Week Ending 18.11.2016
• US data clearly aligns towards a rate rise and debate now turns to the number in 2017.
• The Australian labour market remains weak, indicating that economic growth is likely to remain patchy.
• Europe faces challenging political circumstances, unfortunate given the improving economic momentum.
The chances of a US rate rise in December are all but certain. This week’s economic data unquestionably supported that outcome. The CPI has bottomed and incrementally it is pointing to a higher inflation rate through 2017. Service prices are already rising at over 3% and goods prices are also generally on the up, albeit at a slow pace. Food is, as yet, unchanged. Claims for jobless insurance has declined 14.5% year-on-year to the lowest level since November 1973. Housing starts have increased 23.3% year-on-year to the highest level since August 2007, with both single family and multi-family categories participating in the trend.
US Housing Starts
The debate now turns to the number and timing of rate rises in 2017.
Locally, the employment data was soft, with 9,800 new jobs in October, although full time employment bounced back from last month’s fall. In fact, the decline in full time employment for September was revised downward to -74,300, the largest on record. Other labour market trends suggest that the lower rate of GDP growth is structural. The participation rate at 64.4% is at its low of the last ten years. Participation rose strongly though the 2000’s as more woman stayed or re-entered the workforce. Now, the aging population appears to have taken over. Hours worked has also persisted on a downward trend. From a peak of 150 hours per worker per month, the number is now 140.
The easing AUD/USD can be readily attributed to the differential in economic momentum and interest rates. Nonetheless, many had expected the AUD to follow commodity prices, which may indicate that the market is not convinced the recovery in resource prices is sustainable.
European instability looms again. Italy will vote on Senate reform on 4 December and at this stage polls suggest it will be voted down, triggering the likely resignation of Renzi. This has relatively little economic consequence but is unhelpful in the lead into 2017 with three major general elections – Netherlands in March, French in April and German in September. One can also add the complexity of Brexit, with the Supreme Court ruling to come in January on the parliamentary trigger for Article 50.
This comes against a solid improvement in European economic trends. The number of people in work in German is the highest since reunification, with the measured unemployment rate below 3% in large cities in Bavaria. In the past five years, employment growth has been evenly spread across three sources, with an equal contribution from woman, non-Germans and older people re-entering the workforce. As is becoming increasingly common around the globe, the lack of skills, particularly in technical areas, is the main hurdle for companies increasing their workforce.
Even in the UK, the household sector has now brushed aside the concerns around Brexit. Retail sales are on a roar, rising at their fastest pace in 14 years. On the other hand, this has been funded by household savings, suggesting fading momentum or a breakout in wage growth.
Fixed Income Update
• Bond yields have consolidated at a higher level this week with a rate hike by the Fed now fully priced by the market.
• Emerging market currencies have come under pressure since the US election.
• Bank hybrids have performed relatively well in the recent bond market correction, highlighting the benefits of a diversified portfolio approach to fixed income.
After exceptional moves in the previous few weeks, the spike in global bond yields (fall in bond prices) has taken a breather in the last few days, with a rate hike by the Federal Reserve in the US all but fully priced in for December. An easing of bond yields in the latter half of this week is perhaps evidence of investors reassessing the impact of infrastructure spending and tax cuts in the US. Further, some market participants have been of the view that US yields will be capped by the large appetite for US treasuries from offshore buyers, particularly out of Japan.
Not surprisingly, the Mexican peso has recently been one of the biggest losers as Trump’s policies on protectionism have weighed on the currency. In addition, the peso is often used as a proxy trade for investors looking to take a view on emerging markets (EM) as a whole, as it is more liquid than other EM currencies. This would have contributed to the increased volatility (and a 14% plunge in the peso following the election result) that is charted below.
Mexican Peso/US Dollar
The fallout from this dramatic move, which has also been felt across other EM countries, has led to a swift repricing in the expectations of interest rate movements in these countries. The Central Bank of Mexico took first steps against the peso fall by raising rates 50bp with Turkey and South Africa likely to follow suit. This movement has translated to a downturn in performance for investments in emerging market debt (local and hard currency) as yields have risen and currencies have slumped. While valuations look extended and spending on US military equipment may in fact benefit some in the region, views on the outlook remain mixed from fund managers. The table below does not include the Mexican rate rise.Enlarge
It is worth noting that while fixed rate bonds and long duration bond funds have experienced a downward correction in the last ten days, credit spreads on investment grade bonds are only 2bp wider and bank hybrids are performing well. Diversification across fixed income allocations has again proven key.
In the Australian listed debt market, Origin yesterday announced its intention to redeem its subordinated notesat the first call date of 22 December 2016. This was widely anticipated and follows the recent calls by ANZ (ANZPA) and Woolworths (WOWHC) of their subordinated notes which have a call date prior to year-end.
• James Hardie’s (JHX) earnings guidance for FY17 was downgraded slightly, however the company is well placed to benefit from an improving demand tailwind into next year.
• Telstra’s (TLS) investor day highlighted the challenges ahead of the company as it seeks to plug the earnings gap created by the transition to the NBN.
• Myer’s (MYR) first quarter sales showed some promise, while Wesfarmers (WES) indicated the potential sale of its resource assets.
• AGMs through the week continued to provide a mix of trading updates, including an upgrade from fruit and vegetable producer Costa Group (CGC)
James Hardie (JHX) reported its half year results, announcing a slight downgrade to its full year guidance. With this largely attributed to short-term operational issues, investors were prepared to look through to the more positive picture of robust volume growth. JHX’s experienced a higher level of cost growth in the half as the company ramped up production of new manufacturing capacity. While volume growth in its core North American market was robust in the half at 14%, management suggested that this was also held back somewhat by capacity constraints within the business. Volume growth ahead of underlying demand growth of the market continues to be a feature of JHX’s sales figures.
As such, the group’s margins were weaker than anticipated, although remain at the top of the group’s long term 20-25% target range. While the second half of this financial year may be similarly impacted by the problems of the first half, a positive picture can be drawn for FY18 from a market that can absorb price rises, ongoing solid volume growth and a resolution of the problems that have held back earnings this half. US housing starts are still approximately 25% below long term average levels and we remain attracted to the cyclical and structural market share growth of JHX.
James Hardie: North America Fiber Cement Underlying EBIT and Margin
Telstra’s (TLS) investor day looked to address the key issue of how the company can fill the $2-$3bn earnings hole that will emerge once the NBN is fully rolled out by early next decade. With an existing high market share across its key business divisions and a highly competitive environment pressuring margins, the opportunities for significant top line growth appear to be limited. Instead, much may rely on TLS’s ability to reduce its cost base, with the company targeting an ambitious $1bn cost saving figure by FY21. TLS is also expecting to realise revenue benefits from the $3bn investment program it announced at its full year results in August, although a valid question may be how much of this is simply required to protect its existing position.
Telstra: Targeted Earnings Bridge to FY22
Telstra also revealed that it would be reviewing its capital management framework over the next 6-12 months as it looks to deploy the NBN payments which it is receiving from the government. There is a high likelihood that investors would preference additional dividend payments and/or buybacks over M&A opportunities. The net outcome of this may be a short-term dividend sugar hit which would probably prove to be sustainable within a few years.
At best, the stock can be recommended for the income-seeking investor looking to benefit from a stable medium-term dividend, although we remain wary of the longer-term earnings and capital risks to the company.
Headline sales growth at Myer (MYR) was a modest 0.6%, but like-for-like growth of 1.6% showed the potential path towards a better outcome. In essence, the group is reducing its unproductive sales footprint and along with its restructure plan, this may indicate higher EBIT into 2017/18. The stock price climbed sharply, likely driven by closing down of long-held short positions in the stock. Even so, the company does not pass on a long-term score given the continued change in consumer behaviour.
Wesfarmers (WES) commented that it was ‘evaluating’ options for its coal assets. Many have looked to cleaning up the disparate holdings in WES and concentrating the company on its retail operations. Exiting coal will improve the predictability of profit at WES and reduce the high level of gearing. But the challenges in the supermarket sector, possible change in pace in household goods retail and the struggle to redefine Target is expected to weigh on the share price over 2017.
This week was again busy with AGMs and several companies provided trading updates:
- Brambles (BXB) reaffirmed its guidance of 9-11% constant currency earnings growth along with its three year target for a similar level of annualised growth to achieve a 20% return on invested capital. After underperforming the broader market since early August (with no change in its outlook), BXB’s valuation has become somewhat more appealing.
- Costa Group (CGC) provided a rare earnings upgrade through AGM season, after announcing that it now expects FY17 profit to be at least 15% greater than that of FY16. Helping the group’s earnings has been a lack of any adverse weather conditions and a strong performance from its citrus division. CGC has an attractive medium-term growth profile, which is largely driven by its investment in expanding its berry production to meet consumer demand and still trades on a relatively undemanding valuation.