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WEEKEND LADDER

A summary of the week’s results

13.04.2018

Week Ending 13.04.2018

Eco Blog

- The AUD is notionally at its estimated fair value. Developments in global currency balances may be telling and the USD is possibly due for another bout of weakness.

- CPI is up, but well within boundaries.

- Emerging economies have been resilient considering headline news. We remain optimistic.

Foreign exchange markets have been surprisingly calm in the face of the rise in volatility in equities and changing spreads in fixed income. The flat EUR/USD rate reflects a mix of the recent slowing growth trend for Europe (but not such that it is troublesome), the trade battle of the US (with most believing it would blow over) the rising tension in the Middle East and no change to monetary policy.

The assumption is that European growth is facing a lull rather than a pullback and that any trade impact will be small enough to contain the flow on effect. It is telling that Asian currencies and the Chinese renminbi have recently rallied against the US; intuitively the opposite of what one might expect if trade were to destabilise growth.

Source: BIS, Bloomberg, RBA
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As we have previously noted, US interest rates are not yet high enough to attract flows, especially after the currency hedge cost.

That leaves liquidity to impinge on the apparent stability. The reduction in central bank balance sheets and rise in short term funding costs is likely to see volatility in foreign exchange join other financial assets.

For Australian investors, the debate hinges on the movements against the AUD. Here there are differing views, though recent experience shows that the AUD is one of the more sensitive currencies to rising volatility.

In favour of a higher AUD is the yield now available relative to that for USD investors; the reverse of what we enjoyed for many years. While it is lower than that for the Euro (again based on a USD investor) the AUD adds an element of diversity in a highly rated credit. The impact, however, is self-limiting demand for AUD bonds will relatively quickly suppress the yield, especially given low issuance here as the budget outlook is solid for the moment. It is hard to make a case for much above an 0.80 AUD/USD rate, absent the unlikely combination of a strong rally in commodity prices and rising local rates and the flip side is there as well.

Nonetheless, as frequently noted, currencies can trade outside their assessed ‘normalised’ valuation range for a considerable time. An overshoot is likely to be accompanied by another upward leg in the Euro. European rates are widely expected to rise by the end of the year, or at least price in that probability. Central banks are holding about 20% in Euros compared to the historic average or 25% and highs of 30%. If reports on Eurozone instability fade, given the absence of any important forthcoming elections, some redress of this underweight to the Euro is expected.

Currency Composition of Official Foreign Exchange Reserves

Source: IMF, woofstreet.com
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In time, the renminbi can be expected to incrementally be added to bank reserves, with the Bundesbank noting this earlier this year given the increasing global role for the currency. The impact of both of these could crowd out some USD positions.

  • Traditionally, unhedged USD has been accepted as a positive contributor to return and to reduce volatility. This will require some rethinking if the USD persists as the weakest of the major exchange rates.

The US March CPI barely registered as news coming in at expectations. The core rate was 2.1% annualised, up from its February low of 1.7%. Incrementally, shelter (housing), health and transport services added most, while education was surprisingly flat and goods prices have barely budged.

US Consumer Price Index

Source: Bureau of Labour Statistics, Haver Analytics
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The domestic March quarter CPI, due for release on 24 April, is likely to be similarly benign. Forecasts of 1.9% annualised growth are perhaps only notable that it has been some time since Australian inflation was below that of the US. The quarter does include seasonal education, health and tobacco cost increases, but these are likely to be a touch lower than has been the case for some years.

Below the radar has been the lack of any signal that emerging economies (EM) are rattled by recent events. Rather, it would appear that progress is generally positive. Staying on the inflation theme, EM CPI is converging with developed nations. Lower financial leverage, more open economies and better regulatory oversight have gone a long way to limiting blowouts.

Developed Markets vs Emerging Markets CPI inflations

Source: Bloomberg
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Emerging economies remain an idiosyncratic unrelated grouping. Yet today the weaker, questionable countries are the exception, rather than the rule.

  • While EM is subject to higher risk than other regions, we believe long term investors should consider overweight allocations. Our recommended funds are intentionally selected to limit drawdowns, while ETFs can be the exposure to the tactical weight. Increasingly, global managers are also participating.

Investment Market Comment 

- Style factors are imbedded in financial language with growth and value being the starting base. Index funds and active managers express these in their stock selections.

There are two broad based styles that an investor can chose from in equities: growth and value. As a reminder, value stocks are typically those that are out of favour but can still demonstrate solid fundamentals. Investors seeking value stocks are generally looking for an earnings recovery, decent yields and an element of cyclicality. Growth companies, unsurprisingly, are expected to demonstrate earnings growth well above economic conditions. With the priority to growth, these companies will be reinvesting their earnings and unlikely to pay much in the way of dividend, if at all.

The MSCI index methodology quantifies the variables for both styles and assigns a standardised score to a company, ranking them according to the product of their market cap multiplied by the score.

The value investment style characteristics for index construction are defined using:

  • Book value to price ratio (BV / P)
  • 12-month forward earnings to price ratio (E fwd / P)
  • Dividend yield (D / P)

The growth investment style characteristics for index construction are based on the five variables:

  • Long-term forward earnings per share (EPS) growth rate
  • Short- term forward EPS growth rate
  • Current Internal Growth Rate
  • Long-term historical EPS growth trend
  • Long term historical sales per share (SPS) growth trend

As one would expect, this leads to two considerably different indexes compared to the mainstream index, the MSCI World Index. The chart shows growth is heavily overweight to technology and consumer discretionary (Amazon) whilst value’s highest exposure is within the financial sector. 

Relative Sector Weights vs MSCI World Index as at 31 March 2018

Source: MSCI, Escala Partners
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Inevitably, this will also lead to a difference in performance between the two styles.  Given that IT and consumer discretionary make up over 40% of the growth index, growth investors have enjoyed higher returns in recent times.

In addition to this, macroeconomic factors have an impact on performance. Central banks have anchored rates until recently, which has had a positive impact on the valuation of long term cash flows.

Performance of the MSCI Index, Value Index and Growth Index

Source: Bloomberg, Escala Partners
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Our recommended funds will consist of a selective mix between the two styles. This approach allows investors to be exposed to different situations that favour a range of scenarios.

Fixed Income Update

- The high yield bond market comes under pressure as interest rates rise in the US, however, some support comes from low new issuance levels in the sector.

- The US Federal Reserve, ECB and RBA release minutes and commentary from officials.

The high yield market in the US is the source of funding for companies that have a credit rating below investment grade. By virtue of the fact that these companies are perceived as risky, the credit spreads movements tend to be more pronounced and pricing of bonds volatile. As one would expect the margin over the risk-free rate is higher and tempting in a low rate world. In an risk-off environment, however, credit spreads in this sector react first and by the greatest magnitude.

After two years of strong performance, high yield bond prices fallen for most of this year to date. The cause has been interest rate hikes in the US, which impacts prices in two ways.

  • High yield bonds are fixed rate, priced against treasury yields. As rates rise, the price of the bond falls. Average duration in the US index is at 4.1 years.
  • Higher interest rates will in turn lead to a higher cost of funding. This will start to bite as debt matures and needs to be refinanced at higher levels. Leverage has risen across corporate America and higher rates can lead to a deterioration in interest coverage ratios as companies pay to maintain the elevated debt on their balance sheet.

High yield funds have had net outflows this year. Weaker performance has been saved by low new issuance levels. Issues of new high-yield corporate debt in March was half the amount issued a year prior.  New supply in in 2018 is to expected to be 25% lower than the last year.

The market is best represented by a high yield index such as the iShares iBoxx HYG, which has fallen but remains within the trading range of the last two years.

iShares iBoxx Dollar High Yield Corp Bond ETF (HYG) Price Movement

Source: Iress, Escala Partners
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  • Unconstrained global bond funds that we recommend can invest in high yield debt. Companies will need to raise funding in this market at some point, with further spread widening likely. We rely on their expertise to assess the weight and timing of their exposure, and we note that many are underweight at this time.

Minutes by central banks and comments by their members were plentiful this week.  The Federal Reserve minutes from the March meeting indicated a leaning towards a faster pace of rate hikes. It noted a stronger economic outlook and confidence in rising inflation that would lend to a steeper path of interest rates than previously expected.

Out of Europe, the ECB minutes from its meeting were also released. It noted that euro area wages and inflation will rise as the economy recovers, and the direct impact from US-China trade tariffs were not substantial but could affect confidence. The minutes suggested that the €30bn a month Quantitative Easing (QE) program is likely to gradually phased out, implying it won’t end abruptly in September. 

Domestically, the RBA Governor Phillip Lowe gave a speech which focused on the improvements to business conditions, particularly outside of the mining sector. He noted that wage growth and inflation were likely to be gradual. Nonetheless, the bank’s view is that the next rate move is likely to be up, even though there is no strong case for any adjustments to the cash rate in the near term.

  • While the messages from the central banks were tempered, the take-away is that monetary accommodation is being tightened globally. Higher interest rates, given the current shape of global yield curves are under-priced, at least on the long end. Investors should be mindful of adding duration (long dated fixed global bonds) given the risk to higher yields.

Corporate Comments

- IAG’s medium term outlook is quite good. The rise of autonomous vehicles presents as a longer-term threat and opportunity to one of its core businesses.

- Fletcher Building appears to have caught the eye of Wesfarmers, which will have capital to deploy following the disposal of Coles.

Insurance Australia Group’s (IAG) investor day provided a good amount of information on the current, medium-term and longer-term environment for the company. The underlying assumptions behind the insurer’s FY18 guidance were unchanged, including a reported insurance margin of 15.5-17.5%, low single digit premium growth (which is an improvement on the weaker trends of recent years), reserve releases of around 3% and net losses from natural perils in line with its allowance of $627m.

Over the next few years, the story is as more about cost out to drive its 10%p.a. EPS growth target, unsurprising given that the domestic insurance market is relatively low-growth. IAG has expressed confidence in achieving this target, which amounts to a $250m reduction in its operating cost base. Much revolves around simplifying its platforms and consolidating systems, allowing it to reduce its employee numbers. Retaining high customer satisfaction levels will be the challenge through this process. At this stage, some analysts are yet to give IAG the full credit for these targets and there is potential upside to earnings estimates should it show evidence of progress at its full year result.

Of more interest was IAG’s commentary regarding the longer term impact of autonomous vehicles on motor insurance. With motor insurance representing approximately 40% of the group’s total insurance premiums written, the future of the industry has a significant bearing on what IAG will look like as a company beyond the next ten years.

Admittedly, predicting the pathway of assisted driving and autonomous vehicles is a difficult exercise given the forecasts are well into the future and prone to a wide margin of error. Additionally, IAG is more likely to convey a positive story (or one of slow-take up of autonomy) which would ensure that personal motor insurance will still remain an essential feature of the market for some time. Nonetheless, IAG has provided its own outlook over the next 20 years, which shows personal motor insurance peaking around mid next decade. Relying on other revenue streams will clearly be required beyond this and IAG see the growth in commercial or fleet insurance given the rise in shared vehicle use.

IAG Estimates of Australia/New Zealand Motor Insurance Market

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While it is refreshing to see companies offer their view on the structural changes of their underlying industry, the more immediate investment view for IAG has a fairly positive picture. On the positive side is an improving premium pricing environment, cost out opportunity, quota sharing (which has reduced earnings variability) and the prospect of further share buybacks given a solid capital position. Those with a more pessimistic view on the stock point towards its high valuation (both at an absolute level and relative to its listed insurance counterparts) and weaker dividend yield, which, over the last several years has averaged around 5% but is now drifted to 4%. We note the stock has been a solid contributor to the recent performance of our domestic SMA managers.

Fletcher Building (FBU) shareholders had some relief from the recent poor performance of the stock, gaining 8% on Friday on the unconfirmed news that conglomerate Wesfarmers (WES) had acquired a 3-4% stake. Fletcher Building’s woes have been primarily attributed to its construction business, which, although relatively small in size, has been responsible for several large writedowns.

The losses experienced on a number of infrastructure projects in New Zealand are not too dissimilar to that of complex large construction projects in Australia which have exceeded budget, with Lendlease recently having issues and Leighton Holdings’ significant overrun on the Brisbane Airport Link project some time back. Individual projects are typically high risk/reward, with contracts often at a fixed sum and narrow in-built margin assumptions. Having now conducted a full review of its portfolio, FBU noted in February that it had identified 14 projects out of a book of 73 that were problematic. The two largest of these still have more than 12 months to competition. The consensus view is that the writedowns now assume a fairly conservative set of assumptions, however, after multiple downgrades it has left prospective investors adopting a rather cautious stance.

It is worth reflecting on the composition of Fletcher Building’s revenue base considering the rest of the business has been performing quite well. The key end markets are residential and commercial construction and in NZ, it has strong market positions. Building products include concrete/cement and plasterboard and pipes; its distribution arm is Placemakers in NZ and Tradelink in Australia; International is Laminex and Formica surfaces, while Residential and Land Development is housing developments in NZ.

Fletcher Building: FY17 Revenue Mix

Source: Fletcher Building, Escala Partners
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While there has been some concern around the simultaneous peaking of property cycles in NZ in Australia and the effect that will have on FBU’s business, this is captured in the group’s forward P/E, which had dropped to around 10X prior to this week’s news.

The more significant catalysts are expected to be further news on the company’s discussion with lenders after breaching its financial covenants, the outcome of a strategic review (expected to be released in June) and no further issues emerging in its construction division. On the assumption that the construction losses are behind it, WES could potentially be trading in a relatively expensive asset (Coles) for something much cheaper.

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