A summary of the week’s results


Week Ending 20.01.2017

Eco Blog

Australian employment trends show little signs of improving in the near term. Higher part time employment undermines income security and spending. 

- US data was uniformly strong, though the housing sector may be vulnerable to mortgage rate rises. 

- China’s GDP picked up in line with government support and credit growth. The mix, however, points to a slow down over the coming quarters. 

The Australian employment market edged upward, with 13k new jobs in December, in line with expectations after a strong November. Yet, an uptick in the participation rate to 64.7% (+0.1%) resulted in a 0.1% rise in unemployment to 5.8%. For that matter, the trend in full time (-36k) versus part time (+129k) over 2016 is a major issue for the economy. It goes without saying that part time jobs have lower and insecure income and therefore constrained spending from these workers will dampen economic activity, or they will go into debt and create risks down the track. Intuitively, one views part time as female issue, yet it is the growth in part time males that has caused the trend.

Australian Full and Part Time Employment

Source: CBA

Unsurprisingly, consumer confidence is uninspired given the sluggish labour market. A reading below 10 implies more pessimists than optimists. Notable is the decline in households’ view of their own financial circumstance, as well as persistently low confidence in the economic outlook. Only housing is holding up, at odds with the trend elsewhere.

Westpac Consumer Sentiment


How the housing sector evolves through 2017 will be an important determinant of GDP. Building commencements are holding up, but clearly conditional that the level of demand remains in place, focused as it is on multi-unit dwellings. November data for housing finance show the persistent recovery in investor loans, post the effort by APRA to reign in this form of lending. First home buyers remain well out of the picture.

US data was uniformly behind the growth expectations for 2017. Housing starts reached 2007 levels, initial unemployment claims fell sharply and the long-standing Philadelphia Factory Survey is at its highest reading since November 2014. That said, this is all from last year and evidence is building that housing is likely to flatten out or even fall due to the rise in mortgage rates. It is an elementary reminder that not all bodes well from the improving economy.

Inflationary expectations were confirmed, with a 2.1% reading for December. Excluding energy and food, the rise was 2.2%. Only food and households good are lagging the upward trend.  On aggregate, services prices rose by 3.1% in 2016, up from the 2.6% growth in 2015. Shelter (housing related), medical care and recreational services (rather than goods) all increased more in 2016 than the previous year. Indicators are skewed towards an even larger rise through 2017. Unsurprisingly therefore, the Fed talk is hawkish. If the new administration has its way with appointments to the Fed and probable change in leadership in early 2018, it will be of considerable interest to see what path it will pursue. Ignoring the inflation pressure by containing rates is a dangerous path; this invariably results in distorted allocation of capital and excess lending.

China released its official fourth quarter GDP growth at 6.8%, a lift from the rate for the year. Initial data suggests the momentum is largely due to government stimulus and bank lending. Retail sales trended up, housing was strong but industrial production and fixed investment lagged at 8.1% growth, its lowest rate since 1999. The release was met with the usual scepticism, but it is widely acknowledged that the government had a large role in the economy in the second half of the year. 

A debate on the direction of basic industrial sectors, such as steel and cement, is ongoing. In 2016 the government curtailed production due to losses at state-owned enterprises (SOE), pollution, easing demand and pressure from exports as China came under trade restrictions. The major point of contention, however, is the growth in private sector credit. The bulk has been the rising debt levels at SOE level and some suggest this will effectively be nationalized at some point. But an over-reliance on lending to maintain a high growth rate for an economy that is facing population restraint and diminished trade opportunities will inevitably become a problem.

Fixed Income Update

Bond prices have rallied leading into the US inauguration, with funds welcoming strong inflows. 

- Market participants have expressed mixed views on the direction of rates for 2017.

- Yields on UK Gilts have continued an upward trajectory, as the UK prime minister talked of a ‘hard’ Brexit. 

The post-US election euphoria that catapulted bond yields globally has been tempered over the last four weeks. US 5 and 10-year treasury yields (illustrated below) are back to where they were in mid-November, with Australian government bonds tracking a similar path.

US 10 Year Government Bond Yield

Source: Iress, Escala Partners

The recent rally in bonds is driven by strong net inflows into funds in the last two weeks, following ten consecutive weeks of redemptions. Government and emerging market bond funds have been the main recipients.

Inflows to high-yield US corporate bond funds decelerated from the first week of the year, but remained in positive territory for the eighth straight week. This has helped absorb the record pace of corporate and bank debt issuance, with more than $94bn of bonds sold in the US since the year began. As discussed in last week’s publication, there has been a large increase in bond issuance in the US, as banks and corporates look to lock in rates ahead of further rate rises by the US Federal Reserve Bank.

Market views on the direction of rates are mixed. Some participants predict that bond yields will take off again, with expectations that the US 10-year treasury and the Australian 10-year government bond will hit 3%. At that point, however, the economic outlook is likely to come under pressure given high levels of debt. 

In contrast, some of the larger bond funds are actively de-risking portfolios by increasing cash balances, adding duration and reducing high yield. The view is that the rates market over-extended itself, given US fiscal spending won’t be effective until 2018 and policies are still very accommodative. They expect yields to stabilise, or temporarily ease further, while credit spreads may widen in 2017.

While global yields have, for the most part, fallen in January, yields on UK Gilts have had a big upward move in the face of the hard Brexit talk. The rate on the 10-year gilt (UK Government bond) has risen from 1.09% to 1.40% since the beginning of this year. In part, this reflects the bounce in sterling, as short positions were covered in anticipation.

UK 10 Year GILT Yield

Source: Iress, Escala Partners

Corporate Comments

CSL upgraded its full year profit guidance by 8% and now expects full year profit growth of up to 20% on a constant currency basis. 

- Rio Tinto’s production was in line with the market’s expectations. A boost to cash flows from the rebound in commodities has raised the possibility of capital management in 2017. 

- Sydney Airport reported December traffic performance, with the fastest growth rate in 12 years. 

- Wesfarmers’ significant upgrade to its resources earnings did little for the stock, as investors contemplate a weaker trend in Coles. 

- Bega Cheese got into the limelight with its acquisition of the Vegemite brand, amongst other grocery lines. The foundation is there, now growth is required. 

- Ahead of the first half reporting season, ASX 200 earnings trends show that upgrades have been predominantly confined to the resources sector, with marginal improvement across other key sectors in recent months.

CSL this week upped its full year (constant currency) earnings guidance from 11% growth to 18-20%. It specifically excludes the one-off gains and costs associated with its acquisition of the Novartis flu vaccines business, and was driven by a better than expected sales performance. This has been assisted by higher demand, along with CSL’s ability to fulfil this demand due to its ongoing investment in collection centres (where its competitors have lagged). This effectively allowed the company to take a disproportionate share of this conducive environment via a quick supply response.

CSL also noted that it expects to report a net profit figure of US$800m for the first half, which would represent a significant proportion of the ~US$1,370m figure that the company’s new guidance would imply. It would be fair to conclude that this guidance is somewhat conservative (in keeping with the company’s history), with a low bar in the second half to achieve its full year forecast, even allowing for seasonality in its flu division.

CSL now looks to be well placed to deliver solid results over the next 18 months and while it may eventually cede market share again following a supply response by its peers, the lead time on investing in new collection centres will give the company a head start. Key to maintaining this elevated level of growth for longer will be the turnaround of its flu vaccines division, which has incurred larger than expected losses after being acquired at a significant discount to book value. We believe that CSL is a core portfolio healthcare stock, with a more positive investment view moderated by a mid-20’s PE valuation; high even by its historical average.

Rio Tinto (RIO) was the first of the major miners to report production results, with a reasonably solid fourth quarter. Reflecting the slower pace of expansion following a wind back in capital expenditure over the last few years, production growth was mid-single digits for most key commodities, with aluminium the stand out at 10%. Copper was the key disappointment and below the company’s guidance.

Twelve months ago, the focus of the mining sector was the revisions to the progressive dividend policies, and it is quite remarkable that the attention has now turned to possible capital management in 2017. Following a significant boost to free cash flow (a material increase, based on spot prices) it would be highly unlikely that this would be spent on capital expenditure after the lessons learned from the previous cycle. That leaves the miners with two other options – repaying debt and/or returning capital to shareholders. The former would be expected to be a priority by companies in the first half of 2017, hence the latter may depend on how long the current pricing environment is sustained. Nonetheless, at this point this remains an upside surprise for the year and the sector should continue to have positive earnings momentum in coming months, with spot prices for most commodities remaining well above consensus forecasts.

Sydney Airport (SYD) reported traffic performance for December, with 8.9% growth in international passengers for the year the highlight. This was also the fastest pace of growth for 12 years for the airport and is reflective of the buoyant conditions for tourism-related stocks. Passenger growth remains the key indicator for SYD, feeding through to the various revenue streams that the airport generates.

Like many other infrastructure stocks, SYD has been sold off (-20%) since concerns first emerged around rising bond yields in August. The group will also have to decide on its participation in Badgerys Creek by May. Most believe SYD will not invest in this proposed airport under the current structure, as the cash flows are well below what is required for the large capital outlay. SYD is clearly not immune to a further spike in yields but we believe that it is better placed than many bond proxies, particularly given its strong underlying demand drivers and expected growth in distributions.

Wesfarmers (WES) updated guidance was a salutary lesson in how leverage can work; for analysts, the consequences of excessive reliance on management guidance; and for investors what really matters. On 26 October 2016, the first quarter release on its resource operations proclaimed a downbeat tone:

At Curragh, the relatively high levels of carryover tonnage expected to be delivered in the second quarter will partially offset recent increases in metallurgical coal prices. As a result, the Resources business is expected to report a broadly breakeven earnings before interest and tax result for the first half of the 2017 financial year, subject to production, weather events, shipping and currency in the second quarter of the 2017 financial year.

A few months later, things have changed. This week’s announcement fueled a set of profit upgrades:

The Resources business is expected to report earnings before interest and tax (EBIT) of between $135 million and $140 million for the first half of the 2017 financial year.

A much higher production level was achieved from opportunistic use of contract fleet, timing of shipments and a new mining plan all designed to take advantage of the high coal prices. While analysts may not have been able to envisage these company specific issues, there was a broad recognition that the extent of move in the coal price had lagged in profit forecasts. As is also commonly the case, operating leverage is underestimated.

Notwithstanding this uplift, the share price was flat over the week. In reality, valuations tend to discount these highly volatile commodity earnings when the focus for WES investors is essentially on the developing supermarket tussle. Industry feedback uniformly suggests that Woolworths has managed to claw back some of the lost market share, or at the very least, is no longer losing out to Coles. Add to the mix the persistent pressure from Aldi and talk of Amazon’s forthcoming grocery online service and the supermarket margins still have downside risk.

Based on the new coal earnings, the stock is trading on an 15X FY17 P/E. At face value, this is not expensive for a well-regarded large cap company. However, allowance has to be made for the unpredictability of the resource profit (and possible sale) alongside the problematic outlook for Coles.

Bega Cheese (BGA) scored a home run in retrieving the Vegemite brand, along with the salad dressing brand ZoOSh and Bonox from Mondelez International. BGA will also manufacture Kraft products such as peanut butter under licenses until at least the end of 2017.

To date, Bega has been only in the dairy segment, with revenue of $1.2bn. This acquisition adds $310m to its sales and adds a useful layer of diversification. The stock price jumped given the expectation of an 8-12% earnings upgrade. One key factor is that the transaction includes a large site in Port Melbourne, with the property value a core part. Debt funding adds to the profit contribution but also takes the corporate leverage well above that of what a modestly sized consumer staple company should wear.

Our equity market has lacks good quality consumer companies and if BGA can make this business work, it will be a welcome addition to portfolios. The challenge is to achieve revenue growth in a slow growth sector. Spreads growth is only around 1% as bread consumption remains flat. Fashionable products such as Nuttela and even smashed avocado erode the traditional spread market. The dairy category has its challenges too, not least the export market to Asia, but also the complex relationship between farmers, processors and the retailers. Cheese is one area where Bega may be able to create more of a path of its own. Australian cheese exports are around 170 000 tons, not bad in a global context, but about half of that of New Zealand. As importantly, they are not growing much compared to New Zealand and that out of the EU. How BGA addresses these markets will be critical given the stock is trading around 20X prospective earnings.

With first half reporting season commencing within the next two weeks, it is worth assessing the trends in earnings across the market. It has been observed that the ASX 200 is experiencing an earnings upgrade cycle for the first time in several years. The typical path that estimates follow is a high (often double-digit) starting point for the financial year, which is subsequently cut as the year progresses and optimism is replaced by reality. So how broad has the earnings recovery been?

The following charts illustrate the progression of forward earnings for the key sectors of the market since February last year. Unsurprisingly, materials (predominantly mining) and energy are the two key sectors which have a high level of earnings momentum. The earnings recovery has thus been narrow.

Earnings for materials have more than doubled over this time after a strong rebound in commodity prices over the last 12 months. The index includes building materials, steel and packaging companies, hence the underlying growth of mining stocks has been even greater than this. The oil price is also cycling off a low point from early last year and with a somewhat sustained recovery now expected following OPEC’s recent deal, the earnings across this sector are much stronger.

ASX 200 Earnings Trends

Source: Bloomberg, Escala Partners

Outside of these two, earnings for industrials and financials have actually tracked slightly down, with utilities the only other sector of the market to experience upgrades greater than 3%. The previous negative trend, however, has been arrested in the last six months.

A few key reasons are identifiable and typically relate to ‘less negative’ views of several large cap stocks in the index. Firstly, the outlook for the major banks has marginally improved. An easing in mortgage competition, low bad debts (helped by the commodity price recovery), a reduced chance of capital raisings and a steepening yield curve have all played into this view.

Secondly, the major supermarket chains, Woolworths and Wesfarmers, have each experienced an improvement, with sales at Woolworths stabilising (and with no further losses from Masters weighing down the company) and Wesfarmers receiving an uplift from its coal division (as confirmed this week).