Week Ending 17.06.2016
The Fed has taken a back seat to the tightening Brexit vote over the last week, which would have been a consideration in deciding to leave interest rates unchanged. The FOMC release, however, was relatively dovish, with the primary cause for concern the slower rate of employment growth in 2016, which has given sufficient reason to pause for the time being. Of note, it remains to be seen whether May’s very weak employment data can be dismissed as a one-off statistical anomaly or a sign of a more troubling softer trend.
Despite this, the Fed still remains of the view that economic activity will continue to grow at a moderate pace and that labour market indicators will strengthen. Indeed, forward economic projections of GDP, unemployment and inflation were largely unchanged from forecasts made in March.
Instead, it was the dot plots (which show the individual forecasts of FOMC participants of monetary policy settings for the next three years, as well as the longer run) which again reflected a more cautious approach to policy tightening. Median forecasts, which have consistently been well above that implied by the market, moved down again. The chart below illustrates how the median trajectory has changed since December last year.
Federal Reserve: Change in Dot Plots
The likelihood of two rate hikes by the end of 2016 was reduced, with a further five members dismissing this outcome and the longer term neutral rate was again lowered. Changes in the latter increasingly appear to be an acknowledgement that factors that are more structural in nature, such as an ageing population and low productivity growth, have shifted the neutral interest rate lower. These, of course, are not confined to the US and are present in many developed economies.
Employment growth has also been easing in Australia, with the underlying pattern of 2016 again reflected in the data for May. The headline unemployment rate was stable at 5.7%, in line with economists’ forecasts. However, a key driver of the slight decline in the unemployment rate this year has been a fall in the participation rate, reversing the trend that was established in 2015.
Australian Labour Force Participation Rate
The composition of employment growth could also be criticised. Employment growth in 2016 has been confined to part time positions, with full time jobs declining in three of the first five months of the year for a total of 61k positions lost. Data for April was also revised lower this month. This is contributing to a high underutilisation rate, indicating that a high number of people are either looking for a job or would like to work more hours. The underutilisation across the labour market is likely to have other negative implications for the economy, particularly with regards to benign growth in household incomes and consumption as well as failing to provide a catalyst to help lift inflation. While the effectiveness of further monetary policy easing may be debated, economists continue to expect a further rate cut in coming months.
More promising for the economy was NAB’s Monthly Business Survey, which pointed towards an ongoing recovery in the non-mining sectors of the economy. Conditions, particularly in the services sector, are close to pre-GFC highs. While conditions are robust, business confidence actually fell for the month, despite an interest rate cut by the RBA. Ahead of the upcoming federal election, this outcome is perhaps less surprising.
Fixed Income Update
In days gone by, it seemed inconceivable that any central bank would take interest rates below zero. Now approximately a third of the Bank of America/Merril Lynch Global Government Bond Index is in negative territory, with a further 40% (70% in total) of bonds yielding under 1%. According to the Fitch ratings agency, the end of May marked a historic milestone for markets, as negative yielding debt surpassed $10 trillion for the first time. The table below illustrates the depth of negative bonds in 10 of the largest bonds markets in the world.
Bond Markets: Negative Yields
This phenomenon of negative interest rates globally is very experimental. In theory, such expansionary monetary policy is designed to encourage spending, capital expenditure and ultimately lead to higher economic growth and healthy levels of inflation. However, there are some concerns that threaten the potential for a positive outcome.
• The profitability of banks will be squeezed. This is because negative interest rates cause a compression in their net interest margin. In jurisdictions with negative official rates, some banks only charge large corporations or fund managers to deposit cash. Most do not yet charge retail customers to deposit money. This is because many banks are dependent on deposits and are reluctant to reduce rates, fearing the loss of their funding base. Forecasts indicate that if rates get to -1% in Europe and Japan, we may see some banks become unprofitable.
• A reduction in the risk of default for corporates. This can create (zombie!) companies that do not make necessary adjustments to strategy or business practices and who are reluctant to write off bad loans and investments and restructure their businesses.
• There is an increasing amount of debt outstanding as it is cheap for companies to raise funds. While this is needed for capital expansion, the risks of companies becoming overleveraged is high. However, new regulations which have forced the banks to hold additional capital on their balance sheets will restrict overall lending to corporates.
• With negative returns from investing in many government bonds, investors are searching for yield outside of this asset class. This can lead to a heightened threat to the system as investors plough money into risker sectors.
Just last week, sensationalised articles were abound about a mutiny in the banking sector in response to negative interest rates. Commerzbank are said to be considering storing cash in vaults. In reality, this will incur its own costs of storage, security and insurance which is apparently being valued. The ECB’s decision to stop producing the €500 note will also make this storage issue more problematic.
In addition, the Bank of Tokyo Mitsubishi has also stated that they are considering giving up their primary dealership status for the sale of Japanese government bonds. The Bank of Japan’s decision to push interest rates below zero has also crimped profitability for Japanese banks.
Further, for asset allocators, this negative and low interest rate environment has its challenges. The historic long term correlations between yield movements and equity returns is breaking down. As interest rates have fallen below 4%, the relationship has become positive where it was once negative. This makes diversifying returns within a portfolio difficult.
Correlations Between Weekly Equity Returns and Interest Rate Movements
However, these central bank policies of negative and ultra-low interest rates may yet prevail. If there is one thing that it has done, it is to buy us time. This period of low growth and low inflation will pass and it will be time of the transition which will be the test. Only the benefit of hindsight will allow us to measure the success and effectiveness of this ‘experiment’.
Crown Resorts (CWN) will be hoping that it is worth more as the sum of its parts as opposed to a consolidated entity, with its announcement this week to pursue a demerger of its international investments, along with the possibility of an IPO of part of its domestic hotels into a new listed property trust.
The catalyst for CWN’s announcement has been the group’s recent underperformance of its stock compared to listed peers Star Entertainment (SGR) and SkyCity Entertainment (SKC). The key difference between CWN’s assets and these two companies is CWN’s interests in casinos and developments in other markets outside of Australian and New Zealand, most notably in Macau through its 27.4% equity holding in Melco Crown which is listed on the NASDAQ in the US.
It could be reasonably argued that the performance of CWN has been driven by its international investments, and in particular, its interest in casinos in Macau. The high correlation between the two share prices (illustrated the in the chart below) is not entirely unexpected; after all, the earnings and valuation of the Macau assets have been the most volatile component of CWN’s total valuation, particularly given the changing fortunes of the region’s casino operators in the last five years.
Crown and Melco Crown
The demerger also has some merit in the sense that the profile of the split entities will be quite different. The international assets should have a higher risk profile given the uncertainty of the Macau market and the ramp up profile of casinos that have opened more recently. The international vehicle will also have exposure to other investments that some institutional shareholders have had trouble with, including its 20% holding in the Nobu Restaurants and a project to develop a new casino in Las Vegas, a region which has not been prosperous for CWN and resulted in large asset writedowns several years ago.
The domestic assets of CWN, however, are expected to have a much more stable earnings profile, led by the group’s Melbourne and Perth casinos. These are high quality in nature and so should deserve a premium valuation, although will perhaps be marked down by weakness in the WA economy. A weaker corporate governance record may also see CWN trade at a discount to its peers. Barangaroo will be the key development project for this entity, although an opening of this Sydney casino is still several years away.
CWN will also adopt a new dividend policy where it will pay out 100% of its normalised net profit after tax in dividends which will lift its forward yield above 5%. This move which will certainly have appeal in the current low interest rate environment and plays into current investor demand.
Following these announcements, CWN’s share price has appreciated by more than 12%, closing the valuation gap that may have previously existed between the company and other domestic casino operators. In our model portfolios we have Star Entertainment as our preferred holding, which is better placed to benefit from inbound tourism given its location in Sydney, Australia’s top inbound tourist destination.