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WEEKEND LADDER

A summary of the week’s results

15.06.2018

Week Ending 15.06.2018

Eco Blog

Australian housing activity appears set to drift away for some time, with a combination of high prices, waning investor returns and tightening loan standards weighing on the sector.

‘Not there yet’ is the message from the latest US CPI release and there is no (current) case to be made to protect a portfolio from damaging inflation.

- The US economy is set to print robust GDP in coming quarters. The Fed has adjusted its guidance on rates accordingly. Conversely, European weakness is, if anything, becoming more evident.

The Australian housing market continues to soften, with loan approvals down 0.4% in April. Notably, investor lending is now down 15% year-on-year, while owner-occupied is up marginally at 2.4%. Average mortgage rates, according to the RBA, are stable, with competition holding down servicing costs. Demand is therefore reflecting other factors, such as a perception that capital gains are less likely.

Investor Loan Growth Eases

Source: ANZ
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Momentum in housing finance (if lagged by 4-6 months) is closely reflected in building approvals. While the pipeline of current activity will stretch into 2018, the contribution of home building to economic growth is almost certain to fall in 2019.

The long-standing NAB Business Survey showed a small decrease in confidence in May, implying some uncertainty on the outlook. Positive conditions remain strongly weighted to mining and the services sector, in contrast to the household-facing components.

Included in the survey is a question on the major influences on confidence. The variation across industries illustrates that aggregating data can distort the specific issues that face the corporate sector. Notably, energy costs are not as prominent as one would believe and global concerns are arguably sufficiently so far out of any company’s control that this rates low.

Drivers of Business Confidence (Q1 2018)

Source: NAB
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Jobs data for April was somewhat discouraging. The headline fall in the unemployment rate to 5.4% (down 0.2%) was accompanied by a decline in participation and a mix reversal from full time to part time roles. In total, average hours worked therefore fell in the month. The RBA has clearly indicated that wage growth is the critical factor in its consideration on interest rates. This data would suggest it is 2019 before it would consider an upward move.

April US CPI refuses to reflect expectations that price pressures will arise from the low unemployment rate. The headline rate increased to 2.8%, mostly due to energy prices (up 11.7% year-on-year). Core inflation edged up to 2.2%.

The disinflationary impact of core goods has persisted. Vehicles play a large part, with second hand stock weighing on the sector, but there is no sign of price movement across either household goods or apparel.

US Inflation

Source: Barclays
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Services prices have held steady at a 3% per annum increase for the past five years. Similarly, shelter (rent or owner-imputed rent, weighted at 33% in the CPI index) has also seen a consistent rise.

• Protecting an investment portfolio from inflation is a common theme in financial markets. The implementation, however, depends on the level and nature of inflationary pressure. In this recent cycle, commodities have been an appropriate allocation. If wages become the leading concern, floating rate fixed income and TIPS are best positioned.

The debate on why inflation is low usually comes down to globalisation and mobility of labour, demographics and the impact of technological change. The traditional economic principle of the Philips curve (the inverse relationship between unemployment and inflation) has yet to be observed in the US, where the low level of unemployment historically resulted in a wage rise.

Vanguard, amongst others, has attempted to disaggregate the disinflationary influences across various countries. Inflationary expectations are now commonly measured through survey data; if consumers do not anticipate price rises they tend not to demand higher wages. The impact is pronounced in Japan, along with its structural restraint on price levels. Globalisation, based on the differential between goods and services, has had a large influence in the US (as noted above).

The overall shortfall cited in the following chart is the outcome compared to each central bank’s inflation target.

Estimate of Disflationary Influences by Country

Source: Vanguard
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In the near term it is globalisation that may change the outlook for the US. The proposed tariffs will inevitably require a rise in US prices (or a fall in profit margins).  

US small business optimism is at its highest reading since 1983, based on their opinions on the economy, sales growth and investment. The members of the National Federation of Independent Business represent 24 million small businesses and create 80% of new jobs.

Credit availability is sound while the most pressing issue is labour quality. Yet, the willingness to raise wages registered with only 35% of respondents, not far off recent months. It may take a confluence of the rise in oil prices, possible uncertainty from tariffs and the incapacity to attract staff to see the investment programmes of small business curtailed. There are currently more job postings than available workers for the first time in history. More merger and acquisition activity could then be the path to growth, but brings with it credit risk.

Bullish sentiment on the US extended to the Fed. There were no particular surprises in its rate rise and assessment of economic conditions. The Fed projections are for a cash rate of 2.25-2.5% by year end and 3.0-3.25% by the end of 2019. The Australian cash rate will therefore progressively diverge from the US. While this should imply a weaker AUD, other factors are at play such as commodity prices and the improved current account. The dependence on the export sector is once again high.

Macro influences of the US rate hikes on equity markets have been mixed. The moves by the Fed and ECB (at least to the extent it is winding back its asset purchases) should encourage a view that economic growth is increasingly self-supporting. Yet, equities face another set of factors. Costs are rising, including debt capital, the pattern of demand from technological change and demographics is unabated and valuations are above average. Fundamentally the fall in bond sensitive sectors appears overdone compared to the view that other sectors will entirely escape the new outlook.

 • Equity markets are forward looking and appear less certain on the trajectory of growth and its character than is seen in economic data. The sideways moves and sector rotation may continue for most of this year.

Investment Market Comment

- The global information technology sector has dwarfed the returns of other sectors and as a result, there continues to be new launches of tech-focused ETFs.

Information technology makes up less than 3% of the ASX 200, opening a distinct gap for Australian investors to gain access to large tech companies. Conversely in the US, tech companies make up the five largest companies in the S&P 500 and 26% of the total index. This had been one of the attractions in global index ETFs, which have rapidly amassed nearly $500mn in funds under management in Australia.

Several ETF issuers have launched ASX listed products that follow custom made global tech indices, focusing on themes such artificial intelligence (AI), robotics and cyber security as well as the broader sector. As with any ETF, the underlying index that it follows needs to be carefully examined. In the specialised ETFs the stock selections may include small and speculative companies, as well as stocks with a limited exposure to the themes it has nominated.

ETF Securities launched the ROBO Global Robotics and Automation ETF (ASX:ROBO) in 2017, which offers an exposure to listed companies involved in artificial intelligence, robotics and the automation value chain. The index comprises 40% stocks that are described as ‘bell whether’ or majority related to automation, while the reminder has a ‘distinct proportion’ in this industry. It has been created by Robo Global, a company that has been established to develop such definitions.

Betashares has a self-describing Global Cybersecurity ETF (ASX:HACK). The product follows the Nasdaq index which is based on companies (currently 34) classified as cybersecurity as determined by the Consumer Technology Association. The weight is based on the liquidity of the stock measured by its three-month average trading volume.

These ETFs have a bias towards mid and small-cap companies as well as exposure to emerging companies, which can lead to liquidity pressures. They have performed relatively well since their recent inception; unsurprising given the profile of the themes and the generally strong performance of IT-related companies. They are, however, indiscriminate on 

whether the companies are doing well within their theme. Both have a higher concentration risk and high fees than broadly based index strategies.

ETF Securities also offers a fund follows the Morningstar Global Technology Moat Focused Index. It provides exposure to 25-50 equally weighted stocks that Morningstar determines have the greatest discount to fair value among firms with a strong sustainable competitive advantage in the IT sector. This ETF should not be considered passive, as investors are relying on Morningstar analysts to determine which IT companies should be included in the index. Additionally, with the GICS reshuffling in September and stocks such as Facebook and Alphabet moving to the telecommunications services sector, this fund could have no exposure to the FAANG stocks.

Market Cap Allocation of Australian-listed Tech ETFs

Source: Morningstar, Escala Partners
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To help reduce the risks associated with sector-based indexing, the Nasdaq 100 is a viable option for investment in technology exposure. This index has traditionally been known as the tech index, with a 62% weighting in technology stocks, or 73% if Amazon and Netflix are included (currently classified in the Consumer Discretionary sector).

Another issue with the above ETFs is that they have a limited exposure to Chinese tech companies, commonly known as the BAT stocks (Baidu, Alibaba Group and Tencent Holdings), which have had similarly impressive performance to their FANG counterparts in recent years.

FANG and BATs: Five Year Cumulative Performance

Source: IRESS, Escala Partners
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• With a history of boom and busts, care is required when considering tech ETFs. The niche products that follow megatrends, such as AI and cyber security may have questionable underlying indexes.

Fixed Income Update

The US-North Korea summit, together with a rate rise in the US, failed to move markets, while this week’s meeting and subsequent announcements by the ECB had a positive effect on bond prices.

 - We examine the ASX-listed NAB Income Securities (NABHA) and give our view of fair value.

There was little reaction in bond markets following the US North-Korea summit, with yields broadly unchanged. The next hurdle was the outcome of the US central bank meeting, in which the Federal Reserve Bank raised interest rates for the 7th time since 2015. In the accompanying statement the FOMC signalled that economic strength in the US economy would warrant a further two rate hikes this year. After each meeting the Fed then publishes the projections of the 16 members of the rate-setting body within the Fed (the FOMC), with each dot representing a member’s view on where the Fed Funds Rate will get to at the end of each calendar year, together with the longer run forecast. This was in-line with market expectations.

FOMC Dot Plots

Source: FOMC
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The European Central Bank also met this week and announced that they will cut its bond buying program (QE) in half (reducing from €30bn to €15bn) in Q4 this year and end it completely by December. Balancing this out, the ECB expect interest rates to stay at current levels through till June 2019. The market viewed this as ‘dovish’, with bond prices lifting (yields lower) across Europe.

The media (AFR) featured an article by one of its regular commentators stating that NAB Income Securities (NABHA) will lose its tier 1 status after 31 December 2021 and will then need to be franked.

The article conjectured whether this implied a cost of funding for such a security such that the bank may be forced to call it back (i.e. redeem the security). We take a different approach in forming a view of the worth of this security to an investor.

In 1999 NAB issued what is now known as NABHA. It qualified as tier 1 capital because:

1)            the bank could decide (subject to profitability) whether to pay the coupon; and

2)            it had no fixed redemption date, but a first call date in 2004.

The NABHA paid a (discretionary) cash coupon of 90-day BBSW + 1.25% every quarter.

In 2013 the new Basel III rules meant that the NABHA would, over time (10 years max) lose its tier 1 contribution to the NAB balance sheet. According to NAB’s recent half yearly report, that date is now 31 December 2021, following which this security will lose its tier 1 status, requiring the bank to pay 90 day BBSW + 1.25% franked, i.e. an additional 42% more income than prior to this date.

Given the circumstances, one needs to assess what is fair value for this security given the likelihood investors will then receive 42% more in income payments from 2022. The appropriate reference, in our view, is to use the existing listed NAB preference shares to extrapolate the new value of NABHA, as the conditions of payment (regarding the dividend) and structure of these hybrids are very similar to that of NABHA.

Source: IRESS, Escala Partners
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To find fair value for the NABHA, we use the above NAB hybrid curve and project out 11 years (our version of perpetual). From this we assume a fair value margin of around 3.90% to 4.00% for NABHA, which also includes franking from the end of 2021. By discounting back the cashflows over this 11 year period, in order to generate a margin of ~4% the NABHA’s would need to be priced at $86.45 (margin 4.0%) to $86.82 (margin 3.90%). This valuation consists of:

·         The cash component equal to:                            $64.66

·         The additional franking component equal to       $21.79

          (using a margin of 4.0%)

If we roll forward to the end of 2021, when all of the income is franked (and assuming that rates are still the same as now, as well as the margin), we get a forward price for NABHA of $90.70.

Based on the above valuation, we see the following options for NAB:

1)            It remains listed, with a valuation of $86.50 or better, representing value to the investor (this might not be an optimal use of NAB’s franking credits).

2)            They offer a replacement hybrid which would contribute to NAB’s tier 1 at 100%. The expected value in which they would redeem the NABHA securities would be around $90. NAB would benefit from the profit, as it is below their book value of $100.

3)            They could do an on-market buyback with a price limit of $90. Once again NAB would benefit from the P&L profit.

4)            Call the security for $100 on the quarterly call dates.

5)            Mop up the security for $100 once there are less than $500 million of Notes on issue

Options 2 through to 5 could be sometime prior to December 2021. Option 4 and 5 would imply a higher value than currently quoted above.

Corporate Comments

Challenger Group (CGF) has a bright outlook with growing demand for annuities, however this view does not reflect the margin risks as investment returns become more challenging. 

- A bid for APA Group (APA) appears likely to get approval from the target, however competition and FIRB approvals are a potential roadblock.

Challenger Group (CGF) has been identified as a higher growth option in the diversified financials space and the company hosted an investor day this week to give further detail on the outlook for its various divisions. As a stock there have been polarising views on its investment case.

The positives are somewhat obvious and well recognised by most investors. CGF is the dominant market leader in annuities in Australia, (sales have grown at a 17% p.a. rate over the last five years) and the forecast growth in the market is expected to remain high for the foreseeable future. The annuity market has several factors in its favour, not least the fact that demographic changes (i.e. an ageing population) has increased demand, as they are typically utilised in the retirement phase of a super fund. Further, the regulatory environment is becoming more supportive, with proposals in the recent Federal Budget that will likely incentivise the use of annuities, including for the purposes of means testing the age pension. While this could lead to new entrants to the market, CGF’s entrenched position and relationships are likely to see it remain the leading provider of annuities domestically.

The primary concerns raised over CGF are how it funds its growth and the margin outlook across its book to achieve its targeted 18% pre-tax return on equity. The investor day revealed that CGF’s investment portfolio would be reducing its exposure to property from around 21% to a “mid teens” allocation over the next 12 months. While the risk premium within property as an asset class has reduced over the last two years, this is also true of other alternatives, particularly in fixed income that is below investment grade after the contraction in credit spreads.

The following chart illustrates that CGF have gradually reduced its investment grade fixed income exposure over the last several years, lifting the allocation to riskier asset classes, such as property and equities (along with high yield fixed income). A lower property exposure (notwithstanding the realisation of shorter term profits from asset sales) would represent a change in course, although likely at the expense of higher return potential. The key takeaway from the risk premia chart is that targeted returns are harder to achieve in the current investment environment.

Challenger Investment Portfolio

Source: Challenger
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The key benefit from this change is that it will reduce the capital intensity of the business (CGF is required to hold more capital against its property portfolio), which in turn reduces the likelihood of any near-term equity raising to fund its growth.

The bullish view on the stock would suggest a robust top line outlook while balancing the two risks of investment portfolio returns and dilution from capital raisings. Those with a more less sanguine view on fixed income returns (particularly if credit spreads were to widen) are likely to remain on the sidelines. CGF’s P/E expansion from ~10-11X just over three years ago to 18X today suggests that the former group are holding sway.

A proposal for gas pipeline owner and operator APA Group (APA) this week showed that the appetite for Australian infrastructure assets remains, with a bid of $11 per share at a healthy 33% premium to APA’s previously traded price. From a price perspective, the premium offered would suggest it has reduced the probability of a rival offer emerging and will receive strong consideration from the APA board.

The key hurdles are likely to come from the ACCC and Foreign Investment Review Board (FIRB), with the politically sensitive topic of escalating energy prices for households and businesses throwing an unpredictable element into the mix. Notably, CKI has a history of investment in Australia and has hence dealt with these various regulatory bodies, potentially mitigating some of this risk. The group was recently successful in acquiring Duet last year, although was also unsuccessful in its bid for the NSW electricity privatisation the prior year. The stock’s ~12% discount to the proposal price reflects these various risks to the transaction proceeding.

APA has historically traded at a premium to other comparable domestic utility stocks given the light regulation of its asset base and has been a favoured stock for income investors given its relatively predictable distribution profile. While this being the case, APA had de-rated somewhat over the last two years, with valuations becoming more challenging in a rising interest rate environment. The offer price implies a forward EV/EBITDA multiple of 14.5X, which is at the high end of recent transactions for gas pipelines, although not excessive compared to its recent valuation range.

APA Group: Forward EV/EBITDA Multiple

Source: Thomson Reuters, Escala Partners
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