Week Ending 18.03.216
Very few were expecting any change to the Federal Funds Rate following the monetary policy meeting in the US this week, although the focus was on the expected trajectory of future rate hikes and the tone of the central bank’s statement. To this end, the Fed provided sufficient support for equity markets by suggesting that the rate path will now be lower than previously foreshadowed amid another week of central bank dovishness.
The chart below illustrates the change in interest rate projections since the Fed’s December meeting where interest rates were raised for the first time. In December, the Fed had forecast four rate rises in 2016, although now the projection is two more for the year; closer to market expectations. The consensus view is that the two rate hikes will occur, with one mid-year and another in December. The projections for 2017 and 2018 were also reduced, as was the longer-run estimate to 3.0%.
Federal Reserve: Change in Dots Plots
The “data dependent” mantra that the Fed has espoused for some time now was softened somewhat, with attention turning to risks in the global economy and financial markets. Indeed, the Fed’s assessment of the US economy was quite promising. Economic activity has been expanding at a “moderate pace”, the housing sector has “improved further” and there has been “additional strengthening of the labor market.”
In addition, inflation has picked up in recent months, although muddying the picture is the transitory influence of lower energy prices and the strength of the US dollar. Inflation data released this week showed that it is certainly trending higher in the US, although at this stage this is not of a concern to the Fed; more evidence of wage inflation may be required to change their view. Despite the recent rise, FOMC members also slightly downgraded their forecasts for medium term inflation (as measured by the personal consumption expenditures index), with the median estimate remaining under the 2.0% target in 2016 and 2017. A possible risk may emerge in the second half of the year if inflation continues on its course, causing the Fed to raise rates at a faster rate than expected.
Other central banks were also in the news this week. The Bank of England left its benchmark rate steady as expected, with the UK dealing with its own risks of a possible exit from the EU. A higher level of uncertainty in the economy is likely to persist until the June 23 vote, with the pound sold off in recent months. Elsewhere, the Bank of Japan also left its policy rate unchanged, although left open the option of cutting further into negative territory.
Australia’s central bank released minutes from its meeting held in early March, which were interpreted as mildly dovish and maintaining an easing bias. Much of the statement was consistent with recent trends: the housing market is continuing to show indications that would please the RBA (a slowing in housing price growth in Sydney and Melbourne and lower lending to investors), volatility in investment and foreign exchange markets has continued and the domestic economy, while growing, is doing so at a below-trend pace. The labour market appears to have moved to the forefront of the RBA’s thinking and a lack of improvement in employment may prove to be the catalyst for a further rate cut.
Several data points have been released in the last two weeks that will influence the RBA’s thinking at its next meeting, including the December quarter GDP print (which was stronger than anticipated), this week’s jobs data and the mini-rally in the Australian dollar that has continued in the first half of March. This latter factor may take on more significance following the strengthening this week post the Fed’s decision. While there is some argument over how effective additional rate cuts would prove to be (and how willing the banks would be to pass on the full amount), the consensus view remains that one or two cuts may be forthcoming in the next six months. A lack of inflation and downward pressure from other central banks has provided the RBA with this capacity.
February’s employment data failed to provide a clear trend either way, with mixed indicators among the fall in the headline unemployment rate from 6.0% to 5.8%. Overall employment growth in February of 300 new jobs was well below expectations, with the unemployment rate falling as a result of a drop in the participation rate (i.e. the number of people looking for jobs). On a brighter note, employment growth was driven by a better outcome in full time jobs, which offset the decline in part time work.
While the accuracy of the data has been debated following changes in ABS sampling for the series, the overall trend in falling unemployment has continued over the last 12 months. The pace, however, has slowed in early 2016 after strong growth late last year. forward indicators such as job ads have trailed off somewhat as well.
Australian Unemployment Rate
The RBA also touched on the Australian labour market in its quarterly bulletin as it analysed the changes that had occurred over recent decades. It noted that the adjustment, following the resources construction and terms of trade boom, was continuing. An improvement in productivity and benign wages growth has allowed companies to employ more workers than would otherwise be the case. The transition from the non-mining economy is continuing and the flexibility of the labour market has supported this change. The response by firms in adjusting employee hours downwards (as opposed to reducing headcount) has been an interesting development in more recent economic downturns and has played a large part in capping any spike in the unemployment rate.
Australian Labour Input During Economic Downturns
Fixed Income Update
In the last couple of weeks there has been a broad recovery in risk assets with credit spreads tightening considerably. The Australian iTraxx has fallen from 168 basis points (bp) on February 25 to 127bp, with a contraction of 19 bp since the ECB meeting last Friday.
During the preceding risk-off period earlier in the year, new bond issuance was virtually non-existent, as issuers waited for the volatility to abate. Now that there seems to be some stability in the oil price and equity markets, global bond markets are back open for business, with investment grade new issues leading the way. In Europe, AB InBev (Stella Artois) sold the biggest EUR bond deal ever with an issue of €13.25bn across six bond maturities. This new supply, together with supply from a flurry of banks, has slightly dampened the rally in credit, which we suspect would have otherwise been even more pronounced.
In riskier sectors, the additional tier 1 market in Europe (AT1 securities are commonly called Coco bonds in Europe and bank hybrids in Australia) has finally re-opened after some recent concerns surrounding a Deutsche Bank Coco bond that came under pressure. This week, UBS issued a $1.5bn AT1 coco bond. Demand was strong with $8bn in orders.
In last week’s publication we highlighted the strong performance of the US High Yield (HY) market. Following the ECB meeting last Friday, the European HY market followed suit with $1.3bn in inflows, which was the largest inflow in four months. Even though HY and subordinated debt are not eligible under the ECB's asset purchase program (QE), these assets are benefitting as spread tightening on investment grade bonds has investors looking outside of these sectors in a ‘search for yield’. The chart below depicts the trend in spreads in the US high yield market over the last six months.
OAS S&P US Issued High Yield Corporate Bond Index
Australia’s listed debt market has also seen spreads tighten and increased trading volumes in March. The short end has rallied considerably, with short dated hybrids and the middle part of the curve rising. The longer end has not performed as well, with spreads remaining wide. The secondary market for bank hybrids continues to offer a more attractive premium than the new CBA Perls VIII deal that settles on April 1. The chart below depicts the above average trading volumes for this sector in March.
ASX Debt/Hybrid Securities ($Value Traded, excluding Government Bonds)
After the Fed decision to downgrade the profile for rate hikes in 2016, the US treasury market had some big moves. The two year treasury yield fell 12 bp to 0.86% (a 12% fall), representing the largest drop in six months. Five and ten year Treasury yields declined 7.4% and 3.3% respectively, while Australian Government Bonds followed their lead. The table below shows the movements post the FOMC announcement.
Interest Rate Change Following FOMC Statement
The dovish tone by the FOMC and the resulting rise in the $A will put pressure on the RBA to cut rates in an attempt to lower our currency. At this stage, the Australian futures market is currently pricing in a 70% chance of a rate cut of 25bp by August this year.
The Commonwealth Bank followed its peers this week and raised interest rates on business loans by up to 0.21%. This action demonstrates the power of the major banks to act independently of the RBA to offset the increased cost of funding.
Telstra (TLS) received praise this week for its capital discipline in terminating discussions with conglomerate San Miguel to build a new mobile phone network in the Philippines. Telstra had been unable to agree to terms with San Miguel in what would have resulted in a capital outlay of circa US$1bn had the deal gone ahead.
While management was applauded for not pursuing growth at any cost, the decision again highlights the difficult task ahead of the company as it looks to grow its earnings base outside of its core Australian operations and as it loses its infrastructure margin on its copper network as the National Broadband Network is rolled out around the country. Telstra is receiving compensation from the Federal Government as this transition occurs, although these payments have a finite life and will need to be deployed into other opportunities in order for the business to grow. Given its saturation of the domestic market, further expansion into Asia has been raised by Telstra (with the region now accounting for approximately 10% of its revenues) and appears to be the most obvious path for the company to take, although identifying opportunities that will meet its investment criteria will be a harder task.
Telstra may receive a shorter-term investor boost from the prospect that this capital that was set aside may now be returned to shareholders either via a buyback or to help fund its progressive dividend. A special dividend is the less likely option given the company’s low franking balance. We continue to recommend the smaller telco players in preference to Telstra, which have good prospects for market share growth over the medium term given more competitive pricing on phone and data plans.
Myer (MYR) ained after it raised the bottom end of its guidance range for its full year earnings outlook after announcing its half year earnings result. As some may recall, the retailer announced a new five year strategy late last year focusing on its flagship and premier stores and increased concession sales, which was funded through a large capital raising. For the first half, Myer’s earnings declined by 4%, despite a 1.8% rise in sales. Comparable sales were better at 3.3%, reflecting some rationalisation of the company’s footprint. Further store closures may be required in the long term, which would involve further costs (including the termination of lease arrangements).
Myer’s flagship Victorian and NSW stores posted impressive sales growth, however this implies that its broader store network is recording much weaker numbers. An improvement in cost of doing business was unable to offset a deterioration in gross profit margins (a factor of higher concession sales), leading to the profit decline. With earnings now spread over a much larger share base, earnings per share dropped 25% and the dividend was cut from 7cps to 2cps.
The following table highlights the task ahead of Myer as it looks to evolve in a challenging environment with changing shopper preferences, a rejuvenated David Jones and an increasing presence of global retailers in the Australian market. Sales growth is targeted at 3%, far ahead of what Myer has recorded long term, while a contraction in margins may mean that the company’s EBITDA target will be difficult to achieve.
Myer: Scorecard on Financial Targets