Weekend Ladder 19.01.2018
- Exchange rate moves for the USD appear to be counter to interest rates and economic conditions, yet there is a widely held view this will persist, though not to the extent of previous cycles.
- Domestic data in Australia is improving. Employment growth has been consistent for the past six months, though wage growth is still absent. The bugbear of household debt remains a burden.
- Growth in China picked up into the year end. It sits uneasily with the well-recognised excess credit expansion. The compatibility of very high growth and a stable financial system are being strained.
The weakness in the USD follows the persistent upgrading to growth in other parts of the world and increasingly hawkish comment from the ECB. Alongside has been the US CPI trends that refuse to budge out of a zone, which, in turn, keeps long-dated Treasury yields at low levels.
Forex analysts point out that interest rates in isolation do not necessarily drive exchange rates. In 2004-2006, for example, the FOMC pushed up the rate from a then 40-year low of 1% to 5.25%; 17 hikes in sequence. Yet, the trade weighted exchange rate fell by around 10% over that time. The main cause was the deterioration in the current account, where flows matter more than rates.
Today the potential rate rises are far less and the USD is still at the upper end of its broadly-based exchange rate.
Trade Weighted US Dollar Index: Broad
Further, the flow side of the equation may also work against the USD. While the repatriation of global cash into the US at a headline implies a USD flow, most of this cash (assessed to be circa 95%) is in USD via the Treasury and credit markets. US stocks and bonds are not a compelling investment for foreign capital and there is even scope for a protracted period of reducing exposure to US bonds at these levels.
The corollary to the USD is the Euro and the Yen. Both regions enjoy a large current account surplus and the bear stance to the Euro has yet to fully unwind. Given the economic momentum, the Euro could overshoot in the coming year.
The AUD has some support from the resilience in commodity prices and generally risk-on flavour. The improved current account is also a positive, mostly from lower imports and the services sector. Nonetheless, the forecasts for the AUD are centred around the 75-80 AUD/USD mark.
Through the year, the currency movements could be skittish, reacting to data or policy moves separate to these fundamental drivers. Examples are the looming US ‘shutdown’ as it reaches its budget ceiling. The first comments from the new Fed head, Jerome Powell (who formally takes over on 3 February) will be analysed for any nuanced changes to rates. Over the weekend, Germany will find out if it can form a workable coalition government. And already members of the ECB are showing concern on the Euro’s value and its potential impact on exports. This may cause some to interpret a deferral of changes to monetary policy for the region.
Locally, China data often causes a reaction in the AUD. There are expectations that China GDP may weaken given the tightening of stimulus in the past year and efforts to slow the property market.
- The weakness in the USD has impacted on the unhedged equity component of portfolios. In our view, there is no call to react to this given that most of the anticipated movement is now in the past. Conversely, the relative change in the AUD rate against other currencies is largely neutral. Many of our preferred funds have reduced their USD weight through 2017. In line with that, we have been recommending diversifying global equity holdings to accommodate some value styles and regional dispersion.
- Hedging does remove the currency impact, yet in the long term, the returns from hedged and unhedged equities is almost the same, bar obvious extremes (AUD over 1.00/USD or at 60c/USD for example). The current rate is close to fair value and unless one has undue concern on quarterly or even annual impacts, the level of hedging is recommended to be in the range of 20-50%. That can be determined by the weight in global equities and construct of those holdings.
The Australian labour market release for December was generally good news. Full time jobs rose by 15k and part time by 20k. The slight drag was the fall in hours worked. The unemployment rate rose to 5.5% as more people joined the labour market, partly indicating that there was a greater desire to get work, but also reflecting the growth in population.
The increase in jobs has been centred on a few sectors such as health services (e.g. the national disability insurance scheme), construction (state based infrastructure) and a wide range of service roles.
Jobs growth, 12 months to end November 2017
While the employment data is encouraging for aggregate household incomes, it does not point to wage growth, given the level of unemployment yet to be absorbed. Further, the job categories are likely to prove a drag on productivity growth due to the high proportion of service jobs.
And the problem of high household debt still looms as one of the risks for the economy. The RBA has noted that its capacity to manage monetary policy is constrained by the sensitivity of households to interest rates. The higher housing finance approvals for November are unlikely to please the RBA, even with the improved mix towards first home buyers. This cohort faces the most challenging arithmetic requiring a 20% deposit (circa $110k assuming a median dwelling price of $547k) which implies mortgage payments of $2,900 a month or 28% of average household disposable income.
The improving domestic conditions is welcome news. Yet, highly indebted households are likely to trouble the potential growth for some time. Unlike corporates, they cannot issue equity and need to await wage growth to improve their balance sheets. It also highlights the vulnerability to the wealth effect. Any setback in home values or financial assets will accentuate the debt burden and possibly push to a domestic demand recession.
- Stock selection based on a household income recovery theme requires an attenuated oversight of the company and its relevance in the evolution of changing consumption patterns. Fixed income, conversely, bears the brunt through rising rates as incrementally the evidence points to a rate rise, possibly after mid-year.
China also surprised with a better than expected Q4 GDP growth rate of 6.8%. Yet, this is in the past and the credit tightening of 2017 is yet to flow through. Bank data released earlier in the week reported lending growth notably lower than forecasts. As we mentioned last week, the Chinese financial authorities are running a fine balance between economic growth and curtailing the credit expansion that so troubles many commentators. This year may be a testing ground to judge if interest rate policy rather than volume control works better in managing loan growth. In conjunction, greater flexibility in the currency would add to their capacity to control financial conditions.
The chart below is a compelling way to demonstrate the sheer size of the Chinese economy and therefore the scale of resources absorbed. It draws a parallel between the total size of a country’s economy compared to one year of growth in China. In 2017, the economy increased in scale at an equivalent of a Canada, based on purchasing power parity terms.
China’s GDP growth in PPP terms and country equivalent of the corresponding year
Fixed Income Update
- The yield on the 10-year US treasury breaks through a technical trading level.
- Tech giant Apple are rumoured to be selling their holdings in corporate bonds to repatriate funds back to the US following changes to the tax laws.
- Bond markets expand in Asia, despite investors limiting the terms in which they will lend to Chinese banks and corporates.
The rise in bond yields in the US since the beginning of the year comes as no surprise. A flurry of information has come out including talks of the end of bond purchases from the ECB, changes to the yield targeting by the bank of Japan, inflation discussions from the Federal Reserve at the December meeting, strong economic and employment data, rhetoric of a bear bond market by Bill Gross and unconfirmed reports of Chinese officials recommending a slowing of purchases on US treasuries. Now that this information has come to light, where to from here?
The yield on 10-year US treasuries is teetering at around 2.60% (19th of Jan 2018), which is a break out of its recent trading range. It pushed through technical levels that have held for 30 years, although a failure to push even higher (so far) have kept the trend intact. The risk is clearly to the upside in yields, as a break-through in technical levels has the capacity to trigger ‘stop losses’ (exit levels) on those investors or traders long the security (ie, triggering sell orders at a certain price, or a yield). This would accentuate the downward price action to run further. In contrast, if we see the trading range hold, the yields should range trade back lower.
Yield on 10-year US Treasuries
In recent years some large US corporations, the most prominent being Apple, have been stockpiling cash in offshore bank accounts and then investing this capital into the corporate and treasury bond markets through foreign subsidiaries. Rather than pay the 35% tax rate in the US they would raise funds through the bond market to pay out dividends and share repurchases to equity holders. It was cheaper to pay the interest on a new bond than pay the 35% tax rate. In 2017, Apple issued $30bn of new bonds, with all the proceeds being returned to US shareholders.
Given the new tax reform in the US, and subsequent lower tax rate, WSJ are reporting that Apple plan to move its offshore cash (~$252bn) into a US jurisdiction to fund future dividends or share repurchases. It will therefore be selling some of its holdings in bonds instead of issuing new bonds like previously done. It is said that about $153bn of its portfolio was invested in corporate bonds as at the end of September.
- The US bond market makes up over $USD32 trillion of the estimated $82 trillion global bond market. While the sale of bonds from companies such as Apple is notable, given the size of the market and the investor demand for newly issued bonds over the last year, we do not expect these sales to cause a major disruption to pricing within the market. A weakness in bond prices may occur if many other corporations with large holdings also decide to sell, and at a similar time.
The rising level of wealth and cash savings accruing in the Asian region, especially China, in recent years has resulted in an increase in the number of pension funds, insurance companies and fund managers opening Asian operations. Blackrock, Fidelity and Pimco have established operations in the region, while local fund managers have grown. High demand from these players has new bond issues becoming oversubscribed, including buying of record amounts of those denominated in USD. Issuers in the region have responded to this demand with a record $340bn being raised by companies and sovereigns in Asia (ex-Japan) in 2017, up from $211bn the previous year.
- Given Australia’s proximity, growth in the Asian region should be a positive development. As the global opportunity set expands as will the product suite available to Australian investors and the liquidity of these securities.
Interestingly, it does at come at a time when the Chinese banking sector continues to warrant caution with investors, despite the China Banking Regulatory Commission making moves to tackle “market chaos in the banking industry”. In contrast to developed countries that have had bond maturities lengthen in the last few years, the average maturity on debt issued by Chinese banks has been falling. The weighted-average maturity in the Chinese bond market has fallen from 7.9 years to 4.5 years in the last 8 years. The size of the bond market has grown in the last two years, but rates on these bonds have been higher and for shorter tenors, a reflection of investor’s liquidity and credit concerns.
Weighted average maturity of corporate bonds (years)
- Sector and company price earnings ratios have diverged over the past 12 months despite a reasonable stable overall valuation for the ASX200.
- With a priority of reduced capex and increased shareholder returns, the big diversified miners are in a low production growth phase. Valuations look reasonable compared with industrials and there is upside potential to earnings forecasts if spot pricing is sustained.
Since early December the ASX200 has consolidated above 6,000 points, nearly a 6% price return (10.6% accumulation) over the past 12 months. The forward Price Earnings Ratio (P/E) is modestly higher at 18x yet there has been a significant rotation in the individual sectors’ P/E ratios.
To emulate the rest of the world local investors have sought out local information technology stocks which have enjoyed some of the strongest returns and now has some of the highest P/E’s in the market. This has not just come from the price rises from any headlines announcing ‘blockchain-related activities.’ Companies such as Wisetech (WTC) and Altium (ALU) trade at high multiples as they capture the theme disruptive technology. On the other hand, Computershare (CPU) with its sustainable earnings growth trades at a more moderate valuation that is also up over 30%.
At the other end of the scale Telecommunications has lagged the market. The obvious headline for this has been Telstra (TLS), which took TPG Telecom (TPM) and Vocus (VOC) with it into negative returns. A combination of the NBN transition and a cut to its payout ratio has seen the stock fall nearly 30% over the past 12 months. Given the derating of the sector, there is a view that new technology alongside the scale in use of data may eventually move in favour of the industry. Telstra’s strategic plans of becoming more of a technology company and providing households with the biggest and faster network will be a focus over the coming year.
Not only have we seen dispersions between sectors, but we have also within sectors. A good example has been consumer discretionary attributed to the wider range of companies within this sector. Aristocrat Leisure (ALL) has remained a favoured stock as it continues to increase its recurring revenues and enjoy the rise in market share. Other ‘experience’ companies such as Flight Centre (FLT) and Mantra (MTR) (subject to takeover) joined ALL in high stakes returns. In contrast, we have seen Myer (MYR) sales deteriorate further from an already low base justifying its low P/E. Retail Food Group (RFG) and Domino’s Enterprises (DMP), have also seen a sharp derating.
- This view back into 2017 provides some lessons for equity portfolios. A view on a sector should only apply to those with uniform characteristics. Banks and REITs tend to have common outcomes, while more sectors have a wide dispersion. Another is that high profile stocks require a constant refresher on their merits and risks. In the stocks noted above, TMP and DMP not long ago were heralded as long-term growth stories. The reaction to any perceived or real disappointment is increasingly savage. It requires skill and fortitude to decide if that is an overreaction or the start of longer term deterioration. This role lies with our preferred managers.
A typical January lull in market announcements saw the focus of this week on various production reports from resources companies. As we have noted, it has been the resources sector (and recently energy) that has again underpinned the earnings growth for the ASX 200 in the first half of the financial year, which will be evident in the upcoming February reporting season. Commodity prices pushed higher in the December half, therefore companies that are able to report strong production numbers will be maximising what may be a shorter-term boost to profitability.
Rio Tinto’s (RIO) production numbers were solid, with the company meeting its guidance across is major products. The December quarter was a record for its core Pilbara iron ore operations, shipping 90mt. Notably for the 12 months, however, iron ore production was in line with 2016, the first time that RIO hasn’t grown this division in several years.
Having completed its major iron ore expansion projects, the company’s focus is on productivity improvements and cost reductions for what is a relatively low demand-growth market. Guidance for 2018 is for marginally higher iron ore production, with a focus the automation of its train system – presently around 60% of all train kilometres are being completed in autonomous mode with a driver on board for supervision.
Of the group’s other key divisions, production was softer over the year, including for aluminium, copper and hard coking coal. Copper output in the first half was affected by strike action at the large Escondida mine in Chile (BHP Billiton also has a significant stake in the mine), though improved in the second half.
BHP Billiton’s (BHP) quarterly production was more mixed, with a slight downgrade to its full year guidance for coking coal the key disappointment. Similar to Rio, iron ore production for the half was in line with the previous year and copper output also rebounded in the quarter. Oil production was lower on reduced US shale energy activity and hurricane-related outages in the Gulf of Mexico. As the chart shows, a lift in commodity prices in the last six months will be the key driver of increased profitability for BHP.
BHP Billiton: December Half Production/Price Growth
A differentiator with Rio is BHP’s petroleum division, which will reduce in size by approximately a third following the divestment of its US onshore shale assets. The strategy of realising value by selling weaker portfolio assets is not too dissimilar to what several large-cap industrials have focused on in recent years. The timing of the sale has been quite fortuitous for BHP given the sharp rebound in the oil price in the second half of 2017.
Since the bottom of the most recent commodity cycle two years ago, the share prices of BHP Billiton and Rio Tinto have recovered to such a degree that both have doubled in this time. Despite this, the valuations across the sector remain reasonable, particularly relative to industrials, which have enjoyed a significant P/E re-rate over the last several years as interest rates fell.
On a net present value basis (which discounts future cash flows based on production and forecast commodity prices), on current assumptions, the two diversified miners are trading at close to fair value. The chart illustrates an alternative measurement of value, being enterprise value (market capitalisation plus debt) to the consensus 12 month forward estimate of EBITDA. Both BHP and Rio Tinto currently trade on a forward multiple of around 6.5X, close to the average over the last five years. Notably, this incorporates an expectation of a tapering in commodity prices over the medium term and thus the metric would appear better under a spot pricing scenario, which would see earnings up to 50% higher than what is forecast.
BHP Billiton and Rio Tinto: EV/EBITDA
The outlook for 2018 is balanced by a strong demand environment for commodities (driven by the synchronised upswing in global economic growth) balanced with a potential slowing in China. A key positive for shareholders is that they will be short term beneficiaries of additional capital returns (either in the form of dividends or share buybacks) while spot pricing remains high, with this remaining a key management priority for both BHP and Rio.
Our Australian equity SMAs are typically underweight the resources sector, as these companies screen poorly on measures such as dividend sustainability and predictability of earnings. A low weighting in the sector is more helpful in achieving core objectives of dividend growth and preservation of capital. This has been a hindrance to relative performance to the index in the last two years. However, it was a significant contributor to alpha in the preceding three year period. While it is less visible to investors, several of our smaller cap funds have had a higher participation in recent times, with commodity exposures to the electric vehicle thematic common across portfolios.