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WEEKEND LADDER

A summary of the week’s results

14.09.2018

Week Ending 14.09.2018

Eco Blog

- As has been evident in the listed company reporting period, domestic corporations are doing relatively well, certainly from a cash flow perspective.

- Economic trends in the UK have a good degree of resemblance to those here. The practicalities of Brexit still lie ahead, and so too policy direction in Australia.

- More job vacancies than unemployed, a two-tiered property market and rise of services make for an interesting US economy.

Long established surveys of businesses or consumers have been a good indicator of how these components of the economy see their world. In both cases, the Australian questions to the respondents are based on conditions and confidence. Usually good conditions are paralleled by upbeat confidence. For the past two years, the pattern in the business survey has diverged. Corporations are quite comfortable with their own operations but have a relatively cautious assessment of the outlook.

Weak confidence is attributed to the potential impact from tariffs and the political turmoil. Neither is likely to be resolved in the near term.

NAB business conditions and confidence

Source: NAB, ANZ Research
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Another aspect is profitability, where both the ABS data on gross operating profit and the NAB survey are at elevated levels.  Cyclically high cash flow tends to go two ways; reinvestment in assets or acquisitions (which can result in falling profit margins as capacity and competition increases) or it being redistributed to shareholders.

  • So far, it is shareholders that have been the recipients and supports our bias towards Australian equities for income generation.

The economic pattern in the UK is proving to be relatively similar to local trends and the Brexit debate finds a parallel in our political instability. On the positive side, the household sector is enjoying an upturn in wages growth to 2.9% based on the latest data up from the mid 2% range accompanied by an unemployment rate of 4.2%. The downside is the fall in savings to support consumption, again replicated in Australia, and expected to contain private consumption into 2019. House price rises have also eased to 2-3% from 6% a year ago. Even the confidence indicators have a local feel. The spider web representation shows the positive view on personal conditions (a positive number), but the complete lack of confidence in the wider economy.

Consumer confidence (change from previous month)

Source: GfK, Barclays Research
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The feeble UK GDP growth of 1.3% is mostly due to the lack of private capital spending and the net trade deficit. Services are the mainstay of activity rather than investment capital with the tourism and hospitality sector, along with information and communications growing at a robust clip.

  • UK stocks are priced at a 7% discount to Europe and a 26% discount to the US. As always, the mix and outlook does vary considerably and without Brexit, the discount may linger, but the patient could be rewarded by selective stock picking given many UK companies are not highly reliant on the local economy.

US data is unfolding as expected yet reinforcing the probability the economy could overheat over the next year. Wage rates now look set to accelerate and the scarcity of appropriate labour is striking. The JOLTS report (job openings rate) is at a record 4.4% with particularly high demand from hospitality, professional services, education and health.  The number of vacancies exceeds the number of unemployed. 

US JOLTS report (job openings rate)

Source: Bureau of Labour Statistics/Haver Analytics
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The CPI, however, may still befuddle the full picture. Shelter (housing related), as the largest component, has been relatively subdued. Rent growth has moved up to 3.5% yoy, but recently high-end property rental rates have moved negative. This reflects a combination of supply and affordability. Overall vacancies are moderate at 5%, but for properties built in the last 5 years they are as high as 25%, based on census bureau data.

All indications are that the business conditions in the US are well on track to persist. The missing link is a bigger push into capital spending programmes. Some suggest this is due to the uncertain tariff imbroglio, while shortages of skilled labour to execute fixed investment is another problem. The reality is that a significant amount of job growth is in services, inevitably capital light. The payroll data from last week supported this contention – service producing jobs have been 80% of the total growth in employment in the past 3 months.

Source: Bureau of Labour Statistics/Haver Analytics
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  • The big test for markets is the interest rate outcome heading into 2019. The Fed may be confronted with a persistently moderate CPI, but yet observe the pressure building in other data sets.

Focus on ETFs

- Thematic ETFs can follow macroeconomic or demographic trends, however, investors need to determine whether these themes have longevity or are mostly gimmicks.

The growth in popularity of ETFs spurred by lower fees and competitive returns has been well and truly covered. This has driven providers towards specialization and thematic structures. On one hand it can provide a path to specific regions or countries that may not be easily accessible for individuals. However, there are also ETFs with an exposure to narrower sections of the equity market and has led to the creation of a wide variety of structures. 

When an ETF is established, it needs to ensure that it attracts enough funds to cover costs. Generally, an ETF of more than $100m would be considered a commercial outcome for providers, and if they fail to reach this amount they may be at risk of closing. Locally, the number is smaller as we are a fraction of the global component but that still does not mean they will be sustained. iShares Australia has recently announced that they will be delisting five ETFs with low levels of interest. In 2015 there were 33 new ETFs that came to market, the largest in one year and nearly 20% of the number of total ETFs currently listed. However, in terms of FUM these ETF only make up 7.5% of the total FUM.

Yearly number of newly ASX-listed ETFs (LHS) and cumulative totals (RHS)

Source: Morningstar, Escala Partners
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Another risk for these narrow-themed ETFs is liquidity during times of volatility. This was evident in the US earlier this year, with the now infamous VelocityShares Daily Inverse VIX short-term ETN (XIV.US). After the historically low levels in volatility in 2017, one of the year’s most crowded trades was shorting volatility. When the VIX spiked investors were not able to sell XIV and were left unsure of what value they would receive upon the forced redemption of this note.

Smaller ETFs that are focusing on a theme could again face liquidity issues.  The potential liquidity of the underlying stocks that make up these themed ETFs has to be assessed as some holdings can make up 10-20% of the fund.

Niche ETFs are usually created on the back of a topical theme. These themes are usually well and truly established by the time the ETF comes to market. Therefore, investing via an ETF typically means that an investor is a late adopter. An example is the cryptocurrency enthusiasts that were hopeful of a bitcoin ETF. Bitcoin spectacularly rose to $18,000USD towards the end of last year and coincided with 10 filings for potential bitcoin products to the U.S. Securities and Exchange Commission (SEC). Only last month the SEC finally rejected these ETFs while the price of bitcoin had fallen by 50% by then.

Bitcoin Price and timing of SEC decisions

Source: Bloomberg, Escala Partners
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Not only has there been an explosive growth in themed or macro-focused ETFs but also in rules-based ETFs, such Smart Beta or Multifactor. These funds follow quantitative screens that aim to offer higher returns or lower risks compared to that of traditional market weighted indexes. As an example, minimum volatility strategies aim for lower volatility and lower losses than the market during downturns. iShares launched four smart beta’s towards the end of 2016, including iShares Edge MSCI Australia Mini Vol ETF (MVOL). Since then, iShares Core S&P/ASX 200 ETF (IOZ) has had 6 negative months yet during those month MVOL has only outperformed twice.

Performance MVOL v IOZ

Source: Morningstar, Ecsala Partners
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Providers that use custom built indexes usually employ back testing to vindicate their proposal in the historical performance. These ETFs have no proven live track record and it is not uncommon to see the performance vary from the data shown from the tests.

  • Thematic ETFs can play a tactical role in a portfolio. However, it is important to understand how each product works, to avoid fads and fashion and be mindful of the sustainability of the theme and process.

Fixed Income Update

- The quality of assets in the securitisation market has improved since the financial crisis. We discuss these in light of a potential downturn in the Australian housing market.

- The 15th of September marks 10 years since Lehman brothers collapsed. We use this as a reminder of the application of losses for investors in different parts of the capital structure should a bankruptcy occur.  

Many of the fixed income mutual funds and superannuation funds have an allocation to the securitisation market, particularly Residential Mortgage Backed Securities (RMBS). While it is worth noting that both sub sectors have their place in portfolios, a recent report from Citigroup compares investing in RMBS and corporate credit, with their view favouring RMBS as a better risk reward option. The article focuses on the US market over a medium to long term.

In their findings they discuss the fundamentals of the housing market in the US observing:

  • Demand for housing in the US is strong due to the severe shortage of supply, low unemployment rates, and ‘pent-up demand from millennials’. However, it notes that prices may decelerate as low wage growth confronts affordability.
  • Mortgages within credit markets have de-levered relative to corporates which have increased debt levels in the last 10 years.
  • The Fed mortgage 90-day delinquency rate (those that have missed mortgage payments by more than 3 months) has been trending downward, falling from 9% in the financial crisis to 1% today.

Credit spreads by rating: January 2006 vs. June 2018

Source: BAML, Goldman Sachs Global Investment Research
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 While RMBS bonds are complex and difficult to understand, they are designed to be robust and protect the bondholder should the underlying loans become challenged. The structures and collateral quality of these deals have improved in recent years adding to their appeal. Specifically:

  • New deals now have more credit support through greater subordination.
  • Mortgage underwriting has improved since 2008 with underwriters tightening their credit approvals and becoming generally more conservative compared to the financial crisis.
  • Composition changes to commercial mortgage backed securities (CMBS) where the Loan to Value Ratios (LVR’s) have dropped significantly. As recently as 2015 40% of deals had an LVR ratio above 70%, this has fallen to around 10% of all deals.

The Australian RMBS market weathered the financial crisis well, with all bonds fully returning capital to investors upon maturity, despite significant price drops during the crisis. The avoidance of a domestic recession, together with the recourse nature of our mortgages kept default rates at low levels. 

In todays market, the fear of falling house prices in a backdrop of very high debt to income ratios has some concerned on the performance of domestic RMBS. In a publication in the AFR last week, the headline was ‘housing correction to get worse’. Unsurprisingly, the downturn could be bigger if lenders keep lifting mortgage rates out of cycle as well as the possibility of restrictions to negative gearing and rising capital gains tax on investment properties were there to be a change in government. The claim was that ratings agency Standard and Poors’ (S&P) will automatically downgrade RMBS bonds once national house prices decline by 10% or more. In response, S&P denied this, stating that it would not downgrade RMBS bonds based on this criteria alone as it also looks at a number of other factors on a deal by deal basis. This includes when the loans were originated, excess spread and subordination in the RMBS structure, arrears in the pool of loans and lenders mortgage insurance amongst other factors.

While a housing price drop may lead to credit spread widening for the RMBS sector, other factors would need to come into play before there is likely to be any losses on RMBS bonds, especially those that are of investment grade quality. Arrears would need to rise significantly given they are currently sitting at a low of 1.2% across public deals. This is only likely in the event of a spike in unemployment and/or a large uplift in mortgage interest rates. Further, given the amount of equity that mortgagees have in their homes, a function of higher LVR ratios demanded by banks during the loan approval process, together with some savings in offset accounts, a dwelling that is repossessed would in most cases be likely to pay the borrower back in full even with a correction in the housing market. 

  • For many of the above reasons the securitised market is still favored by fixed income funds that we recommend. Kapstream, Macquarie Income opportunities and Pimco will invest in the AAA rated tranches, whereas Aquasia will lend down the capital structure. While a housing correction may result in less attractive valuations, in the absence of high unemployment, we would see this as a buying opportunity for this asset class.

This Saturday marks 10 years since the biggest corporate collapse in history with the bankruptcy of investment bank, Lehman Brothers. While holders of Lehman subordinated bonds are still waiting for a return of capital, the senior creditors of the bank have been repaid in full (returning 100% of capital). This demonstrates the waterfall effect during a liquidation and the protection of capital offered to investors highest on the capital structure.

The prioty pay out in the event of bankruptcy

Source: FIIG
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Corporate Comments

- Macquarie Bank’s (MQG) presentation to global investors focused on the major change in operations over the past 10 years while also highlighting the challenge in valuing such an entity.

- Myer’s (MYR) now deep-seated problems are far from over, but a small break has come from a new debt covenant structure.

- There have been many comments reflecting on post 2008 financial conditions and market returns given the ten-year anniversary of the meltdown. We have added by referencing some sector standouts and also the very different outcome from the ASX200 price, market capitalisation and accumulation indices.

Macquarie Bank (MQG) gave a presentation to global investors. The structure of the company has evolved considerably over the years. The current business components and contribution to profit are as below:

Macquarie Overview

Source: Macquarie
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In 2007, the annuity style business represented 25% of total income while Australia was 47%. Today, the annuity component is 70% and Australia only represents 33%. Within the international income split, Europe and Middle East (EMEA) is the largest at 29%, while the Americas are similar at 27%. Asia is 11%, a fall from the 15% of 2007.

The Asset Management division is arguably the key in the medium term. Macquarie is the largest manager of infrastructure with 130 assets under its control on behalf of its institutional investors. With developed world infrastructure under need of renewal, the potential for private sector involvement is high as government funding is unlikely to be enough. The second division of interest is the asset financing. Of the $34bn in assets, vehicles, plant and equipment account for half, while the aviation portfolio is at $8m.

The combined divisions speak to the differentiation between Macquarie, other local banks and the global investment banks. Macquarie is an amalgamation of these entities with a relatively traditional small banking service melded in with investment banking (similar to Goldman Sachs), but also an asset management component that fulfils a unique role.  This is matched by a forecast P/E multiple of 15X for FY19, a roughly 30% premium to global banks. 

  • To justify the valuation, investors turn to a sum of the parts which relies on comparable multiples for each of the divisions. It highlights the challenge in valuing such companies where the share price instead reflects scarcity premium and the positive view of its business model.

Myer’s (MYR) full year result could not have been a surprise given the recent track record. Total sales fell by 3.2% for the year with the concessions and Myer exclusive brands well below par. A margin squeeze was inevitable and EBITDA declined by 25%. Net profit before ‘one off’ charges halved, though the extent of costs nominated as an unusual item and other restructuring items pulled the net reported loss to an eye popping $486m.

Myer’s significant items and implementation costs

Source: Myer
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The only positive aspect was that cash flow was stable with working capital flat and capex down 20%.  The fixed charges (including rent) cover skimmed across the line at 1.59X versus the required covenant of 1.5X.  A renewed facility has tighter terms than before, but does see the group through to 2021, subject to meeting the criteria.

It is now up to the new management team to resurrect the group. The CEO is ex House of Fraser, while more recently has been consulting in the US.  The suggested plan to revive the group is somewhat generic - improving customer experience in store, simplifying the business model and getting the brand proposition right. Online sales, at 7.7% of total, are a bright spot and likely be a major point of focus.

  • It is hard not to conclude that the challenges for this business lie ahead as much as they are behind. Yet recently a small number of ‘old style’ global retailers have regained their footing. In the adage, its not over until the fat lady sings, the outcome is not evident yet, but we are nearer the conclusion.

Given the anniversary of the global financial crisis as benchmarked by the collapse of Lehmann Brothers, we have reflected on some equity returns over the past 10 years.

Few would have made a case for three telecommunications companies to be in the top 20 performing stocks in the past month and the sector is now in the lead for this quarter with a 17% return. It barely makes up for the sequential underperformance of the past year but is an example how quickly judgement of conditions can change. Even over a 10-year time frame, telco’s has been a better ‘set and forget’ index outcome than resources. But that does not mean holding Telstra was the answer, it is the newer telco stocks that have kept the sector alive.

Resource stocks are invariably more volatile than other sectors and within specific time frames would have been on top of the list. To participate, it would have required a hefty weight towards stocks such as Northern Star, Sandfire or Syrah rather than BHP or RIO.

A similar argument applies to the financial sector. It has outperformed the ASX200 over the 10 years, but only due to stellar performance from stocks such as Challenger and Macquarie Group rather than the major banks.

ASX200 Accumulation and selected sector rolling returns

Source: Bloomberg, ASX
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Healthcare has been the cure for any equity malaise over the past decade. Yet, the path has been much more variable than many would recollect. The sector held up well through the depth of the 2008/9 sell off, but only marked time during the strong recovery into the following years. There have been a number of periods healthcare has underperformed the ASX200 index or merely held pace.

Monthly 1-year rolling returns

Source: Bloomberg, Escala Partners
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The take-out from these comments is that we do believe long term investing is a critical part of participating in equity markets, but that the oversight of stocks in a portfolio is just as important. The invariable flaws are stocks held due only to tax considerations or familiarity.  Actively managed  direct (and hopefully with tax consequences which implies a gain) or SMA’s/managed funds are, in our view, the optimal portfolio for Australian equities. Passive suffers from sector and stock weightings biases that are hard to screen out.

A final comment is in the debate between global and local equity markets. One key feature of the consequences of the 2008/9 period was the substantial capital raised by local companies with unsustainable debt levels and the inadequate capital ratios in the financial sector. This is evident in the differential between the ASX200 price index and the ASX200 market cap index, the latter a function of price plus new capital from investors. Further, the high payout ratio relative to global companies means the accumulation index for the ASX200 is a vastly different experience to the price only index.

ASX 200, ASX 200 Accumulation, ASX 200 Market Cap growth

Source: Bloomberg, Escala Partners
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