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WEEKEND LADDER

A summary of the week’s results

14.07.2017

Week Ending 14.07.2017

Eco Blog

- Low inflation is coming under scrutiny as determined by global rather than local trends and, therefore, impervious to central bank policy.

- The AUD tracks higher. This can be attributed to commodities, China easing on credit, US mixed signals and domestic business confidence.

- Canada raises its rates. The RBA may well peer across the ocean given some similarities in the economies.

One of the largest investment houses in the world has a released a survey (US centric) of investors attitudes.

Amongst the usual issues is one that strikes at the inflation dilemma. Inflation is perceived as only a modest problem, but cost of living is the top risk. It is quite likely Australian phenomenon as well – measured inflation is low, but costs are believed to be high.

Top risk to Americans’ financial futures

Source: Blackrock
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This is not contradictory. As we have noted the CPI is clearly lower than would be expected at this part of the cycle, yet households feel and probably are, under pressure. No wonder they sit on cash rather than take risk (58% of ‘investable assets’ are in cash in the US). For some time, asset managers have waited for this wall of cash to come into markets. In reality, the respondents say they are in cash as they each have small amounts, want capital guaranteed, instant liquidity and ‘understanding of risk and return’ before they step into investment products.

This raises a host of economic and investment market issues. The Fed has been hanging out for a breakout in inflation. In a recent presentation, the Bank of International Settlements (BIS) notes that inflation is not behaving according to traditional economics. Historically, each countries inflation was driven by the output gap in domestic demand (mostly through rising wages as unemployment fell) with secondary effects from global dynamics. Now the pricing power of labour has diminished due to technology, service sectors and global manufacture.  Inflation is therefore a global, not local, phenomena and is converging regardless of individual growth and interest rates.  The chart shows that inflation trends in one country are much more closely correlated to others than in the past.

Source: Bank of International Settlements
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Unit labour costs can explain 22% of this correlation through global value chains. Even though service sectors are mostly domestic, the impact of global labour costs indirectly comes through the employment slack if any country’s unit labour in goods is excessive. The hollowing out of Australia’s manufacturing sector is a case in point. 

Central bank inflation targeting has recently proven ineffective, and may mean they will have to reset their mandates to GDP growth, wages and asset values. The close link between rates and inflation expectations will then fade and change a driver of the input to fixed interest assets.

To return to the survey, it also points to the conservatism of developed world investors. Their willingness to retain liquidity and security is paramount and points to the continued support for fixed income even if the headline return appears unattractive.

A raft of factors has colluded to drive the AUD uncomfortably higher. It is clear the RBA frets about the exchange rate in its capacity to determine financial conditions and rates. Amongst the likely culprits are:

- China’s credit growth has picked up and the government this week injected US$53billion into the banking system as analysts suggested the tightening in Q2 had gone too far.

- Commodity prices have bounced. Iron ore, in particular, is up over 20% in the month. The recent improvement in the trade balance should therefore get another boost.

- Hawkish central bank chatter has weakened the focus on the Fed and by default the USD. Further, financial markets remain sceptical that inflation is likely to turn, despite tight labour markets. Yellen moved on from describing the weak CPI as ‘transitionary’ implying that persistent lower inflation was now more probable. The Australian 10-year bond rate spread to the US 10-year, therefore, widened.

- The NAB business survey suggests the domestic economic outlook is respectable and is another pointer that the RBA is likely to stay put.

The consensus is that the AUD will remain rangebound in the mid 70c range with downside risk.

One issue to reconcile is the strength in the business confidence survey versus the subdued consumer sentiment also out this week. Based on the business outlook alone, the RBA would be more than comfortable to join other central banks and raise rates. Households are massively leveraged, taunted by low wage growth and focused on perceptions on their cost of living. Rather than focusing on inflation, the RBA will more likely be attuned to labour markets in setting policy and join other countries in the challenge to find the ‘right’ monetary policy for these unusual times.

In that context, the RBA may observe with interest the rate rise in Canada this week. This economy has similarities to Australia given resource dependence, structure of the housing sector. Unemployment is tracking 6.5% (though assessed to be 5.5% based on US equivalent measures) and inflation is 1.6%. The Bank of Canada (BoC) took the official rate to 0.75% from 0.5% and most expect another 50bp within the next year. The housing market has shown a similar pattern to that of Australia. In Canada that has resulted in a sequence of ways to limit the cycle. These include increased minimum down payments, a foreign national property transfer tax, closing down on capital gain exemptions on the sale of properties, rent control and a vacancy tax. Residential investment has stabilised and is forecast to fall into 2018. But conversely business investment has picked up. Sixty percent of Canada manufacturing sector exports go to the US and shipments are up 8% year on year (itself another marker of the momentum in the US economy). 

Any sense that the business sector here does indeed undertake more investment may have the RBA following the BoC notwithstanding the employment, wage and inflation trends.

Fixed Income Update

- Strong demand for Australian Residential Mortgage Backed Securities (RMBS) despite a potential downturn in housing prices.

- The bond sell-off continues with yields on German 10-year government bunds reaching their highest level in 18 months.

- Goodman Group announce the redemption of the GMPPA at next call date.   

The price growth in the Australian housing market has led to many commentators suggesting a correction is likely, particularly for inner city apartments in Sydney and Melbourne. The rating agencies Standard and Poor's together with Moody’s downgraded the banks in the last couple of months based on their exposure to the Australian housing market.

While the banks do have a rather large mortgage book, they are not the only provider and the housing boom has increased opportunities for many non-bank originators. These institutions often write loans to mortgagees that don’t fit the typical criteria of a bank, such as self-employed individuals, for which they will pay a higher interest rate. In order to fund these loans the non-bank originator will look to obtain third party funding, often in the form of a securitization deal.

Securitisation is where the cashflows from a collection of pooled loans are bundled together and resold to investors in a bond structure. Once pooled, the asset portfolio is divided into several tranches, each of which is sold separately as individual bonds. Similarly to the capital structure of a corporate, there are senior bonds, subordinated (called junior and mezzanine) and equity tranches which all offer a different level of risk and return. A typical prime RMBS structure is illustrated below:

Source: Pepper Investment Management
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Despite the negative press on the Australian housing market, including the RBA's latest quarterly data for household debt, which stood at 190% of annualized disposable incomes, the primary securitization market in Australia had another strong month in June. Four deals worth $4.1 billion priced over the month, taking the total priced in the public RMBS/ABS market to $18 billion YTD.

The solid demand for these securitized securities, in the face of mounting pressures in the housing market, is attributed to the support structure that is in place for the bond holders. When rating these securities the agencies assess the details in the loan pool, including the number of self-employed mortgagees, interest only, the number of investment properties, which are in self- managed super funds, the location of the loans, apartments vs houses, the loan to value ratio (LVR’s) of the mortgages in the pool, seasoning of the loans, the competency of the servicer, expected default rates, levels of subordination and excess spread generated. They then stress test the pool for probability of default which includes a rise in the number of mortgage defaults concurrently with a fall in house prices.  The tables show the apartment and house price decline that is estimated would need to occur before there would be losses to bondholders for a given rating by Fitch.

Source: Fitch, Aquasia
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Over the week, after a few days of reprieve, bond yields continued their trajectory led by European markets. The likelihood of less accommodative policies by the ECB has resulted in significant moves, with the German bund (bond) being one of the most heavily sold securities. Fueling the recent bout of selling was the results of a French debt auction, showing a drop in excess demand for 30-year securities. This pushed the German 10 year bond yield to its highest level in 18 months.

10-Year Government bund yield 

Source: Bloomberg, Escala Partners
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In the ASX listed market, this week Goodman Group announced its intention to repurchase all of the Goodman Preferred Step-Up Units (GMPPA) on the 2nd of October 2017. There will be no rollover deal for the $327 million redemption, which will be funded by existing cash deposits. Holders as at the 25th of September 2017 will receive par value together with the final interest payment of $1.414027 per unit. GMPPA will cease trading on the ASX on the 21st of September 2017.

Corporate Comments

- Another private equity group has thrown its hat into the ring to take a look at Vocus Group (VOC), although investors may be reminded of a similar scenario that played out poorly for Fairfax Media (FXJ)

- Telstra (TLS) has had further calls to cut its dividend from as early as next year, although a depressed share price may have already factored this into its valuation.

The battle for control of Vocus Group (VOC) continued this week, with speculation confirmed that a competing private equity non-binding proposal had been lobbed by Affinity Equity Partners. This followed last month’s approach from KKR, which had indicated that they were willing to pay $3.50/share for the company. Unfortunately for shareholders, Affinity’s initial proposal is at the same price and contains a long list of conditions similar to KKR’s, such as the company meeting its earnings guidance and staying within certain debt levels.

At this stage, both parties have been granted the opportunity to conduct due diligence, indicating that the Vocus board is open to the prospect of a sale process. This is somewhat unsurprising given the difficult year the company has been through in integrating its various acquisitions and the sequence of earnings downgrades that has followed. The best case scenario is that both parties are interested to the point that a bidding war emerges for the company.

With no guarantee that a formal offer will emerge, investors will likely have fresh in their mind a similar process that has played out with Fairfax Media (FXJ), which was left empty-handed after two competing private equity groups walked away from takeover discussions. The upside from a VOC turnaround is arguably greater than that of the FXJ deal, which was based on achieving an appropriate valuation for Domain once spun out of FXJ’s remaining assets, but likely so too is the risk. VOC currently trades at around the proposal price, indicating the level of caution reflected by the market.

While VOC has had its troubles in the last year, so too has the dominant telco, Telstra (TLS). This week an additional broker downgraded TLS’s dividend forecasts for FY18, implying a dividend cut will be necessary given the decline in the underlying earnings in its business and its approximate 100% payout ratio. TLS is receiving a series of one-off payments from the Federal Government in the transition to the NBN, which has been (and will continue to) inflate its reported earnings over the next few years.

TLS’s premium market position has recently been complicated by the high levels of competition across its core mobile and broadband products. In mobiles, it can no longer rely on the prior market share gains that it made and data caps have been increasing in mobile plans without a commensurate rise in pricing. Moreover, TPG will soon enter the market and is expected to compete aggressively on price. Broadband pricing has also come under pressure, with the various providers looking to win customers as the NBN transition takes place.

TLS is currently undertaking a capital allocation strategy review, with an announcement possible at its full year results next month. As such, the projected path for dividends may then become clearer and valuation support could potentially come through further share buybacks (most likely on-market given the company’s limited franking balance). Nonetheless, there remain ongoing earnings risks over the next several years as it looks to invest to plug the future gap in its earnings. With the current outlook for the telcos industry looking to be fairly challenged, the necessity of having domestic exposure for Australian equity portfolios to this sector is somewhat questionable.

Telstra: FY18 and FY19 Consensus Dividend Forecasts (cps)

Source: Bloomberg, Escala Partners
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After buying into the long-term growth China plasma market and FDA approval for an extension of one of its subcutaneous therapies, the price movement (-10%) in CSL (CSL) since peaking at $143 in late June may have investors worrying that they have missed a change in the fundamental outlook. Rather, it’s a reminder that when a stock is expensive (circa 30X P/E) any small batch of negative news can have an outsized impact. The first was a patent infringement challenge for its haemophilia treatment followed by competitor Sanofi acquisition of a flu vaccine treatment.

This stock is arguably the best regarded in the large cap segment of the market and widely held across defensive and growth styles. The drawdown does not change the thesis but is a reminder that valuation matters and that there are risks – the sector is prone to patent issues, plant closure due to production issues, price competition and regulation. We have no cause to believe that CSL should not be a core portfolio holding, yet it is a reminder that excess reliance on one or a small number of stocks for performance is potentially bad for financial health.

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