine balancing act with Woolworths. The outlook for growth is subdued at best, though we should remain alert to the possibility that the new management will pull a trick out of the proverbial hat.

The balance sheet of the new Coles is arguably a challenge; debt is relatively high at nearly $2bn, and non-discounted leases are $9.8bn. Businesses such as supermarkets require long leases given the rote behaviour of most consumers and the lower rental rate from long leases, but that does mean that any change in competitive circumstances (a better location that opens up down the road) or refurbishment (beholden to the landlord) may not be to the group’s advantage.

FY19 will be messy for current WES investors, with the separation due in November. Dividends will be split accordingly. In FY20, Coles is offering an 80-90% payout, which may sit uncomfortably with the capex requirements and already-high liabilities. Finally, we note that the Coles board is light on relevant experience. Only two (except the CEO) have seen fast moving consumer goods and retailing. The current focus on management incentives left less clarity on incentives. Short term metrics are largely subjective  - for example, customer feedback and people - while long term returns are based on EBIT, return on capital and the least preferred measure, total shareholder return against a ‘comparable group’. The latter could mean that an incentive is paid even if there is no total return to shareholders as the comparable group in Australia is a subset of one.

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