Week Ending 19.12.2014
We now know – this week’s FOMC meeting seems to confirm that the Fed will raise rates in the second half of the year, as long as inflation is above 2%. Conveniently, another inflation reading came through, with November’s headline of -0.3% month-on-month in line with expectations. Hardly surprisingly, energy prices were the main contributor. On a year-on-year basis, headline inflation increased by 1.3% and core inflation by 1.7%. Goods prices are very soft, not great for retailers, while service providers have been able to edge prices higher. Housing is a major driver in this services category and this is expected to maintain its upward momentum.
US Core Goods and Services InflationEnlarge
The assumption is that the energy impact is temporary, not reflective of economic slack and therefore will be largely ignored by the Fed. It is more likely to pay attention to the low goods pricing, and the rise in the US$ will extend that for imported product. All indicators at this stage confirm that investment markets will indeed have to be patient, as the Fed has been at pains to point out.
Similar inflation trends were evident in Europe and the UK. Energy contributed the most to a low November data set. For example, the UK registered a 1% year-on-year CPI rise, down from 5% at the beginning of 2012. Wages growth, while low, is now above inflation and recruitment companies report placing new staff at a level that would represent 4% wage growth by the end of 2015. Here again, the Bank of England is likely to downplay the inflation data of this week and focus on prospective wages growth. But for all central banks, the trajectory of rates is almost certainly going to be a lot slower and flatter than the cycles of the past few decades.Enlarge
A spotlight fell onto the Russian rouble this week, with extraordinary moves in the currency and interest rates. After firstly a 100bp move by the Central Bank of Russia (CBR), in an effort to stem the sharp fall in the currency, it followed through with a 650bp point rise, taking the base rate to 17%. Clearly, there is likely to be significant economic distress in Russia over the coming year as these moves impact household incomes and corporate behaviour.
Following this, there is the question of counterparty effects. Initial reports suggest there is a handful of European banks with significant, that is more than 1%, of their assets in Russia. It is likely that in the coming weeks we will see increased analysis of the potential impact on Europe, through reduced trade and further financial implications. It may well prove the final requirement for the ECB to ease in March 2015.
For much of the past decade investors have lumped emerging economies (EM) into one bucket. The sharp downturn in oil prices has, however, distinguished between those countries that are sensitive to income effects from lower oil prices and those that will benefit. An investment related conclusion from this is to largely avoid exchange traded funds or benchmark aware managers in emerging markets. An example is in fixed interest where there has been a big sell off in the EM index in this quarter – some 150bps. Asia is only 6bps of that and oil sensitive countries such as Russia, Venezuela, Brazil and Ukraine have carried the burden, as can be seen below.Enlarge
A similar pattern is shaping out in currency markets. Asian currencies have fallen against the US$, but much less so than the commodity-based emerging markets, Europe and Australia.Enlarge
Overall, we see this as a vote of confidence in the structure and management of many Asian economies, notwithstanding the focus on slowing growth momentum on aggregate.
The Mid Year Economic and Fiscal Outlook (MYEFO) for our budget brought forward no expectation that the Australian economy was improving. An unsurprisingly higher deficit was underpinned by a much more sober view of expected growth, employment and commodity prices. With that as a backdrop, the RBA indicated its desire to see the currency weaker, but gave no other hint that it would reconsider its interest rate setting. Christmas spending data and other indicators of activity by the household sector gain heighted importance as the RBA determines the degree of monetary support it is willing to undertake.
Telstra’s (TLS) revised NBN agreement was seen a minor positive. It provided a higher level of certainty for the company in the medium term. The key change to the original agreement is that the ownership of TLS’s copper and cable networks will transfer to the NBN, along with the operational and maintenance responsibilities. Under the initial plan, these networks were to be disconnected 18 months after an area had been declared ready for service by the NBN. Importantly for TLS it has retained its estimate of value for the transitional payments that it will receive.
While this week’s announcement was a good outcome for TLS, we maintain our view that the stock’s valuation looks stretched and that the company will face margin and market share pressure as consumers move their services onto the NBN. The company will likely have to deploy the capital that it receives from the NBN payments into lower-returning assets compared with its existing copper network. We believe that the smaller telcos, such as TPG Telecom (TPM) and iiNet (IIN) will continue to take market share from the incumbent.
Flight Centre (FLT) lowered its FY15 profit guidance this week, with the mid-point of its new range representing around a 6.5% downgrade. The company has become a victim of the weak domestic consumer environment, with confidence remaining low since the Federal Government’s budget back in May. While FLT is very much a global growth story, with operations in 11 countries, the Australian market is still the most important (accounting for around 80% of earnings). For the financial year to date, total transactional values are up around 2%, well below the 10% rate experienced in recent years.
FLT have long maintained that a weak Australian dollar has little impact on its business, with the key driver instead being declining airfare prices and the desire to travel. The chart below of Australian travel departures over the last two decades would support this theory, with fairly consistent growth over time. Nonetheless, we would expect that the sharp decline in the $A in recent months would clearly constrain growth in the short term, as consumers adjust their travel plans accordingly.
Australia: Short-Term Residential Departures (Trend)
For a stock with a solid track record of earnings growth, we are prepared to look through the current cyclical weak conditions, however note that in the near term there is an increased level of uncertainty and risk. We believe that the structural growth drivers of the stock remain and that the stock’s current valuation looks attractive for the long term investor, with the stock now trading on a forward multiple of 12X.
Woodside Petroleum (WPL) this week agreed to purchase various assets from Apache Corporation, including a 13% stake in the Wheatstone LNG project (in WA) and a 50% interest in the Kitimat LNG project in Canada. Of the large-cap energy stocks, WPL has had the strongest balance sheet, and was seen to be in a good position to acquire assets at attractive prices given the cyclical weakness in oil prices.
While this transaction has filled a production gap to a certain extent (as the company had no major projects coming online in the medium term), it is arguable whether the deal will add significant value to WPL. Separately, WPL announced that it had delayed the progress of the development of its proposed floating LNG project, Browse, with a final investment decision now not expected until mid-2016. This is not surprising, given the marginal economics of the project in the current oil price environment.
Market Focus: Australian Equities Year in Review
After two years of solid equity returns the Australian sharemarket took a pause in 2014. The market eked out a positive total return to mid-December. There was three specific themes that drove equity returns in the year – lower commodity prices, falling bond yields and a weaker Australian dollar.
S&P/ASX 200 Overview
Mining and energy stocks were clearly the two sectors that disappointed the most in 2014. The primary reason for the performance of these two sectors was a much faster correction than anticipated in the iron ore and oil markets. In both cases, these moves in commodity prices have been largely caused by new supply to the market growing at a much faster rate than demand. The iron ore market had long been regarded as particularly vulnerable to a correction as additional low-cost tonnes by the three major producers added to global supply. This adjustment was, however, expected to take place over two to three years, or perhaps even longer. At the beginning of the year, the most bearish analyst (in the Bloomberg database) had predicted an iron ore price of US$90/t in the fourth quarter, well above the current price. The result of this correction has been share price declines of 70%+ for the smaller pure iron ore companies, few of which are likely to be profitable in the current pricing environment.
BHP Billiton and Rio Tinto have also been impacted, but not nearly to the same degree. These two companies have much lower cost operations, and thus the margin impact has not been as great. A more diversified asset base across other commodities has also helped. At the beginning of the year, however, investors had been looking forward to increased capital returns as the miners improved their cashflows through cost reduction and lower capital expenditures. This now cannot be expected in the medium term.
For the energy sector, the sharp drop in the oil price was predicted by very few. This development overshadowed the good progress made at the various LNG projects across the sector.
Consumer discretionary stocks underperformed the broader index this year. Those exposed to domestic consumer spending, particularly the retailers, had a difficult year as consumer sentiment remained weak over the last six months.
The normally safe-haven consumer staples sector disappointed in 2014. Relatively full valuations, limited sales growth and the threat of competition across the major supermarket chains held Wesfarmers and Woolworths back, while WOW had the added distraction of its problems with Masters. A number of the smaller staples stocks grappled with company-specific issues, including Coca-Cola Amatil and Treasury Wine.
The major banks again outperformed the broader market, although perhaps less so than would be expected given the underlying thematics that drove equity prices. Credit growth remains benign and low bad debts again assisted earnings. Towards the second half of the year attention turned to increasing regulatory capital requirements, although the recommendations from the Murray Inquiry were not as bad as many had feared.
Other financial stocks enjoyed a much better year than the banks. In particular, the insurance sector enjoyed a cyclical uptick in margins and benefited from the high-yield focus of investors.
These more defensive, high-yielding sectors of the market performed well again in 2014. The primary driver of these sectors has been a further decline in bond yields, something which few expected at the beginning of the year. Earnings growth across these stocks has been low, hence P/E multiples have again expanded. With domestic interest rate expectations recently pushed out further, this basket of stocks could well continue their good relative performance in the short term, although, taking a longer-term view, they appear to be vulnerable to a normalisation in interest rates.
Industrials were a mixed bag, reflecting the diversity of stocks that fall under this category. The defensive high-yielding nature of infrastructure saw these stocks perform well. Companies with a large overseas earnings base also did well as the Australian dollar fell. Within this group we would include Brambles, Amcor, James Hardie and Incitec Pivot.
Health care again justified the high P/E multiple applied to the sector with another solid year of earnings growth. The major stocks within the sector also have varying elements of positive leverage to a falling Australian dollar, proving a further tailwind for these companies. The large IPOs of Medibank Private and Healthscope were opportunistically timed given the premium valuations across the sector.
The Year Ahead
At this stage earnings growth expectations for 2015 are low. Given this backdrop and a forward P/E earnings multiple that is close to its long-term average, the following 12 months may be another year of consolidation for domestic equities. In the short term at least, support for equities should be strong, given the relative attraction of the asset class compared with fixed interest.
The mining sector is expected to be held back by a full year of lower commodity prices. At this stage, the volume impact of LNG growth is forecast to be greater than that of a lower oil price for the energy sector. The banks currently show mid-digit EPS growth for the foreseeable future – a much lower rate than to which investors have become accustomed. Industrials, consumer discretionary and health care look to be the standout sectors over not only next year, but beyond this as well.