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WEEKEND LADDER

A summary of the week’s results

17.03.2017

Week Ending 17.03.2017

Inflation in most countries has increased, not only due to energy.  However, the rate appears to be levelling off and without wage rate pressure, at this stage, the CPI may take a breather. 

- The contents and structure of the inflation index is being restructured in both the UK and Australia. While a modest impact is likely, it points to the difficulty in measuring the CPI.

- To this, add two additional layers: a possible change in trade and the inflation impact from technological change.

Now that rates are on the move, the question is if the data is supportive of a higher or lower pace than the market is pricing in. US employment trends point clearly to higher rates. Jobs growth may level off, but that is likely due to the lack of labour skills rather than easing demand. Inflation has nudged higher and is now measuring 2.7% p.a. at a headline level and 2.2% p.a. at core.  Services prices have maintained their steady upward trajectory with most sub-segments making a contribution, including rent, up 3.5% in the year.

Source: Haver Analytics
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UK unemployment rate also tightened to 4.7% (from 4.8%), though the wage rate surprised on the downside, moderating to growth of 2.2% p.a. This is partially due to the relative increase in youth employment, a promising pattern that has been in place for more than a year.  It comes at a time the UK CPI is moving from its lows of 0% in 2015 and 0.7% in 2016 to an expected 2.5% this year.

As will be the case locally, the composition of the CPI in the UK will be remixed this year. Newspapers are headlining the inclusion of gin, bicycle helmets and ‘alternative’ milk products as a reflection of changing patterns in consumption. Meanwhile mobile phone handsets have been removed (only smartphones left in this segment) as well as children’s swings, which are no longer a regular backyard item. The rebalances tend to dampen trend CPI, a function of these shifting patterns.

The ABS will also reset the components of our CPI later in the year. House purchases is the single largest component at 9% and to date has only included detached housing. This will change to include multi-units, but that throws up significant complexity as to how to construct such a measure given the diversity and lack of repeatable product. The ABS will use a construction cost plus margin approach and, on balance, likely dampen the impact of housing on the CPI. Other components will move to being based off quarterly National Accounts, rather than the infrequent household expenditure surveys. In total, measured CPI is likely to remain range bound; ‘living’ CPI inevitably has a much wider dispersion, given spending patterns in demographics, household structure and income.

These data matter for investors, with some investments CPI linked (particularly property and other asset based utilities) and the RBA mandated to a CPI range.

Contra to the trends elsewhere, the Australian labour market weakened in February, registering 5.9% unemployment, though the composition was a little better, with a lift in full time jobs offset by a fall in part time roles. Yet, it remains the case that all of last year’s jobs added were in part-time positions and that the fall in hours worked implies even greater slack in the labour market than the headline unemployment number.

The impact of a decade or two of globalisation is another dimension in the CPI. It is represented in many ways. Tariffs in advanced economies fell from an average of 10% in 1980 to 4% in 2015. Emerging economies’ share of global trade rose from 27% in 1980 to just shy of 50% by 2015, and has been even more pronounced in value-add products. Notwithstanding a narrowing in the gap, emerging economies wage rates are still, on average, one third of those of developed economies and the corporate tax rate is also lower by around 10%. Mexico is a case in point as the US’s largest trading partner. Any shift in a company’s operations into the US from Mexico runs the considerable risk of being uncompetitive and adding to domestic inflation.

Source: Barclays, US Conference Board
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Without a commensurate (and, therefore, large) pickup in productivity, old fashioned stagflation becomes a real potential outcome if trade is curtailed.

Another level of complexity comes from the persistent changes to technology and automation. While this may keep prices in check as labour costs are removed, it is more than likely to add to productivity. The potential repercussions in some sectors from changes to their industry model is vast. At a presentation this week, one of our preferred global managers, MFS, took investors through the auto industry. The emergence of autonomous cars and sharing services impacts on transport systems, disposable income (based on car ownership as equivalent to about 15% of discretionary spending) and the insurance industry, amongst others.

The impact on the corporate sector is naturally a major topic for the auto manufacturing sector, but also for the providers of technology and services to this new utility service model. Tangible evidence is already apparent in the semiconductor industry, which supplies essential products in auto sensors, mapping systems, etc. Large companies such as Google, Tencent and Apple are also fighting for participation; not surprising given the relative market size of the automotive sector.

Fixed Income Update

Bond markets rallied following the FOMC meeting this week.

- There is a growing spread differential between long dated bond yields in Australia and the cash rate set by the RBA.

- There has been a strong performance for emerging market debt and other fixed income sectors despite a rising yield environment.

The bond market had fully priced this week’s rate hike by the Federal Open Market Committee (FOMC), so the market focused on the commentary by Janet Yellen and the accompanying dot plots. The message was one of gradual and consistent interest rate rises throughout 2017 (a total of three hikes forecast) and the same again in 2018. The market viewed this favourably and in the immediate aftermath, long dated bonds rallied (yields fell), both in the US and domestically.

Nonetheless, the market had already moved considerably in the past month. The long end of the Australian rates curve had followed the US moves leading into this week’s decision, with yields higher across the curve. Australian 10-year government bonds tested 3%, reaching a high of 2.98% last Friday. The 10 year ACGB (Australian Commonwealth Government Bond) hadn’t reached these levels since November 2015, and one would need to look back to July 2015 to see a breach of 3%.

While 2015 does not seem that long ago, it must be remembered that the RBA has cut rates twice (May and August last year) since then. The spread differential between the RBA cash rate and 10-year government bond therefore is of interest. The chart illustrates this spread differential over time, and while not yet at its historic peak, it is a measure that many fund managers are monitoring when trying to predict a potential cap in the 10-year yield. A level around 3.20% (a differential to the cash rate of 1.70%) would certainly be one to watch.

Spread Between RBA Cash Rate and 10 Year Government Bonds

Source: Iress, Escala Partners
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Despite the rise in bond yields over the last few months, returns within fixed income sectors have been favourable. One to note in recent times is the performance of Emerging Market (EM) debt. Rising interest rates in the US are considered challenging for emerging market countries, given the likely strength of the USD against those currencies. A depreciating EM currency is unfavourable for holders of debt denominated in the local currency (they lose on the currency movement) and for USD denominated bonds, as the risk of default rises.

The chart below shows that in this case, this proposition has not held true, as there has been little impact on EM currencies even though Fed rate rises are priced into the market. Improving commodity prices, smaller current account deficits and EM central banks managing their rate settings seems to have voided the correlation for the time being.

Rising Fed Hike Expectations and Emerging Market Debt

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In fact, fixed income has performed reasonably well despite bond yields trending higher in the last quarter. The following chart shows performance results for the underlying index in fixed income sectors, which were positive through 2016, the last quarter and in February this year.

Fixed Income Sector Returns

JPMorgan Asset Management
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Corporate Comments

Changes in state and federal energy policy will likely affect companies in the energy sector in the long term, however the short-term outlook is relatively unchanged.

- Myer’s (MYR) result highlighted the challenges of the department store sector

The national energy market has been at the forefront of the news in recent weeks, with state and federal governments outlining views and plans to address a looming energy crisis. There are several reasons for how Australia got to this point, although the key drivers include a lack of recent investment resulting from policy uncertainty, discovered gas being exported as LNG from Gladstone instead of being retained for the domestic market, and several coal-powered power station closures.

Closure of Coal-Fired Power Stations and Future Closures

Source: SA Government
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There has been several developments in the last few months that have potential implications for the domestic listed energy sector. These include:

- power blackouts in South Australia during extreme heat conditions over summer. The SA government has since followed with an energy plan that includes the construction of a state-owned gas fired power station to be used as a grid back-up, a 100MW battery storage project, and a package to incentivise gas exploration in the state.

- a report from the Australian Energy Market Operator (AEMO) highlighting the expected decline in domestic gas production in eastern Australia, which could result in a shortfall of gas-powered electricity generation within the next two years. The Prime Minister subsequently meet with key gas companies, reaching an agreement to provide more gas to the domestic market.

- an announcement from the Federal Government that it would expand the Snowy Mountains Hydro Scheme by nearly 50%. (Notably, this proposed 2000MWH expansion is less than half of the total coal closures illustrated above).

Eastern and South-Eastern Australia Gas Supply-Demand

Source: AMEO
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The key stocks that would be expected to be impacted by these announcements are the two primary integrated utility providers, AGL and Origin Energy.

South Australia’s energy plan has been viewed as having minimal impact on the outlook for either company. As the proposed state-owned gas fired power station will be used as a peaking plant (i.e. only utilised when demand is high), it will not directly affect the incumbent generators in the state. Nonetheless, Origin Energy, which has a higher exposure to peaking generation, may thus lose some value from these assets. The proposed battery storage project is also inconsequential in its overall size to have a significant impact on pricing.

The announcement of additional gas supply for the domestic market at this point lacks sufficient detail to reach an informed conclusion. Notionally, this would likely benefit AGL, which is short gas supply, as it would likely bring the cost of gas down. Where the gas comes from is another matter, with little capital expenditure in recent years and prices insufficient to incentivise new development. APA would be expected to be in the prime position to benefit from additional domestic gas development should this occur.

The Snowy Mountains Hydro announcement is potentially the most significant for AGL and ORG.

It is not unexpected that escalating electricity prices would prompt a response from the government given the sensitive nature of the topic for most voters. A tightening market has led to the current situation and thus additional electricity supply would help to ease the recent and looming pressures, but there is no easy solution.  

As a consequence, the short to medium term outlook for the existing electricity generators is largely unchanged, short of government intervention into pricing. As we have recently noted, the rapid rise in AGL’s share price in the last six months has been underpinned by a rising earnings profile driven by wholesale electricity prices. At some point in time, this will most likely plateau and potentially fall as additional supply helps to balance the market, however the prospect of enhanced profits in the medium term remains.

While analysts can gnash their teeth on the detail of Myer’s (MYR) first half result, the big picture of an industry in decline has been the overwhelming story for some years. Traditional department stores with multiple brands and large fixed costs have been pushed aside by the assortment of new specialty and own brand retailers, online and global reach. MYR managed a 5% increase in net profit on flat sales, with much coming from cost reduction after taking writedowns and provisions in recent years. History shows that excess cost reduction is inevitably at the expense of service standards while fixed charges, such as lease obligations, will continue to rise.

The sales in the Myer brands fell, compensated for by rising concession revenues.  Efforts to modernise the brand assortment through the acquisition of sass and bide and, recently, Topshop product has done little to induce customers into the stores.

Tactical investors may have been able to trade the occasional change in momentum, but as a portfolio holding, a department store is an unlikely source of long term return.


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