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WEEKEND LADDER

A summary of the week’s results

15.03.2019

Week Ending 15.03.2019

Eco Blog

- There are early signs of stabilisation and, in some cases, improvement, in economic data. The growth rate is unlikely to match the past, but the imbalances that were or could have become problematic are also being muted through lower growth and policy measures. As evidence is the relatively disciplined approach of US households, the low-key stimulus in China and the changing mortgage market in Australia. Recession talk can be expected to be deferred for now.

- Australian residential property prices have come under pressure and while commercial property is showing some signs of softening, there are some sectors that are going against the trend.

The economic outlook has reached an interesting period. A glimmer of positive data is appearing in the US.  The NFIB small business survey hints at stabilisation, with no indication that credit is becoming harder to get, or a change in the trend for selling prices and worker compensation. A larger gap has opened between employment intentions and the availability of appropriate applicants. This parallels the lower jobs growth data, which can be expected to remain patchy at best, given the low unemployment rate and mismatching of skills.

Mortgage loan applications have picked up in line with the lower mortgage rates, given they are aligned to long term bonds. The aggregate number belies the important trend in purchase applications. Unsurprisingly, refinancing peaked when rates hit a low 3.2% in 2016 and have tapered off, with the current 15-year rate rising to 4.13%.

New home sales have recently flatlined between 600k-650k a month. There is a notable shift in regional variation, with almost all growth in the south and west. The Midwest and Northeast have accounted for less than 20% of new homes in the US for more than four years.

Source: Mortgage Bankers Association/Haver Analytics
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A promising data set was the value of construction activity, with a big jump in the value of public sector buildings. The persistent commentators on the third world nature of US infrastructure will be heartened by the 12.7% year on year increase in highway construction value.

This may gain ground in coming months. The US budget allows the President to redirect unspent departmental allocations in any year. It is suggested this will be bundled into an infrastructure spending package, unsurprisingly in keeping with the 2020 election year.

China, too, has shown early signs of a cyclical transition. Not only are there indications some trade arrangement will be struck with the US, but the data in China is stabilising. Retail sales pickup up across Jan/Feb (for China these months are aggregated to take out the timing of the Chinese New Year), rising by 8.2%. The mix caused some interest, though short term trends can be noisy without meaningful impact. Cultural and office product sales (an odd combination) increased 8.8% year on year, so to did communication equipment, cosmetics and catering. More critically, credit growth has been rising in response to the government incentives for lending to small business and housing.

Loan approvals (12 months advanced) and total social financing growth

Source: Longview Economics, Macrobond
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To be fair, there is not yet an overall change in momentum and many point to a weak pattern in industrial production, exports and employment. Nonetheless, there are indications that by around mid-year the China economy is likely to fulfil the widespread view that it has already bottomed.

One issue below the radar is that if there is a trade agreement with the US, the slump in exports may reverse as US importers are given clarity on duties.

Locally, we have not entirely been left behind. There are indications that the mortgage sector will regroup in coming months. The government flip on mortgage brokers is one aspect, but fundamentally there are also signs of change. The bulk of the restructuring of lending standards will annualise in coming months and consistently banks make the point that their approval ratios have hardly changed; it is the volume of applications that has resulted in lower mortgage growth. ANZ notes that borrowing capacity has notionally been cut by over 20% due to changes in income recognition and risk assessment, but that only 11% of borrower exercise their maximums. The fall in interest-only lending has been sharp. From a peak of 42% of all loans, it was only 13% in the last half year, well below the APRA requirement of 30%.

Stepping aside from housing, the government is in line to receive its own little boost complements of tax payers, mostly due to bracket creep. On the other side of the equation, welfare payments are at an all time low. One can debate the politics of welfare, but the impact of negative real distributions unquestionably has an impact on household spending.

Source: ABS, Deutsche Bank
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The probability of fiscal support into the second half the year is without debate, it’s a question of size and the form.

  • Corporate earnings growth may also be at a near term low, yet the consensus is likely still too high given profit margins are under increasing pressure.

The office sector has continued to perform well returning 13.7% over 2018, led by Sydney and Melbourne with total returns of 15.5% and 13.4%, respectively. National CBD office vacancy rates decreased, underpinned by Melbourne and Sydney, with the tightest markets in 10 years. There was a strong take-up of vacant office space with net absorption having the strongest year on record since 2010.

Office Market Indicators – December 2018 Quarter

Source: Charter Hall
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These record low vacancy rates will continue to drive office rental growth. This will counteract the lack of the cap rate compression of the past two years that results in above average capital growth returns. The national weighted prime office yield compressed from nearly 6% to 5.65% in 2018. The rate of yield compression is expected to taper in 2019 and investors should focus on the income yield.

  • Charter Hall Direct Office Fund provides exposure to a diversified high-quality office portfolio, with a focus on long-term leases. The portfolio has a yield forecast of 5.6% with a weighted average lease expiry (WALE) profile of 8.6 years and occupancy of 99%.

Fixed Income Update

- Prices rise on Australian fixed rate bonds (benefitting long duration funds) as further rate cuts are priced in. But will the RBA deliver a lower cash rate?

- Floating rate bonds see coupons set lower as BBSW falls.

The conservative investment approach for fixed income assets over the last few years was to limit interest rate risk. Short duration strategies have been favoured whereby the coupons on floating rate bonds reset each quarter in line with the underlying benchmark rate i.e. BBSW in Australia and LIBOR in the US. This differs to fixed rate bonds in which the capital price will be impacted when benchmark yields move, resulting in interest rate risk. In both cases, prices are affected by changes in credit spreads.

In hindsight, by opting to take on interest rate risk, one would have enjoyed the capital appreciation that ensued as Australian yields tumbled. Long duration Australian bonds performed strongly (comparatively) in 2018 with annual returns of nearly 5%. Following the correction, it appears rates may have fallen too low and are now unattractive for investment (The Australian 10 year government bond yield has fallen to 1.97%). This hinges on whether the futures market is correct, reflecting a 70% chance of a rate cut by September. Value is determined by a judgement call on several factors: whether the RBA will in fact deliver on these outcomes; or whether low yields are warranted and may fall further.

Movement in the Australian bond yield curve in last 6 months

Source: Bloomberg, Escala Partners
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A speech delivered by the RBA governor last week gave little insight as to the likely direction of rates. On one hand he said, “A cash rate of 1.5% is very low historically and it is clearly stimulatory.  It is supporting the creation of jobs and progress towards achieving the inflation target.” He did note, however, the weak GDP (0.2% Dec q/q) which led to the final comments, “We have the flexibility to adjust monetary policy in either direction as required. There are plausible scenarios under which the next move in interest rates is up. There are also plausible scenarios under which it is down. At the moment, the probabilities appear reasonably evenly balanced.”

With rate cuts priced into the yield curve, the market doesn’t view the probability as ‘evenly balanced’. A growing number of investment banks are suggesting one to two rate cuts this year. Others take the view the RBA will also consider quantitative easing as the next policy move. The case for staying on hold is based on the central bank’s reluctance to use its remaining policy scope unless economic conditions deteriorate sharply; a rise in unemployment would be the likely trigger. Instead the central bank sees fiscal policy to be the main driver of support for growth within the economy, which will come into play post the general election.

  • A medium-term rate call with any conviction is difficult. However, in the near term we expect the cash rate to remain unchanged until after the federal election. We concur any cuts will be data dependent and only considered in Q3 or Q4, but our base case is for rates to remain on hold. With this in mind, we would not add to long duration domestic bonds, but instead maintain our current underweight position that offers a hedge to risk assets within a diversified portfolio.

Short duration strategies have not only missed out on capital appreciation as bond yields have fallen, but coupons have reset lower as the benchmark rate (BBSW) has fallen this year. BBSW (Bank Bill Swap Rate) is the rate banks lend to each other and is used to determine the coupons on floating rate securities. The 3-month BBSW moved lower for 25 consecutive days in January and February. It started 2019 at 2.09% but has reached a low of 1.84% at the end of this week. The factors contributing to this move are:

  • A change in sentiment to an easing bias. 
  • A surge in dividends paid out by Australian corporates this quarter. Reasons cited are increased profits and potential changes to dividend imputation under a Labor government, enticing companies to distribute prior to the election. This results in elevated liquidity in cash markets as the dividend payments is temporarily invested in short term fixed income products (bank bills, CDs, TDs) until funds are deployed into other asset classes. Corporate cash flows have also been positive while capital spending is low.
  • BBSW has followed US LIBOR rates, which have declined in 2019.

For investors in high quality investment-grade short-duration strategies, the fall in BBSW will have detracted from returns, but fortuitously this will have been broadly offset by a boost to performance from tightening credit spreads over the same period.

Corporate Comments

- In the quiet news period following reporting season, we highlight the list of companies that could benefit from what is likely to be a stimulatory federal budget in early April.

A slowing domestic economy over the second half of last year and into 2019 has placed a cloud over the outlook for many large cap Australian equities and resulted in many cautious guidance statements. Further, over the last few years, consumer spending growth has outpaced income growth, leading to a decline in aggregate savings rates. Consequently, the interest rate narrative has also moved from hikes to the possibility of an interest rate cut.

A fiscal kick is therefore an increasing possibility. The upcoming federal budget (2nd April) thus provides an opportunity for news on this front, considering the improved budget position and given that it will immediately precede a federal election. Below we highlight some stocks and sectors that would be beneficiaries if this occurred.

The retail sector is the most obvious beneficiary of a fiscal boost. Retail sales have slowed noticeably in recent months, particularly in department stores and clothing retailing. Currently, the earnings expectations for companies like JB Hi-Fi (JBH), Super Retail (SUL) and Harvey Norman (HVN) are quite low and the stock valuations are reflective of this outlook (trading on forward P/Es of 10-12X). A lift from the budget could help lift growth as well as support valuations, while short covering may be necessary from investors who have taken a bearish view. Our preference lies with JBH and then SUL, both of which reported respectable earnings (and sales figures that belied the broader economy) in last month’s reporting season.

We think that the investment case for other retailers, such as the supermarkets, is somewhat weaker. With their products less discretionary in nature, there should be a lower impact from increased money in consumer pockets while like for like sales growth is benign and competition is elevated. Cost growth has picked up again as wage rises are absorbed and valuations provide much less margin for error - Woolworths trades on a healthy P/E of 22x, while newly-listed Coles is on 17x.

Domestic tourism is another area that could be a winner from the budget. Several companies here are possible winners. Flight Centre (FLT) noted  some uncertainty in its core Australian business and a slowdown in the second quarter at its February results. With FLT’s international division performing well (and the translation of profits increased by a weaker AUD), domestic fiscal assistance would be welcomed. After rallying in the first half of last year, FLT has now declined to a point where it is appearing on value screens.

Qantas (QAN) is another in the tourism sector that could receive a temporary lift. The investment case is supported by rationality in the domestic industry, although we believe it is only suitable as a short term trading option.

Casino operators and wagering groups are other companies that would likely see higher demand from a stimulatory budget. Star Entertainment (SGR) and Crown Resorts (CWN) are reliant on domestic demand, although both are also exposed to the overseas tourist dollar. SGR has an appealing valuation and trends in the December half were also better than its competitor. Tabcorp (TAH) is another company that could see upgrades. We note, however, that synergies with Tatts Group (which are on track) are the key earnings driver over the next few years and there are some concerns over competition and margins within its wagering division.

Finally, the banking sector is another that could be supported by the budget. The areas in which this would be evident could include bad debts (which would be less likely to rise given the lift in household incomes), credit growth (the banks will soon by cycling tighter lending standards that were imposed from early last year) and even funding costs (higher consumer balances would equate to a cheaper funding source for the industry). While the net effect may be marginal, again this in the context of the current expectation of a flat earnings growth environment over the next few years.

The table below lists the valuation metrics of these companies. The common thread in the list is that forward earnings expectations are currently quite subdued and dividend yields are generally higher than broader market.

Current Valuation Metrics of Potential Budget Beneficiaries

Source: Bloomberg, Escala Partners
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