Week Ending 12.12.2014
Last week’s Australian GDP data, which suggests the domestic economy (excluding the export sector) is in decline in real terms, has flowed through to increasing calls for an interest rate cut or two and consequently a fall in the A$. Commodity prices have been another big feature, especially as the expectation (hope!) was that LNG exports would kick in over 2015 and, in part, compensate for iron ore. While the volume story is by all accounts intact, it is very clear the price will be at a much lower level and that income flow into the economy from exports is going to be less than anticipated.
The impact of commodity prices on the income of every Australian is perhaps not well understood. Employment in the production of resources is relatively modest (compared to that when the capital investment is taking place), which also has a high level of indirect benefits to a wide range of goods and service providers. When in full production, the effect into the economy is mostly due to the combination of price and volumes. Even then, as a significant amount of the cash flow will return to shareholders (which are in good part outside Australia), the net cash flow into Australian hands is lower than it might appear at face value. Then, as depreciation is high in the initial years, the tax receipts are constrained for quite some time. With general wage growth relatively contained as well, the fiscal budget will not allow for any potential income support to the household sector, as was the case in the 2004-2008 period.
As the RBA is not destined to meet before February, economists will be assessing each new data set to confirm their view on the direction of the economy. The releases of this week were generally on the bearish side. Housing finance for November was up, but once again almost entirely skewed to investment (19.8% year on year growth) rather than owners (0.8% year on year growth). The unemployment rate ticked up to 6.3% from 6.2% even with decent employment growth of 42,000, yet October was downgraded to 13,700 from 24,100. The perceived quality of the labour growth is relatively poor, with 40,800 of the month’s new entrants to the labour market in part time roles, leaving only 1,900 in new full time jobs. A positive take on the labour market is that private sector surveys suggest hiring intentions are starting to improve, mostly in the services sector.
Consumer confidence has also taken a knock. The slide in this index from 96.6 in November to 91.1 in December is a level typically associated with near-recessionary conditions.Enlarge
The gloom is largely directed at external factors to the household, with economic conditions, the budget and taxation, international conditions and employment all registering in the survey as having unfavourable trends. On a practical note, there has been a tumble in the intent to buy a big ticket item, historically the iconic expression of confidence.
Inflation in China was reported at a 5 year low of 1.4% in November. While energy costs caused transport inflation to fall by 0.8%, even other segments were soft. The highest price rise was in clothing at 2.6%. The door is therefore ajar for China to stimulate its economy without inflationary pressures. In some pockets that has already taken place.
Changzhou is an example of a region well known for its excess housing inventory. The central government has picked up infrastructure spending to hold the GDP contribution for the moment, as can be seen in the table below.Enlarge
However, this alone is insufficient. Local governments such as these are highly dependent on land sales revenue for their income, historically contributing around 60%. With property development much lower, some of the quasi-government organisations resorted to funding themselves with ‘wealth management products’, essentially selling loans with high yields. Their capacity to service and repay these has been at the forefront of concerns regarding China’s economic stability for some time. In balancing the political power of the provincial leaders, the central government is treading a fine line of various carrot and stick measures. The first is to ensure interest rates are low so that debt can be serviced, the second is to source tax revenue elsewhere, such as the property tax introduced in a few cities or possibly a fuel tax, given the fall in oil prices. Asset sales are another way and finally, a multi-year programme to replace loans with municipal bonds has recently been put forward by the Ministry of Finance.
Reading the tea leaves on the direction of the Chinese economy has become increasingly complex over the past year and looks likely to remain that way for now. A fall in the currency from an April high of 6.05 to 6.25 USD/CNY at present, will possibly provide a small boost to exporters, though cross currencies in Asia/Pac, Japan and Europe have not moved the same way.
The debate will continue into 2015 on whether an old fashioned mix of fiscal (through infrastructure and social spending) and monetary policy (via selective easing), will be sufficient to generate the current growth expectations for China, or whether it is time to reset the benchmark to a lower level given some of the challenges facing the country.
Little positive news is coming from Europe. Politics, as ever, plays a role, with Greece going to an early election. The risk has thus arisen that austerity measures may be pulled back, though it is restrained by its high level of bond refinancing in 2015. The investment market is virtually howling at the gate for the European Central Bank to undertake easing. The next meeting of the bank will be on 22 January, which is probably too early to expect anything. By the next one on 5 March, GDP growth for the last quarter of 2014 will be out along with enough indications from PMI and inflation to get a sense of how the New Year is unfolding.
Once again, a steady pace of growth appears evident in US data. Retail sales for November were solid and the beneficial effects of lower energy prices will continue to flow through in coming months.
The chart below shows actual (as opposed to seasonally adjusted) year-on-year retail sales excluding auto and gas. The comparative growth into the early part of 2015 will reflect against the weak start of this year which was impacted by weather conditions.
US Retail Sales Ex-Auto and Gas (Year-on-Year % Change)Enlarge
Those less inclined to perusing financial markets are likely to be bemused by the attention being paid to the anticipated language from the forthcoming Fed Open Market Committee (FOMC) meeting on 17 December. Economists are focused on the possible change from noting that interest rates would remain low for a ‘considerable time’ to the use of the word ‘patience’. The implication would be that the Fed is slowly warming up to a rate hike in 2015 given the persistence of better trends in the US, particularly in the labour market. The residual question outside of an unexpected development is whether low inflation will delay the rate cycle.
Optus this week announced a price cut for its unlimited cable bundle (includes phone connection and IPTV service), in a sign that it is looking to become more competitive in the broadband market. At best, it appears to be a shorter-term ploy to win new customers, as we note that the offer is only available over the next two months (i.e. it doesn’t appear to be a more permanent cut to its pricing). What also leads us to this conclusion is the high likelihood of the cable networks of Telstra (TLS) and Optus being acquired by the NBN in the near future as part of the Coalition government’s revamped NBN plan.
This reinforces our view to diversify Australian equity telecommunications exposure away from TLS. TLS typically has not competed with the other telcos on price, something which we believe will become more important under the level playing field under the NBN. We have iiNet (IIN) in our model portfolios as an alternative telco that is capitalising on this structural change through strong organic subscriber growth in NBN connections. TPG Telecom (TPM) is another company that we expect to do well in coming years (and take market share from TLS), with the company having a point of difference with its ‘mini-NBN’ network connecting apartments.
Following on from our discussion last week on the energy sector, Santos (STO) and Origin Energy (ORG) yesterday provided updates to the market. STO has had its credit rating downgraded by Standard and Poor’s to BBB, as well as announcing that it would cut its capital expenditure budget by 25% (or $700m) to $2.0bn in response to the decline in the oil price. Growth capex is now expected to be $1.4bn in 2014 (half of this directly relates to its Gladstone LNG project), while sustaining capex will be $600m.
As we highlighted last week, outside of an unexpected blowout in Gladstone LNG capital costs, Santos’ funding position remains comfortable, with $2bn in cash and undrawn facilities as at 30 November – the equivalent of its entire capex bill next year. What remains a greater risk, however, is the company’s ability to protect its credit rating from any further downgrades. We note that S&P’s assumption for Brent crude in 2015 sits at US$80/barrel, materially above the current price environment. STO’s share price fall relative to the other major energy stocks reflects a heightened equity raising risk, which will likely remain until we see a recovery in the oil price. Few are predicting that the current oversupply issue affecting the market will correct in the short term, given the time it will take for suppliers to adjust their production plans. With the thought of an equity raising clearly unpalatable to STO, given the company’s depressed share price, we expect other measures will take precedence over this course of action, including further cuts to discretionary capex and asset sales. Relative to its major energy peers, STO is currently the highest risk/return proposition.
ORG has taken advantage of attractive funding markets to extend the maturity of its bank loan facilities, as well as reducing the associated interest rate by 0.3%. While ORG also has a significant capex requirement in 2015 as it completes construction at its APLNG project, its position is stronger than STO in the sense that its near-term exposure to the oil price is much lower. What matters more for ORG will be the oil price once APLNG is a producing asset, which the company expects will add $900m to its cash flows per annum. This forecast is based on a cash cost breakeven price of $US40-45/barrel equivalent. The charts from ORG below show how the Brent forward curve has changed in the last six months and that the current low price is projected to recover over time.
Brent Oil Forward Curve
Caltex (CTX) had a profit upgrade this week, with the company expecting a 39% improvement on its 2013 result. The biggest swing factor (and which was not expected by most analysts) was a better result from its refining business, something which is becoming less of a profit driver following the recent closure of its Kurnell refinery. An increased focus on its service station business will result in a more predictable earnings stream into the future, however we note that this industry is low growth with a reasonable level of competition. Much of CTX’s share price appreciation through 2014 has come from a significant rerating of its P/E multiple, and it now screens as a fairly expensive industrial on 18X.
APA Group (APA) has purchased the QCLNG gas pipeline for US$5bn, a key part of the infrastructure of BG’s LNG project at Gladstone in Queensland. The acquisition will be funded through a 1 for 3 entitlement offer, with the balance from a debt facility. With the price paid for the asset appearing to be much higher than the construction cost, the transaction can be viewed as BG benefiting from APA’s lower cost of capital. The multiple paid also looks reasonable, although we note that the QCLNG will have a finite life of 20 years. Amongst the most leveraged entities in the market, infrastructure plays like APA could be expected to perform in the short term, particularly if the RBA is compelled to cut interest rates early next year.
Sector Focus: Murray Inquiry - Implications for the Banks
The Financial System Inquiry (FSI), or Murray Inquiry, was released last weekend, with significant implications for banking sector stocks. In this piece we will discuss the key recommendations of the report and the impact that this is likely to have on the banks.
The first key (and most important) recommendation affecting the banks was a target to improve Australian bank capital ratios so that they would be in the top quartile of all international banks. Calculating what this means in terms of additional capital is required for the banks is not a straightforward task for two reasons. Firstly, the ratio would essentially be a moving target, and would rise should banks around the world, on average, improve their capital positions. Secondly, international comparisons can be problematic, with regulators in each country applying a high level of discretion to global standards. Nonetheless, in the FSI’s judgement, Australian banks currently sit in the second quartile, although the range in which they estimate in which the banks lie – 10.0% - 11.6% - is wide. The FSI has left a more precise calculation in the hands of APRA.
The second key recommendation (which was also expected) was to narrow the difference in average risk weights for mortgages across the various authorised deposit-taking institutions in Australia. Presently, the major banks are permitted to use their own internal models in determining risk weights for various credit exposures, which effectively allows them to hold lower levels of capital compared with their smaller peers. The FSI has recommended that an average risk weighting for mortgages of 25-30%, much higher than the average of around 16% of the four majors.
Overall, these two measures were not as bad as many had feared, and hence the initial share price reaction of the banks on Monday was positive. While it is unclear of the exact requirement of additional capital required by the banks, estimates have centred on a range of $20bn - $25bn across the four majors. The timing of this requirement should be over a number of years. The government will firstly formalise its response to the FSI, and adopting any proposed changes could take some time. ARPA will also have to confirm its view on capital requirements, and then will most likely give the banks a number of years to implement these changes.
As a result of this time frame, we believe the risk of any significant capital raisings is low. The most likely scenario will see additional capital raised by the banks through dividend reinvestment plans. This will have the effect of reducing already low earnings per share growth currently forecast.
The present situation thus sees disparate views on not only the starting position of the banks’ capital, but also how far short each bank is to the new requirements. Given their existing capital positions, Commonwealth Bank (CBA) and Westpac (WBC) are viewed as being in a relatively better situation. Stronger organic capital growth generation in the medium term could also see CBA have a lower requirement to raise capital in the medium term.
On the other hand, CBA and WBC currently have the lowest average mortgage risk weights applied to their respective books. Hence, a requirement to lift this to the 25-30% range as recommended by the FSI will likely play against these two banks.
At this stage, a reasonable base case assumption would be that the banks could raise the additional capital through either a full year of underwritten dividend reinvestment plans (an underwritten dividend reinvestment plan is where the company issues new shares to the value of what would ordinarily be paid out as dividends; the net effect for the company is no capital outlay for dividend payments), or via voluntary dividend reinvestment participation over a number of years.
In terms of earnings per share forecasts, this would have the net effect of reducing earnings per share (EPS) by approximately 3%. A worst-case scenario for additional capital would see a decrease of 5-6% to EPS, while in a best case outcome, EPS may be reduced by 1-2%.
With earnings growth already expected to be constrained in coming years (see table below), this additional capital requirement will add to the expected headwinds of benign credit growth and bad and doubtful debts at cyclical lows. A potential offsetting factor would be the banks’ ability to reprice their lending assets higher, something in which they have had some success since the financial crisis.
APRA provided a further challenge to the sector this week when it announced that it would look to strengthen residential mortgage lending practices. Among the areas that APRA will be closely monitoring include higher risk lending (e.g. high loan to valuation and interest-only loans), loan affordability tests and investor lending. The regulator noted that lending growth to investors of greater than 10% could provide a trigger point to consider further action.
As we have discussed in recent months, growth in investor lending has been the key driver of growth in housing finance this year. Lending to owner-occupiers has been largely flat this year, and hence any measures that could constrain investor lending would provide a significant drag to system growth. In the 12 months to 31 October, the majors each grew their investor lending books by between 9% and 11%, hence each bank is either close to or in excess of this new measure.
The table below summarises the valuation metrics of the major banks before any of the FSI measures noted above are accounted for. Reflecting a more difficult environment than recent times, earnings growth is expected to be modest over the next three years. CBA remains the most expensive of the majors, due to its higher ROE and track record of performance.
Banks: Valuation Summary