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WEEKEND LADDER

A summary of the week’s results

16.11.2018

Week Ending 16.11.2018

Eco Blog

- China is centre stage as financial markets mull on the potential for a trade resolution and closely observe data for signs of slowing. Then there is the debate on the nature and degree of stimulus.

- The domestic housing market remains topical. One of the more certain outcomes is lower revenues for state governments from stamp duty, although the RBA is pleased with a moderation in the market.

The optimists rationalise that both the US and China have a vested interest to come to a resolution. There are claims that behind the scenes the advisors are working on a list of issues.

  • China is likely to offer some concessions on opening its market to foreign ownership. In July, the National Development and Reform Commission reduced the number of industries (from 63 to 48) where it restricted foreign ownership. The most prominent was the auto sector, which had its first high profile move with BMW to progressively increase its holdings in Brilliance Auto from 50% to 75%. There are suggestions Ford will do the same with its JV.
  • A promise by China to buy a committed level of politically-important goods is another possible concession. Agriculture is an obvious one, and aircraft would allow for big ticket items to appear in the trade balance.
  • Another sore spot is protection of intellectual property and common requirement that foreign contractors give full access to their production methods and systems. China may set in place a way to improve their rules on IP.
  • Finally, there is the currency. China would likely be reluctant to push too hard on reflating the RMB, validly arguing that part of the weakness is due to its economic trend and low bond rate. The current account surplus looks likely to turn to a deficit in coming years; a further head wind for the currency.

Current account balance, US$bn

Source: TS Lombard
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To avoid the deteriorating trade balance, China will need to increase its value-add and price points of its exports. This neatly ties in with the government’s industrial policy. But it will be services that also play a role. Australia is a large beneficiary of tourism and education and there is a latent risk that the latter may become a policy tool where the government restricts the flow of students to foreign shores.

Unlike the new NAFTA (Mexico, Canada and US trade arrangement), there is no formal agreement that will emerge, and therefore the wording of a statement will be important to get a sense of the outcome. The hurdle at this stage appears to be a select number of advisors in the US administration that rail against any rapprochement with China.

Getting a clear reading on the Chinese economy is a tricky assignment. Most view the stated GDP data as misleading, though the direction is accurate. The component parts arguably matter more than their sum. The government would be aiming to manage a gentle slowdown, but also avoid perceptions of another credit-fuelled boost.

Recent data shows a small recovery in infrastructure spending to 3.7% growth, with the focus on rail and road projects. Retail sales (ex-auto) are flat, a reasonable outcome given the weaker sentiment in recent months. Manufacturing growth at 9.1% remains strong. To date, the pointers are for a small easing on growth in Q4.

The two trouble spots are property and the potential for a much larger than anticipated fall in exports. Real estate accounts for 20% of GDP and is the only asset for the majority of the population. Land sales have been strong, adding to government revenue. However, demand is relatively weak and the government may resort to supporting mortgage growth. In turn, this would likely mean lower consumption spending. Further, property companies are highly leveraged and have a large refinancing requirement into 2019. Defaults would be a sign that the government will not use its coffers to avoid bankruptcy, but it may see costs for the sector rise as investors price in the riskier outlook.

The degree to which the export sector falls into 2019 is unclear. It is clear that orders were frontloaded to avoid the tariffs and the slump could therefore be larger than expected.

We have noted the many policy changes that the government is undertaking to soften a downturn. Most commentators view these positively in that they are aimed at lower income groups and other specific measures rather than a broad sweep. But their effectiveness is far from obvious. Another bout may be forthcoming.

Magnitude of credit easing in previous cycles

Source: TS Lombard
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  • It goes without saying that the outlook for China forms a core component of that for Australia, though its role in the world is probably underestimated. Sentiment is now key with all ears on the G20 summit.

Locally, the employment data was unquestionably good. 42,000 new full-time jobs were added and the run rate over the past few months has been above trend. The unemployment rate held steady at 5% due to a rise in the participation rate. It is always worth bearing in mind that the Australian labour force is growing at around 2% per annum, unlike the flat or falling trend in most developed countries.

Much of the commentary on housing is, in our view, taking extreme views on the potential fall in price and impact on the economy. One issue that is real is that state governments will see reduced revenues right at a time they are making major (and not so major electioneering-promised) spending commitments. The decline is leveraged given the impact on volume and value. Higher state funding requirements may indirectly weigh on the RBA as another factor in its rate decision.

Transfer duty as a proportion of state government revenue

Source: Various state and territory financial reports, ANZ Research
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The Australian outlook remains balanced. Housing risk in all its dimensions is becoming the most prominent. Notably, the RBA is suggesting that itself and APRA have achieved their goals, which may see a moderation in the tolerance towards mortgage credit.

Focus on ETFs

- We have discussed ETFs that focus on specific regions or sectors. However, there are also ETFs that cover broader global markets across regions and countries. These ETFs follow broader based indexes such as the MSCI World Index and the MSCI All Country Index or variations of these indexes.

There are 10 global ETFs available on the ASX, six unhedged funds and four hedged. We will focus on the unhedged funds. Of these ETFs, iShares Global 100 ETF (IOO) is largest and follows the S&P Global 100 index, consisting of the 100 biggest companies by market capitalization. There is a heavy skew towards US equities and the technology sector, as well as a high concentration risk, with the top 10 stocks making up nearly 40%. As a result of these weightings this ETF has displayed the strong performance over the last 2 years, returning 18% pa.

iShares also offers a broader based ETF, iShares Core MSCI World All Cap ETF (IWLD), which follows the MSCI World Investable Market Index. There are nearly 4,000 constituents and it replicates the index by investing in four ETFs. IWLD also has an allocation to Australia, albeit 2.5%.

Both Vanguard and State Street also offer broad based global exposures, that exclude Australia. SPDR® S&P World ex Australia Fund (WXOZ) follows the S&P Developed Ex AUS Large Mid index and Vanguard MSCI Index Intl ETF (VGS) MSCI World Ex Australia NR AU. These indexes essentially offer the same exposures and number of companies. The main difference between these ETFs is fees, VGS offer a 0.18% fee compared to WXOZ’s 0.30%. The other difference is frequency of distributions, VGS pays semi-annual distributions whereas WXOZ pays annual. Both factors will have an small impact on performance.

Global broad based ETFs regional exposures

Source: Morningstar, Escala Partners
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The United States makes up 55% of the MSCI All Country World Index, therefore, the performance between the MSCI ACWI and US equites are relatively closely aligned. For investors that want to diversify away from US equities iShares MSCI EAFE ETF (IVE) and Vanguard All-World ex-US Shares ETF (VEU) track indexes that exclude the US.

Global broad based ETFs performance as at 30 October 2018

Source: Morningstar, Escala Partners
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  • A blended approach of our recommended international funds will provide a diverse global exposure. IVV, IOO and VEU can supplement these funds depending on the outlook for each regiona or segment. For tactical tilts, we would suggest using sub-regional or sector ETFs.

Fixed Income Update

- Reduced volatility on US treasuries attracts investment.

- We flesh out the implications of APRA’s suggestion of higher capital ratios (via issuance of subordinated bonds) for the banks.

- Reports that the Australian government will support small businesses through a specific fund may change the dynamics of the growing non-bank lending structures.

- General Electric bonds fall in price as balance sheet concerns weigh on their debt.

Global bond yields have pared back as demand picks up reflecting the stabilisation of prices in the US bond market.  This follows the pattern of October in which bond funds had outflows of $36bn, the biggest monthly redemption in almost three years. Emerging market and European debt funds continue to see outflows as trade tensions, China’s growth and Brexit negotiations weigh on sentiment.

MOVE index measuring US treasury volatility

Source: Bloomberg, Escala Partners
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We have noted that the regulator APRA has proposed that Australian Deposit Institution’s (ADI’s) increase their loss absorbing capacities by issuing around $75bn in subordinated bonds (Additional Tier 2) over the next 4 years. This is designed to ensure that the banks have sufficient capital in the event of a failure without needing taxpayer support. The proposal substitutes for total loss absorbing bonds (TLAC “bail in” bonds) that have been introduced into the US and European market. 

The structure is positive for TD’s and the senior bonds of the banks, with total capital ratios set to rise from ~15% to ~20%. Debt that is ranked above Tier 2 will be of lower risk as more subordination (extra loss absorbing bonds) are built underneath.

The extra issuance of subordinated bonds will replace some of the banks senior unsecured borrowings with net issuance of senior bonds set to fall from ~$400m to ~$300m while the Tier 2 subordinated bonds will increase from ~$37bn to above $100bn.   It is likely that the banks will access funding via both the ASX listed and wholesale markets domestically and offshore. This change is expected to increase the average funding costs for the majors by around 4-5bps.

  • Given the increased supply, it is expected that credit spreads on subordinated bonds will widen, while senior bank bond spreads should contract. For existing holders of subordinated bonds, prices are likely to weaken, but the new supply will open up the opportunity to get set at higher margins. Further, the ASX listed market has been starved of these bonds, so more supply is a positive.

The government is proposing an injection of $2 billion into a taxpayer-backed securitisation fund to invest in small and medium enterprise (SME) credit. The fund would buy packages of secured and unsecured SME loans issued by smaller banks and non-bank lenders. With tighter lending standards, small businesses have often found it difficult to access bank funding at competitive rates. The initiative is an effort to boost funding to this sector while lowering their borrowing costs. Capital is expected to be deployed alongside private debt investors in what is known as a ‘warehouse facility’ of loans originated from the likes of Liberty, Bank of Queensland, and Prosper.

  • The new fund will be competing for deals with other private debt funds that we view in this sector. Spreads are likely to tighten in as capital chases these loans.

Recent concerns on the financial health of General Electric has resulted in a dramatic drop in the price of the company’s equity and debt. Despite being rated investment grade quality (BBB+) by the rating agency S&P, the credit spread on the debt is trading akin to below investment grade names. For example, a GE USD FRN maturing in 2023 has had a price fall from $97 to $91 in 6 weeks as its credit spread widened from Libor +1.41% to its current trading margin of +3%. The cost of insuring against the company defaulting on its debts via a credit default swap (CDS) has risen to a 6.5 year high of above +2%, up from +0.57% two months ago.

CDS on GE senior bonds

Source: Bloomberg, Escala Partners
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  • Credit ratings are only one metric one should view when undertaking credit analysis on a company. In the case of GE, the high leverage is a concern, and the market is pricing the risk in line with much lower rated credits. 

Corporate Comments

- While there are multiple factors that are contributing to weakness in the housing cycle, the most likely scenarios in the medium term appear to be manageable for the major banks. A recession would hurt the sector, but additionally most of the domestic equity market.

- Dulux (DLX) has added to its record of consistent profit growth, although the stock has less appeal from the perspective of its outlook and valuation.

- Cost pressures point to margin compression across a range of companies. Earnings estimates for FY19 may be tapped down as a result.

Post their reporting season, the banking sector has remained in the headlines thanks to broker research outlining a range of possible scenarios that may materialise over the next few years. The focus is on the housing market, with prices already rolling over in the last 12 months (particularly in Sydney and Melbourne) after a long period of strong price growth.

The risks to falling prices and housing credit growth have arisen from several cumulative factors. Regulatory pressure from APRA to restrict investor lending and interest-only borrowing came first, then the fallout of the Royal Commision, which has highlighted cases of irresponsible lending practices (broadly speaking, the assessment of potential borrowers’ expenses has been lax, leading to high loan to income ratios), and finally, potentially reduced investor appetite with the prospect of changes to negative gearing and capital gains tax under a Labor government.

It is worth reflecting on the possible scenarios compared to where the market currently stands today. As illustrated in the table below, the worst scenarios painted in the report would represent a marked deterioration from not only current market indicators, but also compared to history. For example, negative housing credit growth is unprecedented over the last few decades; bad debts did not even reach 100bp throughout the global financial crisis; and earnings and dividends fell by less than 30% through that period.

Banking Sector: Stressed Scenarios

Source: Bloomberg, company reports, broker research
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While not discounting the possibility that the current tightening phase underway could lead to a sharper credit crunch, this is hardly the base line expectation of even the most bearish sell side analysts that cover the sector (including the author of said report) and the domestic recession that would likely trigger this outcome would be equally negative for most sectors of our equity market.

A ‘muddle-through’ outcome is closer to consensus expectations: housing credit to remain in a low single-digit range (already low by historic records), cost growth and stable net interest margins to keep the brakes on overall profit growth, bad debts to gradually rise to average levels, which all imply a fairly flat earnings and dividend profile.

Nonetheless, the risks across the sector are sufficient to keep a watchful eye on developments, particularly for investors who have retained a large exposure and are reliant on the current high dividend yield.

Rolling 12-month Housing Credit Growth

Source: RBA, Escala Partners
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DuluxGroup (DLX) is another company that is dependent on the domestic housing cycle, although its earnings profile has typcially exhibited much less variability than others that have enjoyed an extended tailwind from a buoyant market. Led by its high quality, core Paints and Coatings division, DLX reported a respectable, if modest, 5% growth in earnings and 6% rise in dividends for FY18.

DLX’s illustration of its end market exposure helps to explain the longer-term resilience of its earnings base in softer market conditions; 65% is ‘maintenance and home improvement’, 15% is ‘commercial and engineering’, 5% is ‘industrial’, leaving the residual 15% to ‘new housing’. The latter is obviously the risk, although the lag between housing approvals and completions leads to the conclusion that demand may hold up in the short term. It is also worth noting that the more volatile component of housing construction is within the apartment sector, where DLX is less exposed.

Nonetheless, the environment can still be expected to be more difficult in the medium term, although this is scarcely reflected in its forward P/E of 18x.

One area where DLX has got a tick is on managing the costs side of its business, which has been a key takeaway from the recent reporting season and AGM trading updates over the last month. Despite a double-digit increase in the cost of raw materials for the year, a sharp focus on costs combined with price management allowed DLX to hold its margins steady.

Having less success on this front is packaging company Pact Group (PGH), which issued a further earnings downgrade at its AGM. PGH is one of many companies in the market that has inbuilt pricing mechanisms to recover rising costs, although typically with a lag. In periods of high cost inflation (as presently experienced), the impact on the earnings base can be quite siginficant. While there may eventually be a margin recovery over time, the market’s focus on short term earnings will generally mean that the stock will trade at a discount until evidence emerges that conditions are improving.

The high number of companies refering to cost pressure does point to one of two possible outcomes as we progress through FY19: weaker margins as these are partially aborbed, or higher inflation and hence interest rate expectations if these are passed onto consumers. What may add this trend is further emergence of wage growth, although Australia is lagging other economies (such as the US, Germany and even UK) on this measure. The net result for equity markets is less than ideal – in the first, earnings downgrades, or in the latter, higher discount rates. Both scenarios would put a cap on share price appreciation.

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