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WEEKEND LADDER

A summary of the week’s results

15.07.2016

Week Ending 15.07.2016

Eco Blog

The Australian Labour Force survey (June 2016) suggests ‘steady as she goes’ economic growth. The unemployment rate ticked up to 5.8%, but the mix of jobs improved, with solid gains in full time employment at the expense of part time work. Wage costs are barely rising and hours worked have declined in the quarter. This has two implications. Firstly, the CPI (due in late July) will be untroubled by labour costs, paving the way for a rate cut. The second consequence is that household income growth will remain lower than in the past, particularly given tightening of benefits and low yields from income assets.

Business conditions have maintained their upward trend, though the overall level of activity is patchy at best. The industry breakdown in the NAB Survey shows that the mining sector has had a sizeable recovery in confidence. Given the movement in commodity prices and reduction in costs in the industry, it is no surprise that participants are expressing greater optimism. Among the other sectors, retail and wholesale trade confidence is very subdued, but personal services made progress reinforcing the changing household spending pattern. 

Economists have turned to pondering fiscal stimulus as a way to regain growth. This comes off the back of the weakening impact of monetary policy and the distinct trend in political flavour across the western world.

The capacity to undertake fiscal expansion has to factor in each country’s budget. If higher deficits resulted in a rise in interest rates, the impact of fiscal support would be compromised. The US budget deficit has fallen from 6.8% in 2012 to 2.5% in 2015 mostly due to higher tax revenue as the economy recovered, but now progress seems to have stalled.

The revenues and outlay mix for the US is shown in the following charts:

US Government Revenues

Source: US Treasury, Escala Partners
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US Government Outlays

Source: US Treasury, Escala Partners
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Politics will inevitably determine what role the revenue part of the equation can play in fiscal support. On the outlays side, the US faces an immense challenge to reign in its large health budget, while most believe it underspends on education and training. A long-awaited rebuilding of infrastructure has stalled due to the incapacity to pass legislation through both houses.

The success of fiscal and monetary policy is absorbing much of the economic debate. The Ricardian equivalence hyptothesis implies that a rise in government debt is offset by private savings as the private sector anticipates future taxes. Japan may well become the poster example of this concept. The savings rate there has persisted in the 15-20% range of disposable income. As the aggregate level of saving is levelling off due to the aging population, the corporate sector has been squireling away increasing amounts of cash. While there is weak empirical evidence for the causality in this relationship between government debt and private sector attitudes, high debt countries often have restrained behaviour from others in the economy.

The Bank of England held its official rate, against expectations of a cut. Widespread opinion that Brexit would have a meaningful impact on UK growth has not yet have swayed the members of the BOE. It is possible that the potential for inflation due to the fall in the pound may complicate matters. Further, corporate credit spreads have fallen again, suggesting funding flexibility for business and arguably no pressure for lower rates.

China data dominated the news flow at the end of the week, declaring second quarter GDP growth of 6.7%; a little higher than expectations. Retail sales and industrial production strengthened, with the attribution placed firmly on government stimulus. Government spending has indeed risen, up 19.9% in June after a 17.6% rise in May. Bank lending and social financing was up strongly, though this will inevitably draw comments on the quality of the banking sector. The main areas of weakness is exports and small business which are often unable to access credit as they are crowded out by trophy assets.

In foreign exchange markets it has been the Yen that has had all the attention. The currency has had one of its biggest downward moves against the USD in some time, while the Nikkei index looks set to be the best performing equity market of the majors this week. The now familiar story of Yen strength amid uncertainty and Nikkei weakness given the state of the Japanese corporate sector recieved an additional burst from, on one hand, the fiscal possibilities noted above, and on the other, by a Pokeman Go-led direction.

Nikkei and US Dollar/Japanese Yen

Source: Bloomberg, Escala Partners
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Fixed Income Update

The swing in risk sentiment continued this week, back to in favour of ‘risk-on’. Previously, global government bond yields pushed to historic lows following the Brexit vote and concerns surrounding bad debts of the Italian banks, while domestically our market followed suit aided by political uncertainty while there was a prospect of a hung parliament. A week or so on, the concerns have abated (at least for now) with the risk trade dominating. Credit spreads contracted as demand for credit securities rose and government bond yields bounced off their lows. The yield on 5 year Australian Government bonds is illustrated below.

Australian 5 Year Government Bond Yield

Source: Iress, Escala Partners
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This move is unlikely to have had much impact from the S&P review of Australia’s AAA credit rating to a negative outlook.  Rates were unchanged following this and it was the change in risk sentiment that saw yields rise across developed global markets.

If a sovereign downgrade does occur, it is not expected for at least two years. In the meantime, Australian government bonds will remain supported, given the relatively high yield that our market offers for a AAA rated sovereign debt security. Comparatively, about 30% ($12 trillion) of the global sovereign bond market is yielding a negative return, with a total of 70% below 1%. With all Australian government bond yields currently above this level (5 year at 1.62% and 10 year at 1.92%), these securities are still attractive on a relative basis, as illustrated in the chart below.

Source: JP Morgan Asset Management
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Following the changed outlook to Australia’s sovereign debt, the major banks were placed on negative outlook. While this may result in a downgrade on senior debt, it is not expected to impact on the subordinated and hybrid bank debt securities. In contrast, these issues are assigned a Stand Alone Credit Profile (SACP) which is expected to be supported on the grounds that the major banks now have higher capital ratios. Therefore, the news of the ratings revision had no obvious impact on the listed market in the last week.

S&P have taken Crown Resorts off negative watch this week and reaffirmed its rating at BBB. They are comforted from the proposed demerger from certain offshore assets and the quality of cash flows from their Australian held assets. Crown’s listed debt securities (CWNHAs and CWNHBs) rallied, with CWNHA securities up over 11% in the last three months.

Crown Listed Subordinated Debt Securities (CWNHA)

Source: Iress, Escala Partners
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Corporate Comments

Oil Search’s (OSH) expansion plans have hit a road bump in the last few weeks after it was revealed that a competing bid had been made for InterOil. In May, OSH had teamed up with French energy supermajor, Total, to bid for InterOil, consolidating its position as a key player in the PNG oil and gas industry. Reports have emerged that Exxon Mobil may have trumped the initial OSH/Total offer (the identity of the bidder is yet to be confirmed but is thought to be Exxon Mobil and the counter-offer price has also not been revealed). The fact that a counter bid has emerged is not unsurprising given the high quality and expected low-cost nature of the asset base.

ExxonMobil already has a significant presence in PNG as the operator of the PNG LNG project (in which OSH also has a stake). If the company were successful with a bid for InterOil, however, there could still be a silver lining for OSH. In this scenario, the likelihood of InterOil’s gas fields being developed into another LNG facility alongside the existing PNG LNG project would be high, and the shared infrastructure would still result in a high level of synergies for OSH. The downside from a competing bid from Exxon Mobil would be the potential for a price war for InterOil, something which OSH would then be marked down. We hold OSH in our model given its interest in the high quality PNG LNG project and its strong pipeline of attractive expansion opportunities, which remain so even in the current lower oil price environment.

BlueScope Steel (BSL) upgraded its guidance for the third time in the last six months. There are several factors that are influencing the turnaround in the company’s fortunes. Like many other large-cap companies, BSL is undertaking a cost-out program, which is targeting $270m in annual savings by FY17 in its Australian business and a further NZ$50m in New Zealand.

Secondly, a weaker $A is beneficial to BSL given that it makes imports more expensive, reducing competition from overseas and allowing the company to lift its domestic prices. With international businesses, the weak $A also helps with the translation benefits of earnings from these divisions.

Global steelmaker margins, however, are the overriding factor that has caused significant swings in BSL’s profitability and which have, in the past, led to annual net earnings losses at a group level. An improvement in steel margins in the US has been key in this current upgrade, with BSL having acquired the remaining 50% of North Star late last year. US steel prices are trading at higher premium to Asian prices than is typical, with an element of more rational behaviour, combined with some restrictions on imported steel, helping all industry players.

Margins in Asian markets (see following chart) are more relevant for the bulk of BSL’s business, and the region also showed an improvement in 2016, although have more recently retraced much of these gains. The base from which margins have improved, however, was unsustainably low towards the end of last year and was driven by excess production from Chinese steel mills, who had begun diverting tonnes to the export market in the face of weak domestic demand. Many producers were loss making at this point in time, saddled with large amounts of debt and borrowing further to stay afloat. Some rebalance has occurred so far through 2016 and the government has announced that steel capacity will be cut by up to 150mt p.a.

With the consensus view that Chinese steel consumption has peaked and will likely decline from here on (outside of any shorter term stimulus measures that may boost demand), the production cuts announced may only go some way to balancing the industry. Regardless, the industry has acted irrationally over an extended period time, leading one to question the prospect that higher steel margins will eventuate.

In the short term, BSL may continue to benefit from these changing conditions and there is the prospect of higher dividends and possible capital returns for shareholders. The stock currently has strong earnings momentum, however the longer term tough industry backdrop would lead to the stock being a short term trading opportunity at best.

Steelmaker Margin Spread

Source: BlueScope
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