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WEEKEND LADDER

A summary of the week’s results

19.05.2017

Week Ending 19.05.2017

Eco Blog

- Understanding the measuring of inflation is as important as the headline number. This coming week may illuminate whether the Fed has any concerns on the persistence of the low CPI in the US or whether it attributes that to cyclical and structural issues.

- The Australian labour market sends two signals: low income growth is likely to curtail household spending, while employment levels appear to be stabilising.

- Chinese debt growth is one of the most commonly cited tail risks for markets. High GDP growth has been closely linked to easy credit and a moderating level of growth is therefore appropriate, yet also underlines the continued dependence on China for global growth.

After weak inflation data from the US, market observers have turned to closely examine other signs that suggest US economic momentum may be fading. One of the culprits behind the soft CPI was the fall in the value on auto spending, partially due to tightening credit, but more so from a glut in used cars, with a rising number of leased vehicles finding their way into dealer yards.  Medical costs unexpectedly fell and was attributed to off patent drug costs, plus some caution on price increments on other products from drug companies given the heightened attention to the big increases put through in recent years. The largest component, housing, showed easing rent, in line with a high supply of apartment dwellings. The irony is that the low inflation is partly due to the legacy of low interest rates, with the build-up in vehicles and dwellings due to easy financing.

The other issue that has been raised is in the way in which the CPI is measured. In this instance, there has been a reset in cell phone services. Unlimited packages from telecommunication companies nulls the per unit measure and was translated into a 13% price fall in this sector. 

Traditional measures from government statistical services are finding it harder to provide meaningful data as consumption channels change, for example from store to online, from a movie house to Netflix, from taxi to Uber. Labour markets are at least as challenging, with the Australian Bureau of Statistics under scrutiny due to big movements in its reported employment data as it samples different regions. In addition, the question of self-employment and underemployment are wide open to interpretation.

Now the question is whether the US Fed will nominate the persistently good trend in labour markets and signs of business investment as sufficient to lift the cash rate. It could reasonably state that inflation is low due to competitive pressures as well as the abovementioned structural issues and that a normalisation of the rate cycle is warranted. Besides, some economists have fallen back to the oldest culprit in the world to excuse the current softness in housing and business activity: it’s the weather.

In the Fed meeting next week there is expected to be commentary on how and possibly, when, the Fed’s balance sheet will become part of monetary management. Investors should anticipate much debate on the number of rate rises and whether this will be affected by the methodology in addressing the balance sheet.

From a wage perspective Australian labour conditions may be stabilising, though at low levels. Annualised wage growth is at 1.9%, barely covering cost increases and suggesting the inflation rate could fall even further. The flow on effect of low incomes into spending and housing is self-evident. In turn, the RBA is very unlikely to raise rates now that it, along with the banking regulator, appear to have stemmed the tide of investment housing.

A glimmer of light may be appearing in employment growth, with April data improving once again after a recovery in March. The bias however, once more turned back to part time employment and hours worked fell by 0.3%.  Nonetheless the unemployment rate appears to have bottomed, though the repercussions from a lower activity in housing may yet come through.

This places the AUD in a spot. It is not inconceivable that US bond rates will be higher than Australian bond rates this time next year. While interest rate differentials are a determinant of the AUD, the narrowing current account deficit (positive for AUD strength) and commodity prices also play a part.

To complicate matters, the direction of the USD is far from evident. The diagram shows the push-me, pull-me influences on the USD.

Source: Deutsche Bank
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On one hand, financial markets would favour a slowdown in China as evidence the problematic accelerations in credit is being curtailed. On the other hand, China is now one of the anchors of global growth. April activity data shows a moderation in trend growth. The mix was not the best, with resilient property investment counterbalanced by a lower rate of increase in industrial production and asset investment. As is the case in Australia, regional governments have a vested interest in property, be it stamp duty or land sales.

Local Government Land Sales Revenue

Source: WIND, Deutsche Bank
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Inevitably there is attention to any comment or action from the Peoples Bank of China (PBoC) and financial regulators to assess whether they are showing signs of concern. The PBoC was at pains to send a message that over-interpreting its management of monetary policy could result in a flawed assessment of its intentions. This probably applies to other central banks as well. The PBoC has apparently been reducing its balance sheet, interpreted as a signal of tightening policy. Instead the bank stated this was due to seasonal factors related to the Lunar New Year, global timing of Easter and fiscal flows.

China Credit and Ecomonic Activity (% y/y)

Source: Thomson Reuters, CEIC, Economics
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Nonetheless it seems clear that GDP growth will ease back through the year as the credit pulse turns over. Yet there is no evidence of a destabilising event, and that is unlikely prior to the People’s Congress meeting in November. 

Another development is the approval of ‘Bond Connect’ which mirrors the Shanghai and Shenzhen Connect for equity trading between Hong Kong and those exchanges. While the full operational details have not been disclosed, the initial rollout will only include inbound flows and legible participants are to be limited. Over time the opening of China’s bond market has the potential to significantly shift investor allocations as they are fully included in global indexes. Given the weight of passive money, the natural buying of bonds and securities (and selling of those to be down weighted within the index) is an event that will shift the dial.

Finxed Income Update

- The strong performance of the listed hybrid market continues as spreads tighten further.

- The upcoming call date of the ANZPC’s reminds us of the optionality imbedded in these securities given they do not have a fixed maturity date.

- Ratings agency Standard and Poors’ joins Fitch and Moody’s in affirming Australia’s AAA credit rating, however it comes with negative undertones.

- Political upheaval in the US weighs on risk markets as bonds benefit from a flight to quality.

The listed debt and hybrid market has had a stellar run over the last 12-18 months, with spread contraction in the sector aiding asset valuations. Credit spreads on new issues that came to market early in 2016 (when spreads peaked) are now trading ~200bp tighter. The performance of the CBAPE’s, issued with a margin of BBSW+5.20% in March last year is shown below. This week the security price hit its highest level since inception.

Price Movement On CBAPE’S Since Launch

Source: IRESS, Escala Partners
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The whole hybrid market has benefitted as credit margins have tightened resulting in returns averaging ~15% over the last 18 months. While this is good for existing holders of these securities, it makes buying into this market a challenge with valuations appearing overdone. Bank hybrids (preference shares) are now trading only 50bp above the lows in mid-2014, which marked the turning point for a strong reversal.

Yield Movements On Subordinated And Hybrid Bonds Over 10 Years

Source: Mint, Bell Potter, Yield Broker, IRESS
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In a situation where demand remains strong and supply is limited (indications are for a very light new issue pipeline in 2017), it is hard to see what the catalyst will be for this current trend to abate. In 2014 it was the large $3bn CBAPD deal which swamped the market. Along with other factors that supply weighed heavily on markets, weakening prices across the sector.

In 2017, a re-pricing of risk may come if the upcoming call on the ANZPC’s is not exercised. While the terms of these deals clearly state that an issuer has ‘the right, but not the obligation’ to call a bond at the first available call date (or alternatively let the bonds convert to equity), most view this as an unlikely event. The thesis behind this is that the reputational damage an issuer would suffer given a non-call event is too great.

However, a recent article put out by Morningstar (an independent investment research house) discusses the possibility that this ANZ bond may not get called in September this year. The suggestion is that the ANZPC’s are cheap funding for the bank and they will maintain their ‘hybrid-like’ status (known formerly as additional tier 1 equity credit) for the next 2 years till their conversion date.  The bank needs to notify the market 60 days prior to the call date of its intention implying early July at the latest. While this eventuality is not our base case view given the potential fallout, investors in hybrids need to be aware of the possible outcomes given the optionality that the bank has.

In the case of the ANZPC’s these include:

- Extend the security beyond the first call date, allowing the bank to revisit the call every 6 months on the distribution payment date, up to the scheduled conversion in 2 years time.

- Redeem the hybrid with all proceeds returned and no-reinvestment security on offer

- Convert to equity 2 years following the call date

- Refinance the maturing security with a new AT1 issuance

Staying in the domestic market, S&P affirmed Australia’s AAA rating this week, following on from last week’s budget. Rating agencies Fitch and Moody’s had already done so directly after the budget announcement. Despite the affirmation S&P noted that the outlook remains negative, and the AAA rating could be lost within the next two years if it were to lose confidence on the Government’s ability to return to a surplus in the next few years. The sovereign’s credit rating directly impacts the interest rate at which the government can finance its debt. Despite the negative warnings, Australia maintaining its AAA status is a good win for the government, at least for now.  

Globally, yields have moved lower over the week as a risk off tone took hold of markets in response to the Trump related concerns. Bond prices rallied as investors sought safe haven assets, with yields on US and Australian 10year government bonds falling by ~15bp over the week. However, upbeat economic data out of the US appears to have settled risk markets leading into the weekend.

Corporate Comments

- Stock specific news was very light this week and the results were far from encouraging. The mix of cost control and growth are the two themes that predominate discussion.

- Getting the best out of the ASX200 is a balance between the large dominating stocks and smaller risker positions. Even large cap should not be a ‘set and forget’ as leadership does change, while picking the best of the growth is a full time enterprise.

- BHP has had to put its best foot forward with the attention from activists. The attention is now likely to be as much on capital allocation as on commodity prices.

- Volatility spiked this week. It may indicate uncertainty, yet it also is an opportunity for active management.

Clydesdale Bank (CYB) reported its interim earnings. The headline result was a little below expectations, but the full year target remained in place. Cost control was good, though revenue growth was soft. The stock trades on 1X book value and gains little attention from analysts with the shareholder base still in Australia while it is mostly inconsequential to UK analysts given limited liquidity there. Selected managed funds have taken a position based on a credible reduction in costs and solid capital ratio.

The first four months of the year sales at Harvey Norman (HVN) on a like for like basis rose by 4.8%. Behind this number was a weakening trend over that period. The market is factoring in a fall in housing activity and the entry of Amazon against an inflexible and complex business model. While the stock is now below its historic valuation, investors have little appetite to step up given these headwinds.

James Hardie (JHX) came under pressure as the full year release showed that the high margins the group has been able to achieve in the past are proving unsustainable. The combined effect of operational costs (mostly health and safety), renewal of facilities and competitive pressure could persist and reduce the 30%+ EBIT margins the group enjoyed to a 20-25% range.

The combination of expectations of rising demand in the US from single family homes and JHX’s demonstrated ability to extract the best out of the cycle. Few doubt the quality of the company, though the current CEO succession is yet to be settled.

There is now the question whether the profit level it will be able to achieve can be similar to the past which is the key to the valuation multiple. Given this uncertainty is it reasonable to expect the stock give up some of its rich valuation.

James Hardie Historical One Year Forward P/E

Source: Duetsche Bank, Bloomberg Finance LP
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The end of a messy week of trading included a few notable features:

 - Apple became the most valuable company in the US. It highlights the meaningful movements in company and sector weights in equity markets that reflect both cyclical and structural changes. 

- The long awaited spike in volatility is showing up.  In its own right this is not troublesome, and to a large extent should be welcomed, as it introduces an element of stock fundamentals back into markets rather than reliance on macro factors.

- Given this market, the outperformance of the resource stocks is notable relative to ‘safer’ components of the market such as healthcare.

The structure of ASX200 has been much more stable than global indexes, with the big four banks well entrenched in the top 5 in terms of market cap for the past five years.  CSL, as arguably the only growth stock in the top 20, is snapping on the heels of the banks, having increased its market value from 35% of that of the smallest of the big four (NAB) to 80% at present. BHP lost its top spot from five years ago. It is also back within a smidgin of NAB and, subject to managing its balance sheet and commodity prices, it could well move ahead.

Nonetheless, the real returns on the market come from elsewhere, as can be seen in the list below.  This points to the decision investors make with respect to their portfolios. Familiar big cap stocks are still appropriate and not without merit. But the capital gains come from riskier elements. Not only in ‘discovering’ the stock but consistently monitoring and also the positioning size.

Total Return % Over 5 Years To May 2017

Source: IRESS, Escala Partners
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Stocks in this category of the market can quickly become overvalued due to excessively rosy expectations. Recent examples include Blackmores, TPM, Sirtex, Aconex to name but a few – not long ago they featured on the list above. Then there are the ‘fallen stars’ which show large negative returns on a five-year basis, but have recent strong performance. These include Orica, Monadelphous, ALS and Iluka.

These issues form part of the reason we do not recommend index funds in Australia – the weight of sectors and stock mix lends itself to an active bias. It raises the question: if the US is now skewed to a IT sector weight driven by performance and new listings, with the traditional energy, diversified industrial groups and financials loosely scattered across the market in terms of weight, what could our market look like in five or ten years? And what will be our biggest stock then?

The recent activist involvement in BHP highlights another issue for the ASX. Capital investment decisions and capital management have arguably not been our strongest point. The chart below shows that CBA, with its higher ROE and absence of strategic diversification has rewarded shareholders that entrusted it with new money over ten years. Conversely, ANZ (also a consumer of new capital) has not, given its expansion into Asia did not meet expectations.

ANZ vs. CBA (Market Capitalisation and Share Price)

Source: Bloomberg, Escala Partners
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Yet having regrouped in the past year and changed direction, ANZ has outperformed CBA by 14% over the past year. BHP may be on the cusp of such a transition. This moves the emphasis from just tracking commodity prices to cash flow and capital allocation. Expect more companies to follow suite.

Since the approach by the activist fund, the investment case for BHP has come to life with discussion on the merits of its energy holdings, their current value and its longer term options. BHP has talked up its potential organic growth, even the potential to bump up its US shale activity to maximise the outcome given the fall in extraction costs. Other options are shown below.

Source: BHP
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That said, it requires care before jumping onboard. Consensus remains cautious on iron ore with a notable fall factored into forecasts some time into 2018. On the brighter side, the cash flows are modelled to be positive even under those circumstances.

The fall in volatility in the index has a corollary in the dispersion of stock and sector performance. This measures the relative differential in performance. A low reading implies that investors are not discriminating on their stock selections and are following money flow and macro trends. Fund managers struggle to get outperformance as stock analysis is less important. Ominously, the period prior to the 2008 downturn was associated with low dispersion. We hasten to add that this is not a prediction, but with elevated valuations and modest growth, investors should welcome a return to volatility in markets.

ASX200 Cross Sectional Dispersion

Source: Ellerston Funds Management
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