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WEEKEND LADDER

A summary of the week’s results

20.07.2018

Week Ending 20.07.2018

Eco Blog

- The June Australian labour market surprised with a large increase in full time jobs and taking female participation to an all-time high.

- Comments from the RBA, however, painted a sombre tone on household debt. A CBA analysis provides some comfort on mortgages but the pressure inevitably will be on discretionary spending.

- China’s GDP held its pace in Q2. Growth will ease in H2 absent some form of accommodation on credit restrictions or fiscal support. In light of economic tension this may not be a bad outcome.

The good news first.  While it is only one data point, the June jump in employment, mostly in full time jobs points to a more than satisfactory transition from a housing lead economy to one that is better balanced through a mix of service sectors and infrastructure construction.  The skew is firmly in the female camp, with the participation rate for women at an all-time high of 60.6%, implying most of the gains are in the services and government sector. Movement across the states showed a wide variation – NSW and QLD accounted for almost the whole 50k in new jobs as both SA and VIC saw a small fall in employment.

Full time jobs to pick up pace

Source: ANZ
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The caveat to the jobs data is that it is often revised and can vary considerably over the months. Nonetheless there is enough evidence from their fiscal statements of the states (both VIC and QLD have had 6% increases in government wage costs), trends in tourism, education and the healthcare sector that the job market is relatively sound. The nature of the work however is biased to lower paid and it is likely wages will still report as soft until the private sector picks up the pace.

The bad news was the RBA’s call out on household debt, pointing out the risk this brought to the financial system. The headline number is well known. Total debt owned by households (to banks, government such as student loans, debt owed to foreign banks) is 198% of income nearly the highest in the world. The incentive to borrow has been in place for some time as low rates, relatively stable employment and a safety net provided households with some comfort on financial conditions. Then the incentives; negative gearing and a housing market that is imbedded in the psychology of Australians, with about 92% of the debt owed on housing. 

CBA has provided some insights to their mortgage book.  While loan-to-value has fallen, this is recent and partly a function of valuation. A 10% downward move in property values would shift this metric for investors, for example, to 86%. The other feature is the lack of income growth for both owners and investors.  Within the data is a meaningful shift where higher income households have borrowed increasingly higher amounts (unsurprising given house prices), mid income tempered their loan size and lower income become much smaller in the mix.

The average new borrower in 2013 and 2017

Source: CBA
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A positive trend has been that borrowers paid off debt when mortgage rates fell by holding repayments steady. Offset accounts have also been rising for investors.

The key is the projection for investor loans. CBA expects around 20% to convert to principle over each of the coming 3 years.  This raises another risk that we noted in a previous report. Repayments increase by some 30-40% on conversion and will inevitably cause some pain in household spending. It is increasingly important that the supply of apartments eases back as there are likely some that will realise their investment property rather than face the payment schedule.

Credit card data from CBA is telling. Those with housing loans have slowed their credit spending and that increases with the size of the loan.  As concerning is the fall in the savings rate, with CBA illustrating that the big banks are bearing the brunt of this trend.

Source: CBA
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The combination of the improving labour market, high household debt and falling savings makes for a complex outlook for consumption spending. On balance it would appear much more likely that household spending will remain subdued. Widely reported falling house prices affect people’s sense of financial wellbeing and utilities, health and petrol prices worry consumers more than the real impact on their hip pocket.  Mortgage rates are expected to rise if bank funding costs continue to come under pressure.

  • This supports the RBA holding steady, notwithstanding the jobs growth and the level to which rates can rise is most likely to be lower than the RBA has in mind; it recently estimated the ‘neutral rate’ at 3.5% (the rate one should expect when economic growth and inflation are mid-range). That level would push too many households into financial stress.

Once again China did what it said would happen; GDP for Q2 was 6.7%, inevitably met with the usual comments that it is nearly impossible to measure growth so quickly after the end of the quarter for such a complex and large economy. Putting aside this issue, as it is the trend rather than the absolute number that should be assessed, the mix hints at the progressive change taking place in China. Industrial production is running at around 6% growth, while retail sales are at 9%. Other sources support the contention that the household sector is doing well, but it is yet to become dominant enough to reduce the risk growth can falter.

Through this year China has clamped down on its financial system by limiting non-conforming lending. In turn it has eased the reserve requirement (akin to a capital requirement) for banks considered to be toeing the line. Credit is not the best way for China to stabilise or support its desired growth, but at this stage it is the lever of choice.

The fall in the exchange rate attracts attention with innuendo that is manipulating the Yuan. In the floating rate environment, the chances are the currency would have weakened with the trade battle and less certain growth outlook.  The devaluation has, however, neatly compensated for tariffs imposed and comes at a time commodities are a little softer as well.

  • The trade dispute is critical and observers believe the government will aim to distance itself from direct reaction while being firm that it will look after itself. This is arguably the big story for the second half of the year.

Investment Market Comment

- During these times of rising rates, treasuries are usually negatively impacted, however, corporate and high yield bonds can outperform in similar conditions. Therefore, it is important to know the difference between how these different bonds react at diverse times. There are five ASX-listed global fixed income ETFs, each replicating the performance of its own index.

The increase flattening of the US yield curve has been a talking point of this week after Federal Reserve chairman Jerome Powell presented at his semi-annual Senate banking committee testimony on Tuesday. This occurs with the narrowing in difference between short and long-term rates during times of where it is expected the Fed will raise the rates while the longer term outlook is less clear.

Difference in 2- and 10-year US treasury yields (LHS) and US Fed Rate (RHS)

Source: IRESS, Escala Partners
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Unlike an individual bond which has a maturity date, fixed income ETF run in perpetuity through cycles where bond drive prices will move with rate changes. This means that it is hard to mitigate the impact of rising interest rates such as managing duration.  As a result, the performance over the past six months for the ETFs has mainly been underwhelming.

ASX-listed global fixed income ETFs Performance as at 30 June 2018

Source: Morningstar, Escala Partners
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As the chart illustrates, over the past two years the iShares Global High Yield Bond (AUD Hedged) ETF (IHHY) has outperformance the other ETFs. It follows an index that invests in high yield, or sub-investment grade corporate bonds with a notional maturity of 15 years or less. High yield corporate bonds are lower down on the corporate structure and can be resilient in rising interest risks as the duration is typically lower than investment grade given that lenders prefer shorter dated maturity. 

ASX-listed global fixed income ETFs portfolio characteristics 

Source: iShares, Vanguard, Escala Partners
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There has been increased pressure on emerging market debt due to the Fed rates increase, trade tensions and the U.S. dollar strengthen.  The iShares JP Morgan USD Emerging Markets ETF (IHEB) has had negative returns as a result, however, yields have now risen significantly and are likely to attract attention if the conditions change.

The ETF follows an index that provides an exposure to US dollar denominated emerging market bonds. Therefore, a rise in the US dollar puts pressure on countries such as Mexico and Turkey which have used this debt to promote growth in recent years.

iShares JP Morgan USD Emerging Markets ETF Country Exposure

Source: iShares, Escala Partners
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Fixed income ETFs provide investors with a suitable alternative to the managed funds. However, fixed income ETFs are similarly handicapped in a rising interest rate world. Low duration is best achieved through active management with unconstrained mandates.

Fixed Income Update

- Elevated Australian short-term rates have wide spread implications to funding and deposit offers.

- US interest rates get a political tone. The likely path points to two more hikes this year in line with guidance, but 2019 may see more tension as the Fed notionally extends beyond it neutral rate.

The elevated Australian bank bill swap rate (BBSW) has broad ramifications for interest rate product.  Firstly, to the cause.

Banks fund themselves via short term deposits, but for longer term funding turn to wholesale markets.  A recent development is a sharp slowdown in deposit growth pushing banks towards wholesale funding via local and global debt capital market sources.  The US dollar funding component is a sizeable proportion of this and given the rate rises we are already seeing increased cost to the banks. This has trickled into other market related sources of capital, such as the local BBSW rates hitting 2%.   Banks have adjusted by dropping some deposit rates, particularly on call accounts given they are not highly valued since they don’t meet new liquidity requirements (the regulator sees these as opportunistic and more likely to be withdrawn in periods of stress).

4 Major Banks – Funding Sources

Source: Schroders, Annual reports from ANZ, CBA, WBC & WBC issued in 2017, Escala Partners
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The BBSW is the reference rate for short term lending and most investors get exposure through floating rate credit, particularly hybrids. The margin at which the BBSW sits above cash is a function of the stability in wholesale funding and reflects demand and supply. As noted, demand is seeking to cover shortfalls in deposits and the rising global rates, as well as global demand for Australian cash given it is still relatively attractive compared to some other sources. The outstanding repo positions at the RBA for non-residents has risen sharply to 52% from around 20% in 2014 as these global participants seek additional cash funding sources.

90-Day Bank Bill Swap Rate

Source: IRESS, Escala Partners
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Most banks believe this is far from a temporary phenomenon. Falling deposit growth and differential global rates are not going to change in a hurry. For those that expect the RBA to move on the official rate, this rising cost of funding has therefore been an effective rate rise of some 35bp.

The most obvious result has been a rise in mortgage rates, particularly from second tier banks. Even government funding has been impacted. This week the AOFM sold $500m of short term treasury notes at 1.97%, 27bp above the cash rate and the highest since early 2016.

  • Floating rate credit gains a small incremental return while depositors bear some of the overflow. Even fixed rate credit will have to up the ante and raise their coupon yield. Eventually fixed income funds will roll into this debt resulting in higher income returns.

US 10-year rates have traded in a 2.83-2.88% range for some weeks. This is notwithstanding decent enough economic data and this week’s Fed statement expressing optimism on the economy.  Outright yields look too low across the board and appear to be taking a darker view on the potential repercussion of trade tensions, while inflation has yet to make any appearance of note.  Betting on a resolution on trade or an unexpected spike in inflation is akin to a two-up game – the certainty is very low. Add to this mix the highly unusual step for a head of government to comment on the desired direction for the central bank.

For the sake of the argument we can take on board an opinion that interest rates should not go up when the economy is clearly running at a decent pace. Inflation has not budged and if this is the key determinant, the case for low rates is being made.  The other is that the housing market is showing signs of easing. Mortgage applications and housing starts have both recently ebbed away. If the purpose of rate hikes is to avoid building excess demand and debt, the signs are not that obvious.

The alternative case for higher rates is two-fold. Central banks try to be pre-emptive. In the ideal world interest rates move up to stem some demand and reduce poor capital allocation. This comes down to the second argument. Rates need to be ‘normalised’. It is too easy to ignore the reality that the past five years have been highly unusual. The Fed and the RBA have both undertaken work to assess what the neutral rate should be.  Comments from the Fed are that this would be 2.5% only two rate rises from here. Yet the infamous dots imply the Fed members are pencilling in up to 3.5% by 2020 on the assumption economic momentum is sustained.

As yet investment markets are not on board with the Fed’s longer-term view (except maybe the 2-year US bond rate). Other issues will inevitably come into play, though at present the comments from Trump may only push the Fed to reinforce their independence, sticking to their set guidance. Absent a near term unexpected wage or inflation signal, it could be next year when the real action starts.

  • Bonds are yet to be viewed as attractive investments, largely now fulfilling a role to protect downside and reduce volatility.

Corporate Comments

- Resource companies’ production reports initiate the information flow on the half year.  Product levels are generally at or above expectations. Cash flow has become a key feature with capital management across the board. The only taint is the persistence of ‘one-off’s’ in restructuring or write-offs which implies poor operating management and investment still linger.

- Small cap announcements provided a good insight into industry developments. Stock selection is best left to the professional managers intent on outcome rather than promoting a view via investment banks. 

BHP’s production report exceeded guidance across its suite of petroleum, copper, iron ore and coal.

Source: BHP
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Low levels of disruption (intentional due to maintenance, or unintentional due to disruption) were notable in the last quarter allowing the company to beat its numbers, likely struck on a slightly conservative bias. The same applies for FY2019 with management suggesting production growth will be flat for the year.

A positive market reaction to the report stemmed from slightly higher than expected commodity prices that the company is achieving, along with the progress to realising its US shale assets and paving the way for a potential capital return.  Management stated that “bids have been received and we aim to announce one or more transactions within coming months, targeting completion of any transactions by the end of the 2018 calendar year”.

The positive momentum for BHP remains in place against scepticism that this can continue.  Even with a levelling off in commodity prices, the cash flow is robust. The prospect of dividend or buybacks is near certain, yet few have fully factored that outcome.

  • We have favoured BHP due to the mix of assets and high level of management scrutiny that comes from being a large global participant. Even the yield at circa 4.6% is a useful portfolio outcome. Nonetheless investors should not be lulled into security, commodity prices remain inherently difficult to predict and stock prices are volatile, leveraged to global data and influences.

South 32 (S32) similarly met most of its expected production outcome. The company has flagged a degree of cost pressure, something that may require more oversight for all resource companies from here onwards. The company is now managing its South African energy coal external to S32 which will change the functional cost base substantially.  On the positive side the cash flow again is robust enough to maintain its buyback and a 5.5% dividend yield.

  • S32 product mix is less appealing than others in the sector.  As such, it has lost the most ground this year relative to its peers notwithstanding a 5.5% yield and forward P/E of under 10X.

CY18 share price movement

Source: IRESS, Escala Partners
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Alunima’s run up in the share price to a halt with the realised price below estimates. A combination of legacy contract and lower prices chemical grade sales reduced its received price by approximately $20 compared to spot. The near term outlook is still good, with prices expected to hold the US$500/ton mark. Unsurprisingly, energy prices were the main impact on costs.

Spot alumina and implied linkage

Source: Alumina: Platts, July 2018. LME Aluminum: Thomson Reuters, July 2018
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  • AWC has a yield of circa 9%. At face value this would attract investors, but the sustainability of the yield is always in the lap of relatively small variations in pricing. If reliable income is the intent, the judgement on the outlook for alumina pricing is critical.

Alumina Dividend History ($/share)

Source: IRESS, Escala Partners
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We defer to managers for smaller cap stock selections. Nonetheless we follow their fortunes as a guide to what is happening across sectors and industries in general.

Asaleo (AHY) sells tissue (all forms) and personal care (largely female hygiene) products through supermarkets. The cost of energy and pulp is up, along with many commodity prices. The company attempted to push these through to consumers but instead found that promotions were reduced and volume lost. The end outcome has been a 30% fall in EBITDA for 2018, naturally followed by a severe share price drop.

  • Our take-away is that intermediaries are always at the mercy of this squeeze with inevitably major profit leverage. In these products brand value is low. If these events occur the apparent security of demand (after all who cuts consumption in a downturn) and cash flow that supports yield, dissipate entirely.

The other end of the scale was Afterpay. For those unaware, it provides retailers with a ‘buy now, pay later’ option for consumers. There are no loans or notional interest payments. Based on its update it has 2.2 m customers and 16500 retail merchants. The alternative is credit cards whereas many consumer prefer the regular and known payment schedule offered by these services.

A business update indicates that it is firing on all cylinders with every metric above expectations taking the share price up 30% in this week alone.

  • We offer no opinion but observe that there are others in this sector looking to also participate. It is a broader issue that interest us; accessing financial services outside banks is increasingly normal and at this stage very lightly unregulated. In our view two outcomes are probable. Non-traditional services will grow as banks and others are stuck with legacy they do not want to compromise, nor have the appetite to take on such risks. The other is that regulation is ever present. For APRA and others to see credit outside any formal control runs against their efforts to contain excesses. Ironically if this service grows, some form of added regulation appears inevitable.

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