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WEEKEND LADDER

A summary of the week’s results

20.03.2015

Week Ending 20.03.2015

Eco Blog

Central banks retain their rock star status (for the financial sector) with markets hanging off every utterance and then debating the possible ramifications. Unlike dresses with stripes, the Fed watchers prefer dots and the subtle change in dots attracted a good amount of the attention. 

The FOMC meeting noted that US economic growth, while still reasonable, was ‘moderating’.  Low exports and low inflation irked the members enough to temper their forecasts for the US economy compared to December (shown in the table below). Forecasts for GDP growth and shorter term inflation have been pulled back, but in contrast, the Fed expects the unemployment rate to fall more rapidly than before, suggesting they are comfortable with a tightening labour market rather than concerned about any inflationary consequences. Employment growth, which has been running at a rate of around 250k per month, was leading to forecasts of the unemployment rate dropping below 5% in coming months (in the absence of a rise in the participation rate). With this outcome, financial markets would have previously brought forward their expectations of interest rate rises.

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Therefore the key dots move attracted the attention of fixed income markets as the Fed instead eased back their interest rate expectations. The chart below is the expectations of each member (unidentified) of the Federal Reserve for the Feb fund rate with 15 of the 17 members expecting a rise this year. The previous (unlikley) forecast of the federal funds rate reaching 1.5% has essentially been removed. Overall the implication is that a rate rise is now more likely around September than June and that the pace of rates is projected to be lower than before. Some suggest Janet Yellen, with the deciding call, is represented by the fifth dot from the bottom. If correct, she has shifted from a 75bp Fed rate by the end of 2015 to a 50bp rate. 

Federal Reserve: Fed Funds Rate Forecasts

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Rates are an important issue for markets. The first rise in rates is well expected and should not surprise financial markets. The timing and extent of the US rate cycle is likely to be the most challenging issue facing investors around the globe in the coming years. A highly regarded investment manager, Ray Dalio of Bridgewater, has put out a cautionary note on the risks. While some focus on the analogy to the experience of the 1930’s, his intent is to discuss the nature of decision making in the face of difficult conditions, rather than suggest there will be a repeat of events.

In summary, he notes the relative ineffectiveness of easing at this time to stimulate economic activity, yet also the reality that the US dollar is still the reserve currency of the world and that actions appropriate for the US have much wider repercussions. Currency markets are already showing their disruptive capacity. Most emerging economies, on which a large amount of global growth now relies, cannot effectively use monetary policy to temper capital flows. Interest rate sensitivity is possibly at its most extreme in decades, given the level of global debt and fragile nature of economies. 

Dalio further points out the importance of fiscal policy to work in unison with central banks, a feature that has been somewhat lacking to date. Importantly, tax hikes or a rush to close budget deficits were ultimately complicit in the depression of the 1930’s and therefore avoiding those mistakes is critical. The debate is now coming through in the UK, as two parties with very clear opposing views battle out the question of tax and spending on the eve of an election. This will possibly set the tone as the UK, too, mulls over a rate rise.

With our own budget looming, the interplay between the RBA (given the apparent ineffectiveness of our interest rates to induce required domestic growth) and the government (with its efforts to redistribute income or reduce the deficit) will be much more important than ever.

The never ending question of employment conditions in Australia were somewhat illuminated by the detailed release of February data. As we have noted before, the service sector is far and away the dominant employer by number, albeit not quite so much by income. The chart and table below shows the extent of that bias – services account for close to 80% of employment.

Share of Total Employment

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The annualised average growth since 2000 highlights the size and increase in key segments; namely healthcare, professional services (e.g. legal) and public administration. Note that the definition of goods and services is slightly different to the chart above. For example, retailing is considered in the table in the context of movement of goods, whereas the chart more correctly nominates retailing as a service.

Employment by Industry

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The labour market problem, if there is one, is arguably not so much centred on the level of employment but the nature. Two themes are absent from the data presented above. Firstly, an indication of what segment is likely to show productivity growth, and secondly, that the service sector is growing mostly in publically funded or essential services, rather than those with high value add. The persistent conclusion that the Australian economy is likely to experience weak conditions for some time seems inescapable.

The influence of consumers as the primary driver of growth is changing rapidly as the population demographics shifts, with over 65 year old households to represent 30% of the total by 2030 – a short 15 years away. For an extended period the impact of an aging population was disguised by the growth in female participation in the workforce, the lengthening of working age and the tax cuts of the late 1990s/ early 2000’s which bumped up household incomes. These trends are fading and therefore the spending contribution of households are as well. Notable from the chart below is that 65+ households double their proportionate spending on health compared to all others. In turn, spending on transport and, unsurprisingly, education falls sharply. Others, such as clothing or household goods, fade too. An interesting one is food, where it appears older citizens consume vigorously! It is more likely that this offsets the hospitality category and the combination of the two is less frightening for the waistline.

Share of Spending by Household Age

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These trends are important for investment portfolios. While the daily noise in financial markets can at times muddy the water, investments which can progressively be skewed to account for changing behaviour are much more likely to stand the test of time.

Company Comments

BHP Billiton (BHP) this week announced further details of the proposed spinoff of its non-core assets into a new listed entity, to be known as South32. BHP shareholders will vote on the demerger on 6 May, with South32 shares expected to begin trading on the ASX on 18 May. The conversion ratio of the demerger will be one South32 share for every BHP share held, and the primary listing of the shares will be on the ASX. South32 is likely to have a market capitalisation of approximately $10bn; large enough for inclusion in the ASX 50, although it will probably fall just short of the ASX 20.

As a stand-alone company, South32 will also have a different approach to capital management compared with BHP. Its priorities, in order, are: maintain safe and reliable operations and an investment grade credit rating through the cycle; distribute a minimum of 40% of underlying earnings as dividends; competition for excess capital. Excess capital will be distributed in a way that maximises total shareholder returns, either via special dividends or buybacks, or through capital investment in projects. Compared with BHP, investors will not be able to rely on a dividend that is at least maintained each year; the upside to this policy is that it allows a greater level of flexibility for the company to deploy capital in the most efficient manner.

While dwarfed by BHP’s large, industry-leading mines, South32’s assets remain of reasonable quality themselves. As the chart below illustrates, almost all occupy a position in the first or second quartile of their cost curves. What might surprise some is that just 11% of the company’s revenue was sourced from China in FY14, reflecting a suite of commodities that is more leveraged to developed economies.

South32: Industry Cost Curve Position of Assets

Source: BHP Billiton
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South32 will be a large entity in its own right, yet this simplification of BHP’s portfolio will not result in a material drop in its earnings base. The assets that BHP is retaining collectively accounted for 96% of the company’s underlying EBIT in the 2014 financial year. Following the spinoff, BHP has stated that it would not cut its dividend, despite the adjustment to its earnings base. BHP is also of the belief that the diversification benefits it receives by holding these assets are marginal at best, and thus there is no imperative from this perspective to retain them. We will provide a more detailed look at South32 and recommendation on the stock in coming weeks.

Orica (ORI) this week announced the departure of its CEO, Ian Smith, after reports that his abrasive management style became too much for the board. Smith was three years into a five year contract, and while he had some runs on the board in terms of a strategy of restructuring the organisation and taking costs out of the business, the bigger battle was dealing with a deteriorating operating environment. In his tenure, ORI recently completed the sale of its chemicals division, thus resulting in the company effectively becoming a pure play mining services company. An oversupplied domestic ammonium nitrate explosives market (Orica’s key revenue source) could well result in further margin pressure in this business, particularly if there is no recovery in coal prices. The stock has some appeal from a valuation perspective on 11.5X forward earnings, but we remain cautious given the multi-year downgrade cycle that the company has experienced.

Myer (MYR) reported a $62m profit for its half year and a dividend cut to 7c/share (9c/share in pcp) (well below expectations) and also cut guidance for the full year, leading to a fall in consensus of some 20% for FY15. This came three weeks after a change in CEO and CFO where there had been no indication of troubled trading conditions. However, in the context of spending patterns and the particular pressure being brought to bear on the department store sector, it is hardly a surprise. A modest fall in gross margin due to discounting and mix shift to concession sales came up against a 6% rise in cost of doing business.

Some have taken the view that the group may need additional capital to stay within its financial covenants. That will depend on the new management’s capacity to stabilise the profit and then invest into online and store refurbishment. It is difficult to see how gross margins can improve and are more likely to remain under pressure as consumers find different ways to access comparable goods and the fall in the A$ impacts on prices. Cost ratios struggle against the sales trend as well as the required service standards, a key issue that retailers so often get wrong and then have to address at great cost.

It is hard to paint a positive picture for Myer at this time. Inevitably the potential for a private equity deal is put forward. Given low cost of funding and cash balances at private equity organisations, it is possible. However we have some doubts even they would be willing to bet on the sustainability of the current Myer model, particularly given the lease commitments of existing stores.

Elsewhere in retailing, Oroton (ORL) also reported a 30% decline in EBIT as it too attempted to move away from a discount driven formula to capture more of gross margin. Inevitably, sales have fallen by 6% in the half, though stabilising somewhat through the period. ORL’s newer associations with Gap and Brooks Brothers have yet to show a commercial return and its efforts to take the Oroton brand international have also produced little reward. Once again, the impact of consumers being quite comfortable selecting in store or online from a wide range of well-regarded global brands has undermined Oroton. As we noted with MYR, both groups are being challenged by what is a structural change and their attempts to cling to past margins will more than likely prove in vain.

Sector focus: Commodities Forecasts

Commodity price movements are the key driver of profitability and hence, share prices of the resources sector. Across the majority of commodities, prices forecasts have been cut over the past year, tracking the decline in various spot prices. This week we look at how these forecasts have evolved over this time, and whether they presently appear realistic.

Iron Ore

Iron ore remains the most important commodity for investors in the Australian market given the market share and profitability that BHP, Rio Tinto and Fortescue Metals have enjoyed since the financial crisis. The wall of supply that has been added by the major players finally caught up with the market last year, creating an oversupply situation that is unlikely to balance for some years. Global (in particular China) demand growth is slowing, yet low-cost brownfield expansions by several market participants continue, exacerbating the situation. Forecasts for somewhat of a price recovery (as illustrated in the chart) in this environment perhaps appear to be a little optimistic.

Iron Ore: Forecasts 12 Months Ago and Today

Source: Bloomberg, Escala Partners
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Oil

Forecasts for the oil market look remarkably similar to that of iron ore. A year ago, a gentle price decline was expected over the three years, while today, analysts are expecting a reasonably strong recovery in the medium term. Compared to iron ore, the deterioration in the oil market happenened in a much more rapid fashion in the second half of 2014, culminating in OPEC’s refusal to act as the balance supplier (as it had done in the past).

While the timeline for a recovery in the oil price is difficult to forecast, the argument for this outcome has considerable merit. Higher cost supply (particularly in the North American shale industry) should eventually be removed from the market, demand growth will continue and existing fields will experience a decline.

Brent Oil: Forecasts 12 Months Ago and Today

Source: Bloomberg, Escala Partners
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Copper

The copper price held up relatively well over 2014, although falls accelerated in the latter part of the year (and into early 2015) on the back of lower global economic growth forecasts. This may create a short-term market surplus, but the consensus view is that increasing demand and grade decline across the industry will result in an improved market over the next few years.

Copper: Forecasts 12 Months Ago and Today

Source: Bloomberg, Escala Partners
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Coking Coal

Like iron ore, coking coal demand is linked to steel production growth. Supply growth in coking coal was induced by the high prices in the market (at one stage prices were greater than US$300/t) post the financial crisis. Like many other commodities, this supply has now caught up with demand, although limited new capacity from here on should lead to a tighter market. Analysts are still forecasting a recovery in pricing in the medium term, however the currency depreciation of producing countries (e.g. Australia accounts for around half of global seaborne supply) may limit the upside. 

Coking Coal: Forecasts 12 Months Ago and Today

Source: Bloomberg, Escala Partners
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Gold

Due to the large investment component of demand, forecasting the gold price is  perhaps more difficult than other commodities. This trend has gone against the gold price for a few years now, with large investment outflows across the sector.

The gold market is currently a mix of positive and negative drivers. On the negative side is the strength of the $US (and whether this will continue) and a lack of inflation across the world. On the positive side is some signs of buying again by central banks and a stabilisation in investment flows into physically-backed ETFs. Typically today the US$1000 level is seen as a floor due to costs of production. However that does ignore the recycling of existing gold, a much greater component than marginal production. 

Gold: Forecasts 12 Months Ago and Today

Source: Bloomberg, Escala Partners
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Conclusion

The magnitude of the decline in commodity prices was clearly underestimated by analysts in 2014. Many commodity markets are now in a contango situation, that is, higher prices are expected in the future. While there may be an element of cautiousness amongst analysts in being too bearish with these forecasts (essentially assuming some reversion to mean in pricing), going forward, the low current base across the sector provides some optimism for improvement in the medium term.







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