A summary of the week’s results


Week Ending 15.12.2017

Eco Blog

- Australian employment growth brings relief and sets up for a modestly better balance into 2018.

- This will not necessarily translate into a wage rise given the increase in the population.

- Global growth remains upbeat into 2018. No evidence of any threat, bar overheating!

- The UK is captive to the judgements on Brexit. Sterling is considered to be undervalued but vulnerable to swings in sentiment.

The November employment report was a proverbial (Christmas) cracker, with 61k new jobs reported, taking the three-month average employment growth to 30k/month. Full time jobs comprised two thirds of the rise and is now annualizing at 3.7% versus 2.1% for part time. Full time is defined at 30 hours a week or more, as reported by the employee. The trend in employment has now persisted for most of 2017 and while the unemployment rate is holding at a relatively high 5.4%, the participation rate is now at its highest since 2011.

Details on the job categories will be available next week, however there is some interpretation that can gleaned from the data. The mix across the states was fairly even, suggesting this is not being driven by one off factors or smaller industry segments.

Female job participation has been growing in contract to the fall in male participation for some time and has accelerated in the past two years. At a granular level, female full-time jobs are outweighing the rise in part time. Two sources of labour growth have been apparent that speak to the gender trends. The healthcare sector has had the largest number of new jobs, in part due to the national disability scheme and an increase in the aged care sector after media reports on work practices.  The other is the recent pickup in state-based infrastructure spending, while housing activity has yet to taper off.

Source: CBA

The impact of the better employment data on wage growth has been negligible. Median wages are being held back by the rise in lower paid service jobs, the tendency for female employees to mute wage demands and the general expectation that a circa 2% rise in salary is now the norm.

Nonetheless, if these employment trends persist, the RBA may put aside the low inflation rate and talk to a rate rise next year. The now expected fall in house prices adds to that option, as the genie of investor lending growth is back in the bottle.

Another feature of the labour market is population growth. In the past year the population has grown by 1.6%, with two thirds coming from immigration. The natural increase from the number of births has been flat for over ten years. Victoria is experiencing a 2.3% rise in its inhabitants from both immigration overseas and interstate migration. Queensland may also overtake the growth trends from New South Wales as households seek more affordable housing.

Source: CBA

The impact of shifts in the growth and structure of the population has long term consequences. Net overseas migration is a meaningful factor in holding down wages, with many positions in healthcare filled by these arrivals. Then there is the pressure on infrastructure, housing and services. This is predominantly funded by the states, and as we noted in previous weeks, they are all experiencing constraints on revenue growth that is centered on GST and state-based taxes.

As we note in our company comments, states are turning to the private sector to fund some infrastructure. While on one hand this may be a laudable user-pays strategy, the costs are borne by the community and likely to add another chip to tightening discretionary spending.

As we note in our company comments, states are turning to the private sector to fund some infrastructure. While on one hand this may be a laudable user-pays strategy, the costs are borne by the community and likely to add another chip to tightening discretionary spending.

  • Designing the Australian component of an investment portfolio creates some challenges given this backdrop. Rates are flat to mildly up, implying range trading and low duration. Equities can coalesce behind infrastructure spending, but otherwise its likely to be the bout of corporate activity, cost out strategies and hot global themes that create interest.

For most major economies this year is going out at a clip. US retail spending was particularly perky, up 5.8% in November, though off a soft October. The CPI nudged up to 2.2%, with service costs rising by 2.5% and goods prices relatively flat, likely due to the strengthening USD.

Europe’s pace is, if anything, accelerating and even the naturally conservative ECB has bumped up its forecast growth for the region to 2.3% from 1.8% previously.

Flash PMIs for EMU

Source: HIS Markit/Haver Analytics

Chinese retail spending is reported to have increased 10.7% in November as well as a decent 6.1% rise in industrial production.

Last but not least is the UK. Growth here is lagging its neighbours, but the fears of a recession as was mooted post the Brexit vote, have not come to pass. The household sector is, however, experiencing tougher times.Historically low unemployment is matched by low wage growth and a rise in inflation, such that real wage growth is a negative 1.3%. In turn, households are turning to debt to fund spending. Inflation is likely to fade in 2018 as the pound has picked up, but there is no sign wages are about to rise.

The fall in sterling did have a large positive impact on the current account. Not only was consumer demand weaker, but as Britain has a large overseas investment base, the income from these assets rose strongly, while income from UK-based assets held by foreigners fell. This primary balance has shifted the dial on the current account and improved the competitiveness of UK industry.

Many view the GBP as undervalued, but Brexit and associated sentiment is in the way of a near term move in the exchange rate. The GBP is particularly prone to opinion rather than fundamental value. The fragility of Brexit negotiations adds to the uncertain direction for at least the coming year.

GBP/USD and Bullish Sentiment as at 1/12/2017

Source:, Thomson Datastream

  • So far, so (very) good on global growth and equities. There is no reason to think this will not extend into 2018. Financial conditions are the possible trouble spot if lending to riskier sectors is restrained. The US tax reform may limit buybacks given a lack of interest deduction. Along with valuations, this suggests the moderation to equity weight in the US is still valid.

Fixed Income

- The US federal reserve raises rates, taking the interest rate differential between the US and Australia to its lowest margin in nearly 20 years.

- China takes over as the world’s largest issuer of ethically responsible ‘green bonds’.

As expected, the US Fed increased rates this week. The rise of 0.25% was the third this year, taking it to a total of five rate rises in the last 2 years. According to the Fed’s implied rate, it is expect to raise rates another 6 times, 3 times each in 2018 and 2019. This would take the cash rate to a neutral rate of 2.75%. The market pricing, determined by futures trading, continues to trail the Fed’s predictions with only half of those rate rises priced in.

The interest rate differential between Australia and the US has been notable in recent history, and one would need to look back 18 years to see another period when the Australian 5 year government bond and US 5 year treasuries were trading at similar levels. Divergence in monetary policy has closed this longstanding gap with the lack of a data trigger the RBA may be on hold at 1.5% for most, if not all, of 2018. This differs to the continued normalisation of rates expected in the US.  In the last three months the US 5-year yield has moved 0.45% higher, while the equivalent Australian government bond is unchanged.

The interest rate differential drives the cross-currency swap, which erodes the ‘FX carry’ that Australian investors have picked up when purchasing USD hedged assets offshore. While this reduces returns on existing fixed rate investments that have a rolling hedge, new investment opportunities will be set off the higher treasury yield.

Australian 5-year Govt bond yield vs the US 5-year Treasury yield

Source: IRESS, Escala Partners

In previous publications we have discussed the growth in green bonds as sources of funding for projects that have a positive environmental impact. These can be via government entities, banks and corporates, if the proceeds are used and certified against a particular ‘green’ initiative. In recent years France has led the way in terms of issuance levels, with China now taking over as the world’s largest issuer of green bonds. Prior to 2015 bonds weren’t labelled as ‘green’. The growth from China green bonds has mainly come from the Chinese banks refinancing existing bonds that were never labelled as such even though they were issued for ‘green’ purposes. It also speaks to the governments intent to shift towards improving the environment where these bonds can be directly applied to the project.

Banks in other parts of the world have also begun to use green bonds to refinance existing loans. In the UK this year, Barclays bank became the first UK bank to fund domestic assets via a green bond. The major banks in Australia have also been tapping into this market with National Australia Bank (NAB) being the first Australian bank to issue a public offshore green bond earlier this year with a EUR 500 million issue. Bond investors seeking access to these deals can either do so directly or through one of the ethical funds such as the Pimco ethical bond fund.

Biggest green bond issuers in 2017

Source: Moody’s

Corporate Comments

- Transurban (TCL) will be adding an additional road to its existing network in Melbourne. The deal with the Victorian Government highlights its strong competitive position in cities where it is the incumbent toll road operator.

- Westfield (WFD) has agreed to a takeover offer, with the combined entity with Unibail-Rodamco emerging in a stronger position to combat the structural issues that retail REITs continue to face.

- AGL Energy (AGL) has increased its capex guidance, although growing dividends remain on the agenda in the medium term.

Transurban’s (TCL) announcement that it had reached a contractual close with the Victorian Government on the West Gate Tunnel Project was anticipated by the market, part of the large pipeline of road infrastructure work on the east coast of Australia. As such, it was the details of the funding of the deal that were scrutinised, with the conclusion that TCL has fared well compared to expectations. Adding weight to this argument was the fact that the original concept came from an unsolicited proposal from TCL to the Government. The significance of the project is illustrated in the chart , with the only project of comparable size the potential acquisition of Westconnex in Sydney.

Transurban Development Pipeline

Source: Transurban

The project will be funded through a relatively balanced mix of debt and equity, yet it was the additional agreements that TCL was able to achieve that highlighted the strength of its position as a monopoly operator of toll roads in the city. These forms of inducements are not available to any outsider and in effect allow a lower capital contribution from the Government, with the users of TCL’s existing network footing a proportion of the bill.

The existing concession on CityLink will be extended by 10 years to 2045 and from FY20 these tolls will now escalate at 4.25% p.a. for the following decade, rather than the current CPI increase. In a low-inflation environment, this could potentially add significant value for TCL unitholders. While these agreements require Parliamentary approval (and there is an indication that the opposition and Greens will oppose the amendments), TCL will receive compensation payments in the event that the legislation does not pass, mitigating some of this risk.

With a fixed price construction contract fixed price, the cost overrun risk will be borne by contractors CIMIC (CIM) and John Holland, and thus the key variable for TCL will be in the accuracy of its traffic projections. The primary operational synergies are in the connected nature of this project to TCL’s existing Melbourne assets, enabling greater traffic flow across its network.

TCL’s valuation is acknowledged as being relatively expensive compared to overseas infrastructure assets. Its consistent dividend growth over the years, however, sees it placed as a core holding in many Australian equity portfolios (including our SMA offerings). Positions have typically been restricted in recent times as a reflection on the inherent interest rate risk, with the experience of the second half of 2016 (as illustrated in the chart where it de-rated in a short space of time) indicative of the downside risk were rates to rise more quickly than anticipated.

Transurban: EV/EBITDA

Source: Bloomberg, Escala Partners

Westfield’s (WFD) agreed takeover by European property giant Unibail-Rodamco provided some relief for the listed property sector, which had, until more recently, posted some patchy performance this year on cyclical and structural retail fears. The listed property sector is heavily weighted towards retail REITs, with investors becoming concerned on soft retail spending and excess footprint.

Combined Westfield/Unibail-Rodamco Portfolio by Region

Source: Westfield/Unibail-Rodamco

The structural issues may have played a part in the exit of the Lowys. While some retail REITs have countered this change in consumer patterns to online by providing more space to ‘experiences’ in categories such as food and entertainment, there is a finite limit to how far this can be taken.

A potential outcome for retail REITs may be higher tenancy turnover and/or slower rental growth compared to what they have been accustomed to in the past. WFD is better placed than most given the high quality of its asset base, and the inherent value in its development book.  The stock has historically traded at a significant premium to NTA, although this too has contracted in the last few years.

The takeover offer is a mix of scrip (euro denominated) and cash ($US). Currency fluctuations and the change in the Unibail-Rodamco share price in the next six months will play a part in the underlying value to local holders of WFD stock. Should the deal proceed as expected, there will also be significant changes to the local REIT index (with WFD the second largest by market cap), although the merged entity will retain a reasonable weight, given the option of investors to elect to receive an ASX-listed CDI as part of the consideration. ETF flows will also be monitored as the three large ETF providers hold approximately 20% of WFD securities. We note that WFD is a holding in our IML SMAs.

AGL Energy’s (AGL) investor day was viewed as marginally negative, despite the company confirming its guidance for FY18. The key change was an increase in its capital expenditure budget over the next few years, largely being driven by the need to invest in new capacity to replace existing coal fired power generators that have either recently closed or will cease to operate in coming years. For AGL, this includes the forecast closure of Liddell Power Station in NSW in 2022, which will largely be replaced by a mix of gas and renewables.

Nevertheless, AGL remains well placed to deliver a material increase in dividends over the next three financial years, with the majority of the benefits from the spike in wholesale electricity prices yet to flow through to shareholders. Combined with a solid balance sheet, consensus forecasts for dividend growth over FY18-20 sit at 17% p.a. (well above that of most large cap ASX companies) and with a reasonable valuation of 15X forward earnings, the stock has found its way into both value and income style portfolios.

AGL Energy Capex Profile

Source: AGL Energy