Week Ending 18.09.2015
Post the FOMC meeting the question is whether the Fed has real concerns, or merely biding its time, preferring not to change rates against the consensus view that they would. In the case of the latter, one would therefore expect a rate rise before year end, either in October (with a special press conference) or in December, given that is likely to emerge as the consensus forecast.
The possible real concerns are more important than the timing. The Fed would not want to talk down the domestic economy, and shouldn’t, as in general the trends are more than acceptable. Inflation is the missing part of the equation. Recent CPI data from the US still reflects the impact of falling energy prices; now also evident in transport and airline costs. The rise in the USD has restrained goods prices, which are down 0.5% year on year. Higher inflation in rent and ‘owner equivalent rent’ (OER), both running at over 3% p.a., have not been able to push the overall CPI up much, notwithstanding their high weight. The good part is that US household buying power is high, and even the low rise in average wages is exceeding cost of living inflation. That suggests consumer spending is likely to remain reasonably strong.
For the CPI to turn up, the impact of lower energy and possibly food prices has to revert. The alternative is for service prices to rise, as low end wages migrate up in line with lower minimum wages, which are now prevalent across a number of jurisdictions and corporates.
The external issues are worthy of consideration. In our view, the Fed is likely to want to see a few more months of currency management and capital flows from China. While a small risk, there is a possibility China may need to use more of its FX reserves to stabilise its exchange rate than currently anticipated. This could have some impact on the bond market, which may be uncomfortable with the notion that the largest holder of treasuries is realising holdings. Other regions, such as the Gulf states, are likely to be doing the same, given the movement in the oil price and the impact on their budgets.
Post the surprising devaluation, the intervention by the Peoples Bank of China (PBoC) is evident from the trading volume as shown below:
USD/CNY Closing Rate and Trading Volume
Instead of using its FX resources, it is possible the PBoC reverts to other interventionist strategies. It could impose costs on short term capital flows, encourage capital inflows (through opening up more ways for foreign reserve managers to participate in fixed income products) or tighten capital controls to limit outflows. Already, we have heard that capital flows to purchase property in Australia are slowing as the government makes it harder to move money.
Intervention against the market usually results in a sharper readjustment down the track. Recently, Chinese government efforts to stabilise the equity market were roundly judged as poorly executed and it would be damaging if it repeated a similar pattern in FX markets, which matter a lot more than equities. For the moment, however, taking the pressure off capital flows is more critical in the face of weak economic growth and an upcoming US rate hike.
Locally, RBA Governor Stevens gave a moderately upbeat assessment of the Australian economy. Suggestions that the labour market was solid and that the lower currency is starting to work was offset with comments on the time it was likely to take for the economy to adjust to growth outside the mining sector. A dovish tone can be interpreted that the door for one more rate cut was far from closed, but more likely that a 2% cash rate would be a longer-term position.
While there are a handful of bears lurking at the door calling a domestic recession, there is little evidence of such an outcome to date. Even the impact of the fall in commodity prices will, in good part, be borne by external investors, with the RBA indicating that their effective ownership of resources was around 80%.
The domestic risks continue to be concentrated on the housing market and implicitly employment. There may be additional repercussions if there was a sharp withdrawal by China buyers, and that would be linked to any restraint imposed on capital flows (as referred to above). It would be more likely that there is a gradual waning of foreign participation in housing rather than an abrupt end. In the meantime, there is increasing anecdotal evidence the services sector, specifically tourism is picking up strongly.
Fixed Income Update
As expected, the bond market reacted favourably (yields lower, prices higher) to the delay in ’lift off’ by the Fed. The yields on 5 year US Treasurys fell by 8% while the 10 year yield declined by 4%.
While the fall in yields wasn’t quite as dramatic in the Australian market, our rates still pushed lower. Post Fed meeting, Australian 5 year government bonds yield are down 4%, while 10 year yields have fallen 3.75%. The domestic reaction to a central bank policy decision offshore clearly emphasises the global nature of our markets and the impact of the Fed’s pathway for interest rates on our markets. The chart below illustrates historic positive correlations of the US and Australian government bond yields.
This positive correlation in our bond markets remains despite a divergence in our monetary policies. Interestingly, the futures market in the US is now pricing in a 50% chance of a rate hike by the end of this year, while domestically 50% of market participants are calling for a rate cut by year end.
Emerging markets have had a short term reprieve by the Fed failing to act. Higher US rates will be negative for many of the emerging economies who have $US denominated debt, which will be impacted by a stronger dollar. Further, when the Fed does raise rates, capital flows out of emerging markets are expected to continue as investors take advantage of the higher yields and stronger economic prospects of the US.
The common view is that the impact on emerging markets when the Fed does move won’t be as severe for this sector as previous market downturns (such as the taper tantrum). Recent currency devaluations, improved current accounts, and increased capital reserves by many countries are all expected to dampen the impact when interest rates eventually rise in the US.
The Fed’s decision is a positive for credit spread product. This should translate into more favourable conditions for new issues. Domestically, we have seen some potential issuers sitting on the sidelines after originally indicating that they were coming to market. For example, in recent weeks QBE have road showed a new tier 2, 20 year bond with a 5 year call for the OTC market. Given current volatility, they have delayed its launch. Another Australian financial services company is also rumoured to have pulled its plans for the issue of a new bond.
In the listed debt market there has been a slight bid tone, with both tier 1 and tier 2 lifting off their lows. The exception has been Origin, which has been continually sold down by the market as the oil price remains low. This security is now trading at a credit spread of 9.3%, which is a yield to call of 11.5%. However, given the current cost of funding for Origin, the likelihood of them executing their call becomes more remote. Investors brave enough to purchase this security will be rewarded with a healthy return should Origin call the security in December 2016. Alternatively, they will be the holders of a 55 year bond with a coupon of +4%, stepping up to 5% in 2036.
The chart below shows the recent fall in the price of this listed security.
Takeover talk was again a feature of the domestic equity market this week. As was widely expected, Oil Search (OSH) rejected Woodside’s (WPL) initial approach as inadequate, labelling it as “highly opportunistic” which “grossly undervalues the company”. OSH had met with a number of large shareholders over the course of the week, with the offer receiving little support.
In a sense, the view of these shareholders is understandable in that the two energy companies have largely different profiles. WPL has a good asset base although will be subject to natural oil field decline in coming years, challenging its production profile. OSH, on the other hand, has a significant presence in PNG, which has the most attractive development opportunities (from a reserves and returns perspective) in the region. This has been a key reason for holding the company in our model portfolios. OSH, therefore, has been priced as a growth company, while WPL has been viewed as more of a mature cash generator.
Given the little upside that WPL would be expected to achieve from the deal, it would appear that a higher offer from the company will not be forthcoming. OSH has only fallen a little this week following the rejection of the bid. This is more likely in anticipation of a bid emerging from one of the global oil majors, although it would be reasonable to assume that few would be comfortable undertaking such a transaction in this weak oil price environment.
Today Veda Group (VED) received a takeover proposal from Equifax, a much larger US-based peer. The non-binding offer (subject to the usual conditions, such as due diligence and regulatory approvals) of $2.70 per share represents a healthy 35% premium to its previous traded price. When viewed on a more extended timeframe, however, the bid does appear to be timed rather opportunistically, with the stock having retraced approximately 20% since the beginning of August. While some of this has been due to the declines experienced by the broader market, VED’s recent full year guidance somewhat underwhelmed investors and there has been reports of increased competitive behaviour in the sector.
In this particular case, currency movements would have certainly added to Equifax’s interest. The $A has declined 20% against the $US over the last 12 months, thus making a deal cheaper for US companies. In this specific case, the time taken to build an adequate database of credit records in a new market would have led Equifax to the conclusion that the best way to achieve a presence in the market would be via acquisition. While VED is yet to agree to a transaction, it would seem likely that other domestic businesses with attractive asset bases will also come to the attention of international competitors given our weakened currency.
Macquarie Group (MQG) provided a trading update this week when it presented at an investor conference in Hong Kong, adding some additional colour to its guidance for the full year. The company has been keen to highlight the transition in its business from a predominant focus on its capital markets facing divisions (in which large swings in profitability can result from prevailing market conditions) to one that has a more stable proportion of its earnings from its annuity-style businesses (such as asset management, corporate finance and banking and financial services). The lower volatility of the latter should attract a premium rating by the investment community although will clearly result in less upside for the group when market conditions are favourable.
Macquarie Business Mix
For FY16, MQG expects that its first half profit will be up approximately 40% on the first half of FY15, with this level of earnings to be maintained into the second half. The depreciating $A has been supportive of this result and it will also be aided by performance fees in its asset management business and increased levels of volatility assisting its commodities trading division.
MQG’s guidance in recent times has proved to be conservative, and a more favourable environment has resulted in a succession of upgrades over the last couple of years (see below). While it is guiding towards a flat half on half result in FY16, we note that its profitability has typically had a greater skew towards the second half of the financial year and that it will also should be cycling more accommodative FX rates in this period. We maintain the stock in our model portfolios.
Macquarie Consensus EPS Forecast Progression
Stock Focus: Echo Entertainment (EGP)
Echo is a casino owner and operator with a domestic focus on the east coast of Australia. The company’s casinos include The Star in Sydney, Treasury Casino and Hotel in Brisbane and Jupiters on the Gold Coast. Echo also manages the Gold Coast Convention and Exhibition Centre. Echo was previously a part of Tabcorp and became a standalone entity when Tabcorp demerged the business four years ago.
Within its individual city markets, Echo’s casinos hold a monopoly position. In NSW, Echo’s casino licence extends to 2093 and it has an exclusivity clause that runs until November 2019. Crown’s recently approved Barangaroo development will eventually provide some competition to Echo’s Star casino, although we note that this will be limited to the high roller market and is not expected to be complete until FY21. Echo’s Queensland casino licences are perpetual in nature. While they do not have exclusivity provisions, Echo currently is the sole operator on the Gold Coast and Brisbane and is a part of a consortium that is the preferred tenderer to develop a second casino at the Queen’s Wharf location in Brisbane, thus protecting its market position.
While the Australian gaming market is relatively mature in nature, it typically exhibits relatively defensive growth characteristics. Expenditure on electronic gaming machines is generally in the low single-digit range, although NSW and Queensland (Echo’s markets) are currently recording the strongest conditions. Echo’s recent FY15 result also revealed that it has been gaining market share in this particular category, with its marketing spend and loyalty programs driving this outcome. Echo’s casinos are also well placed to capitalise on the flow on effects of a weaker Australian dollar as they are located in popular tourist destinations.
Echo’s high roller (or VIP) business is the area of its operations that is showing the most buoyant trading conditions. While high roller turnover can be quite variable on a year to year basis (and profitability even more so depending on the win rates recorded by the casino), the last 12 to 18 months has seen a large increase in activity that may be structural in nature. Key in driving the pickup in high roller volumes in Australian casinos has been the much publicised crackdown by the Chinese government on corruption, which has led to a shift of gamblers out of Macau and into other casinos in the region. In FY15, Echo reported an increase in high roller turnover of more than 50% on the previous year. The Star in Sydney has been an important driver of this result with its key competitive advantage of its Sydney location.
Earlier this year, a consortium that included Echo was announced as the preferred tenderer for the Queen’s Wharf development in Brisbane. The win was strategically important for EGP in that it solidified its position in the market, beating a proposal from Crown in the process with a partner that has deeper experience with regards to similar developments. The integrated resort would include a casino, hotel and apartment complex in the CBD of Brisbane. While there have been no financials yet released on the project, it should become a significant growth driver for Echo once completed.
Echo’s strong FY15 result was one of the better in the recent reporting season and the group carries good momentum into FY16. The company is finally seeing the benefits of a significant capital expenditure program that it has undertaken at the Star, which is driving higher turnover on its main gaming floor. Echo’s balance sheet remains strong, leaving it well placed to fund the significant investment that will be required for the Queen’s Wharf project. We recently added the stock to our model portfolios.