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WEEKEND LADDER

A summary of the week’s results

21.07.2017

Week Ending 21.07.2017

Eco Blog

- The reaction to the RBA minutes proved to be much ado about nothing, yet the AUD will remain vulnerable to the unwanted interest from the global yield search.

- The ECB also calmed down market talk of its intentions, with a late autumn date the most likely one for action.

- Meanwhile, the US will have to deal with its self-imposed debt ceiling. To date, Congress has done little to establish confidence in resolving tricky issues. 

- Inch by inch the Chinese authorities are edging towards improving oversight of the financial system.

The sharp rise in the AUD, already in the making due to improved commodity prices and recovery in the labour market trends, got a shot in the arm from the ebullient China GDP data and the RBA’s assertion that the ‘neutral’ cash rate was around 3.5% compared to the 1.5% at present. This is by no means a RBA forecast, rather provides concept on the way it is thinking of long term rates. It is worth re-reading the direct comments from the minutes:

Members discussed the Bank’s work estimating the neutral real interest rate for Australia. The various estimates suggested that the rate had been broadly stable until around 2007, but had since fallen by around 150 basis points to around 1 per cent. This equated to a neutral nominal cash rate of around 3½ per cent, given that medium-term inflation expectations were well anchored around 2½ per cent, although there is significant uncertainty around this estimate. Members noted that some of this decline could be attributed to lower potential output growth, but the increase in risk aversion around the time of the global financial crisis was likely to have been a more important factor, given that the bulk of the decline in the estimated neutral real interest rate had occurred around that time.

Economists forecast for rates barely changed on the back of this statement, as few believe the Australian economy is anywhere near being able to cope with rising rates. By midday Friday, Deputy RBA governor, Debelle, had successfully jawboned the AUD back down again. The next piece of data for markets to fret about will be the CPI on 26 July.

The bond market is happy to reflect some of this noise into long term yields, pulling in flows to Australian bonds and therefore the AUD. The Australian 10 year bond yield, at circa 50bp higher than the US equivalent and with a AAA rating aligns with New Zealand (circa 70bp spread, AA+) as the only two with these characteristics. For those looking for positive spread to the US, the next selections move to the more adventurous end, such as Portugal, Poland or Hungary at around 50bp, while Mexico at 450bp and South Africa at 635bp are another step up. The point is that the AUD will inevitably attract investors when spreads widen enough. And a weakish economic outlook may not stand in its way.

A near term reversal of this trend now falls back on the US, given the ECB has also, for the moment, kicked the tightening can down the road. In the short term, European growth is unlikely to accelerate to the point where rates are required to crimp conditions, though the disparity across Europe is becoming more attenuated. The ECB has succeeded to awake the animal spirits of the corporate sector in terms of capital demand given the low costs. As such, its policies can be seen to have been successful, with a respectable growth and balance between bank loans and credit issuance since early 2016. It would not want to derail this trend, as reversing back to a tightening programme would be destructive in its early stages.

Euro area net annual corporate debt flows

Source: ECB, Barclays Research
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The ECB will now most likely wait for the meeting on 26th Oct before any announcement, given that the meeting on the 7th Sept is close to the German election. Indeed, autumn is going to be a busy time for central banks and related government debt debates.

The US debt ceiling imposed by Congress has been around for almost exactly 100 years, having been promulgated in the early days of WW1 to contain debt funding for the war. Since then, the level of debt has largely matched that ceiling. In March this year it reached its upper limit of USD19.8tr. For those that like the Sydney harbour analogy, a pundit states that this represents a 13 500 mile high stack of $100bills. So-called extraordinary measures have been in place to allow the government to function as normal, but these are likely to be exhausted in mid-October. Rather than running into the risk of rationing its payment obligations, the issue needs to be resolved well before that time. The difficulty of getting any agreement amongst the US Republicans however, does not bode well for the deliberations and is a distraction from other issues. It also comes at the time financial markets had hoped a tax reform would be in the limelight. Given the impact lower taxes will have on debt, it seems increasingly unlikely anything will be resolved.

US Debt Ceiling

Source: US Treasury
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For how long the US business community will be as optimistic as it has been this year remains to be seen. To date, they have not wavered and for good reason. While there have been soft spots, the trend is sustaining its positive skew. Leading indicators, such as building permits and employment sectors have picked up, the equity market is voting for the corporate sector, credit spreads are tight and profitability is at highs. The unknown question is whether rate rises, dysfunctional politics and corporate confidence can be a positive mix.

It would be easy to dismiss the National Financial Works Congress as another talkfest where attendees can slumber away, especially so given its unappealing title. Yet this meeting of every five years does reset the direction for the overall management of the financial system in China. Of note was the introduction of oversight from the PBoC of the financial system, though short of full central control. To date, various regulators have been able to head in their own direction with less than satisfactory results. There was much admonishing of state owned enterprises (SOE) for their debt levels and poor allocation of capital.

Such meetings rarely cause any immediate change, yet they portray recognition of the now well-known financial risk in China and the inevitable stop/start stimulus within an increasingly risky economy. Progressive opening of its financial markets to pricing in these risks through credit spreads, equity values and currency movements will stabilise rather than destabilise China in the longer run.

Fixed Income Update

- The futures market priced in an increased probability of rate hikes by the RBA in 2018, however, bond holders will have to wait before any benefit from the higher rates eventuates.

- New capital requirements from AFMA are credit positive for fixed income securities.

The unexpected reference to the RBA’s estimate of a neutral cash rate at 3.5% in its minutes this week, has the market debating the interpretation of this release. Given the global shift towards tightening monetary conditions, and the rate rise in Canada, significant to Australia given the similarities in the two economies, the argument that perhaps a rate rise by the RBA would also follow naturally atracted attention.

The overnight swap rate, which is a forecast of future fixed rates at a point in time, is constantly changing. The recent moves following the minutes factored in an increased probability of the cash rate being higher this time next year. This movement in the overnight swap rate, as depicted in terms of probabilities, marks a turnaround in sentiment in the last week.

The change in rate rise expectations over the last week

Source: Bloomberg, Escala Partners
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The  implications for fixed income securities is that long duration fixed rate bonds have been repriced slightly downwards, as yields on the 3 and 5 year governmnet bonds have moved a few basis points higher. For bonds with a floating coupon rate (ie, the coupon resets every 90 days in line with the market) the capital value will remain unchanged and any benefit of higher rates will be crystallised when the coupon resets.

However, as evidence from the chart above, the forecast for a rate rise is priced in as most likley in 2018 as opposed to the remainder of 2017. Therefore, while the longer end of the rates curve has moved upwards, interest rates on the short end of our yield curve have remained stable. The bank bill swap rate curve (BBSW) pricing in interest rate expectations out to 6 months, has barely moved following the release of the RBA minutes. The 3 month BBSW rate is the most widely used benchmark for the setting of the coupon on floating rate corporate bonds in Australia including bank hybrids. Therefore while floating rate securities have performed better than fixed rate bonds on a relative basis given they have not been repriced downwards, they will not benefit from a higher coupon rate until we also see a lift in the BBSW rate. This is most likely to happen as a rate rise by the RBA becomes imminent.

Bank Bill Swap Rates (mid) – 10 day history

Source: AFMA
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One of the biggest drivers of pricing in the ASX listed hybrid market is that of supply. In 2015 credit spreads on these securities widened as the banks raised additional tier 1 capital via the hybrid market to meet requirements set down by the regulator, APRA.  Increased supply pushed prices down as investors were encouraged to rotate to the new hybrid deals. This week APRA made a fresh round of announcements regarding the amount of capital that banks are required to hold. However, this time APRA focused on banks increasing their “Common Equity Tier 1” (CET1) capital, and not the type that is generated through the issuance of hybrids called “Additional Tier 1” capital (AT1). These changes are positive for bond investors, including holders of bank hybrids, as all bonds sit above equity on the capital structure and will therefore have a higher level of equity subordination protecting them.

Source: BondAdviser
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Corporate Comments

- The major banks scored a win from APRA’s announcement of new regulatory capital rules, although the sector continues to face earnings headwinds in the medium term.

- REITs have underperformed almost all sectors in the Australian market over the last year. While there are perfectly good reasons for this, the dividend yield gap on other bond proxies may see them get short term support from income-seeking investors.

- BHP’s production was poor in FY17, although profits and dividends will be materially higher for the year. If spot pricing were to persist, valuations for the diversified miners looks reasonable.

Investors in the major banks were buoyed this week after APRA finally announced its stricter regulatory capital requirements. APRA’s assessment was in response to 2014’s Murray Inquiry into Australia’s financial system, with a key recommendation from this report that our banks be “unquestionably strong” to reduce the fallout from any future financial crisis. APRA’s interpretation has been to lift the required minimum common equity tier 1 (CET1) capital ratios of the major to banks to at least 10.5% by 1 January 2020. Across the four majors, this equates to approximately $8bn-$9bn of additional capital by this date.

The surprise bonus for the majors in the announcement was confirmation from APRA that any further increases in mortgage risk weights (to refresh, the banks hold a reduced level of capital against residential mortgages as they are viewed as a lower risk than other lending) would be included in the new 10.5% level. This will be finalised after the delayed international Basel IV reforms have been announced.

The major banks have already been building additional capital in anticipation of the announcement. With APRA’s recommendation at the low end of expectations, the risk of large equity raisings in the medium term has now been all but discounted, with the banks likely to be able to achieve the required capital levels via organic means or, at worst, via dividend reinvestment programs (DRPs). Following recent asset sales, ANZ is currently in the best capital position of the majors and may even be able to return capital to shareholders in coming years. Commonwealth Bank (CBA) has the largest shortfall and so is most likely to implement a DRP.

This week’s APRA announcement has lifted a significant regulatory cloud that has been hanging over the banking sector for an extended period of time. The result is undoubtedly a positive one for the majors and will more than likely contribute to some short term positive momentum, which could be assisted by a rising bond yield environment and subsequent rotation out of Australian equities and sectors that are negatively affected by interest rates.

In our view, however the case for an overweight position in the banking sector is weak. Earnings across the sector is expected to be relatively soft in coming periods on benign credit growth, additional taxes, ongoing compliance and technology costs, and margins pressured by a high cost of funding.

A case can be made for the sector on relative valuation grounds, with the banks trading on a larger P/E discount to industrials compared to historic valuations. This, however, fails to recognise a weaker earnings outlook for the sector and the fact that lower provisions (bad debts) are currently inflating the bottom line. On a pre-provision basis, banks are actually trading on a P/E above their historic average (see following chart). Additionally, permanently higher capital requirements have led to lower return on equity and price to book values; current levels should be regarded as the new benchmark.

Banks: Price to Pre-Provision Profit

Source: UBS
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Real Estate Investment Trusts (REITs) have risen in the investment radar given the soft performance of the sector over the last 12 months. On a rolling year basis, REITs are clearly the second worst performing sector of the ASX 200 (after telcos), underperforming by approximately 20% over this time.

Several factors have been behind this outcome, although the key driver has clearly been the rise in interest rates, which was previously behind the preceeding multi-year strong performance (as we highlighted in our most recent quarterly asset allocation report). Some subsectors of the REITs market, however, have had other fundamental concerns. Most notably have been retail REITs, which have had the additional headwinds of benign retail sales, a highly indebted consumer and the threat of Amazon potentially reducing foot traffic and sales in coming years. In particular, through the last year Westfield (-28%), Vicinity Centres (-25%) and Scentre Group (-22%) have all come under pressure.

Some have the view that retail REITs can counter the online threat by restructuring the store composition and layout through moving towards tenants that are less at risk, such as food and those that offer entertainment. This is already the case, although there is also a finite limit as to how much can change and a higher rotation of tenants is likely to be a poor outcome in terms of lower lease security and occupancy levels.

Given the upside risk to interest rates from here, we have been and continue to be comfortable maintaining an underweight position across REITs and other interest rate sensitive sectors of the market in our Australian equities exposure. For REITs, the risk is that higher interest rates translate into higher capitalisation rates and lower valuations over time (the sector is currently trading at close to net tangible assets or NTA).

On a relative basis to the other key bond proxies (infrastructure and utilities), however, the forward yield premium on REITs is now more attractive than at any time in the last 18 months (illustrated in the chart). As such, while there remains longer term risks as we noted above, there is the possibility of shorter term upside if this yield gap where to close.

Interest Rate Sensitive Sectors: Dividend Yield Premium to ASX 200

Source: Bloomberg, Escala Partners
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Quarterly production reports from resources companies filtered through the market this week, including from diversified miners BHP Billiton and Rio Tinto. BHP’s quarterly production was broadly in line with expectations, although has followed a disappointing two years of operational performance. Three of BHP’s key divisions (petroleum, copper and metallurgical coal) reported a production decline for the 12 months, while smaller gains were made in iron ore and energy coal.

The chart highlights the soft production from BHP since FY15, where the group guided towards 5% total growth for the rest of the decade. All key divisions are lower on this period for varying reasons. Petroleum has deferred capex due to lower prices; copper has experienced lower grades and strike action at its key Escondida mine; iron ore has fallen due to the incident at Samarco; metallurgical coal has experienced disruptions from Cyclone Debbie and energy coal has dropped on asset divestments. Some of these factors will normalise in FY18 (BHP is forecasting 8% production growth), however a lower starting base has meant that BHP will have failed to fully capitalise on the more recent rebound in commodity prices in it FY17 results.

BHP: Production Decline Since FY15 of Core Commodities

Source: BHP, Escala Partners
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Nonetheless, the FY17 reporting period is still expected to show a marked improvement for BHP and its peers and the focus of the market has long shifted from large capex and production growth in favour of stronger balance sheets, higher dividends (BHP’s dividend is expected to be almost triple that of FY16) and shareholder returns. Capex and operational cost cuts, coupled with the recovery in commodity prices over the last 18 months has led to the diversified miners now trading at a high free cash flow yield of more than 10%. On this basis, the miners look to have relatively attractive valuations, although the downside, of course, is linked to softer commodity prices, which is currently the base case from sell side analysts.

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