Week Ending 17.07.2015
Contrary to most expectations, China produced 7% GDP growth for Q2 smack on the target for the fiscal year. Cynics will readily point to the astonishing speed at which China is able to produce this data given the size of the economy, and, unlike US GDP data, it is never revised. Further, there was little indication from monthly releases that things were going this well.
When looking at the detail, economists noted that the primary sector was very weak – that is mining and other non-value add operations, while the secondary sector of manufacturing and goods grew at a below par 5.9%. The lift to total 7% came from the tertiary sector - services, which accelerated to 8.9%. Generally there was a combination of scepticism on the underlying strength in the economy and the usual caution on the quality of the data. However, in our view it raises two entirely separate issues.
Firstly, the extent to which data does determine market reaction. We note in this case, there was very little beyond a small blip in the ASX200. The Chinese SCOMP actually fell, though this may still be related to the equity dislocation of the past couple of weeks. GDP and equity markets are in fact weakly correlated. In this case, a stronger than expected growth outlook for China may have been interpreted as a lower likelihood of further financial accommodation and easing, not something financial markets had in mind.
Secondly, it does point to the poor read we can obtain on the tertiary sector, essentially our behaviour. Pertinently, it includes financial services and the stock market activity of the quarter is likely to have made a sizeable impact. However, it also encompasses services such as health and education, travel, entertainment and social media. For example, there has been a massive growth in movie ticket sales. We may wonder why in the age of Netflix or Showtime, yet an evening out in a society of high density living may not seem like a bad idea.
China Industry Sector Growth Trends
Most commentators are expecting further rate cuts and easing in anticipation this will result in renewed investment. On the other hand data shows that the non-financial sector in China is already highly leveraged, especially the property and primary production sectors, and it begs the question what kind of investment now best serves China’s long term growth.
Here are clear gaps for investment, for example healthcare is always nominated, logistics is surprisingly poor with no uniform approach to standards and the unrelenting rise of the middle class consumer has many options.
Domestically the choice of good or bad news was yours for the taking. The NAB Business survey improved in both business confidence and even more so in business conditions. The underlying trends were a little more mixed, with employment expectations still soft and a disappointingly low pickup in exports given the A$ move. However, forward orders were encouraging and capacity utilisation is improving.
In line with comments from the RBA on companies resetting their expected return on investment given low interest rates, NAB asked firms to nominate their required rate of return for new investment. Naturally this varied depending on the industry segment and averages 13.5% for all businesses.Enlarge
While subdued, the corporate sector appears to be consolidating to running low inventory, controlling labour costs and limiting borrowing. The offset is low investment spending and contained final product prices.
The consumer gave a different reading of their circumstances with the Westpac-Melbourne Institute Consumer Confidence Index taking a tumble in July. Perhaps the headlines on Greece and even China did capture the attention of households with the view on economic conditions over the coming twelve months taking a particularly hard knock. On the other hand, few would be surprised to see that the majority had shifted to the view it was not a good time to buy a property, a notable change from June to July.
In comparable commodity based economies, particularly Canada and New Zealand, monetary policy is either still biased to easing or in the case of New Zealand has returned to easing. Both countries are printing CPI at very low levels with New Zealand at 0.3% annualised, which included three quarters of deflation. Most expect NZ to cut rates over this half. Canada did just that taking its overnight rate to 0.5% on the back of underlying inflation of 1.5%.
In the coming week our CPI may therefore be an important data point with expectations of an underlying rate of 0.6% for the quarter, 2.2% on an annualised basis. Petrol prices, up some 12% in the quarter should see the headline CPI above that level. Given the recent weakness in the currency, the RBA may well stay on hold for the moment, awaiting development in the US to do its work on its behalf.
The race to the top of the iron ore production ranks is narrowing. In its production release, RIO has eased back on its earlier target of 350mt to 340mt for this year with Vale restating its intention of 340mt but by shifting from higher cost, low grade mines to lower cost operations. After the rush of comment on whether iron ore producers should limit output to stabilise prices, there appears to be a subtle move by the main participants to maintain their position, although not yet adding unnecessary volume to what looks to be an oversupplied market in the coming year.
Major iron ore producers (m tons per annum)
Assuming RIO’s output rate is edging up incrementally from this point, the price becomes the obvious swing factor and it is therefore no surprise that these stocks are now far more attuned to price rather than production reports. In other commodities, copper was mixed with RIO’s three assets offsetting each other. Escondida output edged up, while Bingham Canyon, after the landslip some time back, registered an astonishingly low 0.25% grade while RIO received no contribution from its interests in the Freeport controlled Grasberg mine. Aluminium has arguably been the best division for RIO with EBITDA looking likely to double over the four years to 2016 due largely to cost reduction and investment.
Time will likely reflect back on the strategy undertaken by RIO over the past decade. Since the pressure from falling commodity prices brought about a U-turn in investment growth RIO’s capex has nearly halved, revenue has fallen 30%, but with cost reductions EBITDA has been held to a similar percentage decline.
As this cycle comes to an end the investment question now hinges on two opposite views. Those with a positive recommendation believe prices can stage a modest recovery over the coming years and with continued spending discipline RIO becomes an undervalued cash flow engine. Others believe the commodity cycle will remain weak and that the dividend payout is unsustainable, especially for a resource company with a natural depletion of its assets. There is no evidence that in our view causes one to lean towards either argument and we prefer a cautious and modest exposure to the large cap resource stocks.
Woodside’s production report was largely within expectations, leaving analysts to tinker with their numbers factoring in maintenance and outages. For the foreseeable future, WPLs production is locked in with the North West Shelf assets in slow decline and Pluto stable. Browse remains a possible swing factor, dependent on the cost curve. The current valuation focus is therefore on the cash flow and 80% dividend payout ratio. The dividend will naturally depend somewhat on production, substantially on the oil price which determines its LNG received price and swing factors such as the timing of resource rent payments.
Reflecting on our bulk resource stocks comments, we prefer to take a portfolio position with respect to energy in Oilsearch (OSH) and Origin (ORG) while balancing that with BHP for the low growth cash flow weight. Woodside has support through its high dividend payout, but in contrast to the other resource stocks faces falling production within the next few years.
QBE continues to make progress shedding its troublesome divisions. This week it has realised the investment in the US Mortgage and Lending Services acquired in 2011 for $90m. While this will result in a one off loss of $120m (largely non cash), various messy adjustments to its reported result and a lower gross written premium, the outcome will be a net benefit in underwriting profit estimates at some $35m.
QBE has been the best performing insurer on the ASX over the past quarter, albeit it has a very different corporate structure to Suncorp and IAG. In this case the driver is the combination of the global exposure, the restructuring and the potential of higher returns from its investment portfolio as bond yields move up. This latter feature is of interest to all investors. Within the context of its regulatory requirements, QBE has to run an extremely conservative book and for many years held that in money markets, sovereign issues and a moderate weight to corporate bonds. In recent years that has shifted to include growth assets to achieve a better return.
Growth assets as shown in the bracket on the right, represented 9% at the end of December 2014 and is moving to its 2015 target of 15%. The gross investment return was 2.8% as at December 2014, of which growth assets contributed 0.2%. This shift, not limited to QBE, adds to the participants in equities, where the need and willingness to seek returns requires a new approach.
Following on from our summary of healthcare stocks last week, the sector staged a strong performance through the week. This sector is the favoured way to gain global exposure and the A$ tumble in the week added incentive after a few stocks had drifted down over the past month. As always there are winners and losers. Cochlear (COH) successfully held its bid to supply the Chinese government with 2000 units which imbeds its penetration in that market as there is an inevitable replacement cycle. The relatively low liquidity in this stock and narrow focus saw COH move up strongly in the month. CSL also performed well as arguably the one ASX listed stock that attracts global fund managers and we remain on the front foot to acquire stock on any weakness.
On the other hand Primary Healthcare’s (PRY) share price fell as it announced an agreement with the ATO to settle tax issues with respect to practice acquisitions in recent years, as well as a downgrade to EBITDA due to weaker attendance at GP clinics. PRY is a highly efficient operator of medical centres but has relied on growth through acquisitions which included large upfront payments to GPs. This distorted its cash flow as well as resulting in the ATO tax claim and it may have to change its compensation model and put some pressure on margins.
Medibank (MPL) has been in the news as the health insurer combats the hospital sector to limit cost growth. It has terminated its contract with the not for profit hospital operator, Calvary, and will likely put pressure on the likes of Ramsay Healthcare and Healthscope when their contracts come up, though at the end it needs to retain these major providers. As the rather complex, but useful, diagram below shows, 40% of Australia’s healthcare costs are hospital services with private operators and funding through insurance a meaningful proportion.
MPL is attempting to get these private hospitals to take some responsibility for rising costs, such as readmission rates and high cost procedures, where there is arguably a perverse incentive given the nature of payments received. It has become evident consumers are resisting the relentless rise in premiums for health cover by moving to lower cost options and forgoing extras. Naturally, insurance funds with a bias to older demographics, such as MPL are under even more pressure. These trends reinforce our view that an obvious theme, such as ageing demographics and healthcare, do not always translate into a good investment case.
In a similar vein Perpetual (PPT) was punished by investors for an expectedly large outflow of funds under management (FUM) in Q4, down 13% over the period. The bulk was from institutional mandates and the company insisted it was rebalancing rather than loss of client. Nonetheless PPT has struggled to hold onto its senior fund managers in recent times though we have noted industry super funds are actively reducing their allocation to Australian equities. Our preference remains with those fund managers with captive streams ( for example, AMP) or with diverse sectors and regions under management such as Henderson.
Fixed Income Update
This week we address concerns of reduced liquidity in fixed income markets. Increased levels of debt issuance in this low interest rate environment, combined with reduced balance sheet capabilities of the banks, has raised the potential that credit lines will not clear should there be a reduction in buyers of this market. Regulatory changes post the GFC are here to stay, so no reversal in trends can be expected.
The graph below shows dealer inventory levels over time relative to the whole bond market.Enlarge
Where dealer inventories have been shrinking, fixed income funds have grown. According to the Bank of International Settlements the net bond holdings of the 20 largest asset managers alone increased by more than $4tr from 2008 to 2012.
Whilst this change in the composition of buyers may be reason for concern, it is also well documented and has been building for some time allowing fixed income fund managers to work through risk mitigating options. The most common response has been an increase in liquidity buckets of cash, cash equivalent and government-related securities. A recent article in Bloomberg cited that bond funds are holding an average of 8% of their assets as cash-like securities, the highest proportion since at least 1999.
Many of the more defensive fixed income funds that we recommend are currently holding near on 20% in this “liquid bucket”, with the likes of Kapstream maintaining a 26% holding during these volatile market conditions.
Whilst we acknowledge that this conservative approach will have a drag on performance and is not an attractive long term solution as it may be prudent whilst bond markets navigate through the start of the Fed rate cycle. Despite the Fed being very clear this week that a rate hike is still very much on the table for this year, the market can still be expected to initially respond with a knee jerk reaction, perhaps putting liquidity to the test.
There are also reports that some funds are arranging credit lines from banks to fund potential withdrawals, however, we understand this to be uncommon. Others such as the BT Pure Alpha Fixed Interest Fund (not currently on our recommended list) prefer to utilise derivatives as opposed to purchasing physical bonds, as they believe this market facilitates quick and efficient trading.
In meeting with market participants they are confident that government bonds will hold their liquidity value, in a stress scenario compared to credit. We are reminded that even during the height of the financial crisis, following the collapse of Lehman Brothers, high quality sovereign debt continued to trade within a narrow bid/offer spread. In fact, it is likely that liquidity will increase for government securities as a ‘flight to quality’ will undoubtedly unfold. Statistics such that US Treasury’s are now turning over 0.6x during a month as compared to 2x in 2006 are often presented, however, it should be noted that the market has experienced significant growth over this period which would account for some of the lower ratio of turnover.
While much attention is paid to the negative elements of the liquidity story, there has been some positive changes to the market structure in the past few years. As seen by the graph below the proportion of the market held by a few large accounts is shrinking, instead there are many more participants. Different market views and positioning lowers the correlation of flows and can prevent ‘crowded trades’ by a few particularly large players. Further, dealing relationships between end buyers has opened up reducing the reliance on intermediaries.Enlarge
Whilst we don’t discount that liquidity in the bond markets is not what it was pre-crisis, we are comforted that the funds we recommend are aware of the increased risks and are taking appropriate steps to mitigate any potential downside to investors in these funds.