A summary of the week’s results


Week Ending 15.09.2017

Eco Blog

Industrial raw material prices rise strongly over two years. Will that feed into inflation or reduce margins?

A lower USD may weigh on unhedged exposure, but is indirectly supportive of Australian growth.

Inflation has picked up in the UK, although has been driven by a weaker pound following the Brexit vote. The BoE is now poised to lift its cash rate in the next six months.

Domestic employment growth in August has continued a recent strong trend through 2017.

- The NAB Monthly Business Survey reported robust domestic business conditions although weaker confidence. Businesses look to be absorbing higher costs through reduced margins.

As we have frequently noted, CPI inflation is the one element still absent in this economic cycle. Nonetheless there are price increases which will translate into higher costs and either flow into prices or reduce corporate margins. For the past year it has been the rise in the PMI index, which measures activity in the manufacturing sector, that has defined this part of the upturn. Prices for industrial inputs have therefore been increasing rapidly and with further growth in manufacturing forecast over the coming year, these may be sustained.

Foundation for International Business and Economic Research Industrial Materials Price Index

Source: Haver Analytics, Foundation for Business and Economic Research (FIBER)

Much of the weight in industrial production is these days in the emerging world. The relative weakness in the USD has been very helpful for these countries, moderating import costs of raw materials notwithstanding the rises seen above, as the pricing is in USD. 

On another level, the lower USD has made the servicing of emerging market foreign currency debt easier. Many emerging countries still run a current account deficit, albeit this is now significantly less than a few years ago. That makes them vulnerable to external funding sources, not only as much for the government sector, but for corporations. Countries such as Singapore can manage that balance as they have a stable currency and a large external sector. The countries at risk are Russia, Turkey, South Africa and some of the South American nations.

Share of Foreign Exchange in Corporate Debt

Source: Deutsche Bank, Haver Analytics

For Australian investors, the negative effect of the rise in the AUD against the USD is outweighed by the benefit the lower USD has brought to emerging countries and their impact on global growth. Rising income across Asia feeds directly into demand for education and tourism services, arguably our most sustainable long-term source of growth.

Inflation has been a key point of discussion this week with data releases in the UK and the US. The UK is one major developed economy whereby some inflation pressures have been starting to emerge this year, with the August annualised reading at 2.9%, or 2.7% when measures of housing costs are included. Some of this is clearly transitory in nature given the depreciation in the pound following the Brexit vote and the impact this is having on imported goods and thus a certain level of moderation is the consensus call into 2018. The UK Office for National Statistics highlighted the effect of the weak pound, noting that inflation in clothing and footwear was 4.6%, the highest rate in this category in more than a decade.

Following this, the release of the Bank of England’s (BoE) monetary policy statement indicated that it may be the next major developed economy central bank to begin to normalise its cash rate, possibly at its next meeting in November. An important consideration in the BoE’s view is that spare capacity in the economy is being absorbed at a faster pace than thought in recent months.

Domestically, the strength of the Australian labour market was confirmed following the release of August’s data this week, with employment growth outpacing that expected by most economists. While the unemployment rate was steady at 5.6% for the month, the detail of the release painted a more positive picture. Total employment growth of 54,200 was the second best outcome this year (and better than any month in 2016) and continued an unbroken run of 11 straight months of jobs creation. Additionally, the participation rate (i.e. the proportion of the labour force that is either employed or actively looking for work) ticked up again, continuing a trend established at the beginning of the year and is now at the highest level in five years.

The composition of employment growth, however, has been one of the more surprising aspects of the labour market this year, with full time jobs making up the bulk of overall jobs growth after declining through last year.

While jobs growth has been robust, measures of underemployment and a broad lack of wage growth across the economy suggest a reasonable level of slack in the domestic workforce. As such, the RBA is likely to remain comfortably on the sidelines for the time being, until such time that greater evidence of wage growth and inflation emerges, particularly considering prevailing high household debt levels and the re-emergence of a stronger AUD.

Australia: Cumulative Full Time Employment Growth by Year (‘000)

Source: ABS, Escala Partners

A number of the themes discussed above were evident in the NAB Monthly Business Survey, which showed that domestic business conditions remain solid, although confidence has eased somewhat. A gap between key input costs and final retail prices has been an issue for Australian businesses this year and the increase in labour costs in the last quarter stood out. The interpretation of this data is that inflation is expected to remain weak in the short term, with increased costs being borne by businesses through a contraction in margins.

NAB Business Survey: Costs and Prices (% Quarterly Change)

Source: NAB Monthly Business Survey

Fixed Income Update

Westpac has issued a 10 year bank hybrid in the US market, following the success of ANZ’s similar bond last year.

Austria has issued the largest 100 year bond in the market, extending the duration of the global bond index.

- Catastrophe bond has fallen in price as the hurricane in the US play havoc on this market.

Following on from the inaugural ANZ additional tier 1 USD bond done last year, Westpac this week priced a similar transaction in offshore markets.  The US$1.25bn perpetual non-call 10yr AT1 bank hybrid priced at a fixed rate of 5%, tighter than the initial price talk of 5.25%-5.375%. This has given Westpac a better cost of funding than what the bank could achieve in the domestic market. On a swapped basis this 10 year security equates in AUD to BBSW+~3.28% (source NAB), which compares favourably to where ANZ recently issued a domestic 7.5 Year AT1 at BBSW+3.80% (ANZPH). While issuing offshore does reduce funding costs and diversify the funding base, the ability to tap into this market is dependent on the banks profit that they have paid tax on in that region. ANZ’s USD hybrid priced at a yield of 6.75% in June last year and was heavily oversubscribed. Since then, it has performed well in the secondary market, with the price rising above $113 and contracting in yield from 6.75% to 4.85%.

ANZ USD Tier 1 Hybrid Performance

Source: Bloomberg, Escala Partners

Confirming investor demand for long dated debt, Austria issued the markets largest 100 year bond at a price of 2.112%. The order book was at €11.4bn for a €3.5bn issue size. Global rates have been falling over the last 10 years as central banks have cut rates and taken on large scale bond buying under Quantitative Easing programs. Sovereign issuers and corporates have been taking advantage of the lower rates by locking in funding for term, with $43.6bn bonds sold with maturities over 30 years so far in 2017. This latest century long bond extends out the duration on the Barclays global aggregate bond index, which is the benchmark often used by global bond managers. The duration on this index is now at 7 years, up from ~ 5 years prior to the financial crisis.


For investors in global bond funds that benchmark against this index, this extension increases interest rate risk. To assess the potential impact of rate rises on this index we multiplying this average duration by the movement in global yields, less the coupons earned over that period to obtain expected returns. As an example, if the current coupon yield on the portfolio is 2.69%, the duration is 7 years and global yields rise by 50bp over a 1 year period then the impact will be: 

(Average duration (years) X Yield move (bp)) +Portfolio Running Yield (bp)= return

(7 X (-.50%)) + 2.69% = -0.81%

As duration extends, this will directly impact positively or negatively depending on the directional move in rates, on the returns for global bond funds that track this benchmark.

Fortunately, Hurricane Irma was not as disastrous as initially thought, but it did play havoc on the catastrophic bond market in the days prior. As discussed in previous publications, these bonds allow insurers to pass on the risk of natural disasters to investors in these bonds. The bond pays interest, but capital is at risk if an insurer’s losses are large. The Swiss Re catastrophe bond price return index fell 16% last week, its biggest fall in 15 years following the devastating effects of Hurricane Hervey in Texas and the threat of Irma in Florida.

Corporate Comments

Macqurie Group’s (MQG) trading update was incrementally positive, with higher performance fees expected to be generated this half. 

Boral (BLD) is expected to enjoy supportive market conditions in the US and Australia in the medium term, while acquisition integration and Australian housing pose a risk. 

- Myer’s (MYR) result highlighted the short and longer term challenges that department stores face.

Post the information saturation that is reporting season, company announcements and updates slowed to the slower pace typical of September. 

Building construction materials company Boral (BLD) conducted a timely presentation in the US which has followed a number of severe weather events that will require significant repair of buildings in areas of Texas and Florida. A few of BLD’s facilities in Texas have also been impacted by Hurricane Harvey and there is expected to be a certain level of disruption as the clean up is completed. Nonetheless, with the Texas market representing a quarter of Boral North America’s revenue, the opportunity to participate in the rebuild is significant.

While its US operations have historically been the poorest performing across its key divisions, often struggling to achieve an acceptable return for shareholders, the expectation is that in coming years this will be a key driver of broader group earnings. A major part of this will be the realisation of substantial forecast synergies from its recent large acquisition of Headwaters, which will likely be supported by a robust demand environment.

Boral’s US business now also has exposure to North American infrastructure spend (around 15% by end market), with Headwaters’ fly ash (which is used as a cheaper substitute for Portland cement in concrete production) business a large part of the broader business. While there is some hope that the Trump administration will deliver on its infrastructure promises that it campaigned on 12 months ago, to date the policy delivery has been underwhelming and is thus a potential disappointment risk for investors.

From a thematic point of view, the twin drivers of US housing (which has continued on a steady trajectory) and domestic infrastructure (which we have highlighted in the past) are the key attractions for an investment in BLD. The possible risks with the stock lie with the integration of Headwaters, potential infrastructure spend not being delivered in the US and, a cooling of the domestic housing market and the potential for cost pressures (such as electricity) to erode margins. On balance, the stock looks reasonably priced at 17X forward earnings for what should be solid earnings growth in the medium term. In our model portfolio, we have elected to invest in James Hardie, which has higher-quality US operations, albeit is limited to the housing market.

Boral’s Australian Project Pipeline

Source: Boral

As it has in recent years, Macquarie Group (MQG) provided a September trading update, which was received relatively well by investors. The company has in recent years issued fairly conservative guidance to the market, which has led to few disappointments when its results have been released. While it retained its full year guidance for FY18 earnings to be ‘broadly in line with FY17’, the commentary for the first half (to 30 September) was relatively optimistic, noting that stronger performance fees from its asset management business are now expected to be realised for the period. Notably, MQG’s outlook has incorporated the expected impact of the new major bank liability tax that has been introduced by the Federal Government, with MQG caught in this net along with the four majors.

MQG’s earnings from performance fees have been quite variable over several years now, with particularly strong contributions in FY15-16. Based on the relative performance and maturity schedule of its funds, the earnings stream from this source is typically difficult to forecast and few would capitalise a certain level of income.

Nonetheless, an improved outcome is welcome for the company at a time when many global investment banks are reporting subdued trading conditions, with low volatility across most markets the prevailing environment. Over the years, MQG has reduced the downside risk from this component of earnings by focusing more on its annuity-style businesses.

Myer’s (MYR) full year result told a familiar story of soft sales figures (down 1.5% or 0.2% on a comparable store basis following a rationalisation of its store footprint), coupled with tight cost control, restricting the translation to lower profitability. The company’s strategy of promoting exclusive brands has so far failed to gain traction with shoppers, with market share consistently lost to the range of global retailers that have entered the Australian market over the last several years. As a result, its 2020 targets (listed below) are looking overly optimistic with each passing year, with poor progress on its ‘New Myer’ strategy.

The last 12 months has been characterised by a cyclically soft retail environment, which has compounded the longer term structural challenges that department stores face. Further, much of the listed retail sector has been de-rated materially on the looming entry of Amazon into the market. A pickup in domestic retail spending and/or a realisation that Amazon fears may be overstated could potentially see a bounce across the sector, however, a longer term proposition is a much harder case to put forward.

‘New Myer’ Target Metrics

Source: Myer