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WEEKEND LADDER

A summary of the week’s results

22.03.2019

Week Ending 22.03.2019

Eco Blog

- Optionality on using debt to bolster growth has been diminished by the rise in aggregate leverage. Higher gearing can make sense if it does result in a growth dividend and often comes with disciplined oversight from the buyers of the debt.

A common macro feature that investment managers in all asset classes note is the high level of aggregate debt across almost all developed economies.  There is a uniform view that this will be a drag on long term economic growth, while also avoiding investment in any sector or company judged to be too dependent on leverage. In the past ten years, total global debt has increased, rather than the deleveraging cycle that was envisaged. Further, the pace of re-leveraging has been higher in the past five years, reflecting the low rates and loss of memory muscle on the trauma caused by the events of 2008/9.

A counterpoint is that a rise in debt can be beneficial in the short to medium term. Locally, the well-known increase in household leverage had a positive impact on GDP via activity in the housing sector.  The problems are invariably further down the track when the debt servicing requirement rises (either via higher rates or insufficient income), or the value of assets that were bought or created lack fundamental support.

The chart illustrates the debt components of developed economies. In the household sector, Australia is the standout, along with a notable number of northern European nations. It is of note that in countries with troubled levels of government debt, the household sector can be conservative, such as Italy or Japan. Concerns on household leverage are by exception rather than the rule.

Financial firms are relatively constrained (high levels for Luxembourg and the Netherland are a function of the location of financial services companies rather than their domestic economies). Banking services are, by nature, leveraged, but now with ten years of regulatory oversight, have been required to hold substantial capital in reserve. Aside from lingering non-performing loans and elevated costs in some parts of Europe, organisations such as the Bank of International Settlements (BIS) and the International Monetary Fund (IMF) generally express comfort on the capacity of banks to handle a downturn. Part of the case is that the bulk of bank funding is locally sourced. Australia learnt that hard lesson in the downturn.

Debt as a percentage of GDP for developed countries (%)

Source: BIS IMF
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Households (HH), Financial Firms (FF), Non-Financial Firms (NFF), Sovereigns (GOV).

Two segments that attract the most attention are the non-financial corporate sector and governments.

Defaults in government debt are relatively rare, though in the post war to 1980 period there were almost none. High government debt, as evidenced by Japan, has no predictable default, even if the implications for growth are transparent. There are now those advocating for governments to issue debt, more or less at will, to support their economies. It may make sense for some countries such as in Northern Europe, but ironically, these resist any fiscal expansion.

To put the numbers in the following chart in context, the US will borrow $1tr this year to fund its deficit; total defaults of $500bn is therefore a relatively small number and include those that have not been resolved from previous years.

Sovereign defaults by creditor class

Source: BoC-BoE database
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The corporate sector is under scrutiny. Almost all fund manager meetings feature a comment on US company debt levels, particularly at the riskier end. This spotlight has helped as the high yield sector shows signs of debt reduction. Nonetheless, the party is over and is one of the issues that is expected to hold back US earnings growth in coming years. Debt costs are turning into a headwind and enhancing EPS through buybacks is anticipated to ease.

  • High debt will, amongst other structural features, hamper growth for the coming decades. This partly underpins a view that investment returns will therefore also be lower. Another consequence is the crowding into and pricing of ‘high quality’ balance sheet companies. In turn, so-called value stocks have struggled to recover any ground.

Investment Markets Update

- Boeing’s share price has come under pressures (down 7%) since the Ethiopian Airlines plane crash on March 11th. This has various degrees of impact on particular indices depending on Boeing’s weight.

Of the three main indices in the US, Boeing is in the Dow Jones and the S&P500, but with a significant difference in the weights. The Dow Jones is weighted by the prices of its constituents, therefore, stocks with higher prices have a greater influence on the performance of the index. Currently, the largest weighting is Boeing and its price move accounts for 10% of the index on any given day compared with less than 1% of the movement in the S&P500. Unsurprisingly, this heavy concentration in Boeing has seen the Dow Jones lag both the S&P500 and Nasdaq in recent weeks, highlighting the impact a single stock can have if it is a large component of that index. Changing the weights of the DOW from price-weighted to market capitalization significantly alters the composition.

Indices can also be constructed differently despite following a similar underlying methodology. iShares Global 100 ETF (IOO) replicates the S&P Global 100 index, which is a market capitalization weighted. The name implies it follows the world’s 100 largest companies, yet this is not entirely the case. The index measures ‘the performance of 100 multinational companies drawn from the underlying index, whose businesses are global in nature and that derive a substantial portion of their operating income from multiple countries’. While the index is weighted by float-adjusted market capitalization, the construction of the index includes a global filter whereby at least 30% of revenue and 30% of assets need to be located outside of the domicile region. Through this filter, 8 of the world’s 20 largest companies are not included in IOO. Using Boeing again as an example, it’s the largest in the industrial sector in the MSCI ACWI, however, it is not represented in the S&P Global 100 index.

MSCI ACWI v S&P Global 100 Top 20 weights

Source: S&P, MSCI, Escala Partners
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Fixed Income Update

- The US Federal Reserve keep rates on hold, but a change in sentiment drives bond market pricing. 

The Fed meeting moved markets this week. Despite keeping rates on hold (2.25-2.5%) the dovish tone was more elevated than expected, indicating rates will be on hold this year and only one rate rise in 2020. The FOMC’s guidance on ending the balance sheet asset runoff remained as expected, with a reduction in monthly change in Treasury holdings from $30bn to $15bn starting in May, and to conclude the reduction at the end of September.

Expectations for interest rates are derived through the Fed members’ interest rate predictions which are dotted on a chart (dot plot). Late last year the medium projection from policymakers showed two rate hikes in 2019. As noted, this has now been scaled and the new dots indicate a more dovish view from the Fed, but still more bullish than the bond market which is pricing in rate cuts in 2020 (@50% probability). Throughout this cycle the bond market has consistently under-priced the number of rate rises compared to the Fed’s dot plots.

US Dot plots from latest FOMC meeting

Source: Federal Reserve, Escala Partners
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The reasons for the shift in sentiment comes as the central bank downgrades its expectations for US growth from 2.3% in December to 2.1%. Rising concerns on the US-China trade deal are likely to have been considered, as well as US household response to rising interest rates. It is not unprecedented for the Fed to alter rate forecasts from one meeting to the next. In March 2016 the current year’s median dots fell 50 bps in response to economic fears emulating from a potentially “hard landing” in China.

Post meeting, the immediate price reaction within fixed income was a sharp rally in US Treasuries (yields fell ~0.10% across the curve), taking the US 10 year to its lowest level since January 2018, despite the 4 rate rises in 2018. When we consider the impact on recommended fixed income funds,  a good estimate is to multiply the spread move (in basis points) by the average duration of a bond fund.  The Pimco Global Bond fund has a duration of ~5.5 years and therefore this overnight rally added ~0.55% in return through capital appreciation of its bonds. Similarly, the duration on the Legg Mason GOFI fund is 6 years, in theory gifting a 0.6% uplift.

Initially the USD fell, although the weakness wasn’t sustained for long. A sustained depreciation in the USD will be beneficial to emerging market’s currencies and their bonds that suffered as the US tightened monetary policy last year. For credit assets, the response so far has been muted, with a tightening bias.  The likely direction for credit spreads is unclear. On one hand lower interest rates equates to reduced borrowing costs for corporates. On the other, profitability concerns are heightened as the outlook for growth is less certain.

Domestically, yields followed the US treasury market lower, albeit not to the same extent with a better than expected employment acting in the opposite direction. That said, the Australian market has rallied considerably more than the US this year as rate cuts by the RBA were priced in. The Australian 10 year rate sits below 2% (c. 1.87%), at its lowest level since September 2016. The resistance to trade even lower in line with US treasuries may indicate we have reached a floor on rates for now, with yields likely to consolidate into a trading range.

Australian 10-year bond yield

Source: Escala Partners, IRESS
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  • In the short term, there is a high probability that rates on hold in both regions. However, the medium-term direction of interest rates in both the US and Australia is unclear, and a case can be made for a movement in either direction. This makes asset allocating a challenge. When conviction on rate calls is weak, the inclusion of both long and short duration style strategies is recommended.

Corporate Comments

- TPG Telecom (TPM) produced a reasonable half year result, although the immediate investment case depends on the regulator’s view of its proposed merger with Vodafone.

- The Australian drought has hurt Nufarm (NUF) with balance sheet issues in focus despite a recent capital raising.

- Westpac (WBC) has withdrawn from the financial advice side of wealth management, an area in which the major banks have struggled to make an adequate return.

TPG Telecom (TPM) remains a company in limbo as it awaits the ACCC’s determination on its proposed merger with Vodafone (the regulator expressed some initial competition concerns late last year). In the meantime, the profitability of its core broadband business continues to be exposed to the structural headwinds created by the nbn, with ongoing margin contraction from markedly higher access costs and competition putting a lid on pricing.

Participation in the projected growth in the mobiles market was potentially a way for TPG to dilute this issue, however these hopes now rest on the Vodafone approval after TPG abandoned its own plans to build a network (leading to a large writedown in this result).

The company’s half year operating report was viewed as commendable, although primarily driven by good cost control as opposed to subscriber adds. As the chart illustrates, subscriber growth has now been stagnant over the last two years and only approximately 50% of the base has transitioned to the nbn.

TPG: Broadband Subscribers

Source: TPG
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In the short term, the ACCC’s decision (due in May) means that TPM is largely a binary outcome, with the share price set to either spike on the merger’s approval or drop on rejection. We remain wary of the broader sector, although Telstra currently looks like the company with the most potential through 5G.

Nufarm’s (NUF) first half was expected to be weak and that was how it materialised, exacerbated by a downgrade to the company’s full year guidance as the Australian drought impacts the operating environment. The company’s dividend was consequently suspended.

The primary concern for investors (and which sent the shares plunging), however, was the ongoing delicate position of the balance sheet, with a further deterioration in cash flow despite an equity raise six months ago. Several slides in the presentation were devoted to a spike in working capital, particularly in the North and South American business. While some of this was related to seasonal fluctuations, a marked improvement will be required in the second half, with the uncertainty likely to overhang the stock.

Nufarm: Net Working Capital Change (Last Six Months)

Source: Nufarm
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Adding to the woe was the news of a second case against competitor Bayer on the cancer risks associated with glyphosate-based weed killer Roundup (NUF’s herbicides also contain glyphosate). NUF continues to be viewed as a deep value play given its current cyclical low earnings level, undemanding valuation and optionality from omega-3 canola over time. These longer term value drivers are offset by the current challenging operating environment and balance sheet risks.

Westpac’s (WBC) decision to exit its financial advice business was not surprising given the simplification of business models across the banks and the issues that had arisen in the Royal Commission. WBC is the last of the majors to make this move and while it will be a costly exercise (restructuring costs of up to $300m will be incurred), weighing on earnings growth (or lack thereof) in the current financial year, the fact that the business was loss-making illustrates the challenges that the banks have had in the space. WBC’s platform business.

Panorama, where it has spent significant capital, will now be the core focus within wealth management for the bank. Flows have recently been positive into Panorama, although likely boosted by sharpening its fee schedule, a lever which has been pulled by a number of its peers. Our view remains that the earnings growth trajectory for the banking sector will be constrained in the short term, while noting their attractive dividend characteristics.

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