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WEEKEND LADDER

A summary of the week’s results

21.04.2017

Week Ending 21.04.2017

Eco Blog

- The RBA Minutes for April conveyed a message that the central bank will give time to see the results of the latest macroprudential measures that are designed to take some of the heat out of the housing market.

- Political risks have returned in the last few weeks, and are likely to remain in the short term as the French election unfolds.

- China’s first quarter GDP was ahead of forecasts, with growth accelerating in the three months.

In a week of fairly light domestic economic news, the minutes from the RBA’s April meeting attracted the most attention. The minutes confirmed the challenge for the central bank in balancing the various risks in the domestic economy.

While the meeting was prior to last week’s release of a strong employment report for March, broad soft trends in the jobs market remain a key concern. Measures of underemployment, that is, those that would like to work more hours but cannot, have remained high. Much of the recent growth in the jobs market have been in part time employment and with spare capacity high, wages growth has been low. Forward looking indicators of labour demand have been positive for some time, however this has yet to translate into stronger jobs growth.This has flowed through to soft household consumption and retail sales (which have been weaker than expected), with high debt levels providing little scope for improvement.

The other key concern, of course, is the housing market. With housing credit continuing to expand at a faster rate than income growth, risks have increased, particularly in the key Melbourne and Sydney markets. While initial macroprudential measures introduced by APRA in late 2014 briefly had the desired effect of slowing investor lending, the RBA looks like it will adopt a ‘wait and see’ approach to the additional measures announced in recent weeks, which include limiting the flow of interest-only lending to 30% of total new residential mortgage lending. The interpretation is that, in the short term, rates are mostly likely to remain on hold. The next important data point for the RBA will be the release of first quarter inflation next Wednesday.

While there is no doubt that economic momentum has been improving in recent quarters, the last few weeks has turned the focus back to what is likely to be one of the key ongoing risks to markets in 2017 – poltical. Rising tensions in North Korea and the Middle East have halted the momentum in equity markets in the past month and led to a strengthening in bond markets. Elections in Europe will also be closely watched, with a snap election called in the UK for June (which resulted in a recovery in the pound) and the first round of elections in France this weekend. This is set to  be the latest test of the strength of the global trend towards populism.

The French election has generated a higher level of interest than usual this year due to the closeness of the race and the various implications of different canditates becoming the next president. The French electoral system involves two rounds of voting in which voters cast a single vote for their chosen candidate. A candidate will claim victory with more than 50% of the vote in the first round (although this is highly unlikely given a large field of candidates), hence the final result is typically resolved by a runoff second round between the two highest polling candidates (scheduled to be held on 7 May).

This year is particularly unsual due to the fact that there is four potential candidates (who are each polling between 19-25% respectively) that could progress to the second round and the race has become much tighter in recent weeks, hence the range of possibilities for the final two candidates is high. At this stage, the most probable scenario would see centre-left candidate Macron pitted against far-right leader Le Pen, with Macron holding a clear lead between the two in head-to-head polling. A Le Pen victory is seen as the key risk to market stability, given her policy to abandon the euro and to conduct a “Frexit” referendum.

French Election Polling

Source: Bloomberg
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While there has been considerable deterioration in the reliability of political polling following last year’s Brexit referendum and US elections, French polling is seen as more reliable given a higher reliance on internet as opposed to telephone polling. Nonetheless, given the current closeness of the race, a high level of undecided voters and the likelihood of Le Pen progressing to the second round, market uncertainty is most likely to remain for at least the next two weeks.

China beat expectations with its GDP for the March quarter, with growth ticking up to 6.9% and the strongest quarterly performance in 18 months. While much of the recent strength in the Chinese economy was attributed to government stimulus and credit growth, the first quarter was characterised by broad-based contributions, with industrial production, retail sales and fixed asset investment all ahead of forecasts. The latter, which is measured in nominal terms, was expected to be strong given the rise in producer inflation over the last 12 months; in real terms the growth would be much lower.

Chinese Inflation Measures

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The growth outlook for 2017 has susequently been upgraded slightly in a year that is expected to be relatively stable, given the possible change in leadership at the upcoming National Congress. In the meantime, the key risks and challenges are largely unchanged: deleveraging from high levels of corporate debt, ongoing economic reform and management of trade relations, particularly with the US.

Fixed Income Update

- Bond yields in the US and Australia have fallen to their lowest level for the year on Wednesday before lifting by the end of the week.

- The British pound has appreciated 3% in the last month.

In last week’s publication, we discussed the ‘risk off’ trade that has been playing out in markets. This has mostly continued over the week, with bond yields in the US and Australia hitting their lowest levels for 2017. Both the 10 year Australian government bond yield and the yield on the US 10 year treasury have fallen around 20 basis points since the beginning of April, with a flight to safe-haven bonds aiding valuations. These falls were felt across the entire yield curve, with a parallel shift taking place in the domestic market and a flattening of the yield curve occurring in the US.  While the market has taken back some of these moves towards the end of the week, the shift in the Australian sovereign yield curve is still evident, as illustrated below.

Change in Australian Yield Curve

Source: Bloomberg, Escala Partners
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There have been a number of causes driving this significant move, which include:

- market expectations for US inflation falling to its lowest level of the year;

- doubts over the US administration’s timeline and ability to implement stimulatory fiscal spending; 

- rising geopolitical risks in Syria and North Korea; and

- uncertainty around the upcoming French election. 

Determining which has had the most profound effect on markets is difficult to ascertain, but interestingly one of the fund managers we met with this week believe that half the move (~12bp) could be attributed to geopolitical risk. With the risks of higher interest rates in the US and Europe remaining, however, a slight reversal of this trend was evident towards the end of the week.

In currencies, the English pound has appreciated considerably recently, buoyed by the snap election announcement this week by Theresa May. The GBP/AUD spot exchange rate has seen the pound strengthen by 3% in the last month.

British Pound/Australian Dollar

Source: Bloomberg, Escala Partners
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A trade idea that we have discussed in this publication in weeks prior involved buying UK bank hybrids (known as coco’s) and taking on the currency risk. The idea was based on the thesis that the GBP was undervalued and it would appreciate throughout 2017. Further, the underlying bonds pay a coupon of ~7%, which would add to returns and offer a decent cushion if the currency fell further. As an update, the underlying bonds have maintained their capital value over the last month, the coupons of circa 7% have been paid, and the currency has appreciated 3%. 

In the domestic listed debt market, the recent new issue by Challenger (a six year hybrid security) began trading in the last week. The bond was issued at a yield of BBSW +4.40% back in February and trading margins have contracted since then. The security has traded above par (c. $100.96) since listing and now reflects a yield of BBSW +4.26%, 14 basis points lower than its original price.

Corporate Comments

- Brambles’ (BXB) third quarter trading update provided no further bad news, however, the soft trends from its half year report remain in place.

- Tatts Group (TTS) has received a counter all-cash offer from the private equity consortium, however this is still likely to be deemed inferior to the current Tabcorp (TAH) deal on the table.

- Oil Search’s (OSH) quarterly production report was solid and there is now a number of catalysts within the next 12 months for the stock.

- Coca-Cola Amatil (CCL) downgraded its earnings guidance as the company continues to deal with a structural revenue headwind.

Pallet pool operator Brambles (BXB) responded well to a third quarter trading update, with investors relieved following confirmation of the company’s full year guidance. Across its various geographies and business units, the trends that were evident in the first half of FY17 were relatively consistent in the March quarter – high sales growth in reusable plastic containers (RPCs) and other containers, improving sales in Europe and a softer result from its American pallets division. While constant currency sales growth is expected to be in the mid-single digit range for FY17, BXB is guiding towards flat underlying profit, indicating a level of margin contraction through the year.

Brambles Nine Month Sales Figures

Source: Brambles
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While the Brambles business has attractive characteristics, with high barriers to entry, strong margins and returns on capital, the short term outlook remains clouded by increased pressure from its key pooling competitor in the US and weaker recycled pallet prices (the alternative to pooling solutions). Lower customer wins were reported in the first half of FY17, although the company did point to some contract wins in the third quarter, which are not expected to add materially to earnings this financial year.

Despite a somewhat challenging outlook, the stock currently trades on a similar multiple to the broader industrials market. Evidence that is able to address these concerns, along with the longer-term question of its ability to adapt to the structural change in retail of businesses shipping direct to consumers, will be required for us to adopt a more favourable view of the company as an investment. We recently removed the stock from our model Australian equity portfolio.

The battle for control of Tatts Group (TTS) continued this week when the private equity consortium returned with a revised proposal to acquire the company for $4.21 cash per share. While the offer (being cash) gives more certainty than the original proposal from the consortium late last year, intriguingly it is below the $4.40 - $5.00 indicative value put forward at that time (part of which was a disputable valuation for its wagering and gaming operations).

At this stage, the consortium’s revised offer is only in line with the current recommended offer from Tabcorp (TAH) of 0.8 TAH shares in addition to a 42.5c dividend. However, for several reasons it would be expected that it will be deemed inferior by the TTS board. These include the fact that the transaction would be delayed longer than what is expected from the TAH-TTS merger as the consortium gains the necessary regulatory approvals (which could extend into next year) and that the consortium’s conditions include no further dividends paid out by TTS until the deal is complete. Moreover, under the consortium’s offer, TTS shareholders would not participate in any upside from combining the two businesses whereas many may wish to retain an equity exposure to the group.

At this stage, the revised proposal from the consortium appears to be little more than a potential foot in the door to undertake due diligence on TTS. Nonetheless, it does provide the potential for higher bids for TTS before a deal is completed. At this point in time, TTS is trading at a slight premium (~3%) to the implied offer price from TAH, indicating that investors see little chance of much improvement in the final deal.

Quarterly production reports from resources companies commenced this week, including from Oil Search (OSH). OSH’s report was largely as expected, with the core PNG LNG project continuing to operate at well above its nameplate capacity. With this now consistently achieved over several quarters, there is increasing confidence that these production rates can be sustained for some time, particularly with the strong resource position that is underpinning the project.

While OSH’s production report was quite positive, the key development over the next 12 months will be ongoing progress with an expansion of PNG LNG. At this stage, there is an expectation that it will enter a FEED (front end engineering design) process in this time frame ahead of a final investment decision in the following year. The recent acquisition of InterOil by PNG LNG’s operator, ExxonMobil, has meant that there is now an increased likelihood of cooperation between the various companies in PNG to leverage off the existing infrastructure. In the interim, the upcoming election in the country is likely to cause some external risk (outside of another collapse in the oil price). We remain of the view that OSH is the best exposure to the energy sector, with low cost existing operations and attractive opportunities for value-enhancing organic growth.

Coca-Cola Amatil (CCL) surprised late in the week with a trading update following the completion of the Easter holiday period across Australia and New Zealand. The company noted that trading had been weaker for the year to date (CCL reports on a calendar year basis), with strong competition and category trends leading to volume and pricing pressure across its business. With the company previously targeting mid single-digit earnings growth in the medium term, CCL now expects a decline in net profit for the first half of 2017.

Over the last 12 months, CCL had gained some traction as a turnaround story, as it took costs out of its business, restructured its domestic supply chain and returned capital to shareholders. However, the company has lost its previous status as a relatively safe, low-beta investment due to the structural issues that it faces, with consumers continuing to prefer healthier beverage options over its core soft drink product. While CCL has among the strongest brands in the market, this ongoing headwind for the company means that there is a higher level of risk over its earnings growth profile.

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