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WEEKEND LADDER

A summary of the week’s results

16.03.2018

Week Ending 16.03.2018

Eco Blog

- The US faces a complicated set of issues this year. Moderate consumer spending, bullish corporations, fiscal and tax largess are all in the mix for the Fed to contemplate at their meeting this coming week.

- Currency movements are not as irrational as one might assume. The USD weakness can be justified on a range of issues rather than the single factor of interest rate differentials.

If the economic cycle does strengthen, wages tick up across the globe and inflation does reach a level where central banks assume a neutral rate setting, will the consumer be better off? Evidence to date from the US, the leader down this path, appears to suggest households are cautious on their financial wellbeing in such an environment. Following the January wages report that precipitated a sell off, the February report was below expectations, though in part due to the composition of employment growth skewed towards jobs with lower wage rates.

This week, retail sales for February reinforced the uninspiring trend of recent months, though the annual growth rate of 4% excluding autos and fuel is in line with gross income growth. The housing index also shows signs of levelling off as mortgage applications ease.

While a cautious consumer will limit GDP growth, given the weight of private consumption in the data, it is better in the longer term that the household sector contains its appetite and debt.

It may well be that inflation proves to be more subdued that expected, outside the one-offs of the adjustment to telco prices from unlimited data plans and fuel prices. Manufacturing indices this week were positive yet ‘prices paid and received’ are among the weaker components, while new orders and shipments were particularly strong.

The 20/21 March FOMC meeting will incorporate language factoring in these trends, which also includes the tax reform and bullish business expectations. The famous Fed dots (each members’ view on rates) could well move from an average of three hikes to four. Further, there may be early indications of the longer-term rate expectations. The Fed may have to balance its setting between an appropriately conservative consumer and an exuberant business climate, tax cuts and fiscal spending.

The budget was lost within the tax changes earlier this year. It allowed for a sharp rise in defence and other spending at a time tax receipts will fall (incorporating the lag assuming household tax increases due to rising employment).

Budget impact of new spending programmes

Source: BEA, CBO, Haver Analytics, Barclays Research
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Many independent economic forecasts are incorporating a slow down or outright recession by 2019/20. The rationale is that the Fed will cause an over-reaction as it seeks to stem these excesses.

  • The combination of overheating and policy settings by the US are increasingly nominated as the primary risk.

The weakening fiscal position of the US contrasts with that of the Euro area.  Notwithstanding political pressure, most countries in Europe have acted with constraint by only recycling increased taxes into spending rather than extending it.

Euro Area vs. US: Fiscal Balance as at % of GDP

Source: IMF, Statistical Office of the European Communities
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To compound the difference, the European current account is a positive 4.4% of GDP compared to the -2.1% for the US.

It is therefore no wonder the USD is weak. Interest rate differentials are only one element of currencies. These deficits or surpluses are a key component as well as judgment on financial risks (which are low at the moment given global growth), purchasing power parity (which implies the USD is only around fair value now) and investment flows. The latter refers to what any marginal investor is doing. This can be a financial party or a corporate. We have noted that there is a reluctance to buy US Treasuries until its clear what the rate will extend to. Further, for a European buyer, Treasuries are marginal if hedged back to Euro, as the cost of hedging is high given the cash rate. Additionally, with corporate growth solid, the investment options are widespread and no longer isolated to the USD.

That being said, the downside to the USD is now assessed to be modest, with even some considering a small reversal if the FOMC goes hawkish. Few think the AUD has much upside.

  • A combined hedged and unhedged global allocation continues to be our recommended allocation. It reduces some volatility, though in the event of a sharp correction it will dampen the downside, but not eliminate it.

Investment Market Comment

- The telecommunications sector will be renamed and expanded to include companies from consumer discretionary and information technology sectors, we look at what possible impacts this may have.

In November 2017 the S&P Dow Jones Indices and MSCI announced that there would be a change in the Global Industry Classification Standard (GICS) structure which determines the stocks within the sectors. The telecommunication services will be expanded and renamed to communication services. This will involve all existing telecommunication services companies, as well as selected companies from the consumer discretionary and information technology sectors that ‘facilitate communication and offer related content and information through various media’. Another change will be the transition of e-commerce companies mostly from the IT sector to the consumer discretionary Sector.

The information technology and consumer discretionary sectors are amongst the larger sectors in the market, whilst the telecommunications sector has been one of the smallest. Consequently, these new classifications are going to have an impact on some of the biggest companies in the world with key examples below.

Source: MSCI
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Under the reclassifications, the new consumer services sector will become of the largest in the market based on market capitalisation:

Weights of GICS Sectors

Source: Marketwatch, Morgan Stanley, Clarifi
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There could be significant implications on portfolios which seek specific exposures using passive sector ETFs. Traditionally, the telecommunications sector has been one where investors sought a defensive allocation of their portfolios and a stable yield, whereas technology companies provide growth exposure. Three Vanguard ETFs that are going to be most effected by these changes illustrate the nature of returns to date.

Source: Vanguard
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Moving three of the five FAANG companies (Alphabet (Google’s parent company), Facebook and Netflix) which have yet to pay a dividend to the new version of the telecommunication services index is going to have a shift on the yield of an ETF portfolio. Equally, investors seeking growth through the information technology sector may need to consider other sectors.

Another implication will be the rebalancing of the ETFs that replicate the performance of these sectors. For example, to accommodate these changes technology ETFs will have to sell down the stocks moving to the communication services sector. This could create some short-term volatility in the affected stocks. Vanguard has released a statement saying they will be using ‘transition benchmarks’ to help minimize this risk.

The benchmarks linked to these sectors will then become somewhat irrelevant. There will be no point in comparing the performance of a new technology fund to that of the past performance of the technology industry as the likes of Facebook and Alphabet, two of the biggest contributors to past performance, will no longer be part of the category. 

These changes will not be implemented until late September and as such the full ramifications are yet to play out.

Fixed Income Update

- Recent price weakness in the hybrid market sees the new Westpac deal (WBCPH) commence trading below its issue price of $100.

- A distressed debt security in Europe highlights the problems with the issuance complex debt instruments which are still being issued despite the fallout from these types of deals during the financial crisis.

- Technology companies increase their footprint into financial markets.

The new Westpac hybrid began trading this week. As noted in earlier publications, this deal came at a cyclical low for credit spreads on bank hybrids. Following on from this issue, was the CBA hybrid that came to market and priced last week at a slightly higher margin (+3.40% vs 3.20%) for a shorter maturity (7 years vs 7.5 years). The CBA represented new supply, in a market that is often very price sensitive to supply and demand dynamics. Unsurprisingly, therefore the new Westpac bond (WBCPH) commenced trading at $98.60 on Wednesday , below its issue price of $100, and reflective of recent price weaknes accross in the hybrid market.  The CBA PERLS X (CBAPG) will commence trading on 9 April 2018. The chart illustrates the average movement in credit spreads on these securities in the last 6 years with recent margins at 3 year lows prior to the new supply from CBA.

Spread margins over bank bill swap rates as at issue date

Source: IRESS, Bloomberg
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  • We maintain a recommended list of hybrids with targeted entry prices. The selection is based on diversifying across industries, issuers and maturities.

Among the catalysts for the financial crisis was the heavily structured ‘special purpose vehicles’ (SPV’s) that contained complex debt instruments including collateralised debt obligations (CDO’S), credit linked notes and structured investment vehicles (SIV’s). Reminiscent of this are two complex bonds, a $700m note sold in 2015 and a $500m note sold in 2016, that contained packaged up loans to a group of airlines and placed in an SPV.The bonds were set up to let Etihad Airways raise funding for its European airlines without breaching EU laws which cap non-European ownership of EU airlines at 49% and restrict them from injecting capital into these airlines.

The exposure included two airlines which have now defaulted: the Italian airline ‘Alitalia’ and the German carrier ‘Air Berlin’. Adding further woes in the last week, is the announcement by the appointed brokerage firm ‘Anoa Capital’ that it is no longer able to carry out the role of managing the defaults of the underlying airlines. As a result, these bonds are now considered distressed debt, bonds trading at around EUR 0.68, over 30% lower than the bonds face value.  Bondholders are hopeful that Etihad Airways will, in good faith buy up these bonds at their face value, despite there being no obligation for them to do so.

Structure of Etihad’s complex collateralised bonds

Source: Tradeweb
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  • As investors hunt for better returns in a low yielding world, they need to be very mindful of the risks, especially on heavily structured deals which can disguise the security.

Discussed in markets of late is the expansion of technology companies into financial products. The large corporations have the biggest footprint with services and holdings that include:

- Google and Apple offering a payment system

- Apple being the largest owner of corporate debt in the world, with greater holdings than even the world’s largest bond fund

- Amazon lending money to consumers, and

- Alibaba managing customer funds like an asset manager

The growth of these shadow banks highlight concerns around regulation as they do not have the same rules imposed as the banks. Systematic risks that may arise from these non-banks could pose threats of contagion to broader financial markets. However, unlike the banks, the technology companies are unlikely to need financial aid in the form of a government bailout if things go wrong.

Corporate Comments

- Labor’s proposed changes to restrict franking credit cash refunds would potentially have an impact on near-term capital management plans and, longer term, dividend policies of ASX listed companies.

- Wesfarmers has received a boost from its proposed demerger of Coles.

The Labor Party brought Australia’s dividend imputation system into the forefront after it revealed a proposal to end the practice of cash rebates for investors who had accumulated excess imputation credits. While it would only affect investors who do not have a taxable income against which to offset their franking credits and there is much water to go under the bridge before such a policy was enacted, it is worthwhile considering how ASX listed companies may react under such a policy.

One possible outcome would be an acceleration in the capital management plans of listed companies, particularly those that are sitting on large franking credit balances. These balances represent the cumulative credits generated over time which have not been distributed to shareholders.

Typically, there is two ways in which a company can realise value from excess franking credits: by declaring franked special dividend payments, or more commonly, an off-market share buyback. The latter option is often preferred, as it generally allows a company to buy back its shares at a discount to its market price. The demand from shareholders for these is also usually high, due to the value of the franking credits attached, particularly to investors who have a zero marginal tax rate.

So, which companies may be in a position to undertake capital management?

The following chart illustrates the stocks in the ASX 200 with the highest percentage of franking credits to their current market capitalisation.

Unsurprisingly, many are domestic-focused companies (franking credits are generated from tax paid in Australia). Retailers feature heavily (in red), while several resource stocks (in green) also have significant balances.

ASX 200: Franking Credits as Percentage of Market Cap

Source: Bloomberg, Escala Partners
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In the ‘unlikely’ category would be companies that are facing challenging operating environment or are under some form of stress (radio groups Southern Cross and HT&E are examples, while some retailers would also be listed here, including Retail Food Group, Harvey Norman, Super Retail and Myer). The makeup of the share register may additionally rule out companies such as Washington Soul Pattinson, TPG Telecom and Premier Investments.

In our view, the more probable candidates from the list would be Caltex and Woolworths, followed by JB Hi-Fi, BHP Billiton, Rio Tinto and Woodside Petroleum. The resources stocks are somewhat complicated, with BHP and Rio operating a dual listed structure where their UK-listed equivalents currently trade at a discount of more than 10%. Woodside has recently undertaken an equity raising and so any near-term share buyback would perhaps be unlikely.

The broader implications of Labor’s proposal would relate to dividend policies of ASX companies. Compared to the rest of the world, Australia has been a high dividend equity market for a long period of time. While this is partly reflective of our largest companies operating in fairly mature industries (the banks, supermarkets, insurance, telecoms) it can also be attributed to the dividend imputation system.

If the attractiveness of franked dividends to a certain cohort of investors was reduced, then it would follow that there would be less pressure on company boards to distribute such high levels of their earnings as dividend payments.

While payout ratios have historically been quite high, we are also close to a peak in the cycle. Over the last several years, this has been driven by investors’ push for greater income from shares following ever-lower yields on fixed income and other asset classes. While the yield gap between shares and ‘risk-free’ measures, such as the 10-year government bond rate, remains high, there is the potential for this to close over the next few years.

The chart shows the one year forward payout ratios of the market and its key sectors over the last decade. Within the ASX 200 it has trended up from a level of around 55% several years ago, to approximately 70% today. The most significant change has occurred across resources stocks, which at one point had a payout ratio in excess of 100% until progressive dividend policies were abandoned.

The increase in industrials and the banks is less noticeable over time, however both sectors are currently expected to pay out around three quarters of their earnings in dividends. The upshot of such a policy change would be increased capex investment by companies into growth opportunities where they are available, which could represent a shift in investor balance in the market towards those who are looking for longer term capital growth rather than near-term income maximization.

ASX 200: Forward Consensus Payout Ratios

Source: Bloomberg, Escala Partners
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  • The potential change in policy settings re-inforces the benefit of utilising the expertise of a fund manager who can make an assessment on any proposed or likely changes in dividend policy. We recommend the Martin Currie SMA for income-seeking investors, with the manager well placed to make this judgement.

The arithmetic of 1+1 = 2 is challenged by demergers where investors appear to value the parts more than the combined entity. Wesfarmers (WES) surprised by annoucing its intent to demerge the Coles supermarkets from the Wesfarmers conglomerate. Coles represents approximately 35% of the profit of the group with the remainder dominated by Bunnings, though also with a mixed bag of variable profit contributors in Officeworks, discount stores, the safety and industrial division, chemicals and a remaining legacy of coal assets.

The Coles business will be headed by Steven Cain who has most recently been at the Metcash supermarket distribution division (and previously at Coles prior to its acquisition by Wesfarmers).

Coles has recently lost market share to Woolworths (WOW) which has regrouped after a period of mismangement. The sense is that price competition betweeen the two will be in a tense but stable equilibrium as long as there is no major shift in their share from now on. Both are likely to pursue other ways to combat the changing consumer patterns of convenient access, including online and convenience product in a higher level of preprepared meals.

The final structure is yet to be formulated. In our view, the market may have been generous in its interpretation (share price up 6% on Friday, however, this is still below the price from earlier this year). Supermaketing is a nominal GDP+ population growth business of around 5% p.a. It does not deserve a valuation premium. Similarly, while the Bunnings business is best in class, the other parts of this component are far from attractive. Not only is there a question mark on the ongoing cost of the UK Bunnings venture, but also its discount department stores where the lease liability hampers restructuring.

This may be an opportune time for investors to consider their combined positions in WES and WOW. Woolworths may capitulate to the pressure to exit its gaming business (which is a useful profit contributor) but as earlier noted, has an excess franking account to do a buyback. Both have merits and issues, and we see no need to hold them at their notional ASX 200 market weight of nearly 5%.

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