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WEEKEND LADDER

A summary of the week’s results

13.07.2018

Week Ending 13.07.2018

Eco Blog

- The US budget shows the impact of lower revenue and higher spending. US bond yields are balanced between demand for stable assets at a time of uncertainty and the supply of bonds in coming years.

- Trade tariffs are now proposed to a level where economic trends will be affected, be it in growth or inflation. China’s response is yet to come.

- The Australian housing cycle is now clearly past its peak. But the impact of mortgage payments has broader implications.

The US budget deficit released by the Treasury Department for the nine months of this fiscal year unsurprisingly shows a marked deterioration in the US fiscal condition. The shortfall is up 16% versus the same time last year. Net revenue increased by 1.3% with individual tax (47% of total revenue) up 8.9% while corporate tax fell 27% (9% of revenue).

Spending was accelerated by 5.5% increase in defence (15% of spending), health and Medicare (both 15%) up 3.9% and 3.3% respectively, and the largest outlay, social security (24%), has risen steadily, up by 4.4% this fiscal year. The only categories that show a decline in spending is income security (-0.3%) and federal support for education, down a whopping 38%.

The debate on funding the deficit at the same time rates are rising is a point of tension in bond markets. To date, the soft CPI data and strong employment conditions allow the Fed to maintain its ‘steady as she goes’ pace of rate adjustments. Powell, as the recent incumbent Fed chair, is viewed as very likely to hold to the rate normalisation agenda rather than react to bond markets or trade disputes. Yet, the constant retreat in 10-year yields back to 3% implies that markets are unsure on how the coming years will unfold. Current policy and political uncertainty leans to the USD ‘safe haven’ status and supressed bond prices. If the yield curve were to invert, the historic implication is that the economic outlook will deteriorate, but if it reflects demand for USD, the interpretation is nuanced.

As we move into the US Q2 profit reporting season, a focus will be on costs and margins. The US corporate sector is enjoying its highest ever share of the economy, while the position of labour has steadily fallen.

US share of GDP

Source: Deutsche Bank
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There is no sign of the long-expected uptick in wages. The majority of new jobs have been in the lower end service sector and predominantly female. Wage growth across industries, age, education and regions have coalesced to a narrow band around 3% per annum. While this sounds adequate, it does not leave a lot of room for more than CPI-based increases in spending.

  • The indisputably robust US economy is set to deliver a solid rise in GDP this year. However, the household sector at circa 65% of the economy is unlikely to accelerate until wages improve. Equity positioning may then need to shift from corporations that have enjoyed margin expansion to those that benefit from an uplift in consumption.

Initially, the trade dispute was judged to be more about politics than have a meaningful impact. This week the potential escalation has a different tone. Into the US mid-term election (6 November), it is perhaps no surprise that populist measures are in the headlines, but increasingly, even US businesses are uncomfortable with the potential impact on prices and margins.

Initially, the trade dispute was judged to be more about politics than have a meaningful impact. This week the potential escalation has a different tone. Into the US mid-term election (6 November), it is perhaps no surprise that populist measures are in the headlines, but increasingly, even US businesses are uncomfortable with the potential impact on prices and margins.

China has so far responded in equal measure and its attitude to the recent $200bn of goods now under consideration will be telling. Its options are to, again, have a similar magnitude imposed on US goods and services, or decide to avoid the risk of even more by encouraging talks to resolve trade another way, or work even harder to remove itself from US influence. This includes accelerating its interaction eastwards, offering attractive terms to non-US companies and partnerships (for example reports state that it has removed import tariffs on agricultural products from Asia) and to manage its financial system (rates, currency and access).

In the first salvo of tariffs on Chinese goods, the list appeared to be crafted so that other countries could fill the void and limit a pass through of the costs to US consumers. The second list will make that harder, as the China share of exports into the US for these goods is high. The categories targeted in these include furniture ($29bn), network routers ($23bn) and computer components ($20bn). Some consumer goods, such as apparel have not been included.

There are many attempts to size the trade dispute on a total basis. The data below represents the potential in terms of global GDP and trade. If autos are to become a weapon, the numbers will blow out considerably. General Motors, for example, sells more cars (4m) in China than in the US (3.6m) or the rest of the world (2m). Most of these vehicles are built in China, yet it is unlikely the company will be unscathed by an escalation of tension.

Source: TS Lombard
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  • Emerging markets have been battered by political issues and the trade dispute. Until this is resolved, investors are likely to remain on the sidelines, notwithstanding historically attractive valuations.

Locally, the fall in house prices is inevitably attracting attention, with NAB’s residential property survey suggesting the weakest outlook in two years.  NAB estimates that prices will ease further into 2019. Sydney is viewed as having the largest decline, while WA would, based on their forecast, have had a decline in house prices in each of the five years to end 2019.

A corollary of the housing cycle is the decline in household deposit growth.  Post 2009, bank deposits rose strongly at 10% per annum. Not only did this provide a welcome buffer for the household sector, but also a better funding base for the banks. Recently, deposit growth has slowed to 5% per annum. Measured through the lens of the National Accounts, this has seen the saving rate slump to below 3% as consumers support spending from accumulated savings.

Percentage growth in saving and spending

Source: CBA
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As mortgage offset accounts are included in deposits, the rollover from interest-only to interest and principal could see those affected face a 30-40% rise in cash outflows. CBA estimates that this would take $1.8bn out of household consumption per annum.

Two further implications would be that the source, and therefore cost of funding for the banking sector will rise and that the RBA will have to delay any rate rise until the full extent of the shift had come through, or until there were clear signs of wage growth.

  • Subdued spending is now accepted as the base case, yet state-based infrastructure and reasonable export momentum keep the economy on an even keel.  The longer low rates are sustained, the more support comes back into interest rate sensitive sectors such as utilities and REITs.

Investment Market Comment

- Investors are able to invest in corporate bonds, government bonds, global bonds in both developed and emerging markets through ASX-listed ETFs.

Since 2012, when the first fixed income ETFs were launched in Australia, the number of ETFs has grown to 22 with over $3.1 billion of assets under management. To put this into context the US has 361 fixed income ETFs valued at $622.8 billion. As expected, fixed income ETFs invest in government and corporate bonds with varying issuers and maturity dates. Unsurprisingly therefore, the risk/return profile will differ between types of securities held within each ETF. Therefore, it is important to understand the variance between indexes.

Unlike most equity ETFs, fixed income ETFs tend to employ sampling or optimisation to replicate the characteristics of an index as full replication is not possible given most indices includes hundreds or thousands of holdings. The structure is therefore achieved through aiming to match risk factors such as duration, yield curve, sector and credit quality of the portfolio with the index. The process reduces the overall costs of an ETF but can add tracking error ( deviation from the index). 

Australian bond ETFs make up over 60% of the AUM of fixed income ASX-listed ETFs. Vanguard Australian Fixed Interest (VAF) and iShares Core Composite Bond ETF (IAF), both benchmarked to the Bloomberg AusBond Composite 0+Y TR AU, are the two largest ETFs in terms of FUM. This index aims to provide the performance of the Australian bond market, which includes Australian Treasury and semi-government, foreign supranational and sovereign and corporate entities. As VAF is  a larger fund, it holds approximately 550 of the 700 securities in the index, whereas, IAF holds around 450 securities.

Government entities tend to issue longer-dated debt than corporates, therefore, the higher the allocation of government bonds within an index or ETF the higher the index’s modified duration and implicitly, higher interest sensitivity. If this is not appropriate, investors should look towards ETFs that follow indices with a focus on either shorter-dated or floating rate securities, typically issued by corporates. Examples of this include the Vanguard Australian Corporate ETF (VACF) or iShares Government Inflation ETF (ILB).

Performance of Australian Bond ETFs

Source: Morningstar, Escala Partners
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The fixed income sector has traditionally seen index tracking ETFs with securities weighted on market value. However, there has been an emergence of rules-based indices for ETFs to track. Russell Investments track DBIQ indexes, which implement a set of liquidity, size and maturity rules to construct an equally-weighted index. The number of securities for these indices is between 10-15, which is significantly less than that of the Vanguard and iShares offerings and adds considerably to the issuer risk.

  • The primary purpose of these Australian bond ETFs is to offer investors a reliable income stream. However, investors should understand the differences between the entities and terms of the securities within an index as this will lead to differing performance in changing environments.

Fixed Income Update

- We analyse US auto loan bonds, which form a significant part of the asset backed security market.

- A platform for new issue bonds has benefits for both investors and the underwriters.

After mortgages, the second largest sector in the US Asset Backed Securities (ABS) market are bonds backed by a pool of auto loans. Within this subsector, there are three categories: prime (strong credit histories), nonprime (lesser credit quality customers) and subprime (lower incomes and/or tainted credit histories). Despite these securities holding up well during the financial crisis, demand dropped as investors became cautious of securitised assets given the damage the sub-prime housing market had on global markets. In recent years, there has been renewed growth in this sector, with issuance levels of US auto loan ABS reaching their highest levels since 2007 last year.

Trend changes to the auto-loan market has raised some concerns. The rating agency, Fitch, tracks performance of subprime auto loans (which make up ~25% of auto loans). Sixty day plus delinquency rates have risen from 5.2% to 5.8% in the past year, marking the highest rate since 1996.  As the Fed raised interest rates in the US, this has been passed on to those taking out new loans (these are fixed rate securities, therefore existing loans aren’t affected), adding to the risk of default.

In addition, terms have extended on US car loans. According to S&P, the average term has reached 68 months, the highest level in 10 years. The longer the loan term, the higher the likelihood a change in circumstances leading to an inability to meet the monthly payments. Relaxed terms when originating loans has also been cited as a concern.

Average length of new car loans rises

Source: FT, Federal Reserve Bank of New York
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Balancing the arguments, usually after 3 months of missed payments on a loan, vehicles are repossessed. Residual values remain high, therefore recovery rates have generally been sufficient. Others also look to the increased credit enhancement that has been embedded in these loans following the financial crisis.

  • While the auto loan market may come under pressure, it is unlikely to have wide spread contagion to other parts of the financial markets. Despite comparisons to the US subprime housing market, a significant differentiator is the volume of securities issued. In 2017 $25 billion of bonds pooling subprime auto loans were sold in the primary market, compared to $400 billion of subprime mortgages in 2006.

The new issue bond market rewards its underwriters with lucrative fees. Financial institutions generated a record $23bn in underwriting fees on debt last year, with the top 10 underwriters capturing 48.6% of the commissions. To protect this revenue stream from new technology companies, the top three debt underwriters, Citigroup, Bank of America and JPMorgan have joined forces to build their own platform to streamline the origination process.

Fees generated from issuing bonds, equity and loans

Source: Dealogic
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Amongst others, the new platform is said to have been signed on by Goldman Sachs, Wells Fargo, BNP Paribas and Deutsche Bank. It will be used to:

- Announce new bond sales

- Communicate pricing of the deal with potential investors

- Supply documents including credit rating information, prospectuses and term sheets

- Process the order book

- Allocate bonds to investors

  • While this initiative will shore up revenues for the underwriting banks, it will benefit fund managers by having all the information they require to analyse a deal in the one place. It should also increase the transparency of deals (eg size of order book, types of investors buying the bond), assisting buy-side investors with market colour. 

Corporate Comments

  • The ACCC has added to the debate around electricity regulation, releasing a long list of proposals for the Federal Government to consider providing bill relief for households. If implemented, the base case is for a modest impact to earnings for both AGL Energy (AGL) and Origin Energy (ORG), although the range of potential outcomes is quite large.

The release of the ACCC’s report into the pricing of retail electricity became the focus of the market in what was an otherwise quiet week of announcements in the lead up to August’s reporting season. The pricing of utilities has been a hot topic in politics given the rapid escalation that has occurred over a number of years, which has been a further constraint on household budgets given prevailing high debt levels and low wage growth.

The ACCC pointed towards a multitude of poor decisions made over the last decade, including poor regulation of network investment spend, privatisation which led to concentrated generation ownership, the costs of solar installation, the quantity of domestic gas destined for export markets via LNG, the closure of coal-fired power stations and opaque pricing structures in the retail market. The chart illustrates the various factors that have led to higher bills (up 35% in real terms over this time), with network charges and wholesale electricity prices the most significant components.

Real Change in Electricity Bills

Source: ACCC
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The ACCC put forward no less than 56 recommendations for the Federal Government to consider bring retail electricity pricing down over the next three years (by approximately 20%, as detailed in the following table). In reality, some of these drivers have already been in train for some time and so perhaps would have occurred naturally, including wholesale electricity prices which how now likely peaked as new generation capacity is introduced, as well as a higher level of competition in the retail market (which has impacted margins). While ultimately it will be at the Government’s discretion on which recommendations to enact, it is worth considering the potential implications from a number of these to the large vertically integrated incumbent operators in the market, AGL Energy (AGL) and Origin Energy (ORG).

ACCC ‘Achievable’ Residential Bill Savings By 2020-21

Source: ACCC
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The ACCC recommended that any company with more than a 20% market share in generation be prevented from growing further via acquisition (AGL and ORG are above this level in NSW, while AGL has a 30% generation share in Victoria). While this may impact the growth strategies of both companies in the future, it is unlikely to have affected the share prices or earnings forecasts for either given that this would have been the base case assumption.

A further recommendation proposed that the Government underwrite new generation capacity at fixed prices beyond the first five years of new projects, suggested at $45-50/MWh. This offer would only be available to smaller market participants with low market share to encourage competition in the generation market. This price is somewhat below the current estimated marginal cost of production and that required to induce new generation investment.  Consequently, this has been judged as unlikely to encourage new investment.

The most contentious recommendation revolved around a light re-regulation of retail pricing and this clearly has the potential to have the most significant earnings impact on AGL and ORG. The current complicated structure of pricing in the retail electricity market makes it difficult to compare any offers with one another. The ACCC has suggested that a ‘default market offer’ is created in each market at a price set by the Australian Energy Regulator (AER), which would be the maximum that each retailer could charge customers.

Without knowing what price would be set by the AER, it is unclear what the downside is for AGL and ORG. However, this default pricing offer may not necessarily be much different from current market pricing; if it were set too low the risk would be that smaller retail operators would be squeezed out of the market as they do not have the advantages of scale benefits, incumbency of market position and vertical integration that ALG and ORG enjoy. While retailer gross margins may be reduced in this scenario, it may be possible that AGL and ORG could offset these with increased market share and potentially less spend on retaining and winning new customers (which is particularly high in Australia given churn rates) following the greater transparency in pricing plans.

In aggregate, the ACCC proposals (if implemented) have been judged to have only a modest impact on earnings, yet the initial market reaction was more significant, perhaps reflecting the possibility of a sharper downside risk. This uncertain regulatory outlook has the potential to weigh on their respective stock prices in the short term, although we would note that neither AGL (on 13x forward earnings) or ORG (on 11x) is priced for a particularly bullish scenario going forward and fall squarely in the ‘value’ category of the market.

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