A summary of the week’s results


Week Ending 13.01.2017

US economic growth is forecast to pick up modestly in 2017. It may be 2018 before any policy changes from the new administration have any impact. In the meantime, wages growth points to an inflation pickup over the year. 

- US dollar strength is an overwhelming consensus call. The reasons why this prove not to be the case are worth considering.

- Early indicators for European GDP point to a decent 2016, with Germany carrying much of the weight. Caution on 2017 appears to be mostly political.

- Australian retail sales remain soft and with employment growth in part time and casual jobs, the RBA would be careful about the impact of a rate rise.

There has been much hullaballoo on the positive impact the new US administration would have on US economic growth. So far, economists appear underwhelmed, with median forecasts for 2017 GDP rising by only 10bp to 2.2%. While that is a meaningful notch up on the expected 2016 outcome of 1.6%, it is roughly in line with the average achieved since the 2009 downturn.

The underpinning of 2017 growth is heavily based on an improvement in business investment spending. Household consumption is expected to be solid, but many economists predict an offsetting softening outlook for housing, given the rise in interest rates. Already mortgage applications have taken a big step back, falling 21% in the September quarter and are likely to tumble even more in the fourth quarter.

The headline GDP number may, however, belie the trend, with forecasts of a modest start to the year, building to close to 3% growth as the year progresses. Given that investment spending takes time, there is logic in that pathway. Encouragingly, small business, the driver of labour demand, is highly optimistic on the outlook for 2017.

It may be that 2018 is therefore the year when it all comes together and, at this stage, economists have a cautious uptick in GDP to 2.3%. While all the usual comments about economic forecasts will inevitably be trotted out if the data is different, some sympathy is warranted given the uncertain nature of the way policy will unfold in the US. For example, tax cuts are on the agenda, but the impact on the budget deficit will taunt Republicans. Similarly, infrastructure spending must be paid for. Tax relief for the repatriation of foreign cash holdings is trumpeted as a positive, yet in the previous round, the capital went into buybacks and debt repayment rather than investment. US companies have no shortage of access to cheap credit and therefore this repatriation seems unlikely to move the dial. 

Indeed, the appetite for debt is turning cautious. Credit analysts have pointed out that the leverage in US companies has been rising steadily.  Lending standards in some sectors, especially commercial property, have been tightening for some time. Households debt, particularly student and credit card debt, has been rising as spending exceeded the low growth in wages. Low rates turn into an Achilles heel as the inevitable rate rises bite. 

But the story has another twist. Nominal GDP growth will likely accelerate sharply as inflation picks up. For most domestic companies, this sets the tone for revenue growth, an absent feature of many of the past few years. Then it will come down to which companies have pricing power and can manage to restrain their costs.

Source: Federal Reserve Bank

There is, however one long term thesis that is unlikely to be disturbed by a lift in US 2017 GDP. It is improbable that the long term growth potential can ‘get back’ to the heydays of the 1990s. The structure of the economy is simply too different, specifically debt levels and demographics. Further, in the absence of an identifiable feature such as the opening up of Eastern Europe, or the inclusion of China to the World Trade Organisation, global growth lacks a compelling thesis.

GDP, it is often noted, is not well correlated with of equity markets, which tend to pre-empt the growth. Accelerating growth usually means higher rates, which eventually restrict equity performance from a slow down in response to the higher rates and the adjustment in valuations from the risk premium. Investment houses cautious on the outlook for the US market believe that the rally in Q4 2016 has already captured much of the value from the expected 2017 GDP uplift.

Over 2016 we frequently mentioned that US inflation was expected to rise. Not only are there basing effects, but energy prices, healthcare and housing were already experiencing upside pressure. The missing element was wages, and with the wage release of a few weeks ago, this final button has probably been pushed.

The Federal Reserve of Atlanta is the primary source of wage analysis within the Fed itself. The three month moving average of median hourly wages has hit 3.9%. History suggests that once established, these trends don’t fall over quickly, but persist for some years unless there is a recession.

Three Month Moving Average of Median Wage Growth (Hourly Rate)


Structural labour shortages in some sectors, the potential infrastructure spending and possible job creation in manufacturing, should take median wages higher, as these jobs tend to higher wage categories. Conversely, there is likely to be job losses in store retailing as big box companies report very weak sales trends, a function of a shift in spending rather than an overall fall.

Lurking in the shadows is the possible ‘border tax’, which can be expected to come through in goods inflation. If it does come about, consumer spending may get a burst to front-run its impact. Time will tell if it can be enacted in isolation without a tit-for-tat elsewhere. The US CPI for December will be released Wednesday (US time) next week.

Currency moves are another war of words. US dollar bulls are overwhelming, and that is usually a worry. Based on this December survey below, other currencies are out of the picture. The contra case for USD strength is based on its valuation, a function of its purchasing power parity (PPP), real interest rate differentials, capital flows and sentiment. Most judge it to be about 15% above its PPP (which can be the case for prolonged periods). Real interest rate differentials represent the vexed combination of inflation expectations versus rates, at this stage favouring the USD. Flows may also, if the repatriation of capital referred to above is important enough, but otherwise are benign. Sentiment is another quandary, with risk-on trading such as we have recently experienced, usually biased to risky currencies and not the USD. The bear side of currency is at least as interesting, though its preconditional that the bull side to the USD plays out.


Based on consensus data, European GDP growth is forecast to end 2016 at 1.8%. That may require a modest upward revision, as German preliminary GDP looks to have strengthened into the end of the year. The lift in consumption spending is a function of the migration intake and solid wage increases on the back of low unemployment.


Even the budget surplus has been sustained, notwithstanding the level of spending on migrants and social security redistributions.

Consensus forecasts are for a slowdown in European growth in 2017. Employment levels are anticipated to continue improving and the exchange rate is unquestionably helpful. But political risk is unreasonably high, and business investment is expected to be cautious.

Local economic data was limited. Retail sales for November rose by only 0.4% with larger stores doing much better than speciality formats. Competition on food and low inflation have preyed on the supermarket sector and the discount department stores are also in a heightened battle for any sales. Industry feedback suggests Christmas spending picked up to an acceptable level, but whether margins could be held remains to be seen.

Employment data will be released on 19 Jan. With recent releases showing a distinct lack of growth in full time jobs compared to part time, income security is lower than the RBA would like before it contemplates a rate rise.

Fixed Income Update

-  Corporate bond issuance has started strongly in 2017 as issuers attempt to front run further rate rises by the FOMC. 

-  Credit spread contraction on ASX-listed hybrids and subordinated bonds outstripped that of senior bonds in 2016. 

The start of 2017 has seen record issuance levels in US markets, as banks and corporates seek to lock in borrowing costs before interest rates rise further. Banks have led the way by selling $42bn of the $73bn that has been issued so far this year. Two of the 20 busiest corporate bond trading days on record were set in the first three trading days of this year.

Emerging market sovereigns are also apparently gearing up to issue prior to further rate rises in the US (as a large bulk of their issuance is USD denominated) as well as a flurry of issuance from countries including Argentina, Brazil, and Saudi Arabia. 

Whether this increased supply will drive up yields further is yet to be seen and will also depend on demand for bonds at a time when rates are destined to rise.  In the two months following the US election, $41.5bn was pulled out of bond funds, the largest redemption since the taper tantrum of 2013. As yields have eased and stabilised in the last couple of weeks, a reversal of this trend has occurred, with bond funds having their strongest inflows in three months in the last week. This highlights the uncertainty of asset positioning in portfolios and supports some exposure to duration.

As highlighted in last week’s publication, the Australian listed debt market for hybrids and subordinated bonds had a very strong year in 2016, with the CBA index showing a 9.83% return. While coupon payments are generally higher in this sector (particularly new issues), a large proportion of the strong performance was from credit spread contraction, leading to a rise in the capital price. This can be attributed to about 3% of the overall performance.

Global credit spreads in general have contracted over the last 12 months and it is the riskier sectors that have benefitted the most (as spread contraction drives up the bond price). High yield and securities further down the capital structure, such as hybrids and subordinated bonds, have all outperformed investment grade senior corporate bonds. As an example, the price of a CBA senior 5 year floating rate note has remained quite stable throughout the last year vs the price performance of a CBA bank hybrid security. The price movements of each of these securities is illustrated below.

Commonwealth Bank Floating Rate Notes and Hybrid Securities

Source: Iress, Escala Partners

From a relative value perspective, the Australian listed debt market is starting to look quite expensive again. However, with low expected supply in 2017, the continued search for yield and increased appetite for floating rate products, it is difficult to determine at what point the market will pull back.

Corporate Comments

-  Bellamy’s plunged after resuming trading this week, with considerable uncertainty remaining over its short term outlook. 

-  Small cap funds faced difficult conditions in 2016, with the performance of specific sectors and market themes impacting the performance of active managers.

Infant formula company Bellamy’s (BAL) finally resumed trading this week after a month on the sidelines, although its bad news was perhaps not as feared, with the company resisting the call to raise equity. To recap, the company has been reliant on its sales growth to Chinese consumers, which has been impeded by regulatory change over the last 12 months, overshadowing a positive underlying demand story. Bellamy’s has lost market share in this transitory period and has faced a cash crunch, with increasing inventories leading to price discounting to clear stock. Take-or-pay key supply agreements have exacerbated the situation.

These recent events led to the departure of the company’s CEO, a review of the rest of the executive team and a restructure of a key manufacturing supply agreement with Fonterra. While this has reduced its near term risk, its excess inventory will likely take some time to work through and there is the possibility that price discounting could impair its brand further. Additionally, Fonterra’s new supply agreement has also introduced a termination clause in the event that Bellamy’s has a change of control, reducing the likelihood of a takeover surprise. Despite the uncertainty surrounding the company’s future, at this point in time the stock trades on a forward P/E of 18x, which we believe does not adequately reward investors for the inherent risks.

The challenges of Bellamy’s have been symptomatic of the difficult environment that small cap managers have faced in the last 12 months. Small companies have been a favoured sector of the market for domestic investors over the last few years, as investors have sought the higher growth opportunities available, given a benign outlook and the subdued earnings growth posted by their larger counterparts, particularly among stocks in the ASX 20. 

While this translated into superior index returns in 2015 and the first half of 2016, the performance of small companies (as measured by the ASX Small Ordinaries Index) began to lag in the second half of the year, particularly in the final quarter. In the December quarter, the Small Ordinaries recorded a total return of -2.5% compared with an ASX 200 (the large cap benchmark) return of +5.2%; a difference of 7.7%.

For investors who have grown accustomed to strong outperformance by small cap fund managers, 2016 also proved to be a difficult year for active managers. While total return of the Small Ords was 13.2% for the 12 months to December 31 (despite the negative December quarter), the median Australian small cap fund manager returned just 6.8%, an underperformance of more than 6%. So, what where the key drivers of this outcome?

Index Composition

As we have previously highlighted, the sector composition of the Small Ords index is significantly different to that of the ASX 200. Specifically, the ASX 200 has a much larger representation in financials (dominated by the major banks and insurance companies), while the Small Ords has a more even weighting across the sectors of the market, including the growth-focused consumer discretionary and info tech sectors. With financials leading the market rally in the final quarter of the year as longer term interest rates began to climb, the Small Ords had little participation in this key driver of overall market performance.

ASX Large and Small Cap Sector Weights

Source: iShares, Escala Partners

managers, which typically construct portfolios that are materially different to the index. Conversely, many large cap managers will have a higher acknowledgment of index weights, often holding stocks as an ‘underweight’ position to reduce active risk.

With this in mind, the performance of individual sectors mattered in 2016. The following chart illustrates the total return of each sector (for large and small caps) plotted against the overall contribution to index return (sector attribution). What it shows is that resources stocks were the key outperformers and drivers of growth for small and large caps; for the small cap index, materials and energy combined was responsible for almost 10% of the 13.2% total return.

In the context of the small cap manager universe this is significant; few managers have large positions in resources (in fact, many have zero). With a large number of unprofitable companies comprising small cap resources stocks, these are often screened out by small cap managers and thus deemed un-investable. While this position hurt many managers in 2016, it provided a large free kick in the preceding years and only partially reversed the previous multi-year trend.

Conversely, this would not have impeded large cap managers as much. While many would have been underweight through the year, it would be rare to find a fund without some notional exposure, whether it be through BHP, Rio Tinto, South32 or Newcrest.

ASX Large and Small Caps: Performance and Estimated Attribution in 2016

Source: Bloomberg, iShares, Escala Partners

Growth to Value Rotation

The rotation from growth to value over the last year has also hurt the performance of small cap fund managers. Some specifically have a value bias,  but the majority seek companies with the capacity for sustainable, high earnings growth. This tends to lead to high weightings in sectors such as consumer discretionary, IT and health care, which all underperformed their respective larger cap counterparts.

As illustated in the table below, the P/E derating of many growth companies has proved to be a headwind for performance. A number of key investing themes that managers have focused on, including food stocks (Blackmores, Bellamy’s, Bega Cheese, Murray Goulburn), aged care (Estia, Japara and Regis) and fund managers (Platinum and BT), all struggled, detracting from overall performance.

Small Caps: P/E Derate in 2016

Source: Bloomberg, Escala Partners

Rising Bond Yields

While much of the analysis of the impact of bond yields on equity returns has focused on bond proxies (companies with defensive, predictable earnings and high yields, such as utilities/REITs/infrastructure), high growth stocks (which comprise much of the small cap index) are also impacted, with the higher discount rates used in valuing these stocks having a greater negative impact. Conversely, small caps are underrepresented in stocks that have positive leverage to rising rates, such as the banks.


Finally, liquidity is a further risk that small cap fund managers face and this has posed problems in recent months. Anecdotally, large cap fund managers have held a greater proportion of their FUM in small cap companies in recent years, given the limited options available to them to find investment opportunities with reasonable earnings growth. To a degree, this trend has reversed in the last few months with an improving outlook for several key large cap sectors. With (until recently) higher valuations across small cap stocks, it was maybe inevitable that they have since become a source of funding. With their larger FUM bases, a large cap fund manager can have a material impact on the share price of small cap stocks if they decide to exit their position, given the reduced liquidity across these stocks.


The performance of many small cap managers was disappointing in 2016, although not surprising if one considers the key drivers of market performance for the year and the rotation out of growth-style stocks. While some managers may have compounded the issue with poor stock selection, the underlying environment has undoubtedly been difficult for the style of investing that most employ.

Following a pullback in recent months, small cap stocks are now trading broadly inline with large caps, despite offering a superior growth outlook. As such, we believe that a small allocation within Australian equities for most investors remains appropriate, but highlight the higher volatility that is typically associated with investing in the space.