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WEEKEND LADDER

A summary of the week’s results

13.04.2017

Week Ending 13.04.2017

Eco Blog

-Food and energy price inflation are considered ‘non-core’ in terms of central bank policies but have a substantial impact on household spending and inflation expectations.

- Australian employment showed a big jump in full time roles, though there is some doubt on the accuracy given potential distortion in the sampling

If chocolate costs more over this holiday period, cocoa is not to blame as the price has fallen due to good growing conditions in central Africa and South America.  Cocoa bean only makes up 6.6% of the cost of a bar and even smaller proportion of the higher value Easter product and is offset by the rise in sugar prices.

NYSE Liffe Cocoa Futures (GBP/t)

Source: London International Financial Futures and Options Exchange
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Bean Counter

Source: Cocoa Barometer, Wall Street Journal
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According to the Food and Agriculture Organisation (FAO) global food prices increased by 14% over the year to March, led by meat, dairy and sugar. But in recent months the trend is more benign and locally ABARE forecasts that Australian agricultural export values will deliver a mixed outcome.

Major Australian agricultural commodity exports

Source: Australian Bureau of Agricultural and Resource Economics and Sciences
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Food remains a high proportion of the CPI, though generally is excluded in central bank deliberations given the prices have little correlation to economic momentum. Nonetheless, for households, food costs can have a meaningful bearing on their spending capacity, especially in emerging countries where it can be up to 40% of income. Country specific issues are also important; pork prices in China and the impact of the monsoon in India are notable examples.

India reported its CPI at 3.8% in March, broadly in line with the Reserve Bank of India’s target. Food inflation has been low at 2.5% as the government allowed imports to ameliorate shortages in 2016. The most important parts of the food inflation basket are pulses, perishable vegetables and sugar. One notable feature is the rising attention being paid to India in financial markets. This CPI release was widely covered and the country continues to attract flows into its equity market, notwithstanding that valuations are well above historical averages.

China’s CPI for Q1 came in at a low 0.4% annualized, with food inflation down 4.3% year on year. This contrasts with the producer price index, which measures the price of goods at the factory gate, up 7.6% year on year and reflects the rise in non-food commodity prices. The implication is that global traded goods, ex food, are likely to show some price inflation into this year.

The other swing factor is energy. Oil prices are up 8% in a month and at the bowser US consumer are paying 17% higher than a year ago as they head into the summer driving season. The bulk of forecasts are of the view oil prices are likely to hang around the mid to high US$ 50 mark for the rest of this year. In simple terms, above US$ 60 more capacity become viable, while supported on the downside by an uneasy mix of inventory movements, OPEC compliance, real or perceived disruption in the Middle East.

While central banks generally look through the combined impact of food and fuel prices in setting interest rates, the household sector is highly attuned to a rise in these costs in terms of inflation expectations and consumption spending.

In local data releases, employment growth took a welcome jump registering a rise of 61,000 mostly in full time positions and well above expectations. A slightly higher participation rate kept the unemployment level at 5.9%.  State wise Queensland lead the pack followed by the consistent growth in Victoria. NSW was surprisingly weak, lagging Western Australia. This data series has been volatile for some time and subject to revision. Sampling has been a problem as regions move in and out of the ABS data. This time the ABS highlights an unusual sample set, where the employment rate within the same sample is very different to that of last month. In short, the person that replied to the survey within the household is different to last month and has decided they are employed versus the response in the previous month. That said, other labour market indicators (job ads, business surveys) imply that employment should be showing better numbers than those reported by the ABS.

On cue, the NAB business survey shows that companies view conditions as favourable, while their confidence is still subdued. Service sectors are particularly strong and there is a big reversal in the mining sector. There is therefore some hope that capital spending will pick up given this index component was up 13 points in the month. Capacity utilization tightened somewhat and cash flow is reported as solid in most industries bar the retail sector.

Capacity Utilisation and Unemployment

Source: NAB
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Capital Expenditure

Source: NAB
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Fixed Income Update

- Bond prices react positively to the shift in sentiment to geopolitical events and expectations of weaker near term trend in growth. Conversely, locally credit sells off given headlines on weaknesses in the Australian economy and tight spreads.

Government bonds are included in investment portfolios mainly because of their low correlation to the equity market and should perform well in times of poor economic growth or political uncertainty. Investors seek ‘safe haven’ assets such as government bonds, cash and gold during such times and riskier securities such as equities and credit tend to underperform (credit spreads widen). Having an allocation to government bonds dampens volatility within a portfolio, giving a smoother return profile for investors.

Since the middle of March when the Fed raised US interest rates, yields have softened resulting in a price rally for government bonds. A combination of, wariness over the US administration’s ability to act on election promises and escalating geo-political risks in the Middle East and have been responsible for this shift in market sentiment. (Bonds prices had been falling in the months prior).  The yield on the US 5-year treasury has fallen from 2.14% to 1.77% in the last month, resulting in the price rise of the underlying bond as shown below.

US 5-year Treasury price

Source: Escala Partners, Bloomberg
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Credit in Australia has been slower to respond to this ‘risk off’ trade, with the index indicating the movement of investment grade credit spreads starting to trade wider since the beginning of April. Credit spreads had been contracting for the last 15 months, but risks have finally been weighing on the index in the last week. Some will also argue that spreads were too tight given the weakness in the Australian economy. The iTraxx has risen 4 points in the last 7 days. See price action below.

Australian iTraxx credit Index

Source: Escala Partners, Bloomberg
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Funds that have the flexibility to move between bonds and credit can go a long way to dampen the volatility in fixed income. In many ways, the low measured volatility of the indexes in fixed income of circa 3% is a function of this combination, with bonds and credit respectively showing volatility in the order of 5%.

Corporate Comments

- BHP Billiton (BHP) has largely dismissed a proposition from an activist investor.

- Earnings in the telecommunications sector are likely to be further challenged by TPG Telecom’s (TPM) entry into the mobiles market.

BHP Billiton (BHP) received a temporary boost this week after the announcement by activist hedge fund investor Elliott that it had acquired a 4% stake in the company and put forward a proposal to the board to ‘realise value for shareholders’. The Elliott ‘Value Unlock Plan’ involves three steps that the company should take: replacing the dual listed entity (BHP is currently partly listed in London and the ASX) with a single UK domiciled company and Chess Depository Instruments listed on the ASX; demerging its US Petroleum assets into a separate entity to be listed in New York; and adopting a consistent capital return policy to shareholders. While each suggestion has some degree of merit, all are not particularly novel ideas, having being canvassed several times in the past. The suggested value that would be unlocked (49%) does, however, look quite exaggerated.

Consolidating BHP’s current structure has been considered before, with two primary motives that give some merit to this recommendation. Firstly, the difference in pricing between the two listings (the ASX premium is charted below) and secondly, the franking credits that could be better utilised under a new structure. While the listing valuation difference is partly explained by the benefit of franking credits for Australian shareholders, a relevant question of collapsing the current structure would be whether the price gravitates to the current ASX-listed price or London price. In any case, we would note that returning franking credits to shareholders is already an option for the company (either via special dividends or share buybacks) in which it has done in the past. By moving to a single listed entity, the company would still have a large internationals shareholder base who could not utilise the franking credits. Moreover, this does not consider the costs involved (including taxation) and the likelihood that it would require Foreign Investment Review Board (FIRB) approval.

BHP Billiton: ASX-Listed Premium to London Stock Exchange

Source: Escala Partners, Bloomberg
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A demerger of BHP’s petroleum division has also been raised in the past. The theory behind this proposal is that oil and gas companies tend to trade on higher earnings multiples compared with mining companies. This current premium represents an approximate 25% uplift on BHP’s current multiple, although other investors would likely value the diversification that this commodity brings to the portfolio.

The final point on capital allocation is perhaps the most relevant for value creation, although BHP is hardly alone in this regard. The mining industry has typically been a very poor allocator of capital, acquiring assets at the top of the commodity cycle (with few synergies involved) and holding excess debt when the cycle turns. BHP Billiton (e.g.US shale gas) and Rio Tinto (e.g. Alcan aluminium) both have recent form in this regard and a policy that was designed to limit this behaviour would likely be welcomed by many investors. We would note, however, that the current mindset of the industry is already to prioritise shareholder returns over further capital investment, once debt has been reduced to more comfortable levels. Formalising such a policy may therefore not result in much change given this change is already in motion.

A competitive telecommunications sector became even more so this week following the announcement by TPG Telecom (TPM) that it had acquired mobile spectrum in the recent government auction and undertaking a capital raising in the process to help fund its expansion plans. Achieving a satisfactory return on its investment could certainly prove difficult for TPM given the high price that it has paid in the auction and its proposed capex spend, which appears low relative to its ambitions. Nonetheless, the company has had a successful track record in the last decade of success in growing into a large player in the broadband market via a price-led strategy, and so it would not surprise to see it achieve some success in mobiles.

TPM’s mobile plans are likely to be significantly cheaper than the market leader, Telstra, and the risk of price discounting by TLS and other carriers to protect market share is a real possibility. This has been reflected in the sharp fall in TLS’s share price this week. Until recently, mobiles had been the primary driver of the company’s profit growth. The end result may be additional pressure on TLS’s core earnings (i.e. outside of NBN transition payments) and its dividend, a persistent risk for prospective investors.

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