Week Ending 17.04.2015
The IMF’s biannual World Economic Outlook confirmed some trends that we have discussed in recent months. While the US is still forecast to be the core driver of growth in developed economies, this expected rate has moderated somewhat since the IMF’s last update in January, with estimated GDP growth of just over 3% for each of 2015 and 2016 (see table below). Conversely, forecasts for Europe have edged up a little, with a better result now expected from Germany, France and even Spain. On aggregate, expectations for overall global output are similar to those at the beginning of the year.
IMF World Economic Outlook Projections
While developed economies are expected to show improved growth in 2015 (compared with 2014), this is offset by a slightly lower emerging market growth rate. Nonetheless, emerging markets are still expected to account for more than 70% of total global growth in 2015, underlying their importance.
The IMF report also highlighted the impact that lower oil prices could potentially have on the global economy. Under its ‘limited pass through’ scenario (which assumes the management of the oil price to a degree in certain countries and is effectively the baseline assumption), global GDP would be expected to be approximately 0.5% p.a. higher in each of the next three years. While on balance this is a clear positive for economic growth, the IMF also suggested that the economic shocks for large oil-exporting countries could be larger than expected, limiting the overall benefit.
Another factor that may determine this potential impact from lower oil will be the willingness of consumers to spend this implied boost to their incomes. In the US, the recent signs are not great. The personal saving rate increased to 5.8% in February, a two year high, indicating that consumers are pocketing these savings and thus reducing this potential flow through to the economy. This was also reflected in retail sales data for March released this week, with a 0.4% rise excluding automobiles.
China captured much of the market’s attention this week, with the release of several data points. Trade data for March was weak, with both imports (-13%) and exports (-15%) posting negative double-digit year-on-year growth. Imports were expected to be lower given the decline in commodity prices, however it was the export data that surprised analysts. While this was the case, few read much into these single data points given the volatility that is typical early in the year around the Chinese New Year holidays.
First quarter GDP growth (year-on-year) unsurprisingly came in line with the government’s target of 7%, the lowest rate in seven years. Other data points missed expectations, including retail sales, industrial production and fixed assets growth. With quarter-on-quarter GDP growth of just 1.3% (or 5.3% on an annualised basis), many commentators are now expecting a slight miss to the 2015 growth target.
There are two key sources for this pessimism. Firstly, the property market has been an ongoing source of weakness for some time now, with little response so far from the government’s efforts to relax a number of policies. Property sales improved slightly in March (although remained in negative territory month-on-month), however property starts were noticeably weak.
Secondly, industrial production figures fell to their lowest level since February 2009 and implied a sharper decline than suggested by the official GDP data. The chart below shows that the weakness was across the board.
China Property Starts
China Industrial Production
This week’s data has increased the probability of further policy easing by the central bank, the People’s Bank of China (PBoC) and anaemic inflation data supports this view. The tool used by PBoC is the reserve requirement ratio (RRR), a minimum level that banks are required to hold as reserves. Currently this sits at 19.5% following a 50bp cut in February, which was the first change in policy in nearly three years. Fiscal stimulus and policies are also likely to be explored by the government as it seeks to achieve its stated aim, with investment in large infrastructure projects at the forefront of this strategy.
Domestically, we had employment data for March, with the unemployment rate defying expectations to drop 0.1% to 6.1%. The key data points were all encouraging; employment growth of 37,700 was primarily made of full time jobs (+31,500), part-time jobs also advanced and the participation rate was also a little higher. Aggregated hours worked, however, increased 0.3% with the rate slowing on a year-on-year basis. It is possible that employment-intensive industries, such as hospitality, healthcare and professional services are supporting the employment data at present, with a larger impact to GDP from those that are more capital-intensive, particularly mining. The result also shows some consistency with the strength seen over the last ten months in the ANZ job ads series, although we note that this has tapered off this year.
While at face value the employment data looked to be relatively robust, unfortunately for the ABS, the data set continues to be plagued by issues of reliability. Recent revisions to the data, volatility in month-to-month results and issues with the seasonality of the data have led to issues interpreting the figures. From a domestic equities perspective, the investment case is also weakened to a degree – the $A has appreciated following the news (a key driver of the appreciation in companies with overseas earnings) and the probability of an interest rate cut in the near term has also been reduced, impacting the yield trade.
Australian Employment and Participation Rate
Fixed Income Commentary
The recent steep fall in the iron ore price has led the rating agency Standard and Poor’s (S&P) to put the State of Western Australia’s AA+ rating on negative watch. S&P has concerns about the impact of lower mining royalties on their budget, and has indicated that they are likely to be downgraded unless the WA state government undertakes significant corrective measures.
As expected the WATC bond prices fell, with spreads widening out about 8-10bp at the long end of the curve. Other semi-government bonds followed the momentum, but albeit to a lesser degree.
State Government Credit Spreads
Despite there being no reference to a downgrade risk to Australia’s AAA credit rating, further falls in commodity prices may put this under the spotlight.
As highlighted previously in the Weekend Ladder, April has $26.75 billion in bond maturities (not including corporates). The rollover of these maturities is well under way with the issuance of the $4.25 billion ACGB 2035 and this week’s 2025 South Australian Government Financing Authority (‘SAFA”) bond yielding 2.835%. Both new issues were well bid, indicating the continued appetite for quality government backed bonds.
The Australian bond index will extend out on the back of these maturities ($17.5 billion maturing this week alone), taking the duration of the bond index beyond 4.5 years. Funds that benchmark against the index and ETF’s will also extend out in duration, and demand for the long end will flatten the long end of the yield curve further. Investors in these types of funds and ETF’s need to be mindful of the increased interest rate risk that this creates.
Returns in the Australian Fixed Income market and the Global Fixed Income market have been at 10% and 11% respectively in the last 12 months. The strong performance of this asset class has raised concerns around a potential for a “bond bubble”. However, as was recently highlighted in an article by FIIG, bond market crashes are rare. The largest bond market crash the US has seen in the last 160 years, was a fall of 12.5% in 1980. The stock market has seen annual falls beyond this level on 23 separate occasions since 1900. Unless we see a sudden tightening in monetary policy by the RBA or Fed, or inflation spikes, we expect that the bond market will continue to produce positive returns, albeit at a lower level than the last year.
Further consolidation in the telecommunications sector was news again this week, with M2 Group (MTU) announcing that it had acquired Call Plus for $245m. Call Plus is New Zealand’s third largest provider of broadband and fixed voice services, predominantly servicing the consumer market. Typical of recent transactions in the sector, it could be viewed as ‘win/win’ given the significant forecast 15% boost to MTU’s earnings per share in FY16.
With the transaction entirely funded by debt, MTU’s debt/EBITDA ratio is now expected to rise to a relatively high gearing level of 2.0x. Given this, it would be increasingly unlikely that M2 will entertain a possible bid for iiNet (IIN) (which has recently agreed to a merger with TPG Telecom (TPM)) leaving Optus as the only other major telco as a possible rival bidder. M2 is another smaller telco that has enjoyed relative success over the last few years, notwithstanding issues it has experienced with customer churn along with strong competition from TPM (who have also employed a low-cost strategy and enjoy an infrastructure advantage over its smaller peer).
Woodside (WPL) became the first of the major oil stocks to reveal the extent of the impact of lower oil prices for the first quarter of 2015. Compared to the fourth quarter of 2014, revenue fell 20% despite being assisted by a drawdown on inventory. Better pricing from its LNG contracts also likely played a part in cushioning the impact. Production fell 7% for the quarter, affected by cyclone activity in Western Australia. WPL also slightly downgraded its full year production guidance due to lower production now expected from assets that it recently acquired.
As we have previously highlighted, however, this guidance already implies an approximate 5-6% reduction in production on 2014 level, despite the addition of some acquired assets. With the growth opportunities that the company has long-dated in nature (and some with what could be described as marginal economics), this is likely a problem that WPL will face in the medium term. We also express some caution over investors who are holding the stock for its high (trailing) dividend, which should be much lower in 2015. While we have some confidence in a recovery in the oil market at some point in time over the next 12 months, WPL has less leverage to this compared with the other large-cap oil stocks in the market and will likely underperform in this environment.
Fortescue (FMG) also released a quarterly production report, demonstrating an ability to draw on several measures to improve its cash flow. Cost savings continue to be realised, with FMG guiding to further improvement in FY16 through a combination of improving efficiency and productivity, consolidating its mining contractors, procurement savings and a lower natural gas supply cost. On this basis, FMG now estimates that it will be break even (from an all-in costs perspective) at a price of US$40/t, a little below the current price.
With its core expansion plans now complete, the fortunes of the company are now largely in the hands of its big diversified peers – BHP Billiton (BHP), Rio Tinto (RIO) and Brazil’s Vale, as they continue to add tonnes to a well-supplied market that is showing little demand growth. Having entered the second quarter of 2015 a number of banks have updated their commodity price forecasts, with fairly significant cuts in particular to iron ore. The chart below highlights new forecasts from four brokers, with two expecting a further deterioration to US$40/t or less. With FMG still carrying a heavy debt burden for its size, concerns over its liquidity as it approaches a 2017 maturity appear to be valid.
Iron Ore: Quarterly Price Forecasts
Transurban (TCL) released traffic and revenue data for the first quarter, showing proportional toll revenue growth of 11.3% compared to the March quarter of last year. TCL has now had a majority ownership of the Queensland Motorways for nine months now and the results of this acquisition have been solid, with 7.2% toll revenue growth for the quarter on the back of a 3.5% increase in average traffic numbers. While this growth was lower than most of its other assets, the number included the impact of Cyclone Marcia, which affected the network over a weekend in mid-February.
The attractive mix of relatively inelastic assets (i.e. demand is little affected by changes in price) that exhibit relatively predictable traffic growth, compounded with tolls that typically increase with inflation (at a minimum) translates into a sound long-term investment proposition. The March quarter demonstrated the value of its low-risk brownfield development pipeline, with traffic increases as the result of upgrades completed over the last 12 months, leading to incremental traffic flow. While we hold TCL in our model portfolios, we remain cautious of the negative impact that would be expected if interest rates were to normalise.
Suncorp (SUN) announced the transition of its CEO, with Patrick Snowball to step down from the position in October. He will be replaced by Michael Cameron, who has led property trust GPT Group over the last six years. Cameron took the reins at GPT at the height of the Global Financial Crisis after it had perhaps extended beyond its core capabilities, employing a higher level of leverage in the process. While he restored and refined this strategy to focus on the ownership and management of Australian property assets, his style was relatively conservative, with GPT not taking part in a number of potential acquisitions in the sector in recent years.
With this in mind, one would expect little change to SUN’s existing strategy of improving the returns on its existing business and simplifying its operations. Reinforcing this view is the fact that Cameron has been on the SUN board for the last three years. SUN has been a solid sharemarket performer for the last three years now, and while the domestic general insurance market may be closing in on a cyclical peak, we believe that the prospect of additional capital returns in coming periods will see the stock well supported.
Nine Entertainment (NEC) received the tick of approval from investors when it announced this week that it had sold Nine Live to a private equity group. Nine Live’s primary income source is booking business Ticketek and the sale price achieved by NEC was at the upper end of analysts’ estimates. While this divestment should be dilutive to earnings per share over the next few years, the positive response by the market was due to NEC’s decision to return additional capital to shareholders through buybacks and dividends, in the absence of other acquisition opportunities arising.
Channel Nine is better placed than most in the ‘old’ or ‘traditional’ media industry (TV, radio, newspapers). Free to air television has held up better in terms of total advertising market share compared to these other mediums (albeit it has still shown a downward trend), and Channel Nine, along with Channel Seven, control a large part of this individual market. Our investment preference in the sector, however, has been for newer media companies, particularly those that have developed a significant online presence.