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WEEKEND LADDER

A summary of the week’s results

20.04.2018

Week Ending 20.04.2018

Eco Blog

- US data looks better through March following the cold winter months. Expected GDP growth is moderate, however, notwithstanding the support from tax and fiscal stimulus.

- China’s GDP was predictably within guidance at 6.8% for the first quarter. The heavy reliance on government fiscal spending, property transactions and rising household debt subdued investment markets from interpreting this as a positive.

- The Australian labour market eased in March. Most expect the unemployment rate to persist at a low 5% level, with participation via population growth limiting much change as well as holding wages in tow.

- The IMF’s headline was ‘Saving for a Rainy Day’, as it pushes countries to reconsider their liabilities.

An improved perky tone is coming through from US data from the final month of the first quarter. Mortgage demand rose a modest 1% year on year, but that is a mix of 10% growth from purchases versus -9.8% from refinancing. Unsurprisingly, refinancing has eased given the benchmark 15-year mortgage rate has risen from 3.59% a year ago to 4.20%.

Manufacturing was stronger across the board in March following patchy reporting in January and February.

Source: Haver Analytics
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Similarly, retail sales held its ground, tracking 4.5% year on year; once again a modest upward trend to the first months of the year.

Nonetheless, for the quarter, GDP appears to be settling at 2.5%; good but far from spectacular. If the March trend holds, GDP should pick up towards 3% over the coming months.

China reported a useful 6.8% GDP growth for the first quarter. As is always the case, there is a suspicion the data is smoothed to present a steady growth path. The focus centred on the role of fiscal policy to achieve the outcome.

Contribution to nominal GDP growth from fiscal spending

Source: Deutsche Bank
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Land sales took off in the quarter, with the government collecting a 40% increase in receipts on the corresponding period. Consequently, government spending accelerated and now the property sector will likely be the next to show growth as these projects moves into the development phase.

The property-driven switch to turn on economic growth is increasing the risks in China. Unfettered building has caused much of the cyclicality that most believe is evident outside the headline numbers and is in denial of the private debt problem that persists. At best, it can be suggested that with a major curb on backdoor lending to formalise the financial sector, the central authorities found it necessary to support growth directly. A strengthening renminbi, weaker export contribution and the potential for trade tariffs (further developments expected in coming weeks) are only likely to have reinforced that stance.

Adding to the concerns is the incremental rise in household debt. Consumer credit has doubled in the past five years, alongside leverage that is harder to measure, such as via peer-to-peer lending. There is some evidence that small businesses have turned to consumer credit as the shadow banking sector crimped their access to funds. The recent easing in the reserve requirement (the level of capital banks must hold) will help to alleviate the tightening on non-formal lending, but it all remains debt nonetheless.

The shape of longer term growth in China is becoming tougher. A combination of unsettled geo-economic issues, high debt that has long term consequences and reports of infrastructure developments outside of China where the returns are very likely to be low or even negative, stand alongside the continuing growth in consumer markets and emergence of local higher end industries. How these counterparts play out will have a major impact on Australia and the world in general.

Locally, employment data was soft in March with a rise of only 5k and a fall in full time jobs. There are mixed opinions on the likely path for jobs growth with the consensus landing on an unimaginative suggestion that it will track sideways. The positive is that the unchanged unemployment rate is in good part due to population growth.  The probable outcome is that employment numbers will hold up and absorb the rise in participants, but, in turn, that is likely to limit wage growth. A false signal would be an improvement in data such as retail spending, whereas the per capita growth is close to flat. More pertinently, household income is still highly constrained and leaves the RBA open to debate whether the better economic trends forthcoming this year can imply that the household sector can withstand a rate rise.

The IMF released its half yearly outlook and assessment of financial conditions. One concern is the persistence, indeed growth, in global debt over the past ten years. Allowing for all committed liabilities, there are some standout countries (with a trivial pursuit question on the abbreviations). US debt is on the rise. Without structural changes to pensions and healthcare, developed countries are in a pickle. The small handful with sizeable sovereign funds stand out.

Debt-to-GDP ratios more than double when implicit liabilities linked to age are included

Source: IMF staff calculations
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Investment Market Comment

- We have compared how the structure of an index changes between different methodologies. There is no perfect way to weight stocks through quantitative screens.

There are three broad approaches to determining the weighting of an index; market-cap weighting, equal weighting and factor-based weighting. The most widely accepted method is market-cap weighting, where the proportion of a company’s free-float market cap is weighted within the index. Equal weighting, as the name suggests, is an index whereby each company contributes equally to index construction. Factor-based, which has become increasingly represented with the growth of ETFs, is a rules-based methodology based on screens such as dividends, volatility or liquidity.

Market cap index weighting of the ASX200 carries a concentration risk as the top 10 stocks equate to over 50% of the index and financials make up over one third.  Therefore, the performance of the broader market is going to be closely aligned to with a small number of very high weight stocks and financials. Rebalancing to a 0.5% weighting per stock reduces the concentration. However, the sector weights will be now determined by how many stocks in each sector. For example, there are 39 stocks within the materials sector and one does not necessarily want to have a 19.5% exposure to this sector?

Source: IRESS, iShares, Escala Partners
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If one compares the market cap S&P500 to equally weighted there is less of a diversion between the two indices and the performance between the two should be similar. The current tech sector performance would somewhat skew to market cap, but historically there has been a continual change in sector leadership.

2-Year performance of the S&P500

Source: IRESS, Escala Partners
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The VanEck Vectors Australian Equal Weight ETF is an equal-weighting offering on Australian share market. This is not a pure equal weighting index, i.e. it is not 200 shares with a 0.05% weighting, but rather individual companies are determined by a rules-based methodology focusing on market cap and liquidity, therefore, this ETF has 85 companies with an average holding size of 1.18%.

Source: Morningstar, Escala Partners
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Nonetheless, despite having less than half the number of shares compared to the ASX200, this ETF could be considered to be more diversified given it has moved away from the overweight to large cap and financials.

2-Year performance ASX200 v VanEck Aust Equal Weight ETF

Source: IRESS, Escala Partners
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By doing so the ETF should have superior performance when mid-cap stocks outperform large-cap stocks, as has been the case over the past 18 months.

Different methodologies will inevitably result in different portfolios but that does not make one better than the other in all circumstances.

Fixed Income Update

- The RBA minutes edged toward a rate rise while market reaction is subdued.

- Elevated short-term funding rates continue to dominate financial discussions.

- Global yield curves steepen up as rates move higher on inflation concerns and reduced bond buying by the Bank of England.

The RBA board minutes from the last meeting for the first time explicitly acknowledged that members had agreed that its more likely that the next move in the Australian cash rate would be up rather that down. We have heard the RBA governor say as much, including in a speech last week, but this had previously not been included as a discussion at the meeting. That said, it went on to note that officials view slow progress in hitting wage and inflation targets and made the point that there is not a strong case for any near-term rate adjustments.  The domestic futures market is not pricing in any meaningful probability of a rate rise this year, with only a 32% likelihood assigned by November. Consensus remains that the first hike is likely to be in 2019.

The increase in short term funding costs continue to dominate market discussions, with the US Libor and Australian BBSW both elevated. Most Australian floating rate notes reset their coupons off the 90day BBSW rate, which is approximately 0.30% higher in the last two months. Investors in bank hybrids and other floating rate securities are the beneficiaries.  As previously noted, this is largely the result of issuance by the US Treasury, with the increased level of supply pushing up short term funding costs. This may be a short-term anomaly, but in the meantime it is affecting borrowers that are highly leveraged with either have floating rate funding exposures or are reliant on short term debt securities. If it persists it is conceivable default rates of lower rated companies may increase. In terms of Libor, it is estimated that $350 trillion worth of contracts reset coupons off this benchmark.

Movement in 90-day BBSW rate in last 2 months

Source: IRESS, Escala Partners
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The other topic that has been well covered in financial publications is the shape of the yield curve, which flattened in the last month. However, some significant rate moves in long dated fixed rate bonds in the latter part of this week has seen the yield curve steepen up, with the rate on the US 10-year treasury at its highest level since February. While the yield on this benchmark bond failed to reach the elusive 3% level, it has participants speculating that long dated bond yields may be ready to break out of their recent trading range and push higher as seen earlier this year. In terms of the steepening of the curve, the difference between 2 and 10-year Treasuries is now at 0.47%, up from its recent low of 0.41%, which marked the lowest level since September 2007.

The move higher in yields is being attributed to two factors. Firstly, inflationary concerns are building with rising oil prices being one of the main drivers. Higher inflation has markets looking for further rate hikes by the Fed compared to what was priced in. The futures market is now reflecting the probability of 4 rate hikes in 2018 at 30%, up from 10% a few months ago. The long end is also responding to an increase in inflation breakeven rates.

This rate move has not been isolated to the US, as yields across Europe and Australia have also edged higher. In addition to the inflation story, actions by the Bank of England (BoE) are having an impact. The BoE currently holds about £435bn in Gilts (UK government bonds) acquired during as part of its monetary programme, of which it has been reinvesting proceeds from maturing bonds and coupon payments. This has stalled, with the BoE not expected to be in the market buying Gilts for a while. The result was the biggest sell off in UK gilts in 2 years and falls across French and German bonds.

  • The rate moves this week have been synchronised across the developed markets. Long duration bond funds, domestically and globally, show the impact and in our view being this bond weakness will continue. Our recent asset allocation piece reinforced our current underweight recommendation in fixed income, and underweight duration within that allocation.

The yield on UK’s benchmark 10-year bond at 2-year highs

Source: IRESS, Escala Partners
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Corporate Comments

- Bank of Queensland’s (BOQ) result fell short of consensus forecasts. A challenging margin outlook is balanced with an attractive fully franked dividend.

- CYBG has raised an additional provision related to legacy issues. While its capital ratio will be impacted, the medium-term drivers of improving earnings remain intact.

- Quarterly production reports from the miners were mixed. Investors are likely to benefit from increased shareholder returns in the next 12 months.

- Oil Search (OSH) downgraded its production guidance following the earthquake in PNG. Positive developments on LNG expansion are expected in the second half of the year.

Bank of Queensland’s (BOQ) half yearly result received a lukewarm response from the market and provided a brief distraction from the ongoing Royal Commission. Cash earnings growth was 4% on 1H17, although short of expectations as revenue trends disappointed. Costs were relatively well controlled and lower bad debts were the highlight, although at 10bp it is unlikely that this will continue to be a tailwind.

The key issues around BOQ revolve around below-system loan growth (in a slowing credit growth market) and the high likelihood that net interest margins will come under pressure into the second half. There are multiple drivers at play to support this view and these are arguably yet to be fully factored into earnings estimates for the banks. Firstly, mortgage competition has recently been high, resulting in an elevated level of discounting on new loans written. Secondly, short term funding costs have recently increased (with a sharp rise in bank bill swap rates). While in a normal environment this may simply be passed on to customers, the banks may be more circumspect in doing so while the Royal Commission continues to highlight flaws in their behavior.

BOQ’s outlook is not too dissimilar to the major banks, however it is currently being marked down due to its high reliance on the retail market (over six months it has moved from a P/E premium to the majors to a discount, despite CBA’s sharp de-rate in this time), and its return on equity remains below that of its peers. The regulatory environment has recently been in its favour (compared to the majors which have had to materially increase their capital ratios and absorb a new banking levy), although it remains exposed to the same environment. Shareholders willing to absorb a tough outlook are likely to be rewarded with a solid yield of more than 7% (and hence greater than 10% on a gross basis), which is backed by a sound capital position.

Bank of Queensland and Major Banks P/E

Source: Bloomberg, Escala Partners
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UK regional bank, CYBG (CYB), which was spun out of NAB two years ago, had a disappointing release this week. The company noted that following a sustained period of elevated complaints through the last six months, it would be raising an additional provision to deal with legacy claims for the mis-selling of payment protection insurance, which will continue until August 2019. The provision will exhaust the conduct indemnity set aside by NAB at the demerger and hence any increase in the next 15 months will be borne by CYB shareholders.

While this development is unfortunate and will have an approximate 100bp negative impact on CYB’s capital ratio, this is expected to be more than offset by the capital release it should achieve later this year for accreditation of its mortgage portfolio. Hence, the investment thesis of cost out opportunity, earnings growth above its competitors and increased capital returns to shareholders is likely only delayed somewhat by this announcement. We have CYB in our model equity portfolio and it also remains a core holding in the IML SMAs.

It was a busy week of quarterly production reports for resources companies, including diversified miners BHP Billiton (BHP) and Rio Tinto (RIO). BHP and Rio reported a typically mixed set of numbers, although overall production was broadly flat for both, reflecting the new environment of limited spending on big projects.

For BHP, iron ore was below expectations and impacted by weather-related outages, with a slight downgrade to its full year guidance. Thermal coal was also weak, although copper came in ahead of forecasts. Meanwhile Rio had better production from its Pilbara iron ore assets as it demonstrated the benefits from its investment in improving productivity. Other divisions were in line or softer, although iron ore continues to be the key driver and dominates the group’s overall earnings exposure at approximately 60%.

For shareholders of the two companies, higher capital returns remain a big part of the investment thesis. This is coming in two forms. Firstly, dividends will be markedly higher this year following the reversion to a payout ratio policy, whereby dividends will fluctuate much more and reflect the change in underlying commodity prices. Secondly, share buybacks and/or special dividends remain a high possibility while commodities remain elevated.

Rio remains ahead of BHP on this measure having already commenced a share buyback and the company could possibly be in a net cash position by the end of the year. BHP has lagged but is now close to its targeted gearing range. The impending sale of its US shale energy assets should accelerate these returns, with the company look at a sale price of circa US$10bn.

As we have recently noted, commodities were generally softer in the first quarter of 2018 which has meant that the earnings upgrade cycle for the miners has slowed. Within this, however, some individual commodities have surprised on the upside for various reasons; such as oil on supply discipline and geopolitical risks and more recently, aluminium and nickel on Russian sanctions. Net present value calculations currently suggest the miners are close to full value, although as we commented on in our recent asset allocation piece, forward EV/EBITDA multiples are reasonable at around 6X and there remains considerable upside to earnings over the next 12 months should spot prices hold. We are overweight the sector in our model equity portfolio through holdings in BHP and Independence Group.

BHP Billiton and Rio Tinto Forward EV/EBITDA

Source: Bloomberg, Escala Partners
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Across to the energy sector, Oil Search’s (OSH) quarterly production was 36% lower quarter-on-quarter and its full year guidance lowered by 17% (at the mid-point), although anticipated by the market after it shut down production following an earthquake in late February. Its key PNG LNG Project was offline for several weeks and only recommenced production last week, although ahead of the initial estimated timeframe estimate by operator ExxonMobil.

Despite the delays caused by the earthquake, OSH confirmed that there was no change to the progress of its LNG expansion activities, with a broad agreement on the development concept reached between the company and its partners ExxonMobil and Total. Further, following the cut to its production guidance, consensus forecasts for OSH’s FY18 profit (the company operates on a calendar year basis) are broadly in line with where they started the year: the rise in the oil price has neatly offset the earnings from lost production. OSH remains our top pick in the energy sector given the high level of optionality in its portfolio and the high cash-generating nature of its existing asset base.

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