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WEEKEND LADDER

A summary of the week’s results

16.01.2015

Week Ending 16.01.2015

Eco Blog

China’s trade data saw its surplus continue to grow. Exports rose by 9.7% in December and 6.1% for the year overall. Imports fell by 2.4% in December and ended the year with only a 0.4% increase. A combination of weak domestic demand and falling commodity prices has left the trade surplus for the year at 3.6% of GDP, while the Renminbi (RMB) fell by a modest 3% versus the US over the year. Foreign exchange participants believe the People’s Bank of China is making efforts to keep the currency relatively stable and prevent large capital flows as well as reduce USD debt servicing costs, with corporate issuance in USD up strongly in recent years. A lower RMB would have been favourable to the export sector, but it would appear that this policy option is unlikely. Stability further plays into the long term potential for the RMB to become a reserve currency.

The growth in money supply (M2) in China edged back in December as new loans volumes fell. While the central bank has carefully encouraged lending banks to extend credit, they seem unwilling to do this in light of the weak position of some state owned enterprises (SOE’s) and the risky status of some local governments. Meanwhile, private demand for credit is subdued by relatively high lending margins and soft demand for goods. At this stage there is nothing to suggest the economic momentum in China is picking up. 

China: M2 Growth

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Fourth quarter GDP for China will be released on Tuesday and possibly give some guidance on the expectations from the authorities on what they hope to achieve for 2015. Anything below 7% would be interpreted as a capitulation towards a much lower growth path for China than most currently factor in.

Elsewhere in Asia, falling inflation is a big positive. Indonesian inflation looks likely to decline from 8% last year to around 1.5% this year. Similarly, inflation in India is now firmly below 5% and the Reserve Bank of India (RBI) surprised with a 0.25% rate cut to 7.75%. While this economy still faces major challenges, specifically its fiscal deficit, this low inflation cycle comes at a very useful period given the potential structural changes from the new government. The risks to Asia lie now more with an unexpected reversal of inflationary trends, more likely from food prices than other commodities.

Currency moves came under the spotlight with the decision by the Swiss central bank (SCB) to remove its 1.20 EUR/CHF exchange rate floor while also reducing (if that is the right word!) its cash rate from an average of -0.25% to -0.75% in order to attempt to stem any capital inflow. At the time of instability in the Eurozone in 2011, the SCB had implemented this exchange floor to prevent excess capital flows from Euro to CHF. With the recent fall in the EUR/USD and the potential for further currency weakness on the back of the expected easing by the European Central Bank, either this coming week or in March, the SCB appears to have taken the view that defending the exchange rate may be too costly and have unintended consequences. Nonetheless, markets were very much taken by surprise with the CHF moving 17% in one day. Whether this results in deflation in Switzerland and investment flows remains to be seen, but this adds another layer of complexity to financial markets. 

Euro Cross Rates

Source: IRESS, Escala Partners
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Another currency battle to drive a competitive edge for their export sector is between the Eurozone and Japan, both current exponents of quantitative easing. As can be seen in the chart, the cross rate has not done much through the year, giving both an even chance to grow trade. Another recent evolution has been a sharp fall in Japanese investment into Australian bonds. Over the past decade Japan has acquired some ¥8tr of AUD fixed income assets to take advantage of the interest rate differential. With our rates now considerably lower, as well as the movement in the AUD, Japanese investors appear to have moved elsewhere, possibly also in anticipation of the US Fed move. This waning appetite for Australian assets could push the currency lower than most expect. Japanese data on consumer confidence and industrial production in the coming week will provide some judgement on the success of QE.

Back in Europe, the path for easing was opened with a ruling by the European Governing Council on the legality of bond purchases. Europe will be in the spotlight for other reasons too. The Greek election on 25 Jan will raise the spectre of ‘Grexit’ or the exit of Greece from the Euro. As was argued at length in 2011, the downside for Greece is likely much greater than the pain for the rest of Europe, but such instability will not help any cause. The UK goes to vote in May and the debate on its European status will again be prominent. Portugal is set to vote in September and Spain in December. Poland, Demark, Finland and Estonia will also have elections with local issues much more dominant.

Full attention will be on the ECB meeting next Thursday. Preceding it will be the minutes from the Bank of England (BoE) where a rate rise decision is finely poised. This is unlikely prior to the election, but looks increasingly possible in the second half of the year. There is a possibility that UK unemployment will drop below 6% and wages growth may emerge.

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US retail data for December disappointed expectations with a low increase of 1.9% year-on-year against a trend of 3.5-3.8% in the previous months, particularly as most expected the fall in petrol prices to lift spending.  It also goes against the relatively positive comments that came from within the retail sector following the holiday season. The pattern of spending is however changing, with a prolonged pickup into the Thanksgiving weekend and Cyber Monday, followed by a lull before a short sharp, but lower profile Christmas and then a good clearance.

Other data was mixed. Jobless claims were higher than expected, apparently due to seasonal factors. The manufacturing indexes (Philadelphia and Empire) gave opposite signals. Nonetheless, the interpretation is that any emergence of more patchy data will possibly defer the first rate rise well into the second half of the year with a rise in wages growth as the most likely determining factor.

Global ‘flash’, i.e. preliminary, PMI data for most parts of the world will be out next Friday. The trend tends to provide a good guide on the direction of manufacturing and industrial production and therefore be a useful indicator on the status of growth. 

Local labour force data was much better than expected, with unemployment falling from a revised 6.2% to 6.1% due to a strong rise in full time employment. After a number of months of sequential major revisions, the outcome was treated with some caution, however the data does better align with other indicators such as job ads. The major sectors experiencing job growth are services – accommodation, entertainment and construction, which captures the apartment and renovations cycle. On the downside, total hours worked data was weak, suggesting few are working overtime and therefore employment growth may soften as this capacity ratchets up. 

The low reliability of recent labour data may well cause headaches for the RBA. Most other indicators would support easing; this one clearly does not. The survey response rate is currently relatively low as the ABS migrates to online, rather than interview based. January typically has an even lower than normal response rate and the population benchmark (which is used to establish the size of the working population) will reset in March with possible backward revisions to unemployment at that time.

While the market has priced in an interest rate cut, there is nothing to suggest the RBA is looking to pull the trigger any time soon. We suspect that the property market could provide the critical signal. With the RBA unwilling to fuel residential investment, indications of lower growth here may be the key. 

Company Comments

Transurban (TCL) released its quarterly traffic figures, which were well received by investors. Traffic on its core CityLink asset recorded the fastest pace of growth over the last 18 month period. In Sydney, the widening of the M5 Motorway has had immediate benefits, with traffic numbers in December up by 8%. TCL’s other Sydney assets also performed well during the quarter. The recently-acquired Brisbane toll road assets reported lower growth compared to Sydney and Melbourne, somewhat reflective of a weaker state economy along with the disruption caused by the G20 Summit in November. A minor negative for the stock through the quarter was the new Victorian Labor government’s proposal to cancel the former government’s East West Link project. The East West Link would have provided a further channel to the CityLink roads.

It is perhaps arguable whether the recent fall in petrol prices will translate into any noticeable improvement in traffic numbers, but at the same time it can only be a positive for TCL. The further recent contraction in bond yields has obviously been a significant tailwind for TCL’s share price, although we remain attracted to the long-term story of traffic growth, inflation-linked tolls and investment opportunities that will all enable the company to continue to grow its dividend over time. With no major projects across its network in the short term, the next news catalyst for the stock is likely to be the financial close of Sydney’s NorthConnex Project.

Woodside Petroleum’s (WPL) quarterly production came in at the top end of its guidance range. For 2014, the group’s overall production was up on the previous year, largely a function of the disruption from maintenance conducted at its Vincent oil field in 2013. WPL also gave guidance for 2015, with the mid-point representing an 8% decline in production for the year. The key contributors to this outcome are likely to be a planned shutdown of its Pluto project for one month and the impact from natural oil field decline across its portfolio.

While Woodside has amongst the lowest-cost assets in the Australian energy industry, it too will still feel the impact of the sharp decline in oil prices in 2015 in the absence of any meaningful recovery. Without any large capital investment in the short term, Woodside has adopted a dividend payout ratio of 80% of its earnings. As there is little room to move in terms of lifting this higher in the face of lower revenues, investors face the prospect of a sharply lower dividend in 2015. The chart below shows how these dividend forecasts have been revised in recent months as oil price assumptions have been pulled downward. Forecasts for 2014 have held up better than that of 2015, largely due to the lag effect of the oil price on LNG prices – typically around three months. On current earnings estimates, this equates to a dividend cut of 32% for 2015. We do note, however, that this is denominated in US dollars and hence the falling $A will cushion this impact to a certain degree.

Within the energy sector, WPL should outperform the other large-cap companies while the current low price environment persists. Longer-term, however, we believe that its peers are better placed with regard to production (and hence earnings) growth prospects.

Woodside Petroleum: Consensus Dividend Forecasts ($US)

Source: Bloomberg, Escala Partners
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ALS (ALQ) this week reported that it had exceeded its guidance on third quarter earnings (to end of December). Highlighting the difficulty in predicting the shorter-term demand conditions in its end markets, the company declined to provide full year guidance to the market. The December quarter performance looks to be a function of improved margins on the back of a focus on controlling costs.

ALS has been in a downgrade cycle for the last two years, so this result will be welcomed by longer-term investors. However, with improvement driven by more internal factors (through lower costs) as opposed to better underlying conditions, the shorter term risk still remains to the downside. While a smaller part of its overall earnings base compared to other commodities, its energy division is yet to see the full extent of an expected fall in capex across the industry in 2015 as a result of the lower oil price.

Market Focus: Review of Analyst Recommendations in 2014

This week we look at how sell-side equity analysts performed in 2014. We have analysed the recommendations of analysts at the beginning of 2014 and compared this to how the actual equities performed throughout the calendar year (on a total returns basis). The analysis below has been limited to ASX 100 stocks, given the higher level of broker coverage across this universe. The key conclusion we can draw from the analysis below is that stock-picking proved to be a difficult exercise for analysts in 2014, with a low correlation between recommendations and performance.

At the beginning of the year, the top-ranked stocks by analysts were Resmed, Orora, Dexus, BHP Billiton and Crown. The returns from this group were mixed, with solid performance from Resmed, Orora and Dexus and the underperformance of BHP Billiton and Crown. The rate of decline in commodity markets (particularly iron ore and oil) was not well anticipated by analysts at the beginning of the year. Similarly for Crown, the impact of China’s crackdown on corruption had a greater impact to the Macau casino market than was expected.

The common theme of the lowest-ranked stocks was exposure to the mining sector, including ALS, UGL, Alumina and Monadelphous. The outlook predicted for these companies, with the exception of Alumina, proved to be quite accurate. The performance of Cochlear also defied expectations, with the stock re-rating higher despite what was already viewed as an expensive valuation.

ASX 100: Performance of Highest and Lowest Ranked Stocks

Source: Bloomberg, Escala Partners
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Source: Bloomberg, Escala Partners
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The chart below illustrates the average performance of stocks broken down into the quintiles of highest to lowest ranked stocks in descending order. The highest ranked group actually performed the worst among all groups, while the performance of the remaining four groups was relatively similar. In short, the relationship between performance and stock ranking was weak in 2014.

ASX 100: Average Performance by Stock Ranking

Source: Bloomberg, Escala Partners
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The final chart below shows the average performance of stocks within each of the sectors and how this compared with the average broker rating of each of these stocks. (NB: A rating of “5” indicates a buy recommendation, “3” is a hold and “1” is a sell). Again, the relationship appears to be weak, particularly with the high ratings that were applied to the energy and mining sectors. The strong returns across the utilities and REITs sectors was, however, reflected in the high average rankings across these sectors. Consumer staples stocks were also predicted with a higher degree of accuracy, with these companies producing the worst average returns across all sectors.

ASX 100: Average Total Return (by Sector) and Stock Rating

Source: Bloomberg, Escala Partners
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Looking ahead to 2015, there remains some commonality among the most and least favoured stocks from 2014. The highest ranked stocks are (in order) Henderson Group, Crown, Aurizon Group and perennial favourites CSL and Rio Tinto. The least-favoured stocks are again Cochlear and ALS. These are followed by Novion Property Group (previously CFS Retail Property Trust), Metcash (which posted disappointing earnings in early December) and infrastructure company AusNet Services (formerly SP AusNet).

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