Week Ending 21.10.2016
• Reconciling the recent direction of oil prices, the USD, inflation expectations and US economic activity is causing a headache for those who follow historic patterns. If the correlations revert back to ‘normal’ it implies a step change for one or more of these important economic factors.
• A number of notable dates loom large before year end. Of course, the US election receives most of the attention, then there is the Italian senate reform referendum, the ECB meeting on December 8 where key decisions on their asset purchase programme will be announced and the Fed will decide on rates on December 13-14.
• Locally, household financial welfare is tied to their high debt levels. While debt servicing costs are low, the value of assets (housing) supporting that debt is one of the larger risks. Any fall may see consumption growth crimp from its already subdued levels.
The direction of the oil price potentially signals two transitions. If oil prices rise, so too will inflation and in turn, this will have a meaningful impact on interest rates. Bowser prices are one of the most powerful drivers of inflationary expectations due to the high frequency of purchase, non-discretionary nature and prominent price display at petrol stations. Over time, oil prices also affect transport costs and therefore goods pricing. This is illustrated in the correlation between inflation expectations and crude prices. If the oil price does fall, it would translate into lower bond yields as well.
The storyline continues into exchange rates. Locally, the usual focus is on the AUD/USD and in the case of the US, the euro and yen receive the most attention, yet these are not representative of the cross currency economic exposure. Within the US Trade Weighted Index (TWI), the Chinese yuan is 22%, the euro 17%, Mexico peso 13%, Canada dollar (CAD) 12% and the Japanese yen at 6%. Ten years ago the yuan and euro were equal at 17%, CAD was at 16%, the peso 10% and Japan just below at 9%. The USD has been stronger against the Chinese yuan, the Mexican peso and the Canadian dollar, while stable against the Euro and therefore has been rising against its TWI.
A strengthening dollar has a high inverse correlation to the oil price, in this case Brent, representative of global pricing, rather than West Texas Intermediate. The reasoning is that, as the most commonly traded global commodity, the US dollar denominated oil price has to adjust to its own ‘trade weighted index’, representing the currencies of the major consuming countries. Recently, this close relationship has broken down somewhat and implicitly the US$ has to weaken or the oil price fall. Of course, this adjustment could come through the yuan, peso and CAD as mentioned above, but these patterns cause a heighted degree of uncertainty in interpreting the familiar ground of financial markets.
Adding to the confusion is the rebound in activity in the US. Existing home sales, housing permits and factory business outlook all showed better trends through the week. The likelihood of a December rate rise therefore gains credit, which should, all else being equal, result in a stronger dollar. Not so fast, say some, pointing to the strengthening yen in the face of monetary easing there as evidence rates alone don’t always set the tone. The USD may indeed weaken, mostly as it is judged to be overvalued against the GBP and euro. Even the yuan devaluation has run its course in the short term.
Turning to Europe, the ECB essentially said nothing at its meeting this week. Expectations are focused on December 8 when it releases its forecasts and tackles what and how much asset purchases it would pursue post March 2017 when its current mandate rolls over. The most anticipated Fed meeting of the year is on December 13-14 and these events are likely to keep many bond traders at their desks rather than enjoying Christmas cheer.
Australian employment data for September showed another month of an uncomfortable trend. Part time jobs were up 43k, but offset by a big fall of 53k in full time employees. The participation rate unhelpfully eased as well, implying further slack in the labour market. While employment has been improving from the weak conditions of 2014/15, these data suggest much of that trend has run its course. A low full time employment rate is likely to hold down wage growth and inflation, leaving the door open for a rate cut. Next week’s CPI release will get close scrutiny.
In his early speeches as the new governor of the RBA, Lowe appears to be taking a slightly broader approach in interpreting economic conditions. In particular, the private sector balance sheets weighs on any decision given the very high leverage in the household sector. Along with the Fed comments in the US, tolerance around inflation is the new language, as central banks grapple with the sensitivity to rates from high debt levels.
In the RBA minutes, after the decision to leave rates on hold at this month, comments on the household sector were mixed, though the members noted that households perceive their personal finances to be in good shape. Many economists beg to differ, pointing out that while debt servicing was at a comfortable level, repayment of debt principal was another matter. In particular, the huge flush of investment property purchases in recent years may test the presumption of financial welfare if prices do fall. Rental growth has levelled off and may come under pressure as the volume of apartments in the pipeline comes to fruition. Without a tax break, these assets don’t stack up from a cash flow perspective and if some distressed or frustrated selling comes through, it will quickly exacerbate the supply issue.
Fixed Income Update
In this week’s publication we examine:
• Central bank policies and the implications for the shape of the yield curve;
• The largest ever bond sale from an emerging market nation; and
• Tatts and Tabcorp listed debt securities.
The yield curve in any market is charted by drawing a line through yields on government bonds with different maturities. In the US, three month treasuries out to 30 year bonds are often used. In a ‘normal’ environment this curve is positively sloped, as issuers pay a higher premium to lock in funding for a longer term and investors are compensated with a term premium for taking the long dated risk on the issuing entity and the expected level of interest rates (forecasted using inflation and growth expectations). In contrast, an inverted yield curve, where longer term rates are lower than the short dates, is a sign that the market expects tighter monetary and economic conditions, consistent with a recession.
Over this year, there has been a flattening of yield curves in the developed world, as long dated bond yields have compressed. Quantitiative easing (QE) programmes by the ECB, Bank of England (BoE) and Bank of Japan (BoJ) have weighed on long dated bonds, coupled with expected slow global growth and low inflation.
A fall in long dated bond yields in the US has been occuring while rates on the short end have been rising. Expectations that the Fed will raise rates in December this year (priced with a probability of 70%), together with money market regulatory changes have pushed up Libor rates (discussed in previous editions), contributing to this flattening of the yield curve.
Historically, a flattening of the curve has been a prelude for an inverted curve, which is often a warning sign to markets that there is the risk of a further slowdown in economic growth. This has happened before in each of the last seven recessions. While the yield curve in the US has only flattened and not yet inverted, it is unlikely that this is a sign of a recession, but instead, according to an article this week, “a disentanglement between financial markets and macro-economics”. To highlight this flattening in the US curve, the spread between the two year and 30 year treasury is trading in its lowest range since 2008. The spread differential between the two is charted below.
Spread Between 2 Year and 30 Year Treasurys
Central banks have often been blamed for the flattening of yield curves through their policies. Now it is central banks that are looking at ways to undo this trend and restore yield curves to being more positively sloped. Steeper yield curves improve net interest margins for banks and aid fixed income funds that can buy longer dated bonds and enjoy a price lift as bonds ‘roll down the curve’. The BoJ has got the ball rolling and moved to a ‘yield targeting’ (effectively a set price) when buying its 10 year government bonds under its QE program, anchoring the yield on this part of the curve. The short end is already determined by interest rate settings, so the central bank has effectively set the yield curve and engineered the shape and steepness. Since the implementation of this policy, the yield on the 10 year in Japan has been range bound.
Ten Year Japanese Government Bond Yields
The ECB and BoE are yet to implement such policies, but market commentary suggests that everything is being considered. In the US, some experts are of the view that the Federal Reserve will be comfortable to see inflation pick up and even overshoot (which would push up long dated bond yields), rather than by raising rates too quickly and crimping growth.
This week, history was made by the Kingdom of Saudi Arabia, with the biggest ever bond sale from an emerging market nation. The Moody’s A1 rated government raised $17.5bn in USD denominated bonds of varied maturities, with investors submitting $67bn in bids. The pricing was said to be tight for this rare issue. This followed a $16.5bn offering from Argentina earlier in the year, indicative of the demand for yield and the strong appetite for emerging market debt.
Domestically, it was announced that Tatts Group and Tabcorp are to merge. Both entities have outstanding bonds listed on the ASX (TTSHA and TAHHB). These bonds have differing terminology for treatment in the event of a change of control. Increased volatility may prevail in these bonds as details become more clear. Holders of these securities should discuss options with their adviser.
• The proposed merger between Tabcorp and Tatts Group appears to be beneficial for both sets of shareholders.
• Crown Resorts’ (CWN) announcement that a number of its employees had been detained in China is a setback to the listed domestic casinos, however the share price falls this week have implied an overly pessimistic outcome.
• The medium term outlook for Sydney Airport (SYD) continues to be positive, driven by passenger growth, although the bond market is likely to determine the share price in the short term.
• Several companies reiterated guidance at their AGMs this week, however a there was a surprise downgrade from Healthscope (HSO).
Tabcorp (TAH) and Tatts Group (TTS) agreed to a long-awaited merger this week, coming less than 12 months after the most recent discussions were called off. Rather than the ‘merger of equals’ proposal that was on the table last year, TAH’s recent relative strength has allowed it instead to make a bid for TTS, no doubt helped by the NSW Government’s decision to overturn its ban on greyhound racing and Tatts’ court loss against the Vic Government (for compensation for the loss of its poker machine licence in the state). The reward for TAH is the CEO’s position of the combined entity. Tatts shareholders are the short term winners, however, with a sharp spike in the company’s share price this week. The deal is effectively a reverse takeover, with TAH shareholders to own 42% of the combined entity.
The motivation for the combined TAH and TTS has been well understood for a long time, with substantial synergies from bringing the groups together. TAH has estimated these at up to $130m p.a. on an EBITDA basis, approximately 13% of the FY16 EBITDA of the two companies. This is after an additional $50m p.a. in additional funding to the racing industry, with cost savings largely from integrating their respective wagering businesses. TAH would also look to improve the recent underperformance of TTS’s wagering division, which has recently been relaunched as a new brand, UBET. UBET’s fixed odds yield has lagged that of TAH, with this margin increasing to 2.6% in FY16. The table below illustrates how the combined group will have a balanced earnings profile from wagering, lotteries and gaming services.
Tabcorp, Tatts and Combined Group FY16 Pro Forma EBITDA
With the Tatts board agreeing to the deal, along with a number of major institutional shareholders, the key hurdle from here will be obtaining the necessary regulatory and competition approvals. The ACCC looms as the most difficult of these, as the competition regulator had previously knocked back TAH’s bid for the UNiTAB business in 2006, which was subsequently acquired by TTS. The market has evolved considerably since then which would have reduced these competition concerns, with a sharp increase in international bookmakers into the Australian market, which have taken market share (estimated at close to 40%) from the large parimutuel operators. The transition to online wagering and via the smartphone medium has also been a significant development, resulting in a large expansion of wagering in Australia.
Overall, the deal looks to be a rare win-win for the acquirer and the target, which has also been reflected in a lift in TAH’s share price. The combined group will be in a stronger position to absorb the higher levels of competition in wagering, while earnings are underpinned by long-dated licences across lotteries and wagering. The combined entity’s targeted 90% dividend payout ratio and a proposed share buyback also plays into the market’s appetite for yield.
The gaming sector was a focus for investors this week with the three major casino operators in the spotlight due to the announcement that 18 of Crown Resorts’ (CWN) staff had been detained in China resulting in a sharp correction in the share price of CWN, while Star Entertainment (SGR) and SkyCity (SKC) also fell to a lesser extent. Few details have been forthcoming from the Chinese Government, though it is speculated that the arrests had been made for the illegal solicitation of VIP (high roller) clients within China.
The rise of the Chinese consumer has been an important tailwind for the success of casinos in Australia, including from ordinary tourists who have a high propensity to visit the various properties in the major cities. The high roller VIP businesses of the big casinos has provided a further leg of growth, particularly given Australia’s relative proximity to mainland China. A corruption crackdown in Macau has also provided a boost in recent times, with significant growth experienced over the last 12 to 18 months.
It is more than likely that the events of this week will impair this trajectory. For CWN and SGR, VIP revenue accounts for approximately a quarter of group revenues. In a presentation today, SKC noted that VIP revenues were 15% of group normalised revenue in FY16. For each of the three operators, approximately half of this business is from mainland China customers.
The potential earnings impact, however, is mitigated to a degree as this business is typically lower margin than the main gaming floor, due to the high costs and incentives involved in luring big spending clients. Earnings can also be more volatile, with profit swings on a few successful hands. Taking this all into account, the direct earnings exposure to Chinese high rollers for the Australian operators is in the mid to high single digits, with share price declines this week implying a more pessimistic outcome than what should be anticipated.
One of the key underlying trends which does help the investment case for the casino stocks is the growth (at double digit rates) in inbound tourism from China and the south east Asian region, particularly given their higher propensity to gamble. The ongoing positive outlook for this theme is core behind our recommendation of an investment in SGR. While CWN shares have suffered more this week, the fact that its new Sydney casino at Barangaroo specifically caters for VIP clients would call into question the viability of this investment going forward and hence a degree of caution for prospective investors.
Sydney Airport’s (SYD) investor day confirmed the positive momentum from south east Asian visitors, with the fastest passenger growth rates from these key markets.
Sydney Airport: Key Market Passenger Growth
While the company’s presentation highlighted the positive medium-term outlook for top line growth driven by these passenger numbers, the limitations were also noted. The airport is currently operating with 32% free capacity in terms of aircraft movements, however much of this unutilised space is during off peak periods, particularly in the early morning.
The construction of a second airport in Sydney’s west will help to address this issue for the city. SYD has the first rights of refusal to develop the project, with a ‘notice of intention’ contract expected to be delivered to the company before the end of the year.
Like many infrastructure stocks, SYD’s share price has been weaker over the last two months, with a rally in bond yields leading to a sell-off in bond proxies across the market. Given strong underlying earnings and distribution profile, SYD may fare better than many of these other companies on a relative basis should yields climb higher over the following six to 12 months, however this remains the key risk for the stock.
AGM season kicked into gear this week, with commentary from several companies somewhat weaker than anticipated. Few companies were willing to provide guidance to the market in August alongside their full year results, leaving it for the AGMs to update on current trading conditions. Below we highlight some of the more notable updates:
- Hospital operator Healthscope (HSO) was a surprising candidate to disappoint on its guidance for FY17 after it said that it expected that its EBITDA for its core hospitals division to be flat year on year. With consensus forecasts of growth in excess of 10%, the stock was heavily sold off. Trading on a P/E in the mid-20s, the stock left little margin for error, similar to much of the healthcare industry given the defensive growth characteristics expected from the sector. HSO noted issues over healthcare affordability and consumer confidence in private health insurance in Australia. The announcement today highlights that while there are several positive long-term investment themes across the market (in this case, the ageing population), growth patterns are rarely smooth and can experience setbacks at various times.
- Aged care operator Japara Healthcare (JHC) reiterated its guidance for a similar rate of earnings growth in FY17 as to that of FY16 (+11%). This provides some comfort for its shareholders and that of Regis Healthcare (REG) that the issues related to the recent downgrade of Estia Health (EHE) are more company-specific and not industry wide.
- Amcor (AMC) reaffirmed its guidance for FY17 growth in constant currency terms. Notable was the confirmation that the company expects its flexible division (which represents approximately two thirds of group sales) will deliver ‘particularly strong earnings growth’ for the year. The stock remains a solid core industrials holding, with moderate earnings growth supported by a mix of organic growth and small bolt on acquisitions made over time.
- Commentary from Spotless (SPO) was weaker at the margin. While SPO again stated that FY17 will be a transitional year for the company as it resets is business, a forecast that earnings will be more skewed to the second half than usual raised some concern. Trading on a P/E of just 8X on rebased earnings, SPO continues to screen well on a value basis, although greater evidence of a turnaround in the business will likely be required for a re-rate of the stock.