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WEEKEND LADDER

A summary of the week’s results

13.10.2017

Week Ending 13.10.2017

Eco Blog

- Industry sectors that are enjoying reasonable conditions – construction and services – are featuring in consumer confidence and likely to be the main act in GDP growth.

- The inflation impact of higher energy prices will be evident in the CPI release.

- Housing debt concerns remain top of the risk list in Australia.

- Global growth accelerates in manufacturing.

- China’s People’s Congress is a unique event that is likely to be long on rhetoric but also a good guide on policy direction.

Some hope was pinned to the long running Westpac – Melbourne Institute Consumer Confidence Index which ticked into positive territory (just) for the first time in a year. The institute suggests the uplift was from certain employment groups, particularly ‘tradies’ and those employed in education and health. The rub was that overall family finances are perceived as deteriorating, which aligns with other surveys showing that 30-40% of households have no discretionary savings to buffer them through spending bumps.

The parallel to the apparent optimism from the construction trade sector is the likely contribution from housing activity and state based infrastructure spending that will reflect in GDP. Most forecasts are for an uplift in growth through 2018 from infrastructure, though housing is expected to detract over the course of the year.

It makes the forthcoming labour market data for Sept (19th Oct) and the CPI (25th Oct) more interesting. Bets are on that employment growth will continue its recent upward trend. The CPI is likely to be open to interpretation as energy prices will cause a lot of noise. The weighting of energy prices (electricity/gas) is 3.4% of the CPI. Total utilities are 4.4%. The CPI assumes a stable consumption pattern across the year, which is clearly not the case.

The CBA has delved into the debit and BPAY data from their customer base which shows that the average power bill is up 17.6% in Q3. Some is attributable to volume (the estimate is around 2.5%) and therefore the CPI impact should be 15%, which translates into a large 0.5% increase in the CPI alone and push the annual rate to over 2%. As CBA points out, the cost is akin to a tax which most households consider unavoidable and behaviour change is low and slow.

Consumer Prices

Source: CBA
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The share of energy as a proportion of household spending has steadily risen from around 2% to 3%. That may not sound like much, but implies the 1% was foregone elsewhere. Add to that the rise in other perceived non-discretionary items such as healthcare and education and it is no surprise households are judged to be in a tight spot. On the other hand, mobile and broadband data costs are falling by the day. Earlier this year this sector saw a surprisingly large fall in the US CPI and here, too, will be a drag.

The RBA is unlikely to react to a CPI bump from energy, indeed the opposite. Every such impost would cause it to reconsider the impact of a rate rise.

Repetitive reports with details on residential mortgages highlight the fine balance of many households.  In the housing investor market, reliance on negative gearing and interest only is a feature. Negative cash flow has been rising as prices have gone up and rental yields fallen. As APRA requires a conversion to principal payments at some time, the situation will not improve. This week the RBA expressed some comfort that the heat had gone out of the investor segment of the market. Too much attention to the nuances from the RBA may, however, miss the real issue. It is clearly in the bank’s interest to fire cautionary shots, while expressing longer term optimism. The likelihood the bank would ever suggest it really troubled by housing lending is low given the interpretation into rates markets may not be its intent. Housing finance data releases will therefore be another key watch point. 

It has become harder to find economic data that does not support the current trend in activity. Japan machinery orders (excluding ships and electric power) are up 17.6% over the past six months, with a notable uplift in the past three months. European industrial production for August was the strongest in the year, and the data to date has been better than expected. Germany continues to power along, with manufacturing output up 10.8% in the past three months, accelerating from 5.2% over the year to date. Italy proved no slouch, with growth of 11.2% in the three months to the end of August. Overall, the rise in output running at 5-6% is likely to be a tailwind for European corporate earnings and we expect the cyclical stocks in this region to post above expected results.

Euro Area IP Main Sectors Y/Y

Source: Statistical Office of the European Communities/Haver Analytics
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The China 19th Party Congress commences Wednesday next week. We covered some aspects in last week’s note and this week a raft of reports on the topic have come our way.

The 2,300 delegates will receive a report on the achievement of the past five years and lay out the board vision for the future. On 24 Oct the Central Committee will be elected, consisting of 205 members. Thereafter, this new committee will elect the 25 members of the Politburo and the seven Politburo Standing Committee. Most stress that big announcements are unlikely. Instead it is about the structure and power base of the key political decision-making bodies that are of interest. There is agreement that President Xi will centralise power and create the overarching ideology.

From a financial point of view, it will be the meetings of the Central Economic Work Conference that will paint the picture of economic policy. The view is that growth of 6-6.5% p.a will be the goal, but that this will come along with reform of the state enterprises, property curbs and a battle with pollution. Reforms do not imply privatisation, arguably the opposite, with greater control by the central authority as a potential outcome. The new Financial Stability and Development Commission will be tasked with controlling financial risk. This brings together disparate regulatory bodies and indicates coordinated financial policy that has been somewhat absent to date.

Fixed Income Update

- The US Treasury market stabilises following notable upward movements in yields in the last month.

- Low volatility in rates markets as yields trade in a tight range.

- Rate rises domestically in 2018 are priced in, yet market experts remain divided on the outlook.

- The suite of fixed income funds made available in Australia is growing.

The recent bond market rally, has all but reversed over the last month, with treasury yields some 0.30% higher over this period.  The Fed’s indication of another rate rise in December is perhaps the biggest catalyst for the move, given a tail wind by the prospect of the tax reforms getting through congress and inflation returning as wage rise and unemployment rates fall.

Yield on 10-year us treasuries in the last month

Source: IRESS, Escala Partners
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Despite hawkish comments by the FOMC and a strong indication that rates will rise in December (80% priced in by markets), the minutes of the Fed’s meeting in September revealed a number of policymakers who are concerned the weak inflation readings and if they are in fact temporary, with the committee divided on how best to respond. Several members wanted to see economic data that would “increase their confidence” of inflation closer to the Fed’s 2% target before they raise rates again. Others argued that if they don’t raise rates further they may end up behind the curve if inflation does jump quickly, resulting in the need to raise rates more quickly.

Volatility has been low across fixed income markets in 2017. Treasury yields have traded in a tight band at only 0.50%. This is much lower than the 55-year average of 1.50%, and the smallest range since 1965. Shallow rate moves despite two rate rises by the Federal bank is indicative of strong communication by the central bank and well telegraphed, gradual normalisation of interest rates.

Trading range of 10-year Treasury yields per calendar year

Source: BT
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Domestically, the possibility of rate rises into 2018 is gaining momentum with the probability of a hike assigned as 60% by the second quarter next year. The domestic yield curve has therefore shifted in the last three months. Forecasts remain divided on the prospect for rates next year, with variations such as ANZ predicting two rates rises while Westpac believes they will be on hold. This makes the domestic market more interesting, and we see trading opportunities for rates given the uncertain path for our market.

Australian Yield curve movements in the last quarter

Source: Blomberg, Escala Partners
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As Australia’s pension pool grows due to mandatory contribution rules, more global fund managers are opening up operations in the domestic market. Many Australian superannuation funds feel limited by the relatively small capital markets domestically and seek out offshore investments. This has resulted in varied fixed income strategies being made available, including the riskier styles such as leveraged loans, distressed debt, frontier debt markets and high yield now in AUD unit trust structures. While local fund sizes are small, they are part of larger strategies situated in offshore markets with the currency hedged to reduce volatility.  In turn they may cannibalise the allocation to local debt markets.

Corporate Comments

- Bank of Queensland’s (BOQ) underlying earnings were relatively flat, although showed better trends in the second half. Special dividends may be a feature in the short term due to its solid capital position.

- WorleyParsons (WOR) was able to make an acquisition at a reasonable price this week from a forced seller. The stock, however, looks to have run ahead of any recovery in global hydrocarbons capex.

- Mantra Group (MTR) has received a takeover offer that looks likely to proceed. The remaining options to invest in domestic tourism on the ASX are somewhat limited.

Bank of Queensland’s (BOQ) full year result was judged as solid given market conditions and gave a window into the upcoming reporting season of the major banks. As has been the trend across the sector over the last six to twelve months, however, a drop in bad debts was the key driver of higher earnings, with income and operating expenses relatively flat year on year. A lower tax rate also improved the bottom line. Dividends were unchanged, an acknowledgement that these profit drivers are cyclical in nature. However, shareholders were rewarded with a special dividend payment of 8c, which came as a surprise to some analysts, although helped the company to distribute some of the excess franking credits.

Bank of Queensland FY17 Earnings Summary

Bank of Queensland FY17 Earnings Summary
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The year was a tale of two halves for BOQ after it reported a disappointing first six-month result. The turnaround was evident in the second half, with mortgage repricing and lower funding costs assisting net interest margins, operating costs well contained and a return to lending growth with QLD seeing net migration from other states. Despite a better outcome, BOQ’s second half loan growth lagged that of broader system growth, at a multiple of 0.4x.

Regulatory developments have generally been favourable for BOQ and the regional banks in a relative sense – it is exempt from the new banking levy introduced by the Federal Government and its average mortgage risk weighting is higher than its major peers. With its share price outperforming the banking sector materially over the last five months, BOQ’s P/E has rerated and is now the most expensive bank in the market when historically it has traded at a discount. BOQ’s forward earnings profile is no better than the other banks, so evidently it would appear that a high value is currently being ascribed to the potential for further special dividend payments.

WorleyParsons (WOR) this week announced the acquisition of Amec Foster Wheeler’s UK upstream oil and gas services business with a 1-10 capital raising to fund the deal. The transaction multiple of 8.9x EBITDA appears to be quite reasonable given the trading range of WOR’s global peers.  WOR has forecast that it will be accretive to earnings per share in the first full year. The price paid was influenced by the fact that the owner (John Wood Group) was a forced seller due to competition concerns after it acquired Amec Foster Wheeler early this year.

WOR will now be among the market leaders in the UK North Sea oil maintenance market, although the region is classed as quite mature in nature, with few prospects for growth. WOR has had a mixed record in M&A activity of late. This could largely be attributable to underestimating the extent of the downturn in the global energy capex cycle. In the supportive market conditions of last decade, the company successfully expanded quickly through a number of deals that saw it grow into a competitor to the industry’s market leaders.

Like many resources engineering contractors that are dependent upon the capex spend of its customers, WOR has rallied off a low base in the last 18 months in anticipation of increased market activity following the rebound in the oil price. There is, however, little evidence that this is materialising; WOR’s own revenues were down 24% in FY17, although encouragingly, flat half on half and its work backlog increased.

Putting a ceiling on the turnaround is the likely return of US shale production should the oil price push higher from here. The link between WOR’s share price and oil is clear in the chart, although in the last six months it appears to have broken from this relationship, increasing the risks of a near term correction.

WorleyParsons and WTI Crude Oil

Source: Iress, Escala Partners
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In other M&A news, Mantra (MTR) received a cash takeover bid from French multinational hotel group Accor (owner of the Sofitel and Ibis brands) which it was quick to recommend just days later. The offer price of $3.96 per share represents a 23% premium to MTR’s last trading price before it informed the market, although the stock had previously risen on takeover speculation through the year.

The combined group would comfortably have the largest room inventory in Australia (~50,000 rooms), although the fragmented nature of the market and the rise of Airbnb may alleviate some of these concerns. While MTR has made some questionable decisions in recent times (such as expanding into Hawaii) this deal would remove one of the pure plays on domestic tourism on the ASX, an attractive long-term thematic.

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