Week Ending 16.06.2017
- A sustained lift in European industrial production is coming from many industry segments. The test will be to see if it is maintained as China slows in the second half of the year.
- Australian labour market data surprised but is viewed as a catch-up given solid business conditions.
- Debate on the likely growth trend in Australia falls to the negative outlook for the household sector and the positive potential of capital spending.
The begrudging recognition that Europe is arguably the growth story of the year is reinforced by the breadth of the lift in activity.
Sector PMIs show a remarkably uniform expansion across almost all segments with an unusual lag in healthcare and tourism (presumably related to recent events). Powerhouse Germany is unsurprisingly leading the pack, though again it is broad spread with Austria and Netherlands not far behind. On May data, major European countries are all expanding more rapidly than the US (yes, even France). Asia is currently the laggard and industrial production across China, South Korea and Malaysia is not growing much at all, with Japan the standout in the region.
European sector PMI
The drivers of this Eurozone phenomenon are not all that obvious. Computers and electronic production has been particularly strong, interlinking with many of the other segments. Pharmaceutical exports, where Europe is by far the largest, has been particularly solid, which, in turn, requires sophisticated and up to date equipment and software.
Durable consumer goods are another sector with momentum, driven mostly by the auto sector, though the pace here is likely to moderate as export demand slows. In turn, manufacturing jobs are being created at a pace not seen for 20 years.
There are ancillary themes that are also shaping growth. For example, the adoption of electric cars, subsided in many European countries, requires investment into recharge stations. Then the expected fall in the demand for diesel cars has several European companies developing the so called 48V system where a 48V battery, belt starter generator and voltage converter is expected to become a mainstream technology to achieve lower CO2 emissions.
This optimistic picture has seen European equities move to the best performing region in the past six months. The question now raised is whether a slowing second half in China will translate into lower momentum in Europe, or whether it has enough traction in its internal demand to stave off this historic association.
Locally, the attention was on the labour market, where three months of improving data supports the contention that employment conditions have stabilised. Importantly, it is full time roles that have picked up as well as a better balance across the states, with Western Australia and Queensland recording the largest improvement.
Full time and part time employment growth
Many believe the data is catching up with other indicators, specifically the relatively positive business conditions and state based infrastructure spending.
In several meetings this week, the debate on the likely path for the Australian economy as well as the upside/downside risks coalesced to the view growth will improve, but be well below historic trends. The constrained household sector and limited policy measures to break away are the reasons for such opinion. On the downside is the inevitable housing market. A large component of mortgages are less than one month ahead of their payment schedule and clearly any income shock would be debilitating.
Mortgage Repayment Buffers
The other related factor is the progressive transition from interest only to interest and principal mortgages. This will unquestionably detract from spending, as these households’ outlays on housing rise.
The potential dampening effect of energy costs is frequently raised. Utility spending is a modest component of the CPI at 2%. Nonetheless, the secondary effects of higher energy costs in products and services means its impact will be greater and households tend to be attuned to any big price moves in these non-discretionary sectors.
Housing and Utilities weightings
On the positive is a stronger than expected capital spending cycle. Queensland is lining up for a renewal of its tourist facilities along with the possible Adani mine. State-based capital programmes are well underway, which may too come under pressure if property related income slows, as it accounts for around 30% of revenue for State budgets.
The free lunch of a fall in the AUD is still there, though less likely given demand for bonds and globally soft inflation, which is keeping a lid on hawkish interest rate movements. An outside chance of a rate cut is part of the debate, though most believe it would not have much impact on growth. It would also only be realised were economic conditions to deteriorate and then the AUD is likely to fall without the need for a rate cut.
Fixed Income Update
- The US Federal Reserve banks’ forecast for future interest rate outpaces that priced in by the bond market.
- Bond markets give back price movements in the wake of the UK election.
- Weakening in the ASX listed hybrid market.
As anticipated the Fed lifted interest rates. The accompanying statement indicated that the members anticipate lifting rates one more time before the year end, with three forecasts for 2018. Further, they laid out plans for a balance sheet reduction, albeit at a very gradual pace. While the policy outline is somewhat hawkish, weak US CPI data pushed bond yields lower and the market continues to price in less than the Fed. The dot plots show an expected rate at 2% by the end of 2018 as delineated by the Fed versus the bond market showing this rate to only be at 1.5%.
The FED dot plots implied forcast for interest rates vs the bond market
Another point of focus was the UK election result. While the GBP took the initial brunt of concerns, the reaction for bonds was fairly muted. The hung parliament creates political uncertainty, the potential for a repeat election and the possibility of a change in leadership. Initially these sentiments slightly aided the UK Gilt market (UK Government bonds) and yields fell across the curve as investors sought safe haven bonds. Subsequently, the bond market took back most of the rally, with many experts viewing the potential for a softer approach to Brexit and the likelihood of increased fiscal policy, in conjunction with the higher than expected CPI data that came out on Wednesday. On Thursday, the Bank of England kept rates on hold, although the votes indicated that 3 out of the 8 MPC members pushed for a rate hike. The net result is that rates are back where they were prior to the election and illustrates how markets have a tendancy to overshoot following an event.
5 year UK gilt yield movement over the week (% p.a)
In recent publications we have noted the fall in domestic bank equity prices following the budget and a ratings downgrade by S&P, but the resilience of the bank hybrid market as credit spreads continued to tighten. In the last three weeks, the hybrid market has finally weakened and credit spreads widened, with some of the biggest price falls in the the major banks tier 1 securities. While some of the shorter dated bank hybrids have held up (seemingly indiscriminately ie, NABPC spreads tighter while CBAPC’s are wider), the longer dated securities are all trading at lower prices than they were three weeks ago. Spread movements in the the insurance sector has favoured the shorter dates as indicated by tighter spreads for the 6 month SUNPC’s versus the longer dated SUNPE’s.
- CSL has paid a high price for the strategic purchase of a Chinese plasma company, although the market opportunity is large over the next decade.
- Vocus Group (VOC) has reiterated its guidance at a strategy day, with the market now waiting for its response to last week’s takeover approach from private equity.
- The Finkel Review should provide a more certain investment environment for Australia’s listed electricity generators, although the recommendations are yet to be implemented by the Federal Government.
CSL rose this week on the news that it was entering the Chinese plasma market, acquiring an 80% stake in Ruide for a price tag of US$352m. The acquisition cost is not overly material in the scheme of CSL’s global operations. CSL has effectively paid a premium for the strategic benefit of being the first foreign company to gain a foothold in the this market, which is expanding at a rapid pace.
Currently, China operates as a closed market in plasma products, with imports restricted. Albumin is the one product that is the exception to this regulation and CSL is the current market leader. As such, the expected high demand growth over the next decade will need to be fulfilled by domestic supply expansion. CSL’s ability to leverage its manufacturing expertise will be critical in the determining the success of its investment.
China Plasma Market Growth
CSL’s announcement this week is the latest in a string of recent positive news for the company, including an earnings upgrade in January, a solid half year result and a slow competitor reaction to the company’s plasma collection centre rollout, which is translating into higher market share in the US. Coupled with the expected turnaround in its acquired Novartis flu vaccine business, analysts expect double-digit EPS growth in the medium term. Arguably, this will be required to support the stock’s elevated valuation. While we view the company as a core long-term portfolio holding, we would caution against adding to positions given its current trading range.
Having received a takeover approach last week, Vocus Group (VOC) was under pressure to reiterate its FY17 guidance and provide a strategy roadmap to realise its earnings potential after a difficult 12 months. VOC ticked the box with its guidance, which remain unchanged, giving it a clear window between now and its full year results announcement in August to address the private equity takeover interest in the company.
A detailed strategy presentation highlighted not only the large market opportunity available to VOC as it seeks to leverage its asset base, but also some of the challenges that the company has faced as it has sought to integrate the combined businesses. While VOC notes that its forecast acquisition synergies remain on track to be delivered over the next few years, the company has clearly dropped the ball with its cash conversion, and this will be a focus of its new CFO.
Growth is likely to be a secondary consideration in this transitionary period, as other problems, such as high churn rates, should improve as customers switch to the NBN. Whether management get the opportunity to implement its strategy, however, is another question, with the company continuing to trade at a slight premium to the price of the private equity proposal.
Vocus: Forecast Run Rate of Cumulative Acquisition Synergies
The release of the Finkel Review into the security of the national electricity market failed to have much impact on the key listed generators, including AGL Energy (AGL) and Origin Energy (ORG). Seeking to strike an appropriate balance between security, reliability, lower costs for energy users and meeting carbon emissions reduction targets, the key recommendation of the review was the introduction of a Clean Energy Target (CET).
Recent crises have brought the national energy debate to a head over the last few months, which has come about by a lack of investment in new power stations and the closure of coal powered generation, itself a function of a high level of policy uncertainty. A corresponding spike in wholesale electricity prices (which is just now translating into power hikes for households and businesses) will put further pressure on the Federal Government to reach an acceptable bipartisan outcome sooner rather than later, with broad consensus now that a ‘business as usual’ approach will result in further undesirable outcomes.
Formal legislation is likely to provide a clearer path for the sector allowing informed investment decisions to be made, however higher electricity prices will still be inevitable in the short to medium term. We have identified AGL as a key beneficiary of this outcome, although the broad consensus view is that this is now captured into share price after a rally since last September.
Investment in New Electricity Generation and Power Plant Retirements