Week Ending 22.01.2016
In another volatile week in investment markets, economic news was largely unhelpful.
Even 6.9% GDP growth for China in 2015 was not good enough, attracting headlines as the lowest run rate in many years. Fixed asset investment declined to 10% growth from 15.7% in 2014, with property investment rising by only 1% from 10.5% in the previous year. Retail growth was conversely stable at 10.9% (10.6% in pcp).
Monetary easing is unlikely to increase the pace of consumption and it remains to be seen if China reverts back to its traditional areas of growth such as property and large scale infrastructure. On the other hand, growth in service consumption is likely to be sustained for some time.
Services as a % of GDP
The aim in the short term appears to be stability in foreign exchange markets. To that end, the PBoC (Peoples Bank of China) has placed some restrictions on offshore banks’ RMB (renminbi) deposits in order to restrain the degree of speculative positions, particularly shorting, in the currency. This may prove counterproductive if banks no longer transfer deposits, therefore tightening capital flows at the very time they are required. Most observers believe it is in China’s longer-term interest to devalue the currency to its assessed fair value, some 5-10% below current levels.
One of the repercussions of weak global growth and China in particular, is the decline in global trade. The latest data to the end of October suggest that world trade volumes are growing at just 1.4%, down from nearly 3% in 2014. Emerging markets are naturally at the forefront of this given their tendency towards exports. Korea released data this week showing an 8% decline in volume in the early part of this year.
The imbalance in current account surpluses, mostly centred on oil exporters and those with large export sectors such as China, Korea and Germany, has largely run its course. With much of those savings reinvested in financial assets and contributing to the low interest rate environment, this transition will impose a shift in the dynamics for bond market and currencies. There is much discussion in financial markets on a ‘savings glut’. The contributors have been these surpluses as well as the low level of investment by the corporate sector. In turn, it is reminiscent of the Japanese outcome: export surplus, very high levels of domestic saving, low inflation and inevitable fiscal deficits. Whether this implies a persistence of the low interest rate phenomenon is even being debated by members of the Fed. If so, it also suggests higher investment valuations can be supported, but as the underlying growth rate of those investment will be weaker, the return will also be lower than before.
US CPI fell by 0.1% in December, unsurprisingly dragged down by energy costs. Other segments such as food fell back too, though that is after a surge in the corresponding period of 2014. Imported goods, such as apparel, electronic products and vehicles were held back by the stronger US$. Conversely, local prices represented by food away from home (up 2.6%), medical costs (up 2.9%) and rent (up 3.7%) are indicative of the pressures in domestic costs.
Closer to home, New Zealand CPI was also unexpectedly weak at -0.5% for Q4 and 0.1% for the year. Food prices have fallen 1.3% year on year, transport costs are down 6.9% and telco charges reduced by 5.4%. The only sectors with a meaningful price rise were housing and utility costs (+3.2%) and education (+3.6%). A notable feature is the lack of inflation in imported goods, such as apparel and electronics. It appears that suppliers have absorbed a good part of the US$ currency move, though that is probably due to the sourcing through Asian currencies which have weakened in line with the NZ$. The Australian CPI, due on the 27th, will more than likely show much of the same pattern. A weak CPI, however, is unlikely to be sufficient to change the direction of the RBA given the causes of low inflation and the relatively solid trend in employment.
This battle against low and falling inflation is likely to occupy much of the first half of the year. The partial recovery in investment markets towards the end of the week came off comments by Draghi hinting that the ECB may undertake further measures in its forthcoming 10 March meeting due to the deterioration in the inflation outlook.
Fixed Income Update
Given the often negative correlation between the bond market and the equity market, it is no surprise that Australian government bonds have benefited from this year’s downturn in the share market. While bond prices have risen across the curve, the moves have been more pronounced in the long end. Yields have fallen (bond prices up) ~15bp on the 5 year and 10 year bonds since the beginning of this year.
Australian 5 and 10 Year Government Bond Yields
Prices have also risen, albeit to a lesser extent, in the short end, as rates are anchored by the RBA’s monetary policy. While in theory the futures market is now fully pricing in a 25bp rate cut by the RBA by mid-year (up from a 49% probability last month), many market participants are of the belief that the RBA will be reluctant to do so. The short end yield compression is perhaps more a reflection of the current ‘risk off’ sentiment in markets rather than any real potential for a rate cut this year.
In contrast to government bonds, credit spreads are positively correlated with the equity market. Since the beginning of this year spreads have widened out across all credit products, yet in the last week there has been a growing divergence between investment grade credit and the high yield market. Spread widening on investment grade products has been mild, while the lower end of the quality spectrum high yield has continued to push significantly higher. The average yield of US high yield bonds has climbed to over 9 per cent this week, the highest since the peak of the Eurozone crisis in 2011.
The listed hybrid market has not been exempt from the heightened volatility. However, as volumes remain low because of the time of year, price moves have often been exaggerated, causing gapping in a few securities. Price disparities exist between similar named bonds with the same maturity profile, opening up good switch opportunities for those happy to trade.
Concerns regarding China has been one of the catalysts for weakening in global asset prices, and the emerging market (EM) sector in fixed income has been adversely affected. China’s role in global trade means a weakening renminbi puts pressure on other EM currencies. While this is good for EM exporters as their goods are more competitive, the weakening currency makes paying their foreign currency debts more difficult.
Concerns for debt markets relates to the amount of foreign currency debt that EM companies have raised in the last few years. This debt is split into those denominated in foreign and local currency. Issues raised are:
- Foreign currency debt for EM companies rose from $900bn to $4.4tn over the last 10 years. A devalued local currency makes paying these foreign currencies more expensive.
- Local currency debt has risen from $4.5trillion to $20 trillion, presenting a compound growth rate of 16%, well above the rise in GDP. Unless banks can self-fund in their own country they have potentially higher global funding costs.
- Local bank lending is also affected by weakening economic growth, sector-specific risks such as those afflicting raw materials and manufacturing industries in many EMs, and market volatility.
The chart below depicts the surge in EM corporate debt over the last 10 years.
While this trend is concerning, it should be noted that the emerging market sector is made up of a large number of countries and not all of these are suffering the burden of this debt obligation.
Several of the larger resources companies filed quarterly production reports this week. Unsurprisingly, given a backdrop of almost universal commodity price weakness, the focus at present is on maximising cash flow, cutting costs and protecting balance sheets, with growth opportunities taking a back seat.
BHP Billiton’s (BHP) report reiterated its full year production guidance for petroleum, copper and coal. An anticipated downgrade to iron ore was the result of the incident at its Samarco mine in Brazil late last year, with operations now suspended. Nonetheless, in the December half, BHP recorded lower production across four of its five key divisions: petroleum, copper, metallurgical coal and energy coal. Growth across its Pilbara iron ore assets was the standout, with ongoing expansion resulting in higher volumes. The pace of the company’s volume growth in iron ore is forecast to slow this year, into a market that remains well supplied.
The lack of any discussion on its upcoming half year dividend was interpreted by many that it will be prioritising its balance sheet over maintaining its progressive dividend policy. While the sustainability of its dividend has deteriorated materially over the last 12 months following the collapse in commodity prices (particularly iron ore and oil), it is only in the last couple of months that analysts have belatedly begun to cut dividend forecasts. A dividend cut of 50% or more is entirely possible when the company reports its half year result, or the company may hold off until the second half. The following chart illustrates the earnings per share and dividend revisions for FY16 and FY17 since mid-2015.
BHP Billiton: Consensus EPS and DPS Revisions (USc)
To date, BHP has largely used cuts to its capital expenditure budget to balance its cash flows. Further cuts are likely to occur again at its half year results (its US shale energy operations an obvious candidate), yet this alone will not be sufficient to balance its cash flows and protect the company from rising debt levels. BHP’s own forecast for capital expenditure for FY16 is presently US$8.5bn. Its estimate of sustaining capex is US$2bn p.a., however it perhaps needs to spend this much again each year to offset grade decline and maintain its production levels.
At spot prices, most analysts would still conclude that BHP is trading above its valuation. The consensus view, however, is that a medium term recovery will eventuate in some commodities towards ‘long-run’ price assumptions, with copper and oil the two most likely. Slowing global growth and the peaking of iron ore consumption in China has pushed out the date when this may occur, with the low-cost nature of its asset base allowing the company to withstand the current environment much better than most. We believe that a position in BHP is the best way to participate in global metals demand growth, although acknowledge that its much smaller weighting in the broader index (now less than 3.5%) has reduced its case as a core holding in Australian equity portfolios.
With a more diversified commodity exposure compared with Rio Tinto (RIO), BHP is our preference among the large cap miners. In the short term, however, Rio appears to be better placed without the distraction of Samarco, no oil price exposure, a lower starting point for its dividends and a reasonable balance sheet.
South32 (S32) is the other diversified mining company of particular note on the ASX. Its portfolio of assets, as we have previously highlighted, are reasonably strong, however it has largely become a marginal cost producer in the current environment. With operations that are barely break-even at current prices, the company’s quarterly report demonstrated its ability to pay down debt in the December half.
The company now has little debt, placing it in a good position to see through the current period of turbulence in commodity markets, although the prospect of any meaningful dividend payments in the short to medium term is low. We have the stock in our model portfolios as a complementary investment to BHP with its different commodity exposure.
Two separate announcements this week confirmed relatively buoyant conditions in Australia’s tourism market. Sydney Airport’s (SYD) traffic data for December showed 5.6% growth in domestic compared to a year ago, while international passenger growth was 8.6%. Continued passenger growth is the key to rising distributions from SYD as it leverages this through increased retail, property and car parking revenue.
Foreign nationality traffic grew at just under 10%, with the benefits flowing through from a weaker AUD. Chinese passenger growth (+31%) continues to be a key driver of this result. China’s transition from an investment-led, commodity-intensive economy to one that is more based around consumer growth will thus translate into certain opportunities in the Australian market, and SYD appears to be an obvious winner from this change. Confounding some views, the weaker AUD has not deterred Australians from travelling abroad, with passenger growth of 7.6% in this category. The relative safety of SYD has led to clear outperformance amid the recent volatility in markets, although we would caution investors holding large positions given a somewhat elevated valuation.
Casino operator SkyCity (SKC) also released a positive trading update, with a forecast first half profit expected to be up to 29% higher than the previous year. With its key casinos in Auckland and New Zealand, the result provided a positive read-through for other listed gaming stocks, including Star Entertainment (SGR) and Crown (CWN).
A key part of the improved result has been strong conditions in its high-roller business. With all domestic casinos reporting solid high-roller figures in the last 12 months, it was thought that the cycling of these comps may prove to be a challenge in FY16. SKC’s performance, however, showed an approximate 50% increase in VIP turnover in the period; further evidence of the local market continuing to benefit from Macau’s crackdown on corruption. We have SGR in our model portfolios.
Treasury Wine Estates (TWE) is another stock that is a beneficiary of consumption trends in China and other emerging Asian countries – the company has forecast that its Asian division will be the biggest contributor to its profit by FY17. The company this week upgraded its first half profit forecast to 20% ahead of consensus expectations, with shipments into the Chinese New Year boosting the result.
Patient investors have been rewarded with TWE’s performance in the last 12 months, with a remarkable turnaround in the company’s fortunes and earnings aided by a falling AUD. TWE even gained credit for making an acquisition, a factor which has seen it run into trouble in the past. In our view, while the momentum in its business and share price may continue in the short term, a forward P/E in excess of 25X leaves little room for disappointment, particularly for a company that is exposed to cyclical agricultural trends and has struggled to deliver on its strategy in the past.
Woolworths (WOW) bowed to the inevitable with a decision to cut its loss-making Masters business. The path to achieve this outcome is complex, first involving a buyout of the stake held by its joint venture partner, Lowes (US), with the price to be determined by independent experts. This will be followed by the liquidation or sale of the assets. We see estimates of the final realised value ranging between a negative $200m to a profit of $500m. The predominant variation will come from the value of property, plant and equipment and working capital. There will also be a tax benefit depending on the ultimate proceeds achieved. In all cases, WOW’s future earnings will be higher simply due to the elimination of the operating losses from Masters.
However, even those bullish on the proceeds from closing Masters are cautious on the prospects for the group. All feedback suggests the supermarkets have lost further ground into the 2015 year end. Without a CEO, the strategy for this business cannot be formulated. Whatever it is, it will likely take some years to implement and will confront a dogged Coles and an expanding Aldi. There is every chance the combination of capital requirements in store, staff costs to improve service standards and changes to product pricing, will result in falling margins in coming years.
While acknowledging the difference in structure, UK food retail, under attack for some years by discounters, is now averaging around a 3% EBIT margin for the mainstream participants (Tesco, Sainsbury, Morrisons). Woolworths’ margins are expected to settle around 5% compared to above 8% at the peak. The loss of cash flow is not insignificant and the valuation should reflect that.
There may well be a time to invest in WOW, we however find that hard to judge the risks given lack of management and strategy. Outside the exposure from our recommended SMA providers, we would not hold WOW directly.
The offset is the possible benefit Wesfarmers (WES) will gain from the closure of Masters. It will be interesting to see if the ACCC takes a view on store acquisitions by WES. Traditionally, the regulator has analysed local catchment competition rather than country wide. In that case, WES would be able to fill its geographic position with select Masters stores. Otherwise, a buyer for the whole business seems unlikely. Metcash would be keen to lift its foothold on hardware retail, but it may struggle to fund this without external capital with a cloud over its balance sheet and yet to be proven turnaround for its food wholesale division.
In recent years, the performance of Bunnings has been the golden division of WES. The possible addition of domestic market share would add to that, though one should bear in mind that the hardware category is in good part discretionary and therefore vulnerable to any deterioration in consumer sentiment. As we noted last week, the likely entry of WES into the UK homeware sector is being viewed with caution, with the evidence of success likely to take a number of years.