Week Ending 13.05.2016
It is hard to push a number of topics out of the limelight and housing is one recurring theme. Countries have quite distinct residential property markets depending on urbanisation, tax breaks, mortgage systems etc. However, there is one metric that can be considered relatively reliable in drawing comparisons: the proportion of household income required to service a mortgage.
The data for Australia inevitably produces a range, with most estimates suggesting the ratio in the major city centres is between 31% to as high as 56%. The variation is based on differences in cities. Canberra is apparently at the low end, while unsurprisingly, Sydney is at the top. Whatever quibble one may have with the data, the numbers are substantially higher than the US, where the most recent composite index of affordability puts the ratio at just under 15%. The mortgage data released this week has the average US mortgage at $283,700.Enlarge
The recent cut in the RBA cash rate clearly helps the equation. Mortgagees however, seem to have a good sense of the arithmetic that could confront them and are continuing to pay back debt faster than required. Perversely, when interest rates were 17% in the late 1980’s, the affordability based on the income ratio was about the same. Then too, the incentive to pay off the mortgage was just as great!
The absence of the first home buyer in recent years is the starkest indicator that housing affordability is limited to those that can sell to buy and who are likely to be on higher incomes. Upgraders have 62% more debt financing than ten years ago, while first home buyers have not increased their level at all.
There is near unanimous agreement that the greatest risk to the housing market is unemployment. The other risk would be a rise in interest rates such that the mortgage payment rose faster than income. To that extent, interest rates are likely to be constrained by low income growth and, in turn, low inflation. This is consistent with risk-averse households with limits to their flexibility.
Real Income Growth
The dialogue on house prices extends across the ditch. The New Zealand Reserve Bank, according to its financial stability report, devotes much of its time to housing risk, presumably as it can have little impact on the two other concerns, the global backdrop and dairy prices. It too would prefer to constrain housing risks through policy measures, while at the same time put downward pressure on the NZ$ through lower rates. It is more than likely the RBA is observing their success in negotiating this path in their decisions on rates.
Escaping from low rates is the global challenge. Many economists argue that low rates are now proving to be in a negative feedback loop by diminishing investment confidence and constraining the flexibility of the banking system. After around 20 years of using monetary policy to successfully dampen the spirit of inflation, central banks have found the same tools less capable of the opposite.
Another tough debate that has more positive overtones is about the potential and quality of economic growth, using GDP as a measure. There are two components: the number of people in the workforce and the productivity of those people. The size of the labour market is a function of population and participation, both of which are unlikely to contribute much to growth in the developed world. Productivity is a tougher assignment to assess. Jobs in manufacturing have generally contributed positively to productivity while, for example, aged care, has not. For some decades, changes to products spawned a range of other activities that added to growth. For example, increased air travel requires not only aeroplanes, but also airports, transport and food services. The claim is now that a product such as a smartphone does not have a similar impact.
Others disagree. The issue is that the traditional judgement of growth is focused on manufacturing trends, construction and the like, which are easy to identify as capital spending on a balance sheet. Conversely, spending on the services that support a business are usually included in operating costs.
Across most regions, services spending has been growing well in excess of goods spending. Unsurprisingly therefore, employment conditions have been the one solid positive trend for some time and show no signs of turning over. Measured productivity therefore may continue to concern many economists, howere these trends suggest that growth is likely to prove quite resilient, even if it is at a lower rate than hoped.
Fixed Income Update
Following on from the interest rate cut last Tuesday, the RBA released their statement of monetary policy on Friday. The central bank has downgraded its forecast for inflation, leading the market to price in further rate cuts this year. The likelihood of the timing is anywhere from July onwards, with the market pricing in a 25bp rate cut by October, with a cash rate below 1.5% a possibility beyond that.
While interest rates hit historic nominal lows domestically, they still remain elevated compared to the rest of the world. Further, in light of the weaker inflation figures, our interest rates offer a real yield that remains attractive to investors and is difficult to find elsewhere in the developed world. The chart below shows global cash rates and highlights why the AUD has remained relatively strong despite the recent easing.
Global Cash Rates
Given low global rates, there is a growing pool of corporate bonds with negative yields (in addition to the 40% of the sovereign bond market in negative territory). JP Morgan notes that about $900bn of the total $8.8tn in global corporate bond markets is negative yielding. Despite this, the new issue pipeline remains strong. This week saw a surge in corporate issuance in Europe, with Chevron and AbbVie coming to the market, together with new bonds issued by Shell, Airbus and Astra Zenica in the US. Further to this, marketing is underway in the US for a $16bn bond sale by US computer maker Dell which, if successfully completed, will rank as the 2nd largest bond deal this year.
Domestic listed debt has had a strong run in the last month, although this upward movement has eased somewhat in the last week. While there is no official index that measures performance for this market, the chart below depicts the price appreciation of CBAPDs, which is often used as a proxy for directional behavior for the longer dated maturities.
Staying locally, Crown subordinated bonds continue their volatile ride, although this week it was in favor of price appreciation. Recently, Crown announced it was reducing its stake in Melco Crown to 27.4% from 34.3%. This divestment was perceived as a positive move for the credit and may be seen as commitment towards the company retaining its investment grade credit rating. In response, CWNHAs and CWNHBs rallied some 6.2% and 8.3% respectively. However, both bonds still remain below their issue price of $100 as privatisation rumors weigh on the credit.
Crown Hybrid Securities
A major change has been occurring for money market funds which will soon have the ability to charge fees on redemptions during periods of stress, or stop investors withdrawing their money altogether. Many investors have been moving out of these funds, which predominately hold commercial paper, in favour of government bonds. This change will be effective at the end of October, with further drawdowns expected for these funds before then. One would suppose that as demand for commercial paper falls, the yields on these securities will rise, making short term funding options more expensive for banks and corporates issuing in this space. The chart below shows the capital withdrawn from these funds in the last year.
Commonwealth Bank’s (CBA) quarterly updates are much lighter on detail than the bank’s semi-annual results, however there was sufficient disclosure to conclude that the broader banking themes in which we highlighted last week also apply to the company. Cash earnings were on the weak side, enough for modest downgrades by analysts.
Bad debts jumped up to 25bp (from 17bp in the first half) and were above expectations, with the run rate at a higher level compared with any financial year since FY11 (see chart below). Similar to the other majors, it has been a small number of large exposures in its institutional lending book which has driven bad debts closer to mid-cycle levels. Net interest margins were flat despite the repricing of its mortgage book and soft investment markets led to a drop in wealth management FUM. With a sector-leading return on equity and solid capital position, CBA screens as a lower risk compared to the other major banks with regards to the safety of its dividend, however is marked down in terms of preferences within the sector due to its premium relative valuation.
Commonwealth Bank: Loan Impairment Expense
Orica (ORI) again illustrated the challenges across the mining services sector after it reported its half year earnings, with the stock sold down heavily. The unexpected surprise in its announcement was the rebasing of its dividend, with the company now having abandoned a progressive dividend policy in favour of a more sustainable payout ratio model of between 40% and 70% of earnings. Compared to other listed mining services companies, ORI is better placed; it has a broad geographical reach, it is more closely linked with volumes as opposed to large capital projects, and the supply side of its industry is relatively concentrated (although oversupply issues currently persist).
Nonetheless, ORI remains exposed to the ongoing cost cutting measures that are being implemented by its customer base and a decline in earnings has been driven by falling volumes and prices. These ‘market impacts’ combined for a total $120m drag on EBIT for the half (or approximately 32% of its base from HY15), which was offset to a degree by ORI’s own cost savings (which are tracking ahead of the company’s targets).
The key question for investors is: has the cycle now bottomed? Most analysts remain of the view that it is still too early to call. ORI has had success with rolling over its existing mutli-year contracts, although this is anticipated to continue to be an earnings headwind as they are negotiated on less favourable terms. The chart below illustrates the contract profile for the company’s two key markets.
Orica: Forward Contract Profile (% of Projected Volumes)
Within our model portfolios, we hold ALS (ALQ), which also has some mining services exposure although, in contrast to ORI, has broader non-mining divisions which continue to perform well. ALS is expected to report its half year earnings later this month.
Myer (MYR) released its third quarter sales, up 3.4% on a comparable basis, resulting in a ‘relief’ rally and short squeeze in the share price. The management also confirmed the estimate of net profit of $66-72m for the full year, before the pre tax $20-30m costs of implementing its new strategy. Given the persistent downgrades of recent years, hitting its expectations is a modest positive. Nonetheless, the deterioration in profitability has yet to be proven; last year the company reported a $77m net profit before significant items. Globally, department stores are taking another downward leg (confirmed with the performance of Macy’s in the US this week) and we do not believe this sector is suitable for longer term investors.
QBE Insurance held an investor day this week, with the company outlining the path for earnings over the next three years. While the global insurance market environment remains difficult, with downward pressure on premiums, QBE still believes that it can achieve a 10% p.a. increase in earnings over this time. The following chart illustrates the composition of this growth, which takes into account the expected earnings drag from soft pricing in the medium term and includes claims and reinsurance savings, higher investment returns and further cost savings across its business.
QBE: FY18 Profit Target
Part of the earnings improvement above is based on better returns from QBE’s investment portfolio. Compared to its insurance peers, QBE presently has a more conservative investment mix, with a much lower allocation to growth assets (such as high yield credit and equities) and a higher weighting to cash. The company believes that transitioning a part of this cash into credit markets over the next two years and extending the duration of its portfolio (from 1 ¼ years to 2 ¼ years) could see the investment yield on its portfolio increase from the recent rate of 2.4% to 3.0%. This is in the absence of any benefit that would be realised from rising cash rates, particularly as is expected in the US.
The investment view for QBE has been predicated on a rising rate cycle in the US. However, with the steps that the company has taken (and has outlined for the next three years) to improve its operating margins ,the focus and drivers of earnings growth have shifted towards these measures and, as such, the prospect of higher US rates is now more of a bonus as opposed to a core driver of the investment case. The leverage to higher rates, however, remains given the low starting base for bond yields. With a strong balance sheet, there is also the possibility of additional capital returns to shareholders in coming years. We have QBE in our model equity portfolios.