A summary of the week’s results


Week Ending 22.06.2018

Eco Blog

· There are indications are that Australian house prices may recede from current elevated levels, driven by tightening credit availability. An orderly correction may result, which historically has not been an unusual outcome.

· The unemployment rate is just one measure of labour market slack, which has been falling across many economies over the last few years. Structural factors more likely explain the lack of a wages growth that would otherwise be expected.

In a week light on for economic releases, domestic house prices were in the news after the publication of two reports predicting further softness in the market over the next couple of years. The forecasts have been made given weaker than expected trends in the first half of the year, along with some softer forward indicators. 

The broad consensus base case among economists is very much one of a ‘soft landing’ in property prices, after several years of strong gains; notably there has been several such instances over the last few decades whereby the market has moderated somewhat and an orderly correction is thus not unusual. The key markets of Sydney and Melbourne are the two that have driven much of the gains in nation-wide measures of price growth and therefore it is not unsurprising to see these two cities leading the current market lower, as illustrated in the following chart.

Australian House Price Forecasts

Source: CoreLogic RP Data, ANZ

The primary difference between this cycle and others is that it is not driven by higher interest rates, but by reduced credit availability, making forecasts somewhat more unpredictable. These began with macroprudential policies introduced by APRA over the last few years, including restrictions on investor and interest-only mortgage lending. More recently, in the wake of the Royal Commission, there is the growing view that the banks will be running a sharper ruler over the borrowing capacity of households. While this may not result in a ‘credit crunch’ scenario, the regulatory environment is certainly less supportive for robust credit growth across the market.

The extent to which credit will be restricted to borrowers following the adoption of tougher lending standards is the key point of contention, although few are predicting a significant price correction, pointing to several factors underpinning the market. The RBA remains firmly on hold, population growth remains supportive, economic growth is reasonable and the employment has expanded at a good pace over the last 18 months. While the RBA wouldn’t be displeased with a gradual cooling of the market, there is the potential knock on effect to household spending that may result. Additionally, if this were to eventuate, the first-rate hike by the central bank would likely be pushed out further, which is currently not anticipated until the first half of 2019.

A much-researched topic in economics in the last few years has been around the lack of pressure on wages in what, at face value, appear to be strong employment markets in many economies. The RBA added its voice to the discussion this week, with a publication that attempted to aggregate the much broader range of indicators of labour market slack outside of the unemployment rate.

While in some cases, separating cyclical from structural factors from several measures can be a difficult task, most indicators of labour market strength point towards conditions that have returned to pre-financial crisis levels. The range of indicators is quite broad and includes underemployment levels (i.e. those that would like to be working more hours than currently), long-term unemployment rates, youth unemployment, participation rates, average hours worked, job vacancies, turnover and consumer and business surveys.

Constructing labour market indices from these data can give a better explanation of the recent breakdown in wages growth and unemployment levels. However, the RBA’s analysis showed that, in most cases, the link between unemployment rates and the constructed indices has been quite high over time, including the last few years, with a few exceptions.

The US is perhaps the most notable of these where the headline unemployment rate is much lower than the labour market index would indicate. Here the long-term unemployment and underemployment rates have not fallen as much as the headline rate and participation rates have not picked up, as has been the case in many other countries. The euro area is a somewhat different case where the index is better than the unemployment rate, although the unemployment rate is still sufficiently high enough to presently avoid any wage pressures.

Labour Market Indices


Australia’s case is different again to the others in that, despite the index currently matching the unemployment rate, this rate remains higher than pre-crisis levels. Further, with the unemployment rate somewhat above the estimated rate of ‘full employment’ in the economy (which typically leads to stable inflation outcomes), there is little expectation of inflation driven by wage pressures in the near term.

Broadly speaking, however, strong labour market indices have not translated to higher wage outcomes in many economies over the last few years compared to what has historically been observed. Other factors are likely to have also had a significant influence (some of which are structural in nature), such as reduced inflation expectations, sluggish productivity growth, the low bargaining power of workers and an increasing globalised workforce.

Investment Market Comment

· Leveraged ETFs potentially offer investors higher returns over the short term, however there are hidden dangers that make these products inappropriate for long-term investing.

Leveraged and inverse ETFs can be used to increase the impact from the performance of an underlying index. An ETF provider will increase its exposure to an index using derivatives. The most commonly used are index futures, equity swaps and index options. However, due to the complicated nature and extra risks of these ETFs, they do not always perform as anticipated, especially over the long-term.

One of the main reasons that performance will deviate from the underlying index is due to compounding returns versus the requirement of daily rebalancing of funds. Leveraged ETFs are usually designed to create between two or three times the return of an underlying index. To achieve this, daily rebalancing must take place to increase or decrease exposure and maintain the fund’s objective of doubling or tripling the index’s returns. Therefore, increased volatility is problematic for these types of ETFs.

Using a two times long ETF as an example, if an index moves in one direction, whether it be up or down for a time period, a leveraged ETF will generally track the magnified returns of the index. However, the more volatile a benchmark for a leveraged ETF, the more value the ETF will lose over time, even if the benchmark ends up flat. If the benchmark moved up and down along the way, an investor can end up losing a significant amount of capital.

In the example below, scenario 1 assumes the index falls by 5% each day; scenario 2 assumes rises of 5% each day; while scenario 3 assumes alternating 5% falls and rises. The two times long ETF naturally doubles these moves. In scenario 3, however, the two times long ETF loses nearly four times the index.

Source: Escala Partners

The Betashares Strong Bear ETF (ASX: BEAR) aims to provide negatively correlated magnified returns of the S&P 500 Total Return Index. When the S&P 500 falls by 1%, this ETF should deliver a 2% to 2.75% increase in value. Typically, the bigger swings in the VIX, the more this ETF does not perform as anticipated.

Monthly and Cumulative Returns of BEAR and S&P 500

Source: Morningstar, Escala Partners

Moreover, using these ETFs as long-term strategies will generally lead to losses an investor. The prospectus clearly lays out that the intention is to magnify the daily return (only for down markets) and not over the long term.

Additionally, these types of ETFs generally have a higher management fee. Leveraged and inverse ETFs offered to Australian investors have an average fee of 1.125% pa compared to 0.46% for all ETFs. Therefore, as ETFs aim to replicate the performance of an index after fees, the higher the fees, the higher the tracking error will be. Furthermore, as these ETFs rely on regular rebalancing, they will naturally have a higher turnover, which will also have higher costs.

· Leveraged ETFs are fundamentally riskier than traditional ETFs. These products are designed to be rebalanced on a regular basis, which means investors can only expect the ETF to achieve its stated performance objective over a the short-term. Therefore, for portfolio protection, we would recommend the use of active market neutral or long-short funds.

Fixed Income Update

· The RBA minutes added to the growing market view that a rate rise will be in the latter half of 2019. 

· The yield on 30 year US treasuries trade below that of the Australian equivalent, with demand from pension funds and insurers supporting the long end of US rates. 

· Banks have failed to increase term deposit rates, despite the rise in the bank bill swap rate.

The US-China trade tariff talks have marginally influenced bond market movements over the week, albeit yield changes have traded within a tight range. Domestically, the minutes from the RBA’s June policy meeting were out this week. Of note was the omission within the statement that “members agreed that it was more likely that the next move in the cash rate would be up, rather than down.” This was included in the previous two meetings with many questioning whether they are losing confidence in the global economy. The Australian futures market has consequently pared back the likelihood of a near term rate rise; the probability of a hike by April next year has reduced to 37%.

Earlier this year, the Australian yield curve fell below that of the US curve for the first time in nearly 20 years. US treasuries now offer a higher yield than Australian government bonds across all maturities out to ten years. US rates are now only below that of Australia for a 30 year term.

US and Australian Yield Curves

Source: Bloomberg, Escala Partners

As yields have increased in the US this year, the 30-year Treasury yield has risen from a low of 2.70% in mid-December to a peak of 3.24% in May, before settling back to 3.07% today. These higher rates have attracted pension funds and insurance companies who are predominately ‘buy and 

hold’ investors with long term liabilities to offset. This recent bout of demand has narrowed the margin between 10 and 30-year Treasury yields and pushed the latter below that of the Australian 30-year government bond yield. A $14bn auction last week for 30-year US Treasury debt was said to have been met with strong demand. In addition to the natural demand for ‘long dated’ Treasuries, this also highlights how resilient the 30-year part of the curve in the US is to inflation expectations. The recent buying has pushed the 30-year breakeven rate of inflation below that of 10-year bonds, indicating that pricing pressures are not expected to be a concern over a longer time frame.

· Global bond portfolios that have a long duration mandate often ‘barbell the curve’ by buying a mix of 30-year Treasuries, together with shorter-dated Treasuries to get an average duration, which is less volatile than only investing in the 5-10 year part of the curve. The ‘belly’ of the curve (5-7 years) is generally more vulnerable to inflation expectations.

The bank bill swap rate (BBSW) is a benchmark rate used for the setting of coupons across many domestic fixed income securities and represents the rate at which domestic banks will lend to each other. We have noted previously the elevated levels of BBSW, stemming from a lift in the offshore LIBOR rate, which in turn is mostly due to an increase in supply of US Treasuries. Despite higher BBSW levels, term deposit (TD) rates remain unchanged, tightening the TD spread over BBSW.

 · While perhaps marginal, it does make floating rate notes and other fixed income instruments that are set off the benchmark rate relatively more attractive.

Term Deposit Spread Over Relevant BBSW: May 2018 vs April 2018

Source: Bondadviser

Corporate Comments

· Telstra’s (TLS) investor day provided the market with further colour on how the company is addressing the structural earnings decline in its business. Weak guidance for FY19 highlighted the challenges ahead for management. 

· CYBG (CYB) has agreed to a takeover of Virgin Money in the UK. The deal has been judged to enhance the investment case for the NAB spin-off.

Much of what was speculated leading into Telstra’s (TLS) investor day this week was realised, with the company outlining its medium-term strategy as it deals with the industry headwinds caused by the rollout of the nbn. The key planks of the strategy can be summarised as further cost out, a more aggressive approach to growing its core mobiles business and separating its infrastructure assets into a separate unit in preparation for a likely sale or spin off into a separate vehicle.

TLS’s mobile strategy was perhaps of most interest as it looks to reassert its market dominance after the decline in the growth profile of this business in recent years. TLS will be simplifying its mobile plans in coming months, vastly reducing the number of plans that it has in the market. Further, the company will effectively be phasing out lucrative revenue generators such as excess data charges in what is a more customer-friendly approach.

TLS previously had success through a more competitive pricing strategy early this decade, although the difficulty in achieving this is much harder in today’s environment; the overall mobiles market in Australia is more mature and lower growth; TLS had then received a free kick from significant network issues at one of its competitors (Vodafone) at the time; and the market will soon have a fourth major player in TPG, who is likely to pursue a price-leading offering.

The establishment of a separate infrastructure unit will include assets such as the ducts and pipes, exchanges and data centres. Notably, the division will also have a declining earnings profile as the nbn is progressively rolled out and so its sustainable earnings base is expected to lower than its current $3bn EBITDA generation. While a different capital structure is probably appropriate for this business in the long term, shareholders are unlikely to see any benefit in the next few years given that any decision to divest the unit has been flagged only once the nbn is complete.

The $1bn cost out initiatives announced by TLS this week are in addition to the $1.5bn previously announced, to be achieved by FY22. Achieving this would be an excellent outcome for shareholders (although arguably should have been initiated earlier by the company) and help to offset the declining revenues in its core business, however it is also not without its risks. The challenge for the company will be maintaining service standards with a much-reduced workforce and as it phases out legacy systems.

Underlying the difficult task ahead for TLS, however, was how the initiatives above translated into its FY19 guidance, which it issued for the first time. TLS’s expectation is for further deterioration in mobile and fixed line revenues, reflecting “intense competition” in the market and the likely impact to margins from TPG’s entry into the mobiles market.

TLS’s guidance implied an approximate 12% decline in underlying EBITDA over the next 12 months, which was not anticipated by analysts. On this basis, and with a new dividend policy in place since last year, expectations of a further dividend cut from next year have been growing. The chart below illustrates how quickly TLS’s dividend forecasts have fallen over the last 18 months and why the stock has failed to find support from a yield perspective given the uncertainty of its outlook.

Critically, these forecasts include ‘special’ dividend payments from the short-dated income that the company is receiving as the nbn is rolled out. The decline in the company’s underlying dividends is thus more significant given than would appear at face value.

Telstra: Consensus Dividend Estimates

Source: Bloomberg, Escala Partners

The news for CYBG (CYB) was more promising this week after it announced that it had agreed to a takeover of Virgin Money. While the deal is a departure from CYBG’s previous cost-out driven earnings thesis, there is some strategic sense involved. The two banks have complementary strengths across a range of retail and SME products and the merged entity will now have a national footprint, leaving it well placed to compete with its larger peers.

CYBG and Virgin: UK Coverage

Source: CYBG

While the premium for Virgin shareholders was material (35% compared to three month volume weighted average price), the deal is expected to be highly earnings accretive for CYBG given the disparity in valuation between the two banks prior to the announcement (with Virgin at a large discount) and the higher rate of synergies that are forecast to be achieved. Just as important, the transaction is not expected to interfere with CYBG’s financial targets that the group has guided the market towards and may even accelerate certain aspects, such as the reduction in its cost to income ratio and higher dividend payments to shareholders. We have the stock in our model given its differentiated growth drivers compared to the issues facing the domestic banks.