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WEEKEND LADDER

A summary of the week’s results

19.10.2018

Week Ending 19.10.2018

Eco Blog

· Australian employment data was messy, with a fall to a six-year low unemployment rate accompanied by a decline in participation.

· A growing number of financial commentators have taken to ‘predicting’ the next recession. This week, the AFR had an opinion piece from Nouriel Roubini (who claims to have predicted the 2008 crisis) on ten reasons the ‘world economy will crash by 2020’. We summarise these ten and comment on each. 

In September, the number of new Australian jobs increased by a modest 5.6k, though on the positive side the mix is increasingly towards full time jobs. It is likely that sampling (a progressive change in regional sample groups) played a role in the lower measured unemployment rate. The debate turns to the point at which wage growth can be anticipated. The global phenomenon of low wage growth is playing out here. Labour has low bargaining power due to industry structures, fungibility via shifting to global labour pools or substituting automation, relatively high local immigrant growth as well as international students and low inflation expectations.

The NAB Business Survey echoed the labour market data. Firms report positive demand for workers, expect a modest tick up in wages, but are finding it hard to get the right skills.

Factors Driving Up Wages Pressure by Industry (% of Firms)

Source: NAB
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These trends reinforce the slow pace of interest rate adjustment expected from the RBA. Economic growth appears to be relatively stable and business conditions acceptable. The responders to the NAB survey unsurprisingly nominate demand, profit margins and labour markets as key in their assessment of conditions. Currently, it is also inevitable that government and state policies are front of mind. Other factors, such as tax, rank well below issues such as weather and even geopolitics.

· With upcoming elections, diverging policy promises may cause business unease in coming months. The RBA is in an unenviable position of having to tolerate lower rates than it would like until there is greater capacity in the household sector to adapt to normalising monetary conditions.

As mentioned, we have leant on the AFR article to delve into the possible causes of an economic recession:

1.     US above sustainable growth.

Most agree the fiscal stimulus (through its tax cuts rather than accelerating government spending) is occurring in an economy that was improving after a slow patch in 2015-17. The growth rate is far from exceptional, rather the stage in the cycle and the drivers are unusual. Also, other issues noted below suggest longer term growth is likely to be below historic norms; therefore GDP will slow into 2019. This is largely factored into expectations.

US Real GDP Growth

Source: St Louis Fed
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o This year’s GDP growth is highly likely to be a one off, but that does not indicate a recession in any forthcoming year.

2.     Overheating

This references the nature of the US stimulus and therefore that inflation can rise above target. The suggestion is that interest rates have to rise (to 3.5%), while oil prices push other central banks to follow suite. In all, liquidity is constrained and financial conditions come under pressure.

The main problem with this argument is that inflation refuses to rear its head. It is possible that wage growth in the US will rise, but by a small enough increment to leave inflation within a modest range – around 2-2.5%. The reasoning is that tight labour markets need another catalyst. Labour has little bargaining power, automation is the new black and low wage segments predominate. A potential rise in productivity would allay concerns that wages are problematic.

It is, however, still possible that there will be a breakout, be it from Amazon heralding its new minimum wage or a general tightening at the lower end. Yet, this may be a one off reset rather than a systematic inflationary move. Further, we hear from companies operating in the US that wage growth is not a major trouble spot.

o    The watching brief remains; we need evidence.

Oil prices (reflected in fuel prices) are rarely the focus of central banks. That is, one of the differences between ‘underlying/core’ and headline inflation. No central bank would react to an oil price rise in isolation; one could argue that as they are aware of the impact on consumers, they would be reluctant to raise rates if this is the major cause of inflation.

o    Cyclical factors are unlikely to trigger a sharper rise in rates. Oil prices could readily ease were political tensions to abate.

 3.     Trade disputes lead to lower growth (and higher inflation).

The trade issues should raise growth in the US, at least in the short term, while dampening that in other countries, particularly China.

 The inflation issue is nuanced by exchange rates. To the extent the US has imposed tariffs on China, the fall in the CNY (Yuan) has mitigated the impact on prices in the US. That may change, possibly in profit margins for corporations, rather than inflation.

 o    Trade barriers can be expected to reduce growth, but are unlikely to be the trigger for a recession.

4.     The restriction to technology flows, supply chains and immigrants along with a lack of infrastructure investment in the US will cause rates to rise due to ‘stagflation’ – inflation and low growth. This replicates the points above, with a twist.

These issues rarely play out in full. We do not quibble with each, but they are unlikely to be the drivers of a major change in the short to medium term. Long term they will matter more.

5.     Rest of world slows. Specifically, China due to private debt burdens.

Emerging economies are growing at a decent pace. We believe that this can continue, though the baton is passed along between countries and regions. China’s debt is well known and may cause growth to take a check in coming years. Further, China does need to reset its ambitions on GDP growth; 6%+ is not realistic given debt and demographics. But this is unlikely to cause a crash. China, as a financial powerhouse, is not yet sufficiently entrenched into the global system to cause a downturn even assuming growth moves from 6.5% to closer to 5%.

Emerging economies have to reset to the USD strength, lower global liquidity and lower export driven growth. A few will struggle, but the majority have reasonable flexibility and have let markets reprice their currencies and sovereign bonds without intervention.

6.     Europe is tightening as well, while Italy is pushing the boundaries of the EU agreements on fiscal discipline. The European monetary union has not gone far enough to remove the risks that became obvious with the Greek crisis in 2013. The banking system remains fragile and a host of political interests prevent a coordinated approach. Italy presents as another in the conga line of problems for the EU, having now delivered another budget deficit. The frustration is that Italy could recover as it runs a primary surplus (before interest payments). If it could control its deficit, take advantage of low EU rates and restructure its spending (the usual culprit of excessively sticky and high pension payments), it could manage. 

Italian Budget Defifict and Debt Growth

Source: Barclays Research, Haver Analytics
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o    The Eurozone is increasingly fragile. Predicting what will happen is as complex as the union itself. At this stage, however, economic growth is modest, but positive.

7.     Equity markets are frothy, as well as assets such as property due to the correlation with bonds.

The equity argument only applies to the US, though the extent of overvaluation is relatively low and concentrated in sectors and stocks. We don’t argue that the return expectations are lower and a negative year is far from impossible. But there are few signs of irrational exuberance while regions such as EM and Japan are better than fair value.

12 Month Forward P/E Ratios

Source: Thomson Reuters, BlackRock
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o    A retracement of up to 15% in equity markets is unlikely to have economic repercussions, particularly given the gains of the past few years.

8.     A financial asset correction results in a ‘fire sale’ due to the lack of market makers (in credit). Countries and financial sectors with USD liabilities no longer have access to Fed funds.

There is a risk that the current structure of market participants could have unforeseen consequences if there is a large scale move to realise holdings. Regulation has limited the ability of investment banks to hold credit on the balance sheet to facilitate an orderly market and match buyers and sellers. The growth of ETFs in fixed income and equities can result in a systematic sell off regardless of merit given the nature of ETFs.

 o    This risk is, in our view, a real one for financial assets. It does presume that buyers stay on the sidelines if there is a gapping in prices to attractive levels. Bouts of volatility may start to shake out holders that cannot tolerate such conditions and reduce the risk that there will be a uniform flight for the door.

9.     Trump may provoke a confrontation with Iran and the oil market is at risk. Political events are hard to predict. We would be surprised to see this go so far.

10.     Policy options are lacking to deal with any of the above events. There is no doubt that this time the toolset is limited given the rise in debt and already low rates. If there is a downturn, it is likely to be more protracted.

In most circumstances, we can list reasons why conditions could improve or deteriorate. Forecasting often is a time-tested path for those that want to be right at some point. Recessions are a function of a cumulation of instability. Today the Fed appears particularly attuned to the risk of too much or too little tightening. It may not get it quite right but is unlikely to tighten regardless of signals (particularly the bond market) that suggest it should hold back. We believe two other issues are the most likely contributors. High debt, particularly the quality of debt – non-investment grade, bond issuance to loss making companies, unregulated debt markets – may unravel, right at the time bond issuance is rising without central bank buying. The second is a broadening of the disputes with China. Tariffs on goods is one thing, but if this moves into capital flows and/or some form of sanctions, the game changes completely.

Focus on ETFs

· Asia and emerging markets, in general, have had a tough 2018 and now represent relative value compared to other regions. Investors can consider adding an Asia-specific ETF to an active EM managed fund.

2018 has been a year of challenges for the Asia-Pacific region, dominated by the continuous headlines from China and its trade wars with the US. In financial markets, Baidu, Alibaba and Tencent (collectively known as the BATs) have had much less of a grip than their US counterparts, the FAANGs, having lost around $165 billion in value year to date and having a significant drag on Asian indexes.

There is a total of nine Asian-focused ETFs, but the majority of them are country-specific. For a broader choice, Australian investors are limited to four Asia-Pacific ex-Japan ETFs. 

In the past 12 months, the best performer has been iShares Asia 50 ETF (IAA) with a return of 15.3%. This fund consists of the largest 50 companies drawn from five major Asian markets— China, Hong Kong, South Korea, Singapore and Taiwan. Along with only 50 stocks there is considerable concentration risk in stock weight and at a sector level. The top five holdings account for over 40% of the fund and there is sector bias towards tech and financials, which combine for 60%. Baidu and Alibaba are excluded from this index as they are listed in the US. UBS provides a similar offering through UBS IQ MSCI Asia APEX 50 Ethical ETF (UBP). The main difference is the very light ethical screening that excludes companies involved in tobacco and those engaged in the production of controversial weapons. Additionally, it includes Asian companies that trade in the US, such as Baidu and Alibaba. 

The Vanguard FTSE Asia ex Japan Shares Index ETF (VAE) is a low-cost option with an annual management fee of 0.4%. It holds over 800 positions over a much greater geographical spread than that of IAA. It also has the highest exposure to markets outside China but has also had the weakest performance in the past 12 months.

Asian Pacific ex-Japan ETFs - Country Exposures

Source: Morningstar, Escala Partners
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The most recent Asia-Pacific Ex-Japan ETF launched on the ASX is the BetaShares Asia Technology Tigers ETF (ASIA). This fund follows the Solactive Asia Ex-Japan Technology and Internet Tigers Index, which consists of the 50 largest tech and online retail companies in Asia. The largest constituents are Taiwan Semiconductor (12.9%), Alibaba (9.9%), Samsung Electronics (9.3%), Tencent (9.1%) and Baidu (7.5%).

· Our recommended actively managed funds have varying allocations towards Asian equities. The use of ETFs can be used to increase the regional exposure via IAA or widen the stock universe by adding VAE.

Fixed Income Update

· A ratings upgrade for the Australian sovereign has potentially positive implications for the bank hybrid market but is unlikely to drive pricing.

· We examine the buyers of US Treasuries and the supply/demand dynamics evolving in the market.

Recently, the rating agency S&P revised Australia’s sovereign debt rating from AAA/Negative to AAA/Stable. It was only last year that it seemed likely that the rating would be downgraded to AA+. S&P noted increased confidence that Australia’s fiscal budget would return to a surplus, potentially by the early 2020s. While the change in outlook is unlikely to affect the Government’s cost of funds in the short term, it does reduce the risk of a ratings downgrade anytime soon.

The implications for the banks is a potential upgrade in their ‘stand alone credit profile’, which could see bank hybrids return to an investment grade credit rating of BBB- and subordinated bonds back to A. This would require one further criteria to be satisfied within the S&P analysis and would mark a reversal of the downgrade of these junior bonds that occurred in May 2017. It should be noted that ASX-listed bank hybrids are not legally allowed to be given a credit rating, therefore discussion refers to an ‘implied’ rating, or the one to be used if it was issued in the wholesale market.

Interestingly, ANZ issued a callable 10 year fixed rate USD bank hybrid in the wholesale market (which can have the explicit rating) in June 2016 when the rating was still at BBB-. The downgrade at the time had minimal effect on pricing, with the bond price pausing briefly before continuing its upward trajectory. Rather, it has been the rise in the USD rates market that has driven performance. With the US 10 year Treasury yield up around 70bp since the beginning of this year, fixed rate corporate bonds have fallen in price. This ANZ USD hybrid has fallen almost 10% (from $114 to $103) over this period, with 6% being attributed to the rate move. General market repricing of risk for below investment grade credit accounts for the remainder, which is unrelated to the initial downgrade 18 months ago.

ANZ Fixed USD Hybrid

Source: Bloomberg, Escala Partners
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· While a ratings upgrade to hybrids would be credit positive, it may have limited affect on the pricing of these securities. Domestically, bank hybrids have floating rate coupons (unlike the USD example shown above) so the market’s risk assessment of these securities will be reflected in credit spread movements and will be the driver of pricing.

Factors that favour higher yields are the continuing fall of foreign ownership as a percentage of the treasury market and other specific to the US.

· Japan, the second-largest holder of US Treasuries, has been a net seller over the last 12 months

· China has not been selling, but hasn’t been buying either, given its reduced current account surplus

· In April, Russia cut its Treasury holdings in half, selling ~$50bn.

· The Fed is winding back its balance sheet. This has now ramped up to $50bn a month (from $10bn a month) of which a high proportion is in US Treasuries.

· The US Treasury Department has been adding to supply this year to fund tax cuts. It is expected to have raised $1.4 trn by year end.

Falling demand side factors from the biggest buyers and increased supply from the US Treasury are expected to drive yields up, unless US households and pension funds see sufficient value in higher yields to pick up the slack. While pension funds and insurance companies will always be natural holders of US Treasuries to match long term assets and liabilities, the household sector is more price sensitive, and will only buy in when the yield is attractive enough to meet income requirements.  

Treasury Debt Holdings (As a % of Total Held by Public)

Source: Thomson Reuters
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· We recommend a tactical underweight to US Treasuries and duration, as supply/demand dynamics may push yields higher yet. However, we acknowledge that the recent bond sell off does make these ‘risk-free’ instruments more appealing and the time to weigh back in may be drawing closer.

Corporate Comments

· Client remediation costs for the major banks are among the first visible earnings consequences from the royal commission and have offset the recent positive earnings uplift from mortgage repricing. NAB’s position is inferior to its competitors, with a weak capital ratio and high dividend payout ratio

· The major miners are ex-growth, although the commodity mix has remained supportive in the early part of FY19.

National Australia Bank (NAB) this week became the latest of the major banks to disclose costs related to customer remediation and refunds, with a $314m after tax charge to be included in the bank’s upcoming FY18 earnings. These charges have arisen following reviews triggered by the Royal Commission and compensates customers where they had been charged for receiving inappropriate advice, predominantly across the banks’ wealth management divisions.

The charges are somewhat material considering they equate to more than 5% of NAB’s expected full year profit of $5.8bn. They also add to the group’s rather high expense growth guidance of 5-8% for the financial year. Additionally, NAB is yet to put this issue behind it, noting that reviews are ongoing and that remediation programs will continue into FY19, with the potential for further costs to arise and impact next year’s earnings.

While the banking sector recently had a brief reprieve from the negative headwinds affecting earnings and sentiment towards the majors when a round of mortgage repricing was announced, this has since been more than eroded by this round of charges. For NAB, the issue has greater significance as it has come at a time where the necessity to improve its capital position is high given APRA’s 1 January 2020 target for the majors to achieve a CET1 capital ratio of at least 10.5%.

Among the majors, NAB is presently in the weakest capital position and additionally has the highest dividend payout ratio (see following chart), while ANZ is positioned the best in the current environment. NAB may possibly be forced to either choose between resetting its dividend lower or raising capital via a discounted dividend reinvestment plan (which would have the effect of diluting earnings per share), both of which are unattractive options for shareholders. In our direct Escala model portfolio and in our recommended SMA portfolios the banks continue to be held in an underweight position.

Major Banks: CET1 Ratio and Dividend Payout Ratio

Source: Company reports, Escala Partners; CET1 ratio as at 30 June 2018, Dividend payout ratio for FY18
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Quarterly production reports began to filter through the market this week, including from BHP Billiton (BHP) and Rio Tinto (RIO). Both companies presently are less focused on expanding production, but rather extracting the most from their existing asset base, reducing operating costs further where possible and divesting businesses that are not considered core. As such, movements in quarterly production are now being driven more by factors such as change in ore grade, maintenance work and unscheduled outages.

For the September quarter, BHP’s production report was judged as slightly weak, with coking coal (maintenance work) and copper (due to a fire at one of its mines) soft, offset by a strong petroleum result. The only downgrade that the company made to its full year production guidance was a 3% revision to its forecast copper production.

Rio’s quarterly was slightly better and broadly in line with consensus forecasts, with the group’s dominant iron ore division on track to meet the upper end of 2018 guidance. Copper production was a highlight, while aluminium was softer following a strike at one of the company’s smelters.

As with other assets, commodity prices have been more volatile through the early part of FY19 on news of rising interest rates and further tariffs between the US and China. For BHP and (to a lesser extent) Rio, however, the mix has been quite favourable, with iron ore, coking coal and oil all rising and among the better performing commodities over the last quarter. For BHP, these three accounted for more than 70% of EBITDA in FY18, while for Rio, iron ore was almost 60% of EBITDA in the six months to 30 June 2018. As such, the earnings momentum for the two stocks has remained positive over recent months, although the edge has been with BHP on the back of its oil and coal exposures (Rio has recently divested its remaining coal assets). With a reasonable valuation (on 6X forward EV/EBITDA) and the imminent announcement of further shareholder returns from its shale energy sale, we have BHP in our model equity portfolio.

Commodity Prices: FY19 to Date

Source: Bloomberg, Escala Partners
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