Week Ending 22.07.2016
The local economic focus is on the inflation data out next week. Universally, there is an expectation of a low print for the June quarter of around 0.4%. As slightly higher numbers from last year drop out of the annual calculation, headline inflation could well be as low as 1.1% and 1.4% at an underlying level (which takes out highly volatile items such as fuel). At the end of the March quarter these numbers were 1.3% and 1.7% respectively.
Adding colour to the Australian picture was the release of the most recent HILDA survey (household income and labour dynamics in Australia). The thrust of the report is on financial wealth and physical health, with a skew towards those with low incomes or on welfare. Of relevance to the economic outlook is the trend in household income. There was a distinct rise in real incomes during the 2000-2009 period, particularly for younger workers. The mining boom appears to have let male workers retain some pace post that date, but is clearly levelling off. More importantly, the high earning 45-49 year olds have experienced a small fall in real income. Females have done worse, with little to no income growth since 2009.
Mean Weekly Earnings of Full Time Employees (Real Terms)
This goes some way to explain the weak trend in household consumption since that time and the likelihood that this will continue. It is even more so the case given rises in costs. An example in the HILDA report is childcare, which has gone up by 109% in real terms since 2001. This is exacerbated by the fall in the use of grandparents fulfilling some of the role, with this ratio declining from 26.9% in 2011 to 24.7% in 2014.
The proportion of people employed in small business (less than 20 employees) has fallen from 26% to 21% over the period of 2001 to 2014. While some of this is due to industries such as agriculture, there is no sign of an emerging small business cohort. A surprising observation is that weekend work and irregular hours are more common in large than in small business, probably a reflection of the broad base of service industries and growth in employment in sectors such as health.
The survey shows that home ownership is strongly correlated with the level of overall wealth, but that non-home owners are growing their wealth at a greater pace. There are a number of reasons for this. Young people naturally have little wealth (and therefore have a lower likelihood of home ownership) but are growing their assets from a low base. Meanwhile, home owners tend to have children and therefore save less in other assets. Yet it does imply that owning a home is not a prerequisite for wealth and indeed may reduce the flexibility and willingness to take risk elsewhere. Finally, the over 65s have not yet started to run down their wealth, albeit this is in good part due to the rise in asset values in recent years. That will inevitably happen soon as wealth growth levels off and a larger group move into a de-cumulation phase. In turn, this is likely to change the asset allocation of many older Australians. It is inevitable that some will need to realise their home in order to fund their lifestyle, as already some 20-30% of elderly are officially defined as in ‘income poverty’.
Income Poverty Rates by Family Type
The US will report Q2 GDP on 29 July. Recent indicators suggest it could be at the higher end of expectations. Retail sales have been strong and the housing sector has persistently rebounded from any short term weakness. The US household sector would appear to be making its sizable contribution to the economy. Manufacturing and services data is mostly mixed, though once again, soft periods tend to be followed by a return to a mild growth trend.
In other circumstances markets would almost certainly have priced in a rate rise, but the Fed has obfuscated its message so much that there is no certainty any more. With many economists increasingly confident that inflation will rise in the second half of the year, the question turns to the behaviour of investment markets if the Fed is seen as being behind the curve.
Somewhat unreasonably, Mario Draghi disappointed those that were looking for further support measures at the ECB meeting. As we noted in previous reports, it is the European banking system which stands as the predominant source of problems. Recapitalising banks without creating more furore within Europe is going to be a tough assignment. On the other hand, credit restraint may not be the hurdle that prevents corporations from accessing capital, given a ready investor market that is willing to step into the gap. The risk in Europe is heavily balanced on political issues and associated business confidence.
Fixed Income Update
Following the release of the RBA minutes, it appears likely that the central bank will cut interest rates by 25bp to 1.5%. In the statement on Tuesday the RBA discussed revising the outlook for inflation and growth and stated that it would make appropriate policy changes if necessary. While the RBA is obviously mindful of global conditions, it showed little concern regarding Brexit. The members noted that the direct effect on the Australian economy was likely to be quite small, given that only around 3% of Australia’s exports are to the United Kingdom, compared with 4.5% to the rest of the European Union.
After the release, domestic government bond yields fell 5-6 bp across the curve. The front end of the futures market is now pricing in a 65% probability of this rate cut eventuating in August. While the consensus in the market is further monetary easing later in 2016, some of the banks are more bearish. For example, ANZ is calling for the cash rate to be reduced to 1% next year.
Despite the cash rate falling, the good news for investors in term deposits is that the spread offered above cash has increased since the May rate cut. With year-on-year retail deposit growth falling for the banks and a need to attract this funding source, term deposit spreads have moved up by an average 20bp since February.
Term Deposit Spread Above Cash Rate
In global markets, yield-hungry investors have been buoyed by the prospects of further monetary easing by central banks around the world, increasing allocations to the corporate debt sector. Flows into long-term US corporate debt set a new record last week and a net $52bn has been invested in US bond ETFs in the year to date.
With $12 trillion of negative bond yields worldwide, it is no surprise that corporate debt has been a recipient. High yield bonds have been one of the main benefactors as investors are tempted by the 6.9% average yield for unrated and below-investment grade bonds. High yield mutual funds received $4.35 billion in deposits during the week ending July 13, which was the biggest inflow in more than four months. Weekly fund flow into investment grade and high yield funds are depicted below.
As an example, Valvoline (the oil change store operator) raised $375m in the US high yield market this week, with apparent demand for $4.5 billion. This allowed the issuer to lower its yield offering by 0.5%.
Sovereign bond yields have bounced a little following their downturn in response to the Brexit vote. Despite this, negative yields have crept out to 50 years in Switzerland, while Japan’s longer-dated bond yields are only slightly positive. German bunds remain one of the most bid sovereigns in all maturities. Yields on the 10 year climbed above zero once in the last month, but now all German bunds out to 10 years are trading on a negative yield.
German 10 Year Bund Yield
Resources stocks are in focus leading into the reporting season each year, as companies publish production reports soon after the quarter’s end. A large part of the sector published production figures this week, but we will limit our comments to stocks that are more widely held.
BHP Billiton (BHP) has historically produced fairly steady production growth, a function of its substantial asset base (no single project has the capacity to transform the company) and ability to invest through the cycle. The vast majority of its operations remain profitable, even under the stressed commodity environment of recent years. The company’s FY16 production was ahead of expectations for its key divisions of petroleum, copper and metallurgical coal, while its Pilbara iron ore achieved another year of record production. Group iron ore production, however, fell due to its Samarco operation in Brazil which was suspended after the dam failure disaster of late last year. While guidance was largely met, the table below illustrates that the severe cuts to its capital expenditure budget in response to the fall in commodity prices are now materialising in lower growth. Overall production across the group was approximately 5% lower for the financial year.
BHP: FY16 Production Summary
Looking ahead to FY17, the outlook was broadly as anticipated, with incremental growth expected across copper, coal and iron ore. The main talking point, however, was lower petroleum guidance. Despite a modest recovery in oil prices in the last six months, BHP is forecasting petroleum production to be 17% lower compared with FY16, primarily driven by its US shale energy operations. The capital expenditure cuts across its petroleum division are even larger; a 50% decline in FY16, and a further expected 44% drop for FY17.
If a positive can be drawn from this guidance, it is the evidence of the supply adjustment in the US shale industry, required to help global oil markets find a balance with demand and to sustain the more recent recovery in the oil price since early this year. Higher oil prices on lower production levels may well result in improved profitability for BHP and its competitors.
Rio Tinto’s (RIO) production was judged as mixed, with a good result from aluminium and thermal coal, iron ore in line with expectations and a weaker performance from copper and metallurgical coal. Pilbara iron ore production growth of 10% marked another strong year of expansion, although this is expected to slow in coming quarters. On Rio’s current estimates, iron ore production is expected to be approximately 2% higher in 2017 (the company operates on the calendar year for its reporting), indicating that price will become the dominant factor determining its profitability.
For both BHP and RIO, with dividends now rebased and minimal production growth, the upside resides in the ongoing focus on reducing costs and the potential for the recent commodity rally to be sustained as current spot prices would typically translate into earnings upgrades across the sector.
A cheaper valuation and greater exposure to high-margin iron ore (at least in the shorter term) are viewed as the key points in a preference to RIO over BHP at present, along with the question mark raised over the potential liability for BHP that may arise from the Samarco incident. The alternate view supporting BHP would highlight the well-supplied, low demand growth (or even declining) for iron ore compare to better medium-term prospects in copper and petroleum. Our model portfolios are currently tilted towards the latter view.
South32 (S32) has an entirely different commodity mix to the major miners, yet retains quite a high level of diversification. Aluminium, manganese, coal and nickel are among its key exposures. Limited production growth was also evident at S32 (the company described it as “predictable production”) and therefore the key source of earnings improvement has been driven by the company’s cost reduction program. To date, management have exceeded expectations on this measure and this will likely be a focus of its upcoming result.
Oil Search (OSH) conceded defeat in its bid to further expand its asset base in PNG through the acquisition of InterOil. As we noted last week, Exxon Mobil submitted a superior offer to that of OSH and France’s Total, with InterOil now recommending this latest bid. The motive for OSH to not engage in a bidding war was strong. Exxon Mobil is the operating company of the already-built PNG LNG project (in which OSH has a key stake)and the likelihood was high that InterOil’s gas fields would be developed by leveraging off this infrastructure, resulting in significant cost synergies. At this stage, the key parties appear to be on the same page; a contrast to the lack of cooperation that eventuated at Gladstone in Queensland. With OSH also holding an interest in InterOil’s key Elk-Antelope gas field, benefits would have accrued to the company from either bid being successful.
Outside of the news on corporate activity, OSH’s production report was deemed to be solid, with the company providing a slight upgrade to its full year production guidance. LNG expansion remains on the table even under new lower oil price assumptions, however this has likely been somewhat delayed in the short term as the company focuses on maximising the cash flow from its current operations. OSH remains our preferred exposure to the energy sector.
Construction company CIMIC Group (CIM) (formerly Leighton Holdings) reported a 3% improvement in first half profit, with earnings per share growing at a greater pace thanks to a share buyback. The result was achieved as the company transitions away from the completion of large mining construction projects to infrastructure-related work. As illustrated in the chart below, the pipeline for major road construction projects in Australia (of which CIM is a major player) is strong over the next five years.
Australian Major Road Construction Project Outlook
However, CIM’s poor operating cash flow was the focus post-result, with the company blaming the seasonality of cash receipts. While such a pattern is not uncommon among the large contractors, this would be a clear red flag if the it were to persist in coming reporting periods. From an investment perspective, the positives for CIM are an improving environment and strong balance sheet supporting a share buyback. The negatives include an elevated P/E for a cyclical company (even following the recent share price retracement), a poor corporate governance history, significant losses on large projects in the past and payment collection issues. We prefer LendLease in the sector, which has a more appealing valuation and is not burdened by many of CIM’s legacy issues.
Metcash (MTS) was given the green light to pursue the acquisition of hardware stores that Woolworths (WOW) is looking to realise. The Woolworths operations consist of Masters as well as Home Timber and Hardware stores. MTS is interested in the latter, but needed ACCC approval given its existing Mitre 10 network. If MTS were successful in bidding for the assets, this had the potential to reduce competition across the sector and leave independents with only one wholesale source. MTS has provided a number of undertakings so that independents will all gain similar wholesale terms. The harder part would be monitoring MTS’s service standards and pricing for all its retail customers. For example, in an effort to gain margin, MTS could reduce delivery frequency or raise prices. The ACCC believes Bunnings’ strength will be sufficient to contain such an outcome, though if MTS were to go down this path, the damage to independents is likely to be done before any intervention.
Now MTS will have to lob in its offer for Home Timber against private equity. MTS has much to gain through the potential acquisition, which would improve its buying terms and reduce distribution and overhead costs. On the other hand, private equity is not answerable to short term investors and may push up the price. If the price is acceptable and MTS can point to cost out synergies, the share price may find some support, though an equity raising is also likely. However, it does not improve the group’s main challenge of an increasingly competitive supermarket sector and any distraction may be problematic.
Aseleo (AHY), a relatively recent listing, was savaged after guiding investors to expect a sharp fall in profit in the second half of the 2016 financial year. The business consists of well-known brands in consumer tissue and hygiene products distributed in Australia and New Zealand through the major retail chains. The attraction of the stock had been based on the assumed stability of demand along with recent favourable moves in pulp prices. Management states that price competition has eroded its margin and that the pulp price benefit would fall into FY17. The sharp fall in the share price not only reflects the large revision from previous indications, but points to a miscommunication with investors who appear to have banked the pulp benefit and a benign price environment. As with the comments on MTS above, the supermarket sector looks set to move to a higher level of competition in the coming year.
This will make it all the harder for Woolworths to regain sales momentum and margin could well disappoint again. Wesfarmers is better off, yet is clearly on the path to stay ahead of any resurgence from Woolworths as well as the ever-encroaching Aldi. If private equity were to acquire the hardware operations from Woolworths, Wesfarmers may too find that its free run in that sector tightens up. We recommend a cautious approach to retailing and trimming any large positions.