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WEEKEND LADDER

A summary of the week’s results

18.04.2019

Week Ending 18.04.2019

Eco Blog

- The focus in equity markets will be on earnings having had a valuation-based rally in the past quarter. The emphasis is on profit margins, pricing power and cost structures. Stock differentiation is likely to become a feature once again.

The risk to the corporate sector is a squeeze on profit margins. While there is little measured inflation, many corporations have noted higher costs as a growing issue. Yet the lack of inflation implies that either cost rises are being absorbed in tightening margins, or that productivity is compensating for these costs. The evidence for the latter is lacking for most economies, though it is clear there is a wide dispersion across industries.

Inflation in the G-7 countries

Source: Macrobond
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Two factors feature prominently in discussions on the falling inflationary cycle. The first is globalisation. A cursory glance across goods markets provides evidence that trade, in particular from Asia, has reduced the price of many consumable products. The initial reaction to the tariff impost on Chinese products in 2018 was that this would result in upward pressure on prices in the US. Instead, a combination of the falling value of the CNY, some transfer of import sources to other countries in Asia and lower profits margins resulted in no decipherable rise in the cost of these goods to the US consumer.

The second debate centres on the labour market. Until recently, wage growth in almost every developed country had been modest for most of the past decade. The recent shift towards 3% may not appear to be meaningful at face value, but could edge up further given the tighter labour markets. Unless there is change in labour utilisation, corporate profit margins will narrow.

Wage rates in the OECD

Source: Macrobond
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Within this mix is the impact of technological change on prices. A recent paper from the Bureau of Economic Analysis (BEA) in the US has estimated the impact on producer prices. In the US, outside the tech sector itself, the professional services sector (accountants, lawyers, architects etc) has been most affected. Conversely, healthcare has yet to feel much of the brunt and the finance sector which has had the highest rise in annual prices, is middle of the pack.

Technology's Effects on PPI by Industry

Source: Haver Analytics, BEA input-output tables, Vanguard, KKR Global Macro & Asset Allocation analysis
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  • It is widely expected that technological change has a much longer way to go to reduce costs in most sectors.  Those unencumbered by legacy costs are in a good position, while others will have to undertake a fundamental restructure. A short term profit focus often stands in the way. This issue also aligns with the equity growth versus value style debate, where value companies are judged to be poorly equipped to deal with change rather than suffering from unreasonable investor neglect.

Australia has much of the same conditions at play. In a newly released paper, the RBA references the similar loss of labour’s proportion of economic output in Australia as elsewhere.

Labour Share of Income*

Source: OECD, RBA
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Amongst the local reasons for this trend is the rising value of housing stock (capital rather than labour) relative to the income it generates and the impact of high capital-intensive mining. A further observation is that the financial sector is becoming a capital rather than labour sector. Intuitively that makes sense given the reduction in bank branches and rise in electronic payments.

  • We view these issues at the heart of the outlook for investment market over the coming cycle. Wage growth would hurt corporations, unless it is passes on in prices. Higher inflation either implies higher interest rates or will undermine real returns.  A lack of wage growth hampers overall economic potential, given households dominate spending. Equity investment will, in our view, have to becoming increasingly selective in identifying companies which can recreate industries or adapt without being whipsawed by short term pressure on profits.

Fixed Income Update

- Credit markets make a solid start in 2019, with indices posting the strongest first quarter results in 10 years.

- Fixed income active managers outperformed passive investments for core US strategies, but we highlight other factors that should be considered.  

As the equity market sold off at the end of last year, so did the high yield (below investment grade) market. Given these debt securities are from companies that have weaker metrics (eg, high leverage, low cashflows, volatile industry segments) a possible deterioration in global growth is viewed negatively. High yield indices had a 4.5% decline in the fourth quarter of 2018 as investors reduced exposure in favour of safe-haven investments such as government bonds. Perhaps unprecedented, issuers responded by retreating from the market and no new high yield bonds were printed in the US in December. The withdrawal of supply assisted in stemming the outflows, in what could have been a worse result for the sector.

By mid-January, high yield was back in favour. The Fed’s renewal of accommodative monetary policy and its telegraphed halt on tapering its balance sheet marked a sharp turnaround in high yield performance. Credit spreads tightened throughout the first quarter of this year from a high of 5.58% in January to near 4% today. Total return for the high yield index in the first three months of 2019 was +6.3%, marking the strongest first-quarter for credit in 10 years, with high yield outperforming investment grade debt.

High Yield Credit Spreads

Source: Bloomberg, Escala Partners
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  • Given the recent rally in high yield we suggest taking profit and lowering exposure to this sector (we use the JP Morgan Strategic Bond Fund). For further appreciation, the market needs evidence of stronger and sustainable growth. The high correlation of this market with equities will also have participants closely watching the earnings season with any disappointments likely to weigh on performance. 

A recent publication talked to the success of active fixed income managers relative to passive investments over the last year. In particular, it highlighted the success of core U.S. fixed-income strategies where 86% beat the Bloomberg Barclays U.S. aggregate bond index in the last year, and a 70% outperformance over a longer period.

As asset allocators that use managed funds, this headline grabbing comment supports our favouring of active over passive fixed income investment. However, it does not take into account the risk the fund managers are taking and whether the returns offer the best risk adjusted reward. Relativity to a benchmark should be a secondary measure. When choosing an active manager there are several metrics which need to be considered. These include the credit quality of the assets, currency exposure, use of derivatives, concentration risk to sectors and to individual issuers,  the manager’s strategy approach, liquidity of assets, fees and past performance. It is the assessment of these that will help protect on the downside and not just outperform on the upside.

  • We note that most actively managed fixed income portfolios deviate significantly from the index. Duration and country selection are the main ones, while issuer weightings vary greatly (especially given fixed interest indices are weighted to the issuers with the most outstanding debt which is often counterintuitive to what one would want to own). Most funds also add in RMBS, ABS, emerging market and high yield bonds to enhance returns which are not in the index.

Corporate Comments

- Dulux Group’s (DLX) takeover is likely to go ahead given the current point in the housing cycle, offer value and board approval.

- Iron ore production cuts were widely expected for BHP and Rio Tinto (RIO). The key factor in higher earnings for this half, however, is the price impact of Vale’s outages following a mining disaster in January.

Following last week’s failed takeover for Crown Resorts, M&A returned to the domestic market this week, with Dulux Group (DLX) agreeing to an offer from Japanese group Nippon Paint. While the deal is to be implemented by a scheme of arrangement, in the absence of a superior proposal from another party, there would appear to be a high degree of certainty of completion given that it has the DLX’s board’s approval. Further, the consideration is to be paid in cash (supplemented by the likely release of franking credits) and a 28% premium to DLX’s previous close price.

DLX is generally regarded as a high quality company, generating strong returns and cashflows from its market-leading paints brand. While the core driver of its earnings is the more predictable home renovations market, an element of cyclicality still exists, with an estimated 15% exposure to new residential housing construction, increased several years ago by its acquisition of Alesco.

The housing slowdown is perhaps not fully reflected in consensus profit forecasts for the group. While low (2% p.a. growth over the next three years), they are in keeping with its recent history of modest growth rather than predicting any downturn. With this backdrop, the price paid looks full (at a forward EBITDA multiple of more than 15x and a P/E of 25x), particularly considering the higher downside earnings risk in the medium term. It is, therefore, not surprising to see the stock trade at a slim discount to the offer price this week.

Dulux: EV/EBITDA Multiple

Source: Bloomberg, Escala Partners
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The key takeaway from production reports from the big diversified miners BHP and Rio Tinto was downgraded guidance for their respective iron ore divisions. The primary factor was the disruption caused by Cyclone Veronica and therefore not unexpected. As illustrated in BHP’s table below, other divisions are showing stable production figures following a lack of investment in new capacity in recent years.

BHP and Rio’s production issues have only added to the tightness in supply in the iron ore market, with the key catalyst for the recent run in the price caused by Vale’s disaster at one of its mines in Brazil. A small miss on production (between 2-5%) is hence relatively immaterial compared to the uplift in both companies’ earnings as a result of the higher pricing environment.

A spot pricing environment would currently result in significant earnings upgrades for both BHP and Rio Tinto, indicating that sell side analysts have been slow to upgrade iron ore forecasts, or that there is an expectation that the market will adjust quickly and the price return to a more typical range.

What is worthwhile monitoring is the developments in Brazil, with news this week of a mine restart expected to help in closing the supply gap (notably, Vale has kept its own production guidance unchanged). Nonetheless, despite both recently completing share buybacks, BHP and Rio Tinto remain well placed to deliver additional returns to shareholders in the next 6-12 months that are over and above ordinary dividend payments given the higher cashflows that will have been generated this half.

BHP March Quarter Production Summary

Source: BHP Group
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