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WEEKEND LADDER

A summary of the week’s results

18.01.2019

Week Ending 18.01.2019

Eco Blog

- Simplistic assessments of risks to the Australian economy are likely to be misleading. We view the services component of our exports to China as more important than commodity prices. Similarly, the housing sector is not all down and out; first home buyers are peeping through the window.

Global investors invariably focus on two risks in the Australian economy, China and housing. One could add in politics, though that is now applicable to most countries.

China looms large as the buyer of resources, taking up 30% of our annual exports by value, with Japan a distant second at 12%. The link is therefore real but does require more than a superficial ‘weak China equals trouble for Australia’ analysis. The dislocation caused by tariffs has little impact on bulk commodity demand, while the tightening of monetary policy which curtailed investment has a more direct influence. Nonetheless, iron ore prices have been remarkable resilient, down only 2.3% over the past year and up 4.4% in the last quarter, notwithstanding the headline news of a deteriorating growth trend in China.

With another bout of stimulus underway, there is good reason to believe bulk prices will hold up, though LNG is linked to the oil price and only loosely related to the nuances of China’s variation in economic growth. Data this week puts natural gas imports up 31.6% year on year, benefiting from the ‘blue sky’ policy.

In trade, China’s goods export surplus has been, in part, offset by a services deficit. With the fall in export growth, the current account is now heading to a deficit.

China trade and current account

Source: Fidelity
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Three outcomes are possible. Either the currency devalues, the services deficit must close, or exports recover. The last mentioned is now less likely. Closing the services component of a deficit usually takes time, though in the case of the Chinese economic system it may be prone to intervention such as regulating flows that support services; for example, education or travel. Both these would hit Australia hard as there is a fair amount of employment directly or indirectly a function of these service sectors.

The currency may be an easy loophole but brings forth a risk of capital flight and inflation. Financial stability is critical to the government while it looks to open its system, such as bond trading to global participants. Nonetheless, the currency can gently devalue, which would not only help the export sector but make the services on offer from Australia a touch more expensive.

The housing market has already seen the withdrawal of some global buyers given restrictions and the trend in apartment prices. The flow on effects of the downturn in housing activity and prices has, so far, had a muted impact. Retail sales have continued to rumble along at a steady, albeit lowish pace. Employment is sturdy and most expect this to be reflected in December labour market data to be released next week. Auto sales have fallen sharply, but this may be due to rising lending rates and tightening credit standards than an active decision by households to curtail spending.

There has been a raft of commentary on a ‘credit crunch’ and calls for APRA to show a more conciliatory tone to the banks. We doubt it will. Having spent a couple of years to flush out lending that could destabilise the financial system, it is unlikely to now revert form. Further, it may welcome the re-emergence of first home buyers which now are at 14% of finance commitments, up from its low of 8% when investor lending and prices crowded out this cohort.

The bland numbers are often cited by global commenters that prognosticate on the risks in the Australian household sector. There is no doubt that debt is too high and households are still overly attached to buy-now pay-later formulations. In reality, the position is more nuanced. The adjustment phase is underway and subject to an external shock, the position should progressively improve in the coming year.

  • The economic outlook for Australia based on a current bond yield of 2.28% suggests a sharp deterioration from here. This seems overly bearish. China’s stimulus, a transition in housing mix and with a fiscal bump likely in coming months, the growth signals should return.

Fixed Income Update

- Investment grade credit spreads start the year at 18 month highs, but margins are contained as net issuance of corporate bonds slow.

- Demand for Mexican and Italian bonds indicate a returning appetite for risk in debt markets.

Following a two year period of contraction, global investment grade (IG) credit spreads bottomed out early in 2018 before drifting higher throughout last year.  This year has started with US IG spreads at their highest levels in 18 months, reflected in the US iTraxx (index) margin of 99bp. Lower growth expectations and higher interest rates have weighed on credit, which is often positively correlated with the equity market. However, talk of the Fed taking a pause from raising interest rates has given credit some reprieve and the iTraxx spread is now drifting lower again (to 87bp).The Australian market has followed the same trend, starting the year at 90bp and retreating to 86bp of late.

While credit spreads may be currently high based on the past 18 months, they are still trading well below the lofty hights of January 2016 when the US iTraxx reached 160bp. Back in early 2016 equities and credit sold off in response to concerns on the energy market, with credit spreads on IG credit widening by 30bp in a two month period as equities weakened. However, during this latest equity correction credit spreads have moved in a more orderly manner. At the peak of equity weakness in December credit spreads on US IG were only up ~15bp from two months prior.

What therefore makes the revaluation of credit spreads less dramatic this time and why has the spread widening been so gradual?

One factor is the slow down in net new issuance of corprate bonds in 2018 versus previous years, notably 2016. Non-financial corporates have steadily leveraged up over the past several years, taking debt levels to their highest in history. Corporates have taken advantage of low interest rates and demand from investors (searching for yield in a low rate environment), with many new entrants issuing in the public markets. The number of corporate bond issuers has risen by 33% in 5 years, and 67% in the last 10 years as companies fund themselves to facilitate M&A activity and share buy backs. While this trend of increased corporate debt continued in 2018, the rate of growth slowed on previous years and is expected to ease further in 2019.  

Net Issuance of Corporate Bonds

Source: Pimco
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Many call out concerns on the high US corporate debt levels, particularly on lower rated BBB credits. The counter argument is that earnings growth can support the debt levels. Interest coverage ratios remain acceptable. The tax cuts in the US have increased cash balances and facilitated repatriation of funds that were pervisouly held offshore, enhancing company’s ability to repay debt.

  • We expect that higher funding costs and increased cash flows will be a trigger for US companies to pay down debt, or, at a minimum, slow down issuance levels, but we note this will be specific to certain industries. While credit spreads may leak wider, the current higher margins on offer give a reasonable risk/reward, in our view, with security selection key. We agree with the opinion from fund manager Pimco that within US investment grade credit  “there remains ample opportunity for issuer selection and sector rotation”. We acknowledge that high debt levels may be problematic for some companies resulting in credit downgrades, with these obviously being the ones we rely on the fund managers to avoid. 

Debt markets are back open for the year, with a few notable new issues taking place in the last week. The Mexican government issued a $2bn 10year bond at a yield of 4.577% (coupon at 4.5%) which was said to be 4 times oversubscribed with 320 institutions participating in the deal. Mexico issued a similar 10-year bond a year ago 80bp lower. Higher Treasury rates and wider credit spreads on emerging market debt resulted in the better yield on offer (spread T+185 vs T +135 last year). The elevated demand for this bond is encouraging for Emerging Market (EM) debt which came under pressure last year as outflows from EM debt funds weighed on prices. 

Also reassuring, the Italian government issued a €10bn bond recently, its largest deal ever, with the order book reaching €35bn with over 250 participating investors. The bond which matures in 2035 pays 3.35%. Italy needs to raise €225bn of medium- and long-term debt this year to fund its fiscal deficit.

  • High quality issuers are always going to have a decent investor base, but this demand for debt from two countries that have endured recent political upheaval is good news for risk assets. We see value in emerging market debt and are comfortable holding positions through the Legg Mason Brandywine GOFI fund. We don’t take a view on Italy which is likely to remain volatile, and bonds will be less supported given the end of QE by the ECB.

Corporate Comments

  • Wesfarmers’ (WES) trading update revealed a deteriorating trend in its department stores division, while Bunnings faces the challenge of a weak domestic housing market.
  • Despite the rotation out of higher growth stocks towards the end of 2018, these companies, along with resources, led the market higher over the year. Individual manager performance needs to be viewed in this context.

January is typically a light month for company announcements, with a key risk for equity investors a ‘trading update’ (which rarely contain positive news) ahead of February’s reporting season. Wesfarmers’ (WES) release this week was consistent with this template, with the company outlining the impact of several one-off items from recent asset sales (predominantly Coles) that will inevitably result in a somewhat messy half year result.

The focus, however, was on an update with regards to its retail businesses. The new look WES divisional split is illustrated below; Bunnings accounts for over half of earnings, Kmart and Target (department) are around a quarter combined, while industrials and Officeworks make up the residual. The positive news was that Bunnings is performing in line with expectations, despite the current negative sentiment around the housing market.

Wesfarmers Divisional EBIT Split post Coles Demerger

Source: Wesfarmers
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The commentary on WES’s department stores was softer though, with relatively flat comp sales growth for both Kmart and Target. Kmart has been a relatively dependable source of earnings growth for WES over the last few years, while Target has struggled and a slowing top line may be symptomatic of an over-saturated discount department store sector, market share gains from Big W and/or a constrained consumer. Regardless, there are medium term top line risks across a large part of the remaining WES portfolio. A forward P/E of 18X for the business is on the high side given this outlook, but is offset by a solid 5.2% dividend yield and a robust balance sheet (following the asset sales, though prior to the new requirement to add lease obligations to the interest cover ratio) that provides some optionality for management.

While the last 12 months has had changing market drivers of the index’s performance, the attribution for 2018 gives an indication of the contribution to returns for each individual stock. An assessment of the top 10 and bottom 10 contributors to the index’s return shows the headwind or tailwind that different strategies may have faced relative to the index.

The themes in the top 10 are clear: ‘growth’ (CSL, Resmed, A2 Milk) did well despite the derating late in the yea. Resources were well represented (BHP, Rio Tinto and Northern Star), while a more stable supermarkets sector underpinned Woolworths and Wesfarmers. Within the bottom 10, the overriding theme was the decline among the big financial stocks driven by the Royal Commission, while Telstra again weighed on the index. Boral and James Hardie were among the cyclicals to drag on the US housing slowdown.

ASX 200: Estimated Attribution for 2018 (bp)

Source: iShares, Escala Partners
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It is worth considering the opportunity set of a domestic manager when assessing their performance over 2018. Income or value focused managers are more than likely to have found the benchmark a difficult hurdle to beat, while those that are biased towards capital growth should have produced solid returns.

These patterns can and do change throughout the years, yet few would expect to switch managers on a regular basis. Our emphasis remains on the rationale for selecting the manager in the first place and their suitability to the investors’ overall portfolio.

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