A summary of the week’s results


Week Ending 18.12.2015

Eco Blog

Perhaps the most protracted, anticipated event of the year, the Fed rate rise, is over. The debate will now be on the timing and extent of rate rises in 2016. The typical pattern would be one every quarter, though there has been many times where that rule has been broken. It would, however, be unusual for the Fed not to follow through in March, with market pundits believing the senior members of the Fed are at present aligned to a Fed funds rate of 1% by the end of 2016.

Data dependency is the 2016 lexicon and two releases matter. The job market has to make further progress, though there is unlikely to be a specific unemployment rate in mind. Assuming this data is not out of expectations, inflation is likely to be more important. After the rate decision, Janet Yellen was questioned on exactly what she and the Fed were looking for in the inflation numbers. No clear answer was forthcoming, but one suspects that any sign of rising wages would be essential for a more hawkish stance.

Rather than a parade of economic data, it may suffice to report that most of the trends are what can be described as gently positive. Europe looks likely to print the best GDP growth for Q4 of 2015 in four years, and employment conditions are promising, based on the Markit index.

Eurozone Employment

Source: Markit

The Japan Tankan survey, a bellwether for large manufacturing companies in Japan, ticked along at a relatively firm pace. Often underestimated as still a large economy, it would be useful to see Japan achieve a decent outcome in 2016.

After some months of troubled conditions, 2016 may well be better than expected. Now that would make Christmas!

Fixed Income Update

Fixed income markets aren’t allowing those involved to have a relaxed wind down into year end. In fact, in the last week, markets have pulled out the big guns by throwing both credit market liquidity issues and rate rises into the mix. Despite both of these events being significant for markets, neither should come as a surprise, as they have been talked about in the media for months.

Credit market woes came to a head late last week when three high yield funds in the US either liquidated their portfolios, or put a freeze on client redemptions. While all of these funds were in the riskier sectors of fixed income, with holdings in unrated and distressed debt, they offered daily liquidity to clients, a mismatch with the liquidity of their underlying assets. The large wave of redemptions in these funds stems from expectations that defaults will rise in the US high yield market; a consequence of a higher Fed funds rate, depressed energy prices reducing revenues for companies in this sector, and over-leverage by some issuers.

Fundamentals in the rest of the corporate bond market remain sound. However, contagion from the US high yield market has been playing havoc on credit spreads across the board, including investment grade credit. Many market participants are citing this as a buying opportunity, as the risk premium hasn’t been this high since 2011. The chart below illustrates the Australian iTraxx index, which is the best proxy for credit spreads on 5 year investment grade credit.

Australian iTraxx Index

Source: Bloomberg, Escala Partners

Bond markets have been waiting all year for the much anticipated interest rate rise in the US. Now that it has been delivered, how did the market react? It pretty much didn’t. Market movements were muted, with only an increase in the front end of the curve, as expected. As yield curves are always forward thinking they are likely to remain stable when expectations are met, as was the case.

Looking Back on the Last Decade

Rather than reflecting on the past year, in our last Weekend Ladder for the year, we have cast ourselves back to 2005 and noted the changes in investment markets since that time. There is no reason 2005 should in any way be a barometer for the current economic and investment climate, yet there are outcomes which remind one that both the unexpected and predictable will occur. There are also uncanny similarities.

The energy sector was the standout global performer in 2005, up 28%, in good part due to the disruption from Cyclone Katrina, a reminder that events can substantially change an investment outcome. Japan was the best regional market, as GDP growth held up at over 2% for the second year in a row and the Yen weakened to a seven year low. Growth that surprises on the upside (as opposed to the absolute level of growth) is often more likely to result in strong investment returns.

Interest rates rose, with the US Fed pushing the cash rate from 2.25% to 4.25% over the year. Along with the drag from a rise in the USD, the US equity market edged up by only 4.6%. The rise in rates did, however, not stand in the way of decent returns in fixed income assets.  Global corporate indexes provided respectable returns of 6-7%, while government bonds fared less well. While rates this coming year are likely to rise much more slowly, it shows that positive returns can be achieved in a rising rate environment.

European growth in 2005 was below par due to high unemployment and uncertainty exacerbated by a messy EU constitutional vote. In the coming year, we have Brexit (Britain’s vote on the EU) and elections in France to contend with. These could well have a meaningful impact on the performance of the Eurozone market. An arguably poorly timed rate rise by the ECB in 2005 would also have been unhelpful, a reminder that central banks need to be cognisant of more than just data.

Ten years ago, China not only become a member of the OECD, but also removed its dollar currency peg and started the process of a managed float (which is still in place today). The renminbi was revalued, coming under pressure from developed countries due to the large trade surplus. At present, the renminbi is more likely to move downward as a way to facilitate easing given outward capital flows.

In the bellwether S&P500, 312 stocks have remained in the index over the past 10 years.  The constituent base has changed mostly due to merger and acquisitions rather than illegibility. For inclusion, a company must have a market cap of over $5.3bn, but the S&P is tolerant of moves well below that level once in the index.

The table below shows the change in the top ten stocks by weight in the index at the time.

Changes in S&P 500 over last decade


Four stocks have maintained their grip – Microsoft, GE, Exxon Mobil and J&J. The banks’ representation has been sustained, but the companies have changed, reflecting Wells Fargo and JP Morgan’s stronger balance sheets through the financial crisis. New entrants, Apple, Amazon and Facebook are a sign of the times. Missing is Google (or Alphabet as it is now known). Due to the structure of the capital, the two classes of shares are represented as separate listings. Together they would take the weight to second largest in the index at 2.44%.

The European markets are no different. A decade ago, stocks such as Total, Nokia and a number of banks and telecommunications companies held fort as the largest stocks. Today Nestle, one bank (HSBC), Total, British American Tobacco, Bayer and five healthcare companies are in the top 10. It is a reminder that investments in Europe can have a low level of reliance on Europe’s economic prognosis.

The globalisation of company operations is also at the heart of a declining home bias. Smaller, less diversified local markets lend themselves to lower local investment as can be seen in the following chart.

Home Bias in Equity Markets

Source: MSCI

The Australian market has proven to be much more static than most equity markets in terms of the index composition over the last decade. A total of seven of the ten largest companies of 2005 remain among the top 10 of 2015: the big four banks, BHP Billiton, Telstra and Woolworths.

Changes in ASX 200 over Last Decade

Source: Iress, Escala Partners

The most notable difference in 2015 is the reduction in resources exposure in the index. Rio Tinto and Woodside Petroleum have dropped out of the top 10, while the weight of BHP Billiton has more than halved (and after peaking at around 13% of the index in 2011) over this time, reflecting the cyclical swings experienced in commodity markets.

The banks have consolidated their position as the largest companies, with the major four now occupying the top spots in today’s list. The two best-performing stocks in this group, Commonwealth Bank and Westpac, have grown ahead of the other two, partly assisted by large acquisitions undertaken through the GFC. CSL’s consistent performance has seen it rise from less than 1% of the index in 2005 to 3.3% today.

The concentration of 10 companies representing nearly half the market (and therefore disproportionate impact on the index) is a challenge for those investors sensitive to ‘beating the index’. We encourage investors to be aware of this dynamic and the search for longer term growth may mean taking risks well outside the top 10, by default therefore implying a variable performance against the index.

Looking at bond markets, the growth experienced has been one of the biggest changes, with ‘cheap’ money being available for some time.

Australian Debt Markets


These numbers are graphically depicted below, showing the massive 25x increase of issuance by Australia’s financial and corporate sector in the last 20 years.


On the other hand, global corporate credit spreads are wider than a decade ago. Based on the BofA Merrill Lynch indexes the spreads in 2005 were much tighter than today:


Not only do these spreads now represent some protection on defaults compared to 2005, but they also indicate the broad opportunity set available  to fund managers in fixed income.

Corporate Comments

Suncorp (SUN) released perhaps the last large-cap equity downgrade of the year, with an update on its general insurance operations. After reporting several successive half-yearly improvements in its underlying insurance margin (see chart below), the company now expects this to fall back to around 10% for the current six month period and below its 12% targeted level.

Suncorp: Underlying and Reported Insurance Trading Ratio (ITR)

Source: Suncorp

SUN pointed towards several factors that contributed to the downgrade, with the primary driver increased claims, particularly in home and motor insurance. Lower investment yields, an increased allowance for natural hazards, a weaker Australian dollar (which has increased its costs) and fairly competitive market conditions have all combined to add to what amounts to a fairly large deterioration in its insurance margin.

With similar market exposures, IAG would also be prone to the some of the issues that have caused SUN’s downgrade, although it appears that SUN’s issues are more company-specific and even a possible rebasing of expectations by its new CEO. We also note that IAG’s insurance margin had already fallen somewhat in the last two halves, while SUN’s had held up well.

We had previously held SUN in our model portfolios, with its solid capital position allowing the company to release this to shareholders in the form of special dividend payments. With these payments nearing an end and the prospect of lower ordinary dividends in the face of the reduced profits in its business, our preference in the sector is currently with QBE Insurance (QBE).

As the Federal Government was clearly looking for savings measures as it aims to eventually balance the budget, it was unsurprising that there would only be losers emerging from the Mid-Year Economic and Fiscal Outlook (MYEFO). Healthcare stocks were thus impacted the most, particularly pathology and medical diagnostics companies Sonic Healthcare (SHL) and Primary Health Care (PRY).

The Government’s changes included approximately $650m in cuts to bulk-billing incentive payments for some pathology and imaging tests. While the final policy may yet face revisions in order to pass the Senate, investors have already marked both stocks heavily during the week. The proposed policies will not be effective until FY17, but initial estimates have forecast a negative earnings impact of around 5% for Sonic Healthcare and 10% for Primary, with Primary’s higher domestic exposure the key reason for the difference between the two.

Aged care was another area that was flagged as a potential candidate for funding cuts. However the three listed operators (Regis Healthcare (REG), Japara (JHC) and Estia (EHE)) all recovered some lost ground after the changes were not as bad as first feared. The funding changes relate to Aged Care Funding Instruments (ACFI) which are determined on an individual resident basis, dependent on the individual’s required level of care. The residential aged care operators have been efficient in identifying residents who require a higher level of care, thus drawing more funding from the Government and causing an over-spend relative to initial estimates.

The impact to the residential aged care operators is more at the margin compared with the earnings hit that SHL and PRY face. It nonetheless highlights an ongoing risk for companies that operate in industries with a large reliance on government funding and how this can be altered without any forewarning, particularly when fiscal balances are tight. Despite this, we remain positive on the outlook for the aged care operators, with strong ongoing demand supporting high occupancy levels, cashflows that are boosted by a robust property market and a large consolidation opportunity available given the fragmented nature of the industry. We have REG in our model portfolio.

The extraordinary story of Domino’s Pizza (DMP) continues. The company has formed a joint venture with Domino’s Pizza UK in acquiring a group of 210 stores in Germany and folding them into the small base the UK business currently has there. The total acquisitions cost including earn out is expected to be Euro79m, as well as the potential for DMP to buy out the share held by the UK business in five years. Unsurprisingly, the pizza sector is fragmented and this store base will be the largest operator, yet have only a circa 5% share. DMP will have 775 stores across Europe after this transaction and believes it can grow to around 2500 stores.

As it has in other regions, DMP will test new products, add online delivery, reformat stores and change the management incentives in this German market. The Australian division of Domino’s has hit upon a remarkable formula of success; all the more interesting as similar operations elsewhere in the world seem to have been unable to replicate its methods. The German operations run by the UK division were struggling – stores too large, overheads too high and delivery zones too wide.

The main issue for investors is the share price. Even with another earnings upgrade to 30% EPS growth for FY16 (from 25% in previous guidance) the stock is trading at around 55X forecast FY16 earnings. Valuing such growth is an investment challenge. The primary method would be to use a discounted cash flow, but few would want to impute a terminal growth rate of much more than 3% for pizza which then struggles to get to the current share price. Investors, however, are perhaps more focused on the current momentum and do no look like being prepared to sell down yet.