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WEEKEND LADDER

A summary of the week’s results

16.09.2016

Week Ending 16.09.2016

Eco Blog

•  The conversation next week will turn to the FOMC meeting and, of course, the football finals.

•  An outside chance is that the Bank of Japan (BOJ) will claim the underdog status and surprise. 

•  Long term trends in labour markets, wage rates and demographics remain one of the most challenging aspects for the developed world and have major ramifications for financial markets

The September FOMC meeting next week is finely balanced. While the forecasters imply there is roughly a 25% chance of a hike, there appear to be far more that are willing the Fed to put us out of our misery and just get on with it. The supporting data has been acceptable, though the inflation trigger seems as far off as ever. If it is not to be next week, the next stop is December, with the election in between.

The central bank in Japan may instead be the focus as it deliberates a ‘comprehensive’ assessment of the economy through the lens of monetary policy and price impact. What can the BoJ do next, given that its already wide-reaching easing has had so little impact? Merely expanding its balance sheet further seems unlikely and so-called ‘helicopter money’ is judged to be ill-conceived as well as facing constitutional hurdles.

The only probable way out for Japan is a lower currency, which should at least induce a level of inflation and change consumption habits. Can the BoJ run counter to the ethos of central banks and induce a loss of confidence in the stability of the Japanese financial structure?

The Australian labour market release showed that employment fell by 3,900 in August, yet the unemployment rate edged back to 5.6%. Putting aside monthly noise, the trend through the year is relatively stable. For the 12 months to August, full time employment rose by 32k while part time increased by 149k, reflecting the growth in service sector jobs and underlining the low wage momentum.

There is, however, one bigger picture issue that will have long term consequences. The participation rate is falling as a function of the aging population. It is remarkable how quickly the pattern has evolved and appears to coincide with the end of the mining and credit boom.

Participation Rate in the Labour Market

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The growth in the labour market is therefore increasingly dependent on immigration, or it has to encourage older workers (and their employers) to remain in the workforce for longer. Based on existing trends, the dependency ratio - the number of retirees per worker - is rapidly falling from the current 4-5 times across the developed world to a number that support the contention that robotic workers are the future! It points to a period where the distinction between developed and emerging economies may well change to a description based on the age demographic of each country.

The recent changes to the superannuation system may well be a precursor to other policies that will have to face this unavoidable pattern.

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Governor Lowe, having assumed the mantle from Glenn Stevens, held a steady rudder in his first outings. In a recent speech he noted that financial imbalances were possibly a better pointer of economic conditions than, for example, inflation. In that context reference was made to ‘the considerable supply of apartments scheduled to come on stream over the next couple of years’. Recent approvals figures suggest this could get worse and ASIC data this week showed that interest-only loans had once again spiked after some restraint last year as the regulator called out this issue. House prices and housing risk will remain a hot topic through 2017.

Fixed Income Update

The European and US summer holidays have come to an end, taking with it the calm levels of volatility on global fixed income markets. This week we discuss:

•  Cases and movements in global government bonds

•  Upcoming issuance by the Australian government, together with changes in the composition of buyers of these bonds

•  Some recent new bond issues, both domestically and offshore

This week has seen some significant downward moves in the global prices of bonds as yields tested three year highs in some regions. The driver has been the talk of a pull back on easing from central banks in Europe, the UK and Japan. The catalyst began when the ECB failed to announce that it is willing to extend its bond-buying program. In Japan, speculation mounted that the Bank of Japan may reduce purchases of long dated bonds in order to restore a steeper yield curve which aids banks margins. This has all played out amongst uncertainty that the Federal Reserve Bank is getting closer to raising rates again.

The reaction has been felt across all markets, with Australia being no exception. The short to middle part of the local yield curve has gone from inverted to flat, while the longer end has shifted upward.

Movements in the Australian Yield Curve in the Last Week

Source: Bloomberg, Escala Partners
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Higher yields will not be welcomed by the Australian government which has just recently unveiled plans to issue its first ever 30 year bond. Investor interest remains quite strong for Australian bonds given the relatively high yield, however, there has been some softening in demand at the regular bond tenders held by the Australian Office of Financial Management and ownership by foreign buyers has also fallen. In the last five years international central banks and sovereign wealth funds have been major buyers of local bonds, owning up to 80% of issuance. This has fallen to 60%, with domestic investors now purchasing the difference.

The reasons for this reduction in foreign ownership can be attributed to the increased rate of issuance of government debt, the lack of offshore demand for longer dated maturities and the continued strength of the Australian dollar throughout 2016. Australia's government would welcome a weaker currency to help attract foreign bond buyers. 

AUD/USD in 2016

Source: Iress, Escala Partners
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In what could be impeccable timing, French pharmaceutical company Sanofi and German consumer goods company Henkel, became the first non-bank corporates to issue a negative yielding bond just prior to the global bond sell-off. Sanofi sold €1 billion of a 3 ½ year bond with a yield to maturity of -0.05% (issued at $100.167, maturity value of $100 with a zero coupon) while Henkel issued a 2 year bond at the same yield (issued at $100.10, maturity at $100 and a zero coupon).

In previous publications we have discussed the upcoming changes to the regulatory framework for money market funds and the impact that has had on demand for short term debt instruments such as Commercial Paper (CP) and Certificates of Deposit (CDs). In light of this, banks have been issuing short dated bonds, with NAB, ANZ and Westpac all printing 1 year bonds since July. All three transactions were for at least $1bn at a spread of 3mth BBSW+ 43bp.

There has also been increased volatility in credit markets, with spreads widening (bond prices falling) following a period of contraction. Last week the Australian iTraxx (which measures a basket of 5 year senior debt credit spreads) hit a one year low of +95 before moving to +100. The listed debt market has followed the pattern, trading lower with bank hybrids weakening the most over the week, closely followed by corporate subordinated bonds, such as AGL and Caltex.

Corporate Comments

In a well flagged deal, JB Hi-Fi (JBH) is to acquire The Good Guys for $870m. It is funding this through a $394m renounceable rights offer and $450m of debt. On a full year basis, before implementation costs and synergies, the acquisition is expected to be 11.6% EPS accretive. Costs of $10-12m will be incurred in the first year and balanced by subsequent benefits within the combined group of $15-20m p.a. after an integration period.

To date, The Good Guys has run a blended model of wholly-owned and joint venture stores. This is moving to a wholly owned structure under JBH and it is expected that the transition will temper sales growth for the course of this fiscal year.

JBH will gain considerable scale in the home appliances segment and has suggested it has scope to add 4-5 Good Guys stores per annum, while also rolling out its own Home format.

JB Hi-Fi and The Good Guys

Source: JB Hi-Fi
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For JHB investors the key questions are:

•  The level of cost saving and sales growth appears to be conservatively pitched. A degree of caution is clearly warranted, but to under-promise and over-deliver points to positive share price momentum given the tendency of analysts to congregate around ‘guidance’.

•  The store growth is relatively aggressive, particularly through two brands, The Good Guys and Home. JBH will have to convince investors that there is room for two propositions and that it can manage both without compromising either. The most direct competitor in Harvey Norman has also recommenced store openings, after closing a number in recent years. The recent history of hardware and supermarket retailing show the destruction that can come from two groups seeking to dominate headline growth through rapid expansion of floor space. Globally, the case is made that store sizes can be reduced to showcase only and all stock coming from warehouses delivered within a short time to the home.

•  The sector clearly aligns with the housing cycle. Is this time different? First home buyers have not participated, with affordability at a low level.  Conversely, apartments and rental property are the bulk of the momentum and the need or willingness to spend on home appliances is lower. 

Compared to many other retailers, JBH stands out with stable management, profit margins that appear defensible and a demonstrated capacity in moving its product assortment along with the times. The valuation for FY17 is muddied by the transitional period and the share price is more likely to react to updates and general trends in demand.  The FY18 P/E of 16-17X appears to balance between the risks versus the potential that could emerge from the acquisition.

Staying with the retail sector, Myer’s (MYR) full year result to end July was met with some disappointment. In FY15 the group had reset its destiny, closing stores, changing the mix of concession, own brand and external brand sales and undertaking a large equity issue to reduce the debt levels. While sales growth made some progress at 2.9% on a comparable basis, gross margin fell by 164bp. Cost of doing business edged down, though some of that may be from the restructure provisions and it will take further time to confirm that the business can run at lower costs on a sustainable basis.

The outlook for Myer remains difficult. The competitive pressures have not let up, consumers are less loyal to destinations and overall spending is muted. After its fall from grace in 2015, the stock has largely marked time. It may be a productive pursuit for very active funds to trade the stock within its broad range, but we can find no good reason to hold MYR longer term.

The Vexing VIX

The VIX is often quoted in financial media on a regular basis, although is perhaps less well understood by investors. In this article we explain what it is exactly, what it tells us and how effective it is in predicting future returns and market movements.

What is the VIX?

The VIX measures the level of expected volatility of a market over the next 30 days as implied by the options market. The most commonly quoted VIX is the Chicago Board Options Exchange Volatility Index (CBOE VIX or often simply referred to as ‘the VIX’), which measures the level of expected volatility on the S&P 500 Index (the primary US large-cap index). For the purposes of this article we will focus on the Australian equivalent, the S&P/ASX 200 VIX (which we will refer to ‘the VIX’ for the rest of this article). Volatility levels are typically highly correlated across equity markets, thus a high CBOE VIX level will correspond with a high S&P/ASX 200 VIX level.

Put simply, a high VIX level means that there is considerable uncertainty over market direction in the near term, while a low VIX means that investors expect little change in the market. As a result, the VIX is a good indicator of aggregate investor sentiment and is often referred to as the ‘fear index’; the higher the VIX, the more investors believe that the market is less predictable, the higher the premium to insure against future losses. The VIX is also important with regards to active funds management. A low VIX level will generally make the task of achieving high returns relative to a benchmark more difficult (the level of correlation across stocks and sectors is also important).

For the statistically-minded, the VIX is presented in percentage terms as the expected standard deviation (calculated on an annualised basis) of a market in the next month. This is a useful reference point to compare the current VIX level against the historical volatility (standard deviation) of the market, which has averaged 13.2% over the last 15 years.

Where is the VIX currently trading?

Presently the VIX is at 15.5. While it has risen off a low base over the last few weeks as uncertainty around central bank policy has crept into markets, the VIX has come off an historically low base, which has been reflected in reduced volatility in market returns. At the height of the global financial crisis in 2008, the VIX peaked above 60, however over the last four years has largely oscillated between 10 and 20.

As a result, while there have been short spikes in volatility over the last 12 months around certain events (e.g. Brexit and Federal Reserve deliberations), the level of volatility has not been unusual and, if anything, has been lower than long term averages.

How good is the VIX at predicting future near-term volatility?

The following chart illustrates the VIX level at the beginning of the month along with the actual realised volatility of the ASX 200. The VIX appears to be a fairly reliable indicator of future volatility, with the two series tracking each other closely.

What is evident is that the average VIX level is higher than the average realised volatility over time. The primary reason for this is the inherent premium in options prices to justify the market. The higher the premium, the greater the difference between the two series.

ASX 200: VIX and Realised Volatility

Source: Iress, Escala Partners
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Can it be used to predict future returns?

Of more interest to investors would be whether or not the VIX is useful at all in predicting future market direction. A common perception would be that a high or rising VIX would lead to weaker market returns. An analysis of monthly market returns and changes in the VIX, however, suggests otherwise.

The following charts plot the monthly change in the VIX and the benchmark ASX 200 since 2008. The first chart illustrates a clear negative relationship between the change in the VIX and the monthly return of the ASX 200. An approximate 7% rise in the VIX corresponds with a 1% decline in the market.

However, the chart shows that the changes occur at the same time, i.e. the VIX changes as the market does. In order to test the predictive nature of the VIX, we have compared the change in the VIX in the month prior to that of the market. This is shown in the second chart, which shows no discernible relationship between the two.

Source: Iress, Escala Partners
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Similarly, the absolute level of the VIX has little predictability in forecasting monthly market returns. The following chart shows that there is little relationship between the VIX level at the start of the month and the return on the index for that month. Essentially what this shows is that high levels of expected volatility do not necessarily lead to low market returns.

Source: Iress, Escala Partners
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Conclusions

•  the VIX is a useful indicator as a measure of market sentiment as well as future near-term volatility levels

•  the VIX is typically a few percentage points above actual volatility

•  the VIX is not helpful in predicting future market returns. This is true of the change in the VIX and the absolute level of the VIX. An increase in the VIX will typically coincide with weakness in equity markets, however provides little information about future market returns.

 



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