Week Ending 20.05.2016
The RBA’s minutes confirmed that combatting weak inflation has gone to the forefront of the central bank’s mind. While other data series (notably employment) have come under criticism for measurement error, CPI is less so, notwithstanding the different spending patterns across demographics. The RBA concluded that weak inflationary trends had been broad-based in the quarter and thus lowered its outlook for inflation and wage growth. While Australia’s position remains much better than many other economies, the RBA’s own forecasts are for inflation to return to the middle of its 2-3% target band by 2018.
Two developments over the last year have no doubt pleased the RBA. One is a weaker $A, which was beginning to cause some headaches amidst $US weakness earlier this year, although has now resumed its downward trend following the rate cut and inflation reading. The other is a cooling in the housing market, with introduced macroprudential policies targeting investor lending beginning to have the desired effect. While there continues to be the broad expectation of at least a further rate cut in coming months, the effectiveness of such an outcome is debated; borrowers are likely to bank the savings, retirees take an income hit and productive business lending by the banks could well be limited.
The RBA also noted that lower inflation figures could soon be reflected in lower wage growth and this was borne out to a degree in the first quarter figures, with the annualised rate of 2.2% growth the lowest on record. Weak wage growth has been a feature of many developed economies for some time now and domestically has trended down over the last four years. While Western Australia and Queensland have been among the states with the lowest rates of growth, the weakness has been widespread geographically and across industries.
Australian Wage Growth by State
The detail in April’s employment data was consistent with this soft wage growth reading. While the unemployment rate remained steady against expectations of a slight increase, the composition was weaker. Employment growth of 20,200 part time positions was offset to a degree by a fall in full time jobs of 9,300, continuing the recent trend of sluggish full time employment growth (see chart below) and providing little catalyst to anaemic wage growth; the bargaining position of a part time worker in pushing for a wage increase is less than that of a full time worker. The participation rate, too, fell slightly to 64.8% and forward indicators, such as the ANZ job ads series, have levelled off in recent months. The data this week most likely will do little to change the RBA’s easing bias.
Australia Monthly Employment Growth ('000)
The Federal Reserve’s April minutes were also closely scrutinised, with the odds of a hike in the next few months increasing following the release. After a pause in economic growth in the first quarter (a common occurrence in first quarters in the last few years), economic indicators have improved again over the last month, including consumer spending and manufacturing data. The key sentence of the minutes noted that, “most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the Federal Funds Rate in June.”
What may stop the Fed hiking next month? Global macro risks had recently been raised by the Fed in explaining the reluctance to raise through the first part of 2016, however concerns over China have receded and equity markets have rebounded. Aside from any surprise inflation weakness between now and then, the key unknown is the outcome of the Brexit vote, which is in the week following the next Fed meeting. Fed officials may instead decide that the reaction to this event warrants consideration before hiking again.
Japan’s first quarter GDP gave some cause for optimism, with a 0.4% read (or 1.7% on an annualised basis) ahead of expectations of 0.1% growth. The negatives of the announcement were instead focused on; an extra day in the leap year is not accounted for in the numbers, while the growth for the fourth quarter of 2015 was adjusted lower. Further, the economy has contracted in two of the previous three quarters, providing a headache for the government and for the country’s central bank. Further fiscal stimulus is on the cards and there is an increasing expectation that a proposed increase in the sales tax for next year will be delayed again.
Japan’s economic performance this year has come in the face of quantitative easing and negative interest rates, which have not had the desired effect; deflationary concerns continue to plague the economy and the yen has actually risen against the US dollar. More so than other developed markets, the ability of central banks to support markets is being diminished with reduced marginal benefits from ever lower (and, in many cases, negative) interest rates.
Fixed Income Update
Global divergence in monetary policy became more evident this week as yields fell in the domestic market following the rate cut by the RBA, whilst yields backed up steeply in the US as the probability of rate hikes by the Federal Reserve Bank increased.
The RBA’s monetary statement painted a picture of the domestic economy remaining in a low growth, low inflation environment for the next few years. This, together with the view that the RBA typically cuts rates more than once in an easing cycle, sent our bond yields tumbling, with the 10 year bond yield hitting its lowest level in history. On Monday, the yield on this bond traded down to 2.2%, as shown in the chart below.
Australian 10 Year Government Bond Yield
However, by Tuesday some of these falls had been retraced following the release of the RBA minutes, which highlighted some reluctance to cut rates, with discussions on whether to adjust the policy at this meeting or await further information before cutting. Despite this, the futures market is still pricing in a 100% chance of a 25bp rate cut by November this year.
In the US, momentum is gathering for further increases in the Fed Funds Rate. This week’s release of minutes from the central bank’s April meeting showed a willingness of policy makers to lift rates in June should economic conditions continue to strengthen. The probability of a June rate hike has increased from 4% to 32% over this week, with a 75% chance of a rate rise by year end. The following table shows the implied probabilities by the futures market.
US Federal Reserve: Rate Hike Probabilities
Understandably, many investors are gun shy when it comes to investing in the Australian listed hybrid market. The $3bn CBAPD (Perls VII) deal that came to market in October 2014 is perhaps to blame. With an issue margin of 2.8%, an 8 year maturity and inappropriate deal sizing, it is no surprise (in hindsight) that investors have seen their capital eroded, with this bond trading down to below $90 (on a $100 issue price).
However, the upside of this is that the market is now pricing in a more appropriate spread for the risks inherent in these deals. These securities are complex instruments, with issuer call risk, a low position on the capital structure, discretionary coupon payments and embedded non-viability and capital triggers that may see these ‘bonds’ convert to equity. The intrinsic value of these risks is subjective, but it does feel that with a spread of ~5% for a 5 year security (a fully franked yield to maturity of ~7%) is possibly about right. With the cash rate at 1.75%, there is definitely a risk premium priced in. Further, this pricing now puts the Australian market in line with our offshore peers, with the spread representing the same level that Australian banks can issue in the global markets.
This week Westpac announced the refinancing of its WCTPA hybrid, which matures next month. The high level details of the deal are listed below.
Westpac Notes Offer
This is a very similar transaction to the CBA Perls VIII deal that came to market earlier this year. While the CBA deal was priced at a slightly higher margin of 5.2%, globally credit spreads were then wider, and this new Westpac deal is reflective of where the secondary market is currently trading, albeit with a slight new issue premium added.
The Westpac deal is book building until Friday. NAB are also expected to announce a new tier 1 deal in the near future.
This week the US printed its fourth largest corporate bond deal ever with a $20 billion bond issuance by Dell. The structure included maturities in the 3, 5, 7, 10, 20 and 30 year part of the curve, both floating rate and fixed rate, secured against some of Dell’s assets. The order book was said to be in excess of $85 billion.
DuluxGroup (DLX) reported a half year result that was broadly in line with expectations, representing a modest 4% increase in net profit. DLX’s broad full year guidance of profit growth on FY15 was reiterated, with the lift in the dividend matching the company’s earnings growth.
DLX’s core paints business has attractive investment characteristics, with a strong brand name that allows the company to achieve a premium price point in the market, a dominant market share and an alignment with the leading retailer in the category, Bunnings. While DLX has diversified away from this paints division via acquisition over the years, it still accounts for close to three quarters of the company’s EBIT. The company’s other divisions include home improvement products (Sellys is the primary brand), construction products and equipment, garage doors and openers, garden care products and cabinet hardware. The earnings in these latter groups have been less consistent over time and are also still largely driven by the level of new housing activity as well as the renovations market.
While commonly viewed as a housing-related stock, it is actually the renovations and home improvement market that is more important to DLX, with the company estimating a 65% end market exposure. While the renovations market is less cyclical than new housing, there is still evidence to suggest that conditions in the medium term are likely to be more challenging, with slowing house price growth (which has followed tighter investor lending criteria imposed on lenders by APRA) reducing the incentive to renovate. DLX also has a smaller (15%) exposure to commercial and infrastructure markets, with the company acknowledging subdued market activity. Despite limited forecast earnings growth in the next few years, DLX has attracted a premium P/E rating (at approximately 18X forward earnings) by the market on the back of fairly robust markets, however the risk of this unwinding if conditions were to weaken remains.
DuluxGroup: End Market Exposure
James Hardie (JHX) is also exposed to the building sector, although with a bias to the improving US market. The company met its guidance for its fourth quarter and full year result (albeit at the low end) while the final dividend was lifted by 7% and a $100m buyback was announced, indicative of management’s confidence in the outlook. Lower margins in the quarter in the company’s core North America and Europe division were the primary reason for this outcome due to higher production costs following an isolated production matter at one of the company’s US plants. While prices were also slightly weaker in the quarter, volume growth remained strong at 11% and ahead of analyst forecasts. Market share growth continues to be a feature of James Hardie’s results, and FY16 was no different, with the company’s US volumes tracking ahead of broad measures of overall market growth.
While JHX’s EBIT margins were weaker in the quarter, for the full year they remained at the high end of the company’s 20-25% target. As the chart below illustrates, this improvement over the last few years has been significant and shows the fixed cost leverage in the business as conditions have steadily improved. We have JHX in our model equity portfolios based on the ongoing recovery in the US housing market, with housing starts still below historical averages and the strong returns that the company is able to achieve in its business.
James Hardie: North America and Europe Fiber Cement EBIT
Foreign exchange transaction provider OzForex (OFX) reported a full year result that on face value looked softer than the pace of growth that investors had become accustomed. Underlying profit for the year fell by 2%, although there were several factors that impacted the result. Foremost among these was the distraction that would have arisen from the company’s defence of a takeover bid from Western Union, which failed to result in a binding proposal for OFX despite several months of negotiations and led to OFX terminating the discussions. Secondly, OFX had undertaken a rebranding exercise that also appears to have been disruptive to the business, slowing client growth in the second half.
In addition to all this, OFX had previously foreshadowed a step up in its investment spend in areas such as its technology platform (including a migration to the cloud), risk management and compliance, and marketing. The benefits of this are unlikely to be realised in the short term but should set the business for the next few years as it looks to achieve its longer term FY19 target of a doubling of revenues. As a result, the growth in OFX’s expense line (22%) was at a greater pace than the solid 15% growth in revenue, crimping margins.
While this increased investment is expected to continue into FY17, the company’s next few results will be important in assessing the return that this spend is generating. Success may result in the stock re-rating higher than its current P/E of 19X, while it would be unsurprising to see corporate interest return in the event of failure, particularly following the weakness in the Australian dollar.
Mantra Group (MTR) announced the acquisition of the Ala Moana Hotel in Honolulu, Hawaii and an associated capital raising to fund the purchase. The acquisition is expected to be mildly earnings accretive in FY17 for the company and provide a material increase to the group’s resorts segment. The hotel’s model operates in a similar way to MTR’s other resort properties in that MTR will own the key freehold areas (such as reception, bars and conference facilities) while the capex responsibility is shared with the individual apartment owners, thus de-risking MTR’s exposure during periods of cyclical weakness. We recently added MTR to our model portfolios on a buoyant domestic tourism market.
The hunter became the hunted today as Oil Search (OSH) agreed to a deal to buy US-listed InterOil for US$2.2bn. After Woodside Petroleum (WPL) walked away from a bid to buy OSH late last year, OSH has now consolidated its position in Papua New Guinea through the acquisition of InterOil. As part of the deal, OSH has agreed to sell 60% of the key gas field acquired along with a stake in exploration assets to French-based Total. A further selldown to the PNG Government could occur should it exercise its rights to participate in the project. As such, the capital outlay of the transaction for OSH will be much lower than the US$2.2bn price tag and with new OSH shares issued to InterOil shareholders, OSH’s balance sheet metrics will strengthen.
While the 27% premium to InterOil’s previous closing price looks full on paper, the transaction makes much more strategic sense than most M&A deals in the resources sector, where synergies from a combined group are typically low. The acquired assets were slated to be developed into a stand alone LNG project, called the Papua LNG Project (not to be confused with the already running PNG LNG Project). With Oil Search and the PNG Government already involved in the PNG LNG Project (with ExxonMobil the operator), today’s deal further aligns the parties between the two projects, increasing the potential for Papua LNG to leverage off the existing infrastructure in place, improving the economic returns. The motivation for co-operation is much higher in the new energy environment of lower pricing.
The chart below illustrates that OSH’s LNG interests are in projects in the lower part of the cost curve, with the potential Papua LNG Project sitting below the strong returns being generated by PNG LNG. Integration would bring these costs down further and also improve the economics of PNG LNG expansion. Aside from the usual regulatory approvals required, the deal is subject to InterOil shareholder approval, which is expected to go to a vote in mid July.
LNG Projects: Break-Even Costs