Week Ending 22.04.2016
We are becoming accustomed to a weekly perusal of data that gives no particular sense of direction. US jobless claims fell, yet regional activity surveys were weaker than expected. The composite of leading indicators is confirming the expectations of soft growth so far in 2016 and implicitly the growing chance the Fed will do nothing for some months.
US Leading Indicators
Nonetheless, Fed watchers are taken by the increasingly divided and uncertain edicts from each of the members. Simplistically, employment trends support those wanting to ‘normalise’, while all other factors have the dovish overtone. Separate to that are other issues. The sensitivity of the US economy to a rate rise is very hard to judge given the unusual circumstances. Mortgage rates are priced off the bond yield and are mostly fixed, suggesting a long time lag before higher rates impact on the housing sector. US corporates have locked in low cost funding. It can therefore be suggested the predominant impact will be on the financial sector, which perversely may benefit from a rate rise.
To muddy the water is the currency impact. The causes of the movement in currency rates this year belie a simple explanation. The combination of overcrowding the US$ strength trade and therefore pushing the exchange rate to ‘expensive’ arguably started the unwinding process. In turn, that was confirmed by the Fed’s dovish stance this year. A strong US$ exchange rate is a contributing factor to deflation (as the US$ is still the reserve currency of choice and commodities are priced in US$) and tightening financial conditions, as capital flows to the US.
The change in pattern for the US$ is therefore a major part of the conditions we have seen in the past few weeks. Emerging markets have got breathing space from the US$ pressure on their current account. Commodities have rallied (in US$) driven by the currency, combined with a shift in the view on some of the fundamentals. China’s growth is judged as stabilising, also supporting commodities and riskier assets. The feedback loop is therefore reinforced as the US$ is typically a ‘flight to safety’ valve.
There are inevitably gaps to this argument. A stronger Yen and Euro fly in the face of their increased level of monetary easing. And while the US may be on hold, it is much more likely that will be temporary compared to the path of the other central banks. Even the commodity story has somewhat weak underpinnings. China’ s growth has seen property activity pick up, yet the excess supply of housing is still said to be around 3-4 years.
China Property Inventory
The commodity oversupply issue is far from resolved. At best, it is likely to find some uneasy balancing point, with higher prices encouraging production which in turn limits the upside.
The other repercussion of the relative weakness in the US$ may turn out to be the trigger to an upturn in US inflation rather than the well anticipated wage rate. As we have reinforced in past comments, this is about a small change in inflation, or more critically, the direction and inflation expectations. The incapacity of US inflation to turn up is somewhat perplexing given the weighting of healthcare and housing in the CPI. These issues are, in our view, still likely to play the biggest role in investment markets this year, outside tail events. The discomfort in establishing a clear argument either way supports our view to maintain relatively defensive asset allocation and not to chase the rallies.
Fixed Income Update
The bank hybrid market has continued its strong performance over the last week as spreads have tightened across the curve. Commonwealth Bank’s recently listed hybrid, CBAPE, has been one of the best performers, rallying to $102.70 from an issue price of $100 in three weeks. There is market speculation that a couple of large institutions took large positions and received a placement fee on the understanding that they will retain the securities for at least 12 months. This has obviously been supportive for the bonds in the secondary market.
The next new issue that is very likely to come to the market is the refinancing of Westpac’s WCTPA securities, which mature on June 30. The expected timing of an announcement on a new deal is mid to late May. Westpac are in a blackout up until May 2 with the release of their results, and with the upcoming RBA meeting and Federal budget announcement, volatility is likely to be heightened in the first week of the month. Once the outcomes of these have been absorbed, an announcement will be imminent. Looking at the maturity profile of existing hybrids, a 5 ½ year transaction is the most probable tenor if Westpac is to avoid other maturing bonds.
Spread contraction has been widespread across all credit products since the February 12. The Australian iTraxx, which is the index that measures a basket of 5 year credit default swaps, and is the best measure of movements in investment grade credit spreads, has fallen over this period. This has aided performance for many of the credit funds to which we allocate.
Australian iTraxx Index
Emerging markets have also participated as the risk trade gains momentum. BlackRock's iShares ETF which tracks emerging-market dollar bonds is up 6.5 per cent this year. Despite this, these bonds are still showing value compared to historic levels, with yields 390 bp above US Treasuries, compared with a 5 year average of 340 bp. US high yield has also performed well over the week with the CDS index tightening 24bp, taking the spread to ~413 bp.
For the first time in a while, resources stocks reported quarterly production this week with the backdrop of an improving commodity price environment and considerable positive momentum. The recent rebound in commodities, however, has come off a very low base and consequently, prices on average were well below those cycling from 12 months prior.
BHP Billiton (BHP) met expectations with its quarterly, although the company downgraded its guidance for its iron ore operations for the full year. The performance of its Pilbara iron ore division can often be quite variable in the March quarter due to weather disruptions and this proved to be the case this year. While the divestment of South32 (S32) into a separate listed entity was a major step in refining its mines down to its four core profit-making divisions, the evolution has been sustained. Large investment spend continues to be deferred, asset sales made and costs reduced. BHP reported that it is on track to deliver 14% cost reduction across its major assets. Growth continues to take a back seat, as the table below illustrates; for the nine months, production was lower across its commodity suite.
BHP March Quarter Production
Rio Tinto’s (RIO) production results were also in line with forecasts. An improvement in copper grades at its Kennecott mine saw production bounce back from the previous quarter, while iron ore production advanced again although, like BHP, was weather-affected.
Much of the focus, however, was on RIO’s iron ore guidance for the 2017 calendar year as it reduced its forecast from flat production to a decline of approximately 4%. The company has had some delays with the progress of its fully-autonomous railway system in the Pilbara and the new guidance by RIO would imply that 2017 will be the first year in more than a decade that its global iron ore production may decline year on year. Some may take the view these comments are engineered to create a perception of tightening supply rather than a real limit to output. Production trends will be more closely watched than ever.
Rio Tinto Annual Iron Ore Production and Guidance
Impressively for a more mid-tier mining company, South32 (S32) moved to a net cash position in the quarter, placing it in a strong position relative to its peers. Similar to the majors, production growth is expected to be constrained in the medium term and earnings therefore driven by cost control. On this measure, S32 has done an excellent job. On average, the group has higher cost operations compared with the major diversified miners and the leverage to the recent commodity price rally will be greater.
Positive sentiment, momentum and weakness in the US dollar appear to be driving the run across commodities, with showing double-digit gains on a rolling quarter basis. The rebound in iron ore has been quite remarkable (+71% in this time), although most are sceptical of a sustained recovery. While the miners have historically had a poor record of commodity price forecasting, BHP itself still played down the recent strength given the seasonal drivers (including weather-affected supply) that have been behind the price spike. Steel prices have been key. Improving prices have incentivised higher production levels and restocking, driving the iron price higher. Overall, however, the increase in steel production has been marginal – in March, China recorded 3% year on year growth, the first instance of a positive figure in 18 months. RIO’s bias towards this commodity may see it outperform should the current rally persist.
Analysts typically value miners using a net present value (NPV) model, and the recent rally has resulted in many pushing towards these valuations. If the current rally becomes extended there will be upgrades across commodity decks and hence price targets for stocks. In our models, we have recommended BHP and S32, which combined gives a broad mix of commodity exposure to the investor.
Oil Search’s (OSH) production topped estimates, with the company reporting very strong production at its PNG LNG operation. The group continues to debottleneck the project effectively, with production rates 16% above nameplate capacity (i.e. 100% capacity) in the quarter. The downside for OSH and its partners in the project is that these excess shipments are being sold on a weak spot market and thus realising less value than its contracts.
OSH also pointed towards further opportunities to potentially enhance production. Despite producing at a run rate ahead of its guidance range, OSH did not elect to raise expectations, leaving it well placed to beat this number.
Growth opportunities remain on the table for OSH, with the company making steady progress on its two projects – an expansion of the PNG LNG project, as well as the separate Papua LNG project. In its quarterly, OSH talked to the potential realisation of value for the project partners across each if they were to co-operate and share infrastructure. Being the only oil company with an interest in both developments, OSH would stand to benefit more than most, although the argument for co-operation makes a lot of sense, particularly in the weak oil price environment. We also note that, despite a similarly compelling case between the three Queensland Gladstone LNG operations that were constructed simultaneously, no agreement was reached. With a solid balance sheet, low cash costs (OSH estimates operating and interest costs of US$19/barrel for this year) and attractive expansion options, OSH continues to be our top pick among energy stocks.
Tourism and travel is an investment theme that continues to be robust, albeit with short term seasonal and cyclical factors at play. This week saw two somewhat conflicting reports on the current environment.
Traffic figures from Sydney Airport (SYD), provided strong support for the thesis of a demand pickup from international visitors following the realignment of the Australian dollar. For the month, growth in foreign inbound passengers was 10%, led by figures from Asian countries, including Japan, Taiwan, Hong Kong and South Korea. Increased capacity from several airlines associated with these countries supported the growth. Aside from Sydney Airport, we have a couple of stocks in our guided portfolios that are beneficiaries of inbound tourism - Mantra Group (MTR) and Star Entertainment (SGR).
While the highlight of SYD’s traffic figures was international passengers, growth in domestic passengers was still respectable at 4%, although the early timing of Easter this year may have enhanced this figure. Judging from an update by Qantas (QAN) on Monday, the June quarter may be more challenged. Qantas noted that there had been some recent softness in demand ahead of the upcoming federal election and a consequential drop in consumer confidence. Qantas has thus wound back some capacity from the domestic market, consistent with its more rational approach to expansion.
Brambles (BXB) had provided a slight upgrade to guidance at its half year result in February, which was reaffirmed with its third quarter trading update this week. Incremental business wins in its core pallets division have continued along with steady volume growth, while Brambles has been winning customers in its reusable plastic crates (RPCs) business. Recent benign transport cost growth in the US is also likely to be supportive of margin improvement in the June half.
Brambles has outperformed the market in the last few of years and the company’s relatively predictable earnings (at rates in excess of most other large cap industrials) has seen a re-rate of the earnings multiple applied to the business. While the rate of sales growth has picked up in this financial year, the company arguably needs to show progress on achieving its long term return on capital targets in future reporting periods to support its valuation.
Brambles Constant Currency Sales Growth (Nine Months)
Wesfarmers (WES) third quarter sales report did little to sway investors’ opinions. Coles supermarkets maintained its steady pace of above-industry sales growth at 5.4% (4.4% comparable). Similarly, Bunnings stumped up with another 8.3% comparable sales rise. The surprise was Kmart, where sales jumped by 17.9% in the quarter. Target was the one weak spot for WES and will cost the group to restructure.
Much of this momentum is off the back of its weak competitor, Woolworths (WOW) and the outlook for WOW remains troubled. The debate for WES investors is how long it can sustain its growth in market share and what profit margins that might imply. Our sense is that the general thrust of the business is to maximise the sales, put persistent pressure on costs and assume the bulk of those savings will have to be invested back into the price. That should keep the potential of a recovery at Woolworths and keep the impact from Aldi at bay. The implication is that WES will move into a mature phase, allowing for some profit to bounce around its resource assets, Target and potentially the investment into Home Base in the UK. Then the question is what to pay for such earnings. At face value, a 17-18X forward P/E is on the expensive side for a modest growth company, but in keeping with the big cap industrial sector at this time. A 5% franked yield confirms the case for WES to maintain its position in a portfolio while accepting that relative outperformance to the index is unlikely.