Week Ending 14.10.2016
• The focus is now very much on fiscal policy to back up monetary easing. Questions on what kind of spending is really required and the inevitable rise in government debt are becoming the topic de jour.
• The appropriate measure of economic growth should be GDP per capita or per working population. That would paint a different picture of Australia’s long period of growth.
The global scenario of lower for longer interest rates, no recession but low growth and inflation looks to be the textbook outcome for this year and may well repeat in 2017. Under these conditions, low investment returns are inherently logical, though as we have pointed out, events and market momentum cause a cyclical pattern in the trend.
Two risks that are noted are the potential for US rates to rise or monetary policy to tighten at a time economic momentum is waning. Unintended tightening can also occur through restricted bank lending, currency movements and capital flows.
The other is the increasing likelihood of a lift in fiscal spending. Many point to the deterioration in infrastructure, where an improvement could be positive for productivity. The aggregate data from developed countries supports that contention.
General Government Expenditure Composition 2007-16 (Rebased ratio to GDP, index 2007=100)
There are some that contest the notion that a major lift in capital spending can simply be the key to improving GDP. While there are always projects that have a robust business case, reminiscing on the glory days of 1950-60s capital works may miss the point. If this fiscal largess comes our way, expect considerable debate on what spending is the best bang for the buck.
In the meantime, government debt has continued to rise due to spending on other sectors, mostly services. This creates a dilemma. Should governments reduce support in these areas to accommodate more capital works, or should deficits be allowed to rise on the basis GDP growth will lift and stabilise the debt ratio? A reduction in spending on services is very hard to achieve, given obligations in pensions, inextricable rises in healthcare and a range of other ‘essentials’. That means that higher deficits are more than likely. Emerging economies are in no better position (albeit at a lower staring base) with the aggregate expected to be in deficit for the coming few years.
As we note in our fixed income commentary, Australia has for the first time issued a 30 year bond. With government issuance likely to increase to cover deficits, bond buyers are either central banks or those with long term liabilities such as pension funds. There are risks in both. Central bank balance sheets have now become inextricably linked with bond buying, compromising the discipline in rates setting the tone for markets. Those with liabilities are deeply into bonds as a benchmark, be it in fixed assets, with bond yields as the valuation parameter, or in equities, with duration (bond-like characteristics). Any change in the bond market now has substantial flow on effects.
The IMF projections for fiscal balances across the globe highlights the issue. Aside from Germany, no other major economy is expected to have a fiscal surplus through to the end of 2017 and likely beyond that.
Global gross debt to GDP sits at 84%. Developed economies are at 107%, while emerging economies carry a 47% debt burden. Net debt to GDP is 73% for advanced economies while the relatively large holdings in overseas assets lowers the ratio for emerging economies to 15%.
All this points to a tricky assessment of fiscal stimulus as a path to better economic growth. Higher fiscal debt is often associated with lower private sector debt (the Ricardo principle) and the application of those funds becomes highly important.
Higher domestic spending through government projects could be the path to higher inflation as the global deflationary impact of consumer goods will play much less of a role. Demand for skilled and relatively highly paid labour could see wage growth coming through well before any benefits from productivity emerge. In turn, that is likely to see the bond curve steepen in anticipation of monetary tightening and make fiscal deficits expensive to service. In the least attractive outcome, it results in stagflation.
Fiscal Balances to GDP
In the past weeks our banks have come under scrutiny given the high profile cases of mismanaging their customers. Below the radar is another set of issues; how they accrete income from a variety of fees. We are highlighting these without intending to join ‘bank bashing’, rather to show where inflation is taking place. Financial service inflation, covering a very broad range of activities, has been one of the most resilient. While the data shown below lags by a year, the trend in 2015 compared to the previous seven years is clear. The example of credit card fees illustrated the issue. The high level interest rate on debit balances may be visible; what is not is the increasing charges on non-revolving card holders. The example of transaction fees on any overseas entry has been raised. This may include an Australian website, but where the transaction is processed outside Australia. All of these charges in the fine print of a credit card contract is the source of growing fee income for the banks.Enlarge
It is no wonder that measured inflation is no longer representative of household experience.
Similarly, GDP is struggling to represent each country’s economic growth given the level of cross-border activities, consumption of services and how they should be valued. The CBA has released a report delving into the background to Australia’s good-looking GDP numbers. As they point out, the per capita data is far less attractive and the per working population figure is even less so given the fall in the participation rate. The recent recovery in real income growth in the following chart is a function of the fall in inflation and the modest recovery in commodity prices, but the contribution of productivity remains lukewarm at best.Enlarge
Fixed Income Update
• Bond yields have been rising due to changing messages from central banks, the increasing likelihood of a rate rise in the US and the possible emergence of inflation
• History was made through the issue of Australia’s first 30 year bond. It sets the benchmark for valuation of long dated assets and has attracted large foreign interest.
Global and domestic yields continue to push higher, causing bond prices to fall across the yield curve. This is mostly driven by talk of restraining central bank easing (particularly by the ECB and Bank of England), increased inflationary expectations and an anticipation of a US rate rise by December. In domestic markets the new 30 year Australian government bond issue (discussed in more detail below) has also put upward pressure on domestic bond yields. The Australian 10 year government bond yield started October at 1.90%, and is now at 2.23% and the 5 year yield has risen from 1.59% to 1.90% over the same period.
Australian 10 Year Government Bond Yield
The impact on the performance of the Bloomberg Composite Bond Index (the main benchmark for duration bond funds) has been quite significant given the high weighting to long-dated fixed rate government debt securities. This index is tracking at -1.1% in October to date.
In October, a negative correlation between equities and bonds has also been restored after the two moved in the same direction over August and September.
In offshore markets, the German 30 year bond yield is at its highest since the Brexit vote. The pound continues to tumble and Gilt (UK Government bonds) prices fell as inflationary expectations rose. Speculation about fiscal spending has raised the possibility that the UK is poised to increase the supply of government bonds, putting further downward pressure on Gilts.
In the US, 5 year treasury yields are up 0.15% in the month, and the 10 year has risen 0.17%. The chances of the US Federal Reserve raising rates in December is gaining traction, with the market pricing in a 67% probability. As yields rise and bond prices fall, the Barclays Global Aggregate Bond Index has fallen -0.66% for the month to date.
As pre-empted in last week’s publication, the Australian Government came to market this week with an inaugural 30 year bond issue. The demand was high, with the bookbuild showing $13.8 billion in orders for a $7.6 billion deal, pricing at a yield of 3.27%.
Interestingly, this bond attracted unprecedented buying from offshore accounts, which invested in over 65% of the issue. This is in contrast to the general decline in offshore holdings of domestic government bonds, with data showing that foreign ownership has slumped to 59%, the lowest since 2009. The rarity of a AAA rated sovereign bond with a 30 year maturity offers good diversification (the tenor would be particularly attractive to pension funds who have long dated liabilities) for offshore buyers, and the recent stabilization in the AUD would have been positive for demand.
Secondary market volatility for a bond of this length is untested in the domestic market, however, this part of the curve tends to be comparably stable in Europe and the US where pension funds are the major buyers and generally buy and hold.
Australian 30 Year Bond Investor Breakdown
Highlighting another new issue this week, CBA tapped the US market with a rare US$750m tier 2 subordinated fixed rate bond, with a final 10 year maturity and a call in 5 years (10NC5year). The order book was said to be at $3 billion and it priced at treasuries + 2.1%. The excess demand has already boded well for the bond’s performance, with it tightening 10 basis points in pre-trade transactions.
• CIMIC Group has bid for rival UGL, which has been timed opportunistically following some large contract losses at the target company
• Large caps Telstra and CSL both reiterated earnings guidance for FY17 at their AGMs
• The CEO of Vocus Telecommunications survived a leadership spill this week following an eventful few months
CIMIC Group (formerly Leighton Holdings) this week gave a boost to the engineering and contractors sector with an off-market bid for UGL. The bid was priced at a steep 47% premium to UGL’s last traded price before the offer was received. However, it appears to be opportunistically timed, given UGL’s share price has recently been battered by the announcement of material losses from two contracts for the Ichthys LNG project off the coast of Western Australia. The potential for further losses or provisions on these contracts lead to a greater focus on the company’s balance sheet and was no doubt contributing to UGL’s low valuation; CIM’s offer for the company has been made at a forward P/E of just 10X.
The engineering and contracting sector has been a favoured area for fund managers which have the ability to short sell stock, on a thesis of the roll-off of the resources construction boom, low recurring revenues and customers which have looked to cut costs as much as possible.
With commodity prices recovering off a low base earlier this year, several stocks within the sector have rallied strongly this year as earnings appear to be finally stabilising after a multi-year downgrade cycle. In this time, the sector has no doubt also benefited from a rotation into value given the low P/Es attributed to many of the stocks. We have held ALS in our model portfolios, which has traded in a similar manner to the peer group below, despite also having a significant non-mining exposure through its laboratories business.
Mining Services Stocks in 2016
CSL reaffirmed its guidance at its AGM of 11% constant currency growth in net profit. While the company did not provide clarity on the composition of its expected earnings growth, it noted continued strong demand for its plasma therapy products. Another lift comes from a more normal flu season, which has become more important since its acquisition of the Norvartis flu vaccine business, making CSL the second largest global player in this area.
While there was thus some cyclical reasons for CSL’s disappointing outlook at its FY16 results back in August, the bigger challenge for the company will be turning around the performance of the Novartis businesses, which is taking longer than anticipated. On a more positive note, the underlying trends in its core portfolio remain strong, with double digit sales growth in FY16. CSL also announced that it would conduct a further A$500m buyback over the next 12 months, adding to the group’s earnings per share. The benefits of CSL’s buybacks, however, are diminishing due to CSL’s expanded P/E multiple, although a lower cost of debt is still ensuring that this capital management will be mildly accretive.
Telstra (TLS) also held its AGM and made no change to its outlook for FY17. As we have previously noted, the key issue for Telstra over the next four to five years will be replacing the earnings gap that will materialise once the NBN build is complete, a figure which the company estimates at up to $3bn in EBITDA. This would represent an almost 30% decline from the group’s EBITDA in the last financial year. Achieving this in what is a fairly competitive telecommunications market will be difficult, whether it be via acquisition or growing market share.
Vocus Communications (VOC) is a smaller telco which has faced a few issues that have been weighing on the stock in the last few months. These have included the resignation of the company’s CFO, a large sell down of shares by a (now former) director, weaker earnings guidance provided by competitor TPG Telecom due to a lower margin NBN environment (something of which does not impact VOC materially) and this week, the resignations of two directors. The resignations followed a failed leadership spill from the two, who were the founders of Amcom and Vocus. The current CEO of Vocus was formerly head of M2 Communications, the third company that has been merged into the now existing Vocus business over the last 18 months.
Disagreement over the direction that a business should take is perhaps not overly surprising given the merged group had included parties from each of Vocus, M2 and Amcom who had been influential in their success over many years. While the loss of well-regarded people from the business is no doubt a negative for the company, it now provides clear air for management to execute on the large integration task ahead, something of which the CEO has had considerable success in the past. Nonetheless, the recent developments will likely have proved to be a distraction at the very least and so progress commentary at the group’s upcoming AGM and then at half year results in February will be keenly watched. While the stock thus carries some shorter term risk, it is now trading on a P/E discount to Telstra despite a far superior earnings outlook over the next few years.