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WEEKEND LADDER

A summary of the week’s results

22.09.2017

Week Ending 22.09.2017

Eco Blog

- The outcome of the FOMC meeting was as expected, with a tilt towards a more hawkish tone. Inflation readings in coming months will determine whether an additional hike will materialise in December.

- Few surprises emerged from the Bank of Japan’s monetary policy meeting.

- The normalisation of monetary policy poses a greater risk to Australia given high levels of household debt.

- Germany’s elections this weekend are likely to have implications for European growth and monetary policy in the medium term.

With little economic news released this week, the focus was back to central banks and, in particular, the Fed in the US. The Fed largely played to expectations, keeping the cash rate on hold although announcing that it would begin what it is expected to be a long, slow process of reducing the size of its US$4.5tr balance sheet. This will begin at US$10bn a month (US$6bn in treasuries and US$4bn in mortgage backed securities) starting in October and will gradually increase over time. The balance sheet reduction is, in effect, an additional measure of monetary policy tightening, although is more linked to longer term rates; by the Fed’s own estimates, the balance sheet actions undertaken since the financial crisis have likely lowered long term interest rates by approximately 100bp.

With no surprises on this front, more attention was paid to the Fed’s assessment of current economic conditions and inflation and consequently the immediate outlook for interest rates. On this measure, the central bank was mildly more hawkish, with all but four of sixteen committee members forecasting an additional hike before the end of the year (likely at its meeting in mid-December). As indicated by the quarterly published dot plots, the median forecast for 2018 is for a further two hikes, which remains above the market’s expectations.

FOMC Monetary Policy Forecasts

Source: FOMC
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While the Fed remains upbeat on the current state of the US economy and prospects for further growth (and was prepared to look through the disruption created by recent extreme weather events), a key takeaway from its commentary was its assessment of inflation. Inflation has surprised on the downside this year, however Yellen noted that this was due more to one-off transitory factors (such as a reduction in mobile phone services).

The market, however, remains more sceptical of this view and this will continue to be monitored closely in coming months, while the impact of the aforementioned weather events is likely to cloud the interpretation of the data. Into 2018, an additional complicating factor is the high turnover of Fed members and how this might change the FOMC’s outlook. This could possibly include the Fed chair, with Yellen’s term due to expire in February.

Meanwhile, the Bank of Japan (BoJ) stayed on script following its monetary policy meeting, with no change to its current strategy. The BoJ has now been committed to a policy framework of yield curve control and monetary base expansion until the consumer price index exceeds its 2% target. While this has helped lift the country out of its previous deflationary environment, official inflation measures remain much below that of other developed economies despite what has become a tight labour market.

Domestically, economic releases were also limited, ensuring that two presentations by RBA members would gain broad coverage, including one by Governor Lowe. Lowe presented on the prospects for the Australian economy as the world emerges from the financial crisis, and domestically, as the end of the recent decline in resources capital investment becomes less of a headwind for growth.

Lowe touched on several aspects that are going to be important going forward, each of which pose a varying degree of risks and opportunities. A positive view was put forward on the influence on technological change in driving global growth, while our geographical proximity to other emerging Asian countries, such as India and Indonesia, is a positive. Our leverage to Chinese economic growth will largely be dependent on our ability to tap more into food and services growth as opposed to natural resources.

The broad global normalisation of monetary conditions was also noted, with an acknowledgement that growth in advanced economies is now becoming more self-sustaining and less dependent on monetary stimulus.

Australia is more exposed to this transition than most developed economies, however, given the leverage that many households have used in bidding up the property market.

With higher debt levels, this has meant that households are less inclined to let consumption growth run ahead of growth in incomes for too long. The RBA’s concern is that a small shock could turn into a more serious correction as households prioritise balance sheet repair. This interest rate sensitivity is likely to be critical in limiting the extent of any domestic rate hikes. A pick up in wage growth would an important development in emerging from our current state, although this is yet to materialise this year despite more promising employment data.

Over the weekend, elections are back on the agenda, with votes across the ditch in New Zealand and, more importantly for Europe, in Germany. Merkel appears to be all but over the line in Germany to win a fourth term, although more interest will likely lie in who ends up being her coalition party going forward, with implications with European monetary policy and the continuation of the region’s ongoing economic recovery.

Fixed Income Update

- Global bonds sell off in the lead up to, and post the US FOMC meeting.

- Strong domestic employment data has the market pricing in rate rises by the RBA in 2018.

- The Westpac USD tier 1 issued last week rallies in pre-settlement trading.

Prior to the outcome of the Federal Reserve Bank’s September meeting this week, the market priced in higher yields and a steeper curve in both the US and Australia. Since the beginning of September, yields on 5 and 10-year domestic government and corporate bonds rose by 0.25%, outpacing the US which has moved 0.15-0.20% higher.

Following the FOMC’s meeting, bonds continued to sell off, as the market interpreted the commentary as hawkish. The Fed’s intent to still go through with a +0.25% rate hike in December and three more hikes in 2018, was met with some surprise. The futures market is showing a 67% probability of a rate rise in December. As we have noted, the Fed confirmed its process for the tapering of its balance sheet. The unwind will begin in October with a capped amount of $4 billion MBS and $6 billion Treasuries to be rolled off each month. This will be raised quarterly until they reach $20 billion and $30 billion, respectively, in the next year. The Fed’s balance sheet has expanded to ~$4.5 trillion under the quantitative easing program, up from under $1 trillion prior to the financial crisis. 

Total Assets of the Federal Reserve as at 31 August 2017

Source: PIMCO, Bloomberg
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In addition to the US central bank policies, the recent spike in yields has been driven by other factors which include:

-       Geopolitical concerns surrounding North Korea subsiding, resulting in a reversal of the ‘flight to quality’ trade.

-       Inflation figures from some key economies ticking up.

-       The strong domestic employment data that came out last week.

On the latter, the market reaction has been quite notable, with the probability of a rate rise by the RBA gaining traction over the last two weeks.  The futures market is now pricing a 35% chance of a rate rise by March next year, up from 33% 10 days ago and 66% by July 2018, up from 49%.

Source: Bloomberg, Escala Partners
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This ‘risk-on’ tone in markets has driven credit spreads tighter. The Aussie iTraxx is now trading at 63bp, which is a new post GFC low. One must look back to November 2007 to see the index at a tighter margin.

The Westpac USD tier 1 bank hybrid that came to market last week is already trading at a premium, with settlement of the security occurring yesterday. The yield on this security has tightened in to 4.91% from its new issue yield of 5%. Given there was said to be $11bln in orders for the $1.25 billion issue size, this is not surprising.

Price movement of Westpac USD tier 1 hybrid issued offshore last week

Source: Bloomberg, Escala Partners
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To issue a hybrid in the domestic market, the security needs to have a franking credit attached. In contrast, banks can issue offshore via a special ruling from the ATO that permits the origination of hybrids without franking credits, if done through an offshore branch. ANZ issued one through their UK entity and Westpac’s was done using their New Zealand entity. The benefits of obtaining cheaper funding levels and a diverse funding base will be appealing to the other major banks, with NAB being the most likely to utilise this given their NZ operations through BNZ.

Corporate Comments

- TPG Telecom (TPM) beat market expectations with its full year result, however there are two significant challenges for the company in the medium term.

- Seven Group Holdings (SVW) is better placed to participate in the increase in infrastructure spend in Australia after increasing its stake in Coates Hire. Corporate governance and exposure to old media may moderate some investors’ enthusiasm.

TPG Telecom’s (TPM) full year result had a mixture of good and bad news and the share price swing post the announcement led to the conclusion that investors were unsure on which to focus. It was twelve months ago that the company shocked the market with FY17 guidance that was well below market expectations which implied that its previous successful multi-year period of growth driven by consolidation of smaller telco companies was about to be halted by the transition to the National Broadband Network (NBN).

TPM’s result actually slightly exceeded that initial guidance; somewhat unsurprising given its track record of beating its own forecasts. The year was solid in terms of further growth in its broadband subscriber base of its core TPG brand (+8%), although the acquired iiNet business has had more limited success in this area, with subscribers flat year-on-year.

The primary issue, however, for TPG is the margin contraction that it is experiencing as its customer base transitions to the NBN, with retail service providers facing higher access costs which have not been recouped through higher charges to consumers as a result of competition. The magnitude of this was initially underestimated by the broader analyst community, although TPG has now spelt out the expected drag on its earnings in the next 12 months. With less than 30% of its broadband subscriber base currently on the NBN, this headwind will remain for a few years to come.

TPG Telecom: FY18 EBITDA Bridge

Source: TPG Telecom
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An additional challenge for TPM in coming years will be convincing investors that its foray into the mobile markets of Australia and Singapore will be successful, given the large capital spend (approximately $600m over the next two to three years domestically) that it is undertaking to be a viable competitor to the incumbents. Presently, there is a high level of scepticism that it will achieve an acceptable return on this investment, with TPG noting that it would likely need to build a market share of approximately 7% before it is breaking even at an operational level. It will be several years before an assessment of the success or otherwise can be made on this decision. In the interim, however, there is expected to be some pressure on TPM’s balance sheet given the upfront costs involved in the build of the network and acquiring spectrum.

With the payoff from its mobile investment could potentially be material, this is long-term in nature and in the next couple of years, the focus is expected to remain on the declining earnings profile of its consumer broadband business. With the other major telcos (Telstra and Vocus) facing similar and other company-specific issues, our view is that investment in the sector is not entirely necessary for domestic equity investors.

Seven Group Holdings (SVW) got a tick from investors after it announced that acquired the remaining 53% stake in Coates Hire that it didn’t own. With the deal pitched at an expected 15% accretion to earnings per share on a full year basis, the 10% rally in SVW’s share price was unsurprising. Seven had initially acquired an interest in Coates a decade ago just prior to the global financial crisis in a deal with private equity group Carlyle Group.

Coates Hire is Australia’s largest equipment hire company with a significant scale advantage over its competitors – it is approximately four times the size of its biggest rival. Coates faced a declining revenue and margin profile over several years due to a collapse in major mining and infrastructure activity, particularly in Western Australia, although conditions have stabilised in the past 12 months. Earnings showed a sharp improvement in FY17 following a focus on costs and asset utilisation. The current outlook for the business is quite strong given the growth in infrastructure activity (predominantly government spending) on the east coast of Australia and major long term projects underpin the positive view of management.

WestTrac, which is the authorised dealer of Caterpillar equipment in WA and NSW/ACT, is the other large division of SVW and its performance is leveraged to domestic iron ore and coal markets. WestTrac has also faced a challenging market environment given the scale back in large capital-intensive projects and the focus on cost reduction by the majority of the mining industry. The recent rebound in commodity prices has provided an opportunity for improved returns in the medium term, particularly on the product support side given the deferral in what may be otherwise viewed as ‘maintenance’ capex by many of its customers.

Seven Group has already rallied strongly over the last 18 months on the back of this turnaround in the operating environment of these key sectors, which will now represent approximately three quarters of group earnings and should lead to solid earnings growth in the next few years. When looking at the broader group, the key negatives that may moderate some investor enthusiasm is its exposure to structurally challenged, old media assets through its investment in Seven West Media (Channel Seven, West Australian newspaper and various magazine titles) and the corporate governance discount that should be applied to the group given the controlling stake held by Kerry Stokes.

Seven Group Holdings: Earnings by Division following Coates Transaction

Source: Seven Group Holdings
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