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WEEKEND LADDER

A summary of the week’s results

20.10.2017

Week Ending 20.10.2017

Eco Blog

- Australian labour data and corporate surveys remain in an upward tone.

- Property market participants have quite different objectives in mind. Residential is still dominated by investment and foreign buying.

- The ECB is expected to shift its asset buying programme as it aims to spread positive trends across Europe.

- China’s growth mix is changing. Global trade will also come under the spotlight into 2018.

The labour market provided another steady rise, taking the unemployment rate to 5.5%. Two sectors are doing the heavy lifting - health and construction. Aged care and disability workers are thought to be underpinning the rise in health, while in construction, state-based infrastructure spending is overlapping with the last vestiges of housing activity.

Jobs by sector

Source: CBA
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NAB’s Business Survey also retained its upbeat tone, supported by the Australian Industry Group. The only sector that is less optimistic is retail. Mining, construction and finance are leading the pack and intentions indicate further support for jobs growth.

Ai Group composite conditions and NAB business conditions

Source: NAB, Ai Group
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Foreign interest in the property market has not let up. The latest ANZ-Property Council reports shows the extent of these purchases. An analysis of the state records indicates that 87% of the residential foreign buying comes from China, Hong Kong and Macau.

Foreign investor purchases, share of total sales, Sept QTR 2017

Source: ANZ, Property Council
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Along with the continued high level of investor lending and focus on interest only loans, the housing sector will remain in the spotlight into 2018 if, as increasingly expected, the RBA raises rates.

On the 26th Oct, the ECB will announce its intentions on its asset buying programme, though there is little expectation it will be ready to change interest rates. The rise in the Euro over the past year has already tightened financial conditions in Europe, as well as contributing to low inflation. A rate hike would exacerbate this, contrary to what the ECB would like to achieve. Asset purchases have already been tapped down and there is now an expectation that they will be maintained for longer, but at half the current pace at €30bn per month.

Central banks look set upon achieving a reduction in the unemployment rate in Europe. The disparity between members such as Germany and the Czech Republic, which are both experiencing higher inflation in tight labour markets, versus those that need support – Italy first and foremost - may cause tension in this aim. The hope would be that excess demand in Germany and its neighbouring countries flows south, looking for more and lower cost labour.

As expected, the China People’s Congress was about politics rather than economics. The Q3 GDP was no surprise at 6.8% over the corresponding quarter. The mix of growth is now at play. Consumption, services and infrastructure spending were strongest. Conversely, manufacturing is weaker and the industry balance shows the progressive move from basic sectors.

Output growth of industrial products, Sept 2017

Source: Deutsche Bank, National Bureau of Statistics
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The change in output also comes with a reduced trade balance for China, even though global trade overall is strong. Other Asian countries and Japan have experienced a higher uplift. In part, exports out of lower income Asian countries is partly Chinese, as factories have been developed there to either export into China or other parts of the world.

As the US contemplates its NAFTA arrangements with Canada and Mexico, the attention to trade barriers is likely to be increased in 2018. Consensus is that the US will change its NAFTA agreement or even walk away entirely. On balance, any restrictions will push inflation up without any net beneficial change in growth. Further, unravelling global supply chains that have been integrated for the past two decades may be a corporate headache yet to come. We also note that, in discussions with fund managers, the expectations of a US tax cut are rising. Some of the valuation for US stocks includes an assumption of lower taxes. If the legislation does not pass, the S&P500 may come under pressure.

Fixed Income Update

- The RBA minutes are released as markets price in rate hikes in 2018

- Spreads on emerging market debt contracts, even as US bond yields rise

- Bendigo and Adelaide bank launches a new bank hybrid

The RBA released the minutes from the October meeting this week. While interest rates were kept on the hold at 1.5%, observers examine this release to predict the future path of rates and how likely the central bank is to raise rates in 2018. Key comments of note:

- Australia's central bankers expressed increasing confidence in the economic outlook, although they remain watchful of risks due to high household debt levels and balance sheets.

- The board judged holding the cash rate steady was consistent with sustainable economic growth and attaining its inflation target over time.  Members noted low inflation although wage growth is expected to increase gradually.

- Increased spending on public infrastructure projects.

- In relation to other central banks “members observed that moves towards higher interest rates in other economies were a welcome development, but did not have mechanical implications for the setting of policy in Australia, where the timing of any changes in interest rates would be dependent, as always, on developments in domestic economic conditions.”

The market responded with a mild sell off in bond markets and the probability of rate rises in the next 12 months jumped from 80% to 85% following the release, with the market split between 1 and 2 rate hikes throughout 2018.

Emerging market debt has historically come under pressure when yields rise in the US. As the Fed began its tightening cycle, concerns were raised as to the likely impact on EM debt that is priced off the US treasury curve (the US denominated debt component). While yields on US Treasuries have rebound recently, EM sovereign bonds in dollars and local currency have increased to a lesser extent. This is due, in most part, to the tightening of credit spreads in this market. The search for yield has benefitted the EM market, together with the improved economic outlook for many of the countries. Money has flowed into EM ETF’s in the last 12 months and it has been a popular trade amongst bond managers.  The current spread on this index is at 3.03%, 1% lower than a year ago, and 2.4% tighter than the beginning of 2016 when it was trading at ~5.40%. While many bond managers still think this market holds value, outperformance is more likely to come from holding local currency bonds that are unhedged, opening up opportunities for FX appreciation.

Spreads tighten on Emerging Market debt in the last month despite a rise in US treasury yields

Source: JP Morgan Emerging Market bond spread index, Bloomberg, Escala Partners
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Domestically, Bendigo and Adelaide Bank announced a new hybrid this week.

The new security looks tight at a margin of 3.75% for a 6.5-year issue by a regional bank. While it is difficult to attain comparatives with the same maturity, we are of the view that some of the hybrid issues in the middle part of the curve by the major banks offer better value. That said, according to the book build there is already strong appetite for this deal. Given supply has been shrinking in the listed market, any new deals tend to be well received.  

Margin versus Term to First Conversion/Maturity

Source: Escala Partners, IRESS
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Corporate Comments

- AGM season ramped up this week, with the majority of companies reaffirming their guidance for the year.

- Brambles’ (BXB) first quarter trading numbers were an improvement on FY17, although the margin outcome for the year is more uncertain.

- Lendlease (LLC) downgraded its profit forecast as it faced challenges on a number of infrastructure projects.

- BHP’s first quarter production was weak, yet the focus remains on portfolio rationalisation and capital returns.

- The partial wealth management exit by ANZ has come at a high cost. The bank is well placed ahead of new stricter capital requirements.

AGM season is typically the first opportunity for companies to update the market on their trading in the first few months of the financial year. Earnings downgrades are thus not uncommon, so it was encouraging that most companies holding meetings this week made no change to their outlook. These included:

- Healthscope (HSO), which has been battling weaker patient growth linked to escalating private health insurance costs. Its FY18 hospital division is expected to flat year on year, however down in the first half;

- Treasury Wine Estates (TWE), which confirmed its longer term target of achieving a 25% EBIT margin, primarily driven by the ‘premiumisation’ of its portfolio (and which is now recognised in a 32X FY18 P/E); and

- Ansell (ANN), which is finally achieving a better level of organic growth across its broader portfolio.

Fears regarding Brambles’ (BXB) first quarter update were not realised, with solid sales growtht. Most pleasing was the result in its core CHEP Americas pallet pooling division, which recorded 5% growth in constant currency terms. This was underpinned by net new business growth, a point which had been lacking through FY17. All other regions likewise recorded good numbers, with the exception of Asia-Pac, which was expected to be weak on the back of the loss of a large reusable plastic container contract with Woolworths and the wind down of the domestic automotive industry.

Brambles First Quarter Sales

Source: Brambles
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While BXB’s sales were good, the key unknown for this year is the cost pressures that the business has been experiencing, which was a drag on its FY17 result following an increase in its competitive environment. Some of these costs have been noted as cyclical in nature and the profit translation from better revenue growth this may be delayed into the following year. The short term issues that BXB faces is captured in a more reasonable valuation, with the stock now trading in line with the domestic industrials sector despite the strong competitive advantage that its assets and network base gives it over potential new entrants to the industry.

Lendlease (LLC) also updated the market on its progress in the financial year, and received a poor response from the investment community. While it noted that the majority of its businesses were performing well, weak execution in its Australian construction division has led to a downgrade to earnings for the first half, which was attributed to a “small number of engineering projects”.

Little further detail was given on which projects the losses were attributable to, nor their magnitude, leaving analysts to speculate. With problems in its construction division noted at the company’s full year result in August, the widely held view was that a turnaround would emerge in this year’s profit. Instead, the division will be a drag on earnings when investors would have been hoping for some transition from the reliance on apartment construction.

LLC’s $1.3bn NorthConnex project contract would seem the most obvious   source of problems for the company, as it involves significant tunnelling work. Tunnelling projects are typically the more complicated of road projects and have in the past resulted in significant losses for domestic contractors. While a positive view can be made given the large backlog of work in domestic transport projects (LLC’s current major projects are listed below), the downside risk from poor execution leads to the conclusion that profitability is much more variable. NorthConnex still has more than two years to completion and thus there remains a possibility that additional downgrades may emerge, particularly given the little detail that LLC has provided to date.

Lendlease – Major Engineering Projects

Lendlease – Major Engineering Projects
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We had recently taken LLC out of our model portfolio on the basis that the domestic apartment market will face headwinds in the medium term given potential oversupply, which remains our view. With profitability from infrastructure projects much less certain (and a low overall exposure for the group), we prefer Adelaide Brighton (ABC) and Boral (BLD) to leverage this theme.

BHP Billiton’s (BHP) first quarter production report fell short of expectations, although the company maintained its full year production targets. This was perhaps unsurprising, given that there is three quarters of the year to recover lost ground, however a poor December quarter may see some downward revisions. The primary miss was in the iron ore division, with production dropping on the back of planned maintenance work. As the following table illustrates, performance was mixed across the portfolio, with better copper production the highlight.

BHP First Quarter Production

BHP First Quarter Production
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BHP’s earnings momentum has had an additional leg up in recent months amid broad strength across many commodity prices. The stock also has positive upcoming catalysts, including the progress of the disposal of its lower-quality US shale energy assets. While there was little new information at BHP’s AGM today, the eventual disposal is likely to free up capital that could potentially be used to buy back shares; a position that the company is in following the recent strengthening of its balance sheet and capital allocation policy evolution that is becoming more disciplined in nature.

Another company downsizing its business to focus on its more profitable operations is ANZ, which announced the partial sale of its wealth management business to IOOF (IFL) in a trend that is being replicated across the four major banks. The division is relatively small in the context of the overall ANZ business (~1% of earnings) and thus had little impact on the share price. Nonetheless, it had been performing poorly in recent years, with a progressive deterioration in earnings. Arresting this trend will be a priority for IFL, with the motive for the transaction primarily driven by cost synergies.

ANZ Wealth Management Gross Income ($m)

ANZ Wealth Management Gross Income ($m)
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The downside to the transaction is an eye-watering $300m in post-tax separation and transaction costs; a rather substantial proportion of the $975 sale proceeds. However, it will incrementally add to the bank’s capital base, which was already well placed to meet APRA’s new ‘unquestionably strong’ benchmark of a 10.5% CET1. In light of this, there is a growing view that ANZ will soon be able to commence a share buyback. The timing of this this could be dependent upon the successful disposal of its life insurance business, which remains on the block. ANZ kicks off the major banks’ full year reporting season next Thursday.

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