Week Ending 15.01.2016
Deviating from our usual commentary on economic data, this week we will focus on the potential causes of investment market volatility.
To set the scene, however, it’s worth summarising what the economic world looks like. In broad terms, momentum is much as anticipated. Subdued GDP due to weak industrial production and constrained consumer spending is the case in most developed economies. On the other hand, the services sector has, if anything, increased in pace of growth. Households are cautious, notwithstanding a windfall from lower energy costs. While wage rises have been very modest to date, the growth in employment means overall incomes are rising at a reasonable pace. Household wealth is also in a relatively decent position given returns from investment markets and house prices.
While perma-bears will call out the risks of recession at the hint of softening momentum, there is no evidence to date that global economic growth is about to deteriorate. That is not to say we are sanguine on the outlook. Trade flows have eased considerably, inflation speaks for weak demand in many sectors, the global financial system is still not in great shape and political or central bank missteps could cause a multiple of problems.
Holding back the corporate sector is excess capacity in a number of industries. In particular there is excess capacity in basic manufacturing – steel, cement and the like. Low capital-intensive industries such as IT, healthcare and consumer brands have accrued substantial free cash flow which has often been deployed in acquisitions or capital management, rather than new investment. Even in retailing, store closures are the name of the day as consumer purchase through the web.
After good gains over three years, investment market performance started to deteriorate mid-2015. The rationale was said to be due to a combination of the sharper than expected fall in commodity prices, particularly oil, the initial devaluation of the Chinese renminbi in August and its unknown repercussions, the rate rise in the US and generally full pricing of investment assets compared to their long term average.
Our first comment on this is that there is always some problem in economic conditions or financial markets. When investment returns are rising, these get lost in the good news; naturally when markets turn, they get wheeled out as the cause. For example, while the aforementioned issues were arising, the US was printing consistently good employment growth, south Europe was demonstrating that it could come back from its near-death experience, the benefits of low oil prices to consumers were clear and easing from the ECB and BoJ was widely seen as an offset to the US rate rise.
With the missteps in China over the last few weeks, the finger has been largely in that direction. This week, however, discussion is turning to the health of the corporate sector overall. It is clear that at current oil prices, some companies in that sector are in trouble. Specifically, the US shale oil producers that invested heavily in new assets. As we have noted in our fixed income sections, the high yield credit market in the US sold off heavily due to the rising risk of default. Energy makes up some 16% of the high yield index and other commodities take that to 26%. Late last year, a number of high risk funds in this sector have liquidated or closed. The question is whether these problems are contained to those with commodity exposure or whether it is an early signal that credit has been too easy to access.
High Yield Energy Index Less Corporate Index (bp)
There is no question that companies, particularly in the US, issued debt at historically low yields. As interest rates fell further and spreads tightened (we have a section on spreads in our fixed income commentary later in the document for those that want a refresher), investors, hungry for income, fuelled the high yield sector through demand for such investments. It brings up the simple reminder that position in the capital structure and risk matters.
It has also turned the debate to the appropriate pricing of such instruments, the use of that debt and the risk in the corporate sector as many industries face rapid evolution. Even in US-based investment grade companies, leverage has risen. Buybacks, acquisitions and rising payouts have been in part funded by debt. While profit growth was relatively decent in recent years, it has levelled off considerably.
A meaningful rise in default risk in investment grade is unlikely at this time, but that may not prevent spread widening or outflows in the asset class if investors are unsettled by the volatility in returns. That would feed even more sharply into equities. We stress that we do not see any signal for a major deterioration in investment markets. The US, however, is likely to see a change in shape and leadership. Assuming greater restraint in credit growth, buybacks are likely to fade, mergers will be paid through equity issuance, rather than debt, and highly-valued sectors will come under pressure.
This underpins the view of many fund managers that other regions present better opportunities than the US at this time. In summary, the change in credit dynamics is likely to reinforce the view that the US equity market was somewhat overvalued. This reporting period from the US is possibly a good bellwether on the outlook.
Turning briefly to economic data, the US Beige Book, which provides a well-regarded qualitative survey of activity, indicates somewhat subdued growth across the states. Manufacturing is slowing, as well as the auto sector. Some of this may be due to the US$ strength in the past year, giving credence to the role of currencies and the battle to devalue in most other countries. Wages growth remains frustratingly low, resulting in comments from Fed members on low inflation, interpreted by markets to mean interest rate rises are likely to align with most expectations of possibly two more this year.
Locally, the labour market is clearly in reasonable shape, notwithstanding debate on the quality of the data. As an indication of the nature of employment growth, concentrated in services, youth employment in particular has picked up.
While there was a small recovery in investment housing loans in November, the clear indication is that housing’s contribution to economic growth will level off through 2016. What picks up that baton in 2016 is becoming a critical debate. The employment data and recent trends indicate that retail, tourism and other services may well help us avoid any risk of recession once again.
Fixed Income Update
As previously mentioned, we are reminding investors on the nature of fixed income assets given their current importance.
Within the fixed income sector there are two generic options available: namely credit bonds and government bonds. Despite falling under the same banner, the risk/return profile is quite different. Government bonds are a risk free option (near zero default risk), and, if held to maturity, will deliver a low fixed real rate of return. Credit bonds have a higher default risk, the amount of which will depend on the viability of the underlying issuer, and are therefore require an additional ‘spread’ above government bonds to compensate. Both government bonds and credit bonds will have capital movements throughout their term, but in a non-default scenario they will return principal upon maturity after paying regular coupons.
The capital movement in a long fixed rate credit bond is determined by movements in credit spreads and interest rates. Credit spreads and interest rates (as represented by government bonds) are negatively correlated, so an adverse (widening) movement in the credit spread often means a positive move for interest rates. Depending on the issuer and the size of the moves, this often results in somewhat stable pricing of the underlying securities as these two factors can offset, or partially offset each other.
There is a strong correlation between the equity market and credit spreads. As equities have been falling since the start of the year, credit spreads have also widened. Both represent a risk-off trade. However, the impact on long fixed rate credit bonds has been quite benign, as they have enjoyed some cushioning on a falling price as the rates market has rallied.
Bloomberg Composite Bond vs ASX 200 This Year
The chart above shows the performance of the 5 year Bloomberg Composite Bond Index vs equities in the last two weeks. While this may not be a true reflection of most investors’ fixed income holdings (as its weighting towards government bonds vs credit bonds is ~ 80/20) it does illustrate the stability of bonds, both government and corporate, during equity volatility.
The market view that the RBA will ease rates further this year has increased slightly this week given concerns around China. The pathway for further rate cuts is priced in towards mid-year. The logic here is that it will give the RBA time to assess the continued drag on energy costs, deflationary pressures and risk of further market contagion from China. Though consensus is that they would prefer the lower Australian dollar to ease financial conditions, not the level of the cash rate. Despite this, the futures market is currently pricing in a 68% probability of a 25bp rate cut by the RBA by June this year.
Turning to other issues, the process of securitisation involves creating investment securities out of cashflows. The most common form is residential mortgage backed securities which in its modern format was first brought to market in the 1970’s. Auto loans and credit card receivables followed in the mid 1980’s.
This week’s death of musician David Bowie brings to the fore the innovative impact that he had on the securitisation sector of the bond markets. In 1997, Bowie sold a $55m asset-backed security, called "Bowie bonds", which were bonds securitised against the future cashflows of his royalties for the next 10 years.
He struck a deal with record label EMI which allowed him to package up and sell bonds on royalties for 25 albums released between 1969 and 1990. These bonds paid a fixed annual return of 7.9% and were self- liquidating over the 10 year period. They were originally rated AAA by Moody’s, but were later downgraded to one notch above ‘junk’ in 2003. Despite this, the bonds went on to fully repay principal by 2007, whilst paying the fixed interest component.
These new style bonds created by David Pullman were the first of this kind, and paved the way for the creation of “Pullman Bonds”. Rod Stewart, James Brown and Iron Maiden have all gone on to issue similar structures. The table below shows the original terms for the “Bowie Bond”.
Origin Energy (ORG) this week announced the first shipment of LNG from its completed project in Queensland, while BHP Billiton (BHP) today reported a US$7.2bn impairment of the carrying value of its US shale assets. These events have coincided with the unfortunate timing of a new 12-year low in the oil price. Oil markets have been front and centre of investors’ attention in the early part of 2016, with few predicting the capitulation experienced in markets after a disastrous 2015, where the price declined by 40%.
The primary drivers of the falls this year (18% for Brent crude and 16% for WTI) are not particularly new; concerns over a slowing global economy and how this translates into lower oil demand, high inventory levels and the strength of the $US, the currency in which it is priced. The high level of financial market participation in oil as a commodity trade has also undoubtedly had an impact this year, with short positions at a high level.
As we have noted recently, oil markets currently remain oversupplied (estimates are at around 1mbl/day), a position which did not improve during 2015 despite lower prices. The initial catalyst was OPEC’s decision in late 2014 to engage in a market share war (despite falling prices) in an effort to push high cost producers out of the market.
US shale production was clearly a key target for OPEC, and while onshore drilling rigs in the US have reduced sharply in this time, this is yet to materialise in lower production levels. OPEC has held two meetings since, reaffirming this policy and effectively dropping its production caps (in which it had already been exceeding) late last year. Recent speculation that Saudi Arabia is considering a sale of some of its oil assets (most likely in refining) highlights the implications of the current environment for large oil-exporting nations.
The return of Iran to the market is imminent and is another factor that is being closely watched, with a decade of sanctions expected to be lifted in coming days. This is likely to add approximately 500,000 bl/d to the market within months, thus countering some of the expected declines that should be experienced from non-OPEC supply sources.
While the above issues may point to a continuation of the soft market conditions in the short term, several factors should provide support for an eventual recovery. Unlike some other commodities, where the demand outlook is somewhat clouded, oil demand is still growing in the order of some 1m bl/d each year, largely from growth in developing countries. The actual growth in the short term may be higher, given the demand boost from lower prices.
Investment has been cut significantly across the industry. According to a recent report from consultants Wood Mackenzie, the global oil and gas industry has deferred or delayed $380bn worth of new projects as companies prioritise cash flow maximisation in the current environment. Many of the large international oil companies have high, unsustainable progressive dividend policies (in a similar vein to BHP and Rio Tinto), further constraining investment.
The effect that this halt in investment spending will not be immediately apparent in oil markets given the long lead times of new capacity investment and projects already under construction are still likely be completed. The price to incentivise new investment is however much higher than the current price, with forecasts typically in the US$60-70/bl range.
Lastly, it could also be argued that little geopolitical risk is currently factored into the price and thus any one event could easily result in a price spike.
As a result of all of these factors, the expectation remains that, while prices may continue to be weak in the short term, ultimately a recovery will occur within the next couple of years. For direct equities, there remains a significant disconnect between what the forward curve is assuming for oil prices and the prices which are used by analysts in modelling cash flows for companies in the sector. Consensus forecasts, which typically lag moves in the market, are thus assuming a much quicker recovery in the oil price than what the forward curve would suggest. The chart below shows this difference in broker consensus and the forward curve for Brent and how this has changed over the last six months.
Brent Oil Price Forecasts
The implications for this are twofold. Firstly, if the oil price remains at these prices for an extended period, then this will inevitably lead to downgrades in the sector throughout 2016, putting further pressure on share prices.
Secondly, while equity prices will inevitably rise should we see a recovery, possibly in the second half of the year, the upside may be capped due to the fact that they are already currently implying such a recovery.
For the Australian equity market, the short term safety is in the lower cost producers and those with strong balance sheets. Woodside Petroleum (WPL) is the standout in this regard, although its longer term growth options are limited. Oil Search (OSH) is next best-placed, with a higher cost of production than WPL and higher debt levels, a legacy of its recent investment in PNG LNG, yet better growth options.
Santos (STO) and Origin (ORG) are similar in the sense that both are in the ramp-up phase of new LNG projects, both have raised equity in the last few months, and their production costs are also higher in a relative sense to the other large caps. While the balance sheets of STO and ORG have been strengthened by additional capital raised, the two companies still have their differences. ORG is better protected thanks to the retail utilities side of its business and the fact that it implemented hedges on its production for FY17. STO have noted a cash breakeven price (free cash flow after interest, tax and capex) of US$50/bl of oil at a AUD/USD exchange rate of 0.70, with a sensitivity of A$400m for a variation of US$10/bl. While this will reduce further in CY17 as its LNG project ramps up, it highlights the shorter term pressures that the company will continue to face.
In the upcoming reporting season, dividends will certainly be lower than previous reporting periods, however there will be an element of capex relief going forward following the wind-down of investment in Queensland’s LNG plants. M&A activity may again emerge during the year should we see some stabilisation in the oil price.
After sharp share price moves in the last 18 months, the energy index has fallen from a 7% representation in the ASX 200 to just 4% today and will thus have less of an impact on the performance of the average equity portfolio. We remain of the view that OSH is the best way to participate in the sector through its ability to survive the shorter-term turmoil and realise longer-term value through its future investment options.
Wesfarmers (WES) has made a £340m offer to buy the Homebase store division from Home Retail Group (HRG) in the UK. HRG had already received a takeover offer from Sainsbury, the supermarkets group which, in turn, was expected to sell the Homebase division were it to be successful.
The detail in the proposal suggests the transaction is likely to go ahead, giving direction to a long-anticipated path of expansion for WES. Homebase has struggled as the number two houseware retailer in the UK, behind Kingfisher’s B&Q. Sales have been falling, in part due to store closures, and profit margins have stayed in a 1-3% range for 10 years. The sales per square metre is weak and gross margins appear high, implying a lack of value in the offer. WES has licensed the in-house brands, Habitat, Hygena and Schreiber for a year, as well as maintaining the link with Argos, the other business in HRG that Sainsbury appears keen to acquire. WES has indicated it will convert the stores to Bunnings, both in name and scope. Importantly the current product range is skewed to home decoration rather than Bunnings’ ‘blokey’ product.
The subdued market reaction is in part due to the relatively small scale of the acquisition, but also discomfort on the prospect of WES stepping into international retail. Globally, there are only a small handful of retailers that have successfully grown across continents. Inditex, the owner of Zara, is one. High end luxury goods retailers appear to manage boarders. The likes of Ikea and Aldi are also successful global, but notably have the patience of a private company to achieve this. If WES does well in the UK, it would join this very small group. Another is Masters, however is on everyone’s lips.
The risk is that it also distracts from local issues, or at least is perceived to do so. Staying with the UK for the moment, after a number of years battling the discounters Aldi and Lidl, the mainstream supermarkets appear to have bottomed in terms of market share. But it came at considerable cost to margins. Locally, Coles is doing well, mostly given the malaise at Woolworths. If this group can stabilise under new management, Coles may find the competitive environment a lot more challenging.
For the moment, we support an investment in WES. The retail business is likely to have a good first half off the back of decent Christmas spending. However, we would limit the portfolio weight and remain mindful that these are not necessarily set and forget holdings.