Week Ending 14.11.2014
With the release of Australian housing credit data and followed by dwelling prices, the inevitable commentary on the risks associated with housing surfaced once again. The opinions, however, appear to broach the issue from only one angle – either through the lens of the banking sector, or through the impact of high prices and the high concentration of investors rather than owner occupiers. In our view the two are different.
Domestic banks have manageable risks with respect to mortgage debt, based on the average loan to value ratios and with a relatively benign labour market. A meaningful increase in interest rates and/or a sharp rise in the unemployment rate would signal heightened concern. Even within the highly leveraged investor market, the risk of default for the banks is, in our view, relatively contained at this time, assuming these investors will service their debt as long as they believe there is a prospect of capital gain at some point. While this may not occur at all, or may take a considerable time to eventuate, we doubt this will influence them based on current settings.
On the other hand, the chase into investment property is doing far less for the economy than intended by the low rate environment. In NSW, the investor share of housing finance is nearing 60%, pushing owner occupiers out of the market. Higher investment property prices keep upward pressure on rents. This absorbs a growing proportion of income and, as recently pointed out by the RBA deputy governor, is at the top of the range experienced in the past couple of decades at 40%.
Investors Find a HomeEnlarge
If these trends continue, the pressure will build to enact macro-prudential policies, in other words, directly influence the nature of financing in the housing market. An example would be a higher risk weighted requirement for interest only loans, which are favoured by many in the investor market.
The wage price index for the third quarter came in at an annualised rate of 2.6%, the lowest since 1998. By industry sector, those working for utility companies managed the highest rise, at 3.2%, while the lowest was in professional services at 2%. Consumer sentiment, as measured by the Westpac/Melbourne Institute, edged up, though remains below last year. Households are relatively comfortable with their own circumstances while expressing doubts on the longer term general economic conditions. The demographic divide in confidence is notable, albeit not unexpected. Older, higher income cohorts are relatively upbeat, whilst young people, tenants and lower income earnings are losing faith in their financial wellbeing. A specific question on Christmas spending indicated that more (38%) are likely to spend less than the 12% which thought they might spend a higher amount than before.
For a prolonged period little seems to have changed in terms of household behaviour – saving rates remain stable, retail spending respectable but subdued, moderate activity in housing and a penchant for consumption of services and experiences rather than goods.
Along with most regions outside the US, the decision on rates is a major challenge for central banks. The Bank of England (BoE) is confronted with a declining inflation rate, now expected to be only 1% next year and indications the rate of economic growth is levelling off, yet is seeing accelerating wage growth (though at 1.8% per annum is measurably below Australia) and the risk of a weak Europe. Consensus is still for a rate increase in the first half of the year, edging ahead of expectations for the US, where the second half of the year looks more likely.
Even the People’s Bank of China (PBoC) is following central bank language in its quarterly release, stating that it intends to maintain a neutral stance and pursue adequate monetary policy. The subsequent October CPI of 1.6% has lowered the bar for the central bank to ease. The PBoC report also showed that the effective lending rate was 7%, leaving scope for official rate cuts to have an impact on the cost of debt capital.
The Asian economic growth outlook is likely to become a heightened topic of debate into 2015. Policy options for many of the countries are limited by their individual circumstances. If China sticks to its current stance that there will only be modest support for the property sector, GDP growth is likely to slip below the 7% mark during the year. Given high private sector leverage, any form of excess stimulus through easier credit would backfire in time and the authorities at this stage appear to be taking a longer term view.
India, as the next largest Asian economy, holds out much promise that it will become a powerhouse, contributing to global growth in the same way China has done. Based on the most recent data, India’s GDP per capita is approximately US$1,500 versus China at US$7,000 and, for reference, Australia at US$65,000. The total size of the Indian economy, based on GDP, is about the same as Canada or some 20% larger than Australia’s.
In comparing countries at the time they were the same economic size per capita, India has a low share of manufacturing, certainly in contrast to China. Consequently, India’s net exports per capita has actually fallen, largely due to a strong rise in imports. As an aside, some 25% of India’s trade deficit is due to gold imports.Enlarge
The weak manufacturing performance will require considerable change in attitude and support. India experts lament the condition of infrastructure and logistics, where only 40% of transport time is actually on the road, moving, the rest taken up by checks, stalled traffic, etc. Corruption and poorly performing government services are frequently mentioned. Recently the new government of Mr Modi has rolled out a website for 149 departments to track the attendance of the civil servants. For those that recall the somewhat colourful stories of Greece, this has a distinct parallel, with many officials now discovered to be rarely turning up to work at all.
Modernising the agricultural sector and coping with urbanisation is a massive challenge, yet essential to achieve the desired outcome. Nonetheless, India is presently in a sweet spot, set to show a modest acceleration in growth, while lower oil prices not only take the pressure off the current account, but have also dampened the negative effect of reduced fuel subsidies.
One intractable problem has been inflation which, has run at over 6% p.a. since 2005. The latest data, however, indicates that the entrenched price rises have potentially run their course level and inflation looks set to ease off further.
If the efforts to shift the Indian economy from its stupor of the past few years takes hold, it could well be able to achieve the best growth in Asia in 2-3 years’ time. A young, relatively well educated, workforce is a rare commodity in today’s world.
Indonesia is the other Asian country where a change in government holds out hope that economic growth could become more balanced. The offset is lower commodity prices and excess credit growth in recent years and an eventual uplift may be dependent on reforms which are more likely to hold the economy back in its initial stages.
Emerging market equities have underperformed developed markets in recent years. Concerns on the potential consequences of China’s property market and shadow banking made way for a broadly-based unease on the ability of these economies to grow without good demand for their exports and the risk to their funding position once the US pulled its easing. Most investment houses have a cautious view on expected growth for these economies, but do view the equity market as good relative value. For patient investors we believe a decent allocation to funds which can navigate their way through the idiosyncrasies of each of these markets and their representative companies makes sense.
Returning in that context to India, we prefer access through an active fund. As is common in small developing equity markets, the concentration is high. For example, the top 10 stocks in the benchmark Nifty Index represent 56% of total market capitalisation and sectors such as financials predominate. These markets, notwithstanding an attractive economic outlook, can also very quickly become overheated and appreciating their particular dynamics is important.
Myer (MYR) reported weak first quarter sales growth of 0.1%. The pace should pick up through the rest of the fiscal year as a number of major refurbishments are completed. While management have suggested they will be able to generate an increase in the bottom line this year, the combination of low sales, higher costs and competition from other formats make this a tough assignment. A flat net profit will see MYR tick over a fifth year of no increase in earnings. The floor to the stock is the potential yield of 7%, however the under performance of the stock price (-30% over past 12 months) is a good reminder that yield alone is an insufficient criteria for investment.
Some investors may be surprised to learn that DuluxGroup (DLX) has only performed largely in line with the ASX 200 Index this year, despite the strength in the residential housing market. In reality, however, its core paints business has a much larger exposure to the renovations market (approximately 75% by volume) as opposed to new housing (approximately 20%), with commercial markets making up the balance. While the existing home improvement market provides a relatively stable and predictable earnings base, it means that DLX will not be a significant beneficiary when the cycle in new housing improves. DLX’s participation is also typically late in this cycle, given when painting occurs in the timeline of a house’s construction. For the 12 months to 30 September, DLX’s EBIT grew by 12% on a comparable basis, adjusting for the full year contribution of its Alesco acquisition in 2012. Guidance for FY15 was somewhat ambiguous, with the company expecting profit to be simply ‘higher’ than FY14.
What has recently emerged in the paints market, is somewhat of a price war at the entry level range, initiated by Woolworths’ (WOW) underperforming Masters hardware chain in order to boost its market share. DLX currently claims that entry level paints only represent a small part of the overall market, and hence its premium paints will not be affected. Nonetheless, this will still be a test of how much consumers value a premium product when purchasing paints, with the differential between the two pricing points opening up. Parallels can be drawn from other industries whereby the market leader has suffered from aggressive pricing by a competitor, which typically results in either loss of market share and/or margin contraction. Investors will likely have to wait until its next half yearly result in six months for the first signs as to how its strong brand name has been tested.
Seek’s (SEK) Chinese subsidiary Zhaopin reported unaudited first quarter results, with EBITDA growth of 34%, a little better than expectations. After acquiring an initial 25% stake in 2006 for $US20m (valuing the business at $US80m and making a number of additional investments, SEK sold down part of the business earlier this year via an IPO on the New York Stock Exchange. On a mark to market basis, the value of its current 68% shareholding is approximately US$550m, which would account for more than 10% of SEK’s total market capitalisation. SEK has increasingly expanded its online employment market presence into new geographic regions, and it is these investments which have underpinned the strong profit growth of the company over the last three years at a time where the domestic employment market has been more difficult. The recent fall in the $A will be an added tailwind to these fast-growing international investments.
Computershare (CPU) was sold off after it retained its full year guidance (EPS growth of around 5%), yet noted that its “operating environment has softened since August”. CPU is a company that historically had a good track record of acquisitions within its core share registry business, however has sought to expand outside of this industry as further consolidation opportunities dried up, arguably weakening the earnings quality of the business. The company is also seen as a play on US and global interest rates, as it invests cash held on behalf of its clients in the short term money market. While this should be a positive driver for the company over the next few years, little movement in short term rates is expected this financial year. Further to this, the roll off of interest rate hedging is expected to be a drag on its first half result.
Incitec Pivot’s (IPL) full year result was ahead of consensus, with better earnings in both its fertiliser and explosives divisions. IPL has a large exposure to the US market, and the rise of the shale energy industry has been somewhat of a two edged sword for the company. Cheaper gas has contributed to declining US coal production, in turn, reducing demand for IPL’s ammonium nitrate explosives for the coal industry. At the same time, quarrying and construction markets (and the general economy) have been assisted by lower energy prices, thus boosting this component for IPL. Coal demand, however, still remains the primary end-market for IPL, and weak commodity prices could certainly lead to pricing and margin pressure in this business. The re-contracting of gas supply (a key input) at its Phosphate Hill fertiliser plant in Queensland also remains a risk for the company.
Suncorp’s (SUN) quarterly was mixed, with the bank appearing to sacrifice asset growth in favour of improved credit quality and a higher net interest margin. This trade-off between growth and lending quality will be important to monitor in coming periods as management look to sustain positive earnings growth, made more difficult by higher capital requirements. In terms of the impact to FY15 profit forecasts, the various effects look to have largely offset each other. The bank’s total lending declined by 0.9% over the quarter, with SUN highlighting an “increasingly competitive mortgage lending market”, however SUN still expects to see a return to lending growth in the December quarter. The shift in its LVR mix over the past year demonstrates this more disciplined lending approach:
Suncorp: Mortgages LVR Mix
With the likelihood of further special dividends in upcoming periods as it puts its ‘bad bank’ issues behind it, SUN is one of our preferred exposures in the banking and insurance sector.
Sector Focus: Real Estate Investment Trusts
The Australian property trust sector has been the best performing this calendar year, generating a total return of 22% as at the close of trade yesterday. So what has driven this performance and is there still value in the sector?
Corporate activity in the REITs sector has been particularly high over the last 12 months helping to lift the overall sector over this time. Over the past year we have seen Dexus Property takeover of Commonwealth Property Office Fund, the restructure of the two Westfield Groups, and the recent internalisation of management of CFS Retail Property Trust, which is now known as Novion Property Group.
A strong argument can be made that the sector’s returns this year have simply been a result of a further rally in bonds. Property trusts typically have a high correlation with bond prices (or an inverse correlation with yields) because they are seen as relatively defensive, high-yielding investments, and thus an alternative opportunity to fixed income to generate yield for a portfolio.
Valuations should also rise when interest rates are falling given the lower costs of debt for these companies. Since the start of the year, the yield on Australian 10 year government bonds has moved in a similar fashion to that seen in global markets, contracting from 4.24% to 3.32%. The correlation between this change and the appreciation in property trusts in the chart below is clear. What investors should be cautious about is the forecast movement in yields (taken from the average of Bloomberg forecasts) over the next 12 month period and how this could impact the performance of REITs:
REITs and 10 Year Government Bond Yield
The strong performance from REITs this year also belies the conditions in their underlying end markets. Broadly speaking, the sub-sectors of the REITs market are retail, office and residential. Some REITs focus on one particular sector of the market (e.g. Investa Office Fund), while others have a more diversified exposure across the various sectors (e.g. Mirvac).
Currently, two of these three in the domestic market, retail and office, are experiencing difficult conditions. A good indication of the relative strength of these markets is income growth, which gives shows the growth in rental income. For the six months to 30 June, income growth across the retail sector was approximately 2%, with this rate of growth halving across the last few years. The trend for consumers to direct more of their spending to services as opposed to goods has obviously been a poor outcome for REITs with a retail focus.
The office market has been under even more pressure in recent periods, with effectively zero income growth in the second half of FY14. The market appears to be well supplied, with lower occupancy levels, increased incentives for tenants and subdued demand have all contributed to this outcome.
Residential is perhaps the one bright spot of the market. As opposed to the passive investments in the other sectors, residential exposure is more transactional in nature, with profits realised from development income as opposed to rents. Robust market conditions, particularly in Melbourne, Sydney and South East Queensland have assisted Mirvac and Stockland in this area, however it should be noted that both are diversified REITs, with investments in other sectors of the market.
On most valuation measures the REITs sector presently does not represent compelling value. Three of the more important measures are net asset value (NAV), dividend yield and capitalisation rates. For a passive portfolio of assets, one would expect the security price of a REIT to approximate net asset value, as this should be a true representation of the portfolio. In reality, most REITs supplement their passive income earnings with either a development arm and/or a funds management division, both of which could add incremental value above NAV. Nonetheless, all of the major REITs are currently trading at a premium (of various quantum) to their respective NAV.
The dividend yield on the listed REIT sector is currently 5.2%, approximately 0.5% higher than that of the ASX 200 Index. While this is weighed down a little by large cap stocks Westfield and Lend Lease, the fact remains that there is other sectors of the market that offer better income returns, particularly when franking credits (lacking in the REITs sector) are taken into account. Capitalisation rates (which give an indication of the yield that a REIT is achieving on its underlying properties) are also particularly low at present, which points towards limited capital growth in the medium term.
Considering all of the above, we are comfortable retaining an underweight position in our model portfolios. We believe that there is other sectors of the market with a defensive/income focus for investors that offer a better outlook over the next few years.