Week Ending 23.03.2018
- The trade battle hit investment markets this week. The risk is that politics and imbalances combine into a scale of protectionism that undermines the economic momentum of the past year.
- Already, there is a softer tone in the PMI indices, though mostly ascribed to structural limitations within the supply chain and the rising Euro and Yen.
- Inflation frustrates all central banks. Wage growth implies some movement.
- Locally, the jobs market is bifurcating between the public and private sector. Household consumption is expected to remain subdued.
It will take a little longer to assess the risk that the US tariff battle with China brings to financial markets. The full list of products on which the 25% rate will be imposed will only be released next week. So far, the statement cited ‘aerospace, information technology equipment and machinery’. Then, there will be a 30-day comment period where industries and consumers can make a case against the inclusion of these products and, in all likelihood, China policy makers will enter discussions. Another aspect is the intention to impose restrictions on Chinese investment into certain ‘sensitive technologies’.
The view is that China will be measured in its response. Its main leverage lies with US companies that have a vested interest in China either in a supply chain or in developing business within the country. It first salvo has been to target pork, fruit, wine and recycled aluminium. Soybean imports from the US (citing agricultural subsidies as the cause) may follow.
A longer-term repercussion will be that China intensifies its efforts to deepen its industrial base with value added products. This may deprive some global companies of a major source of revenue and growth and even result in another round of price deflation as China adds to capacity in these goods. There have been emerging signs of rising costs in China, not least in the recent CPI data, where core (ex food and energy) prices rose by 2.5%; a notable uplift on the soggy 1.6% of 2017.
The trade storm arose in a week where the US current account deficit data for Q4 2017 came in at the highest since 2014. The main cause remains goods, with a 7.0% increase in imports exceeding the 6.5% rise in exports in 2017. While the differential may appear small, the resulting dollar amount is large. The US does have a positive services balance, but, in turn, has a net deficit on income. The primary income is from direct investment and portfolio income, while the secondary is transfers by residents; in particular people that work in the US and remit income to outside the country.
While China is easily singled out as the largest cause of the trade gap, it is by no means due to an unusually heavy tariff impost on its part. Most emerging countries have some protectionist measures, with countries such as Brazil and India applying an average rate of 6-8% according to data from the World Bank. China is at an average of 4%, while most developed countries have an average 2% rate.
The case for the US to introduce a goods tariff would therefore rest on the question of government subsidies and indirect support, excess capacity due to a disregard for the cost of capital and/or the value of the currency. China may turn this on its head by redirecting its imports to sources outside the US where practical.
Where the US probably has a stronger case is in intellectual property. China has limited the participation of US and most foreign companies in its services sector. There is a widely held view that transfer of processes and IP are part and parcel of the cost of doing business in China. Contracts with government or semi government bodies has long created discomfort where there is a high level of sophistication in the requirements. Loose adherence to brand assets is another widespread issue across Asia.
- The end result of this tension cannot be construed as in any way positive for economic development, even if there is some validity in the argument. If it does become more than a warning shot, the China economy will most likely slow absent another round of fiscal stimulus or credit expansion. For the US, it raises the risk of inflation and therefore higher interest rates.
Coincidentally, there were some signs of a plateauing in economic momentum, as European PMIs eased back. As is often the case, a partial cause was weather related, but the other contributors were, perversely, a result of the growth in the past year. Supply chain delays, raw material shortages and even a lack of skilled labour were cited by the manufacturing sector. German supply chain shortages were reported to be at their highest in the 22 years of the survey. However, one factor that may play out further is an easing in export orders. Whether this symptomatic of a global slowdown or due to the strength in the Euro remains to be seen.
The story had a parallel in Japan. Here too the PMI is high (a reading of 54) but has dropped back into the end of the first quarter. There was a similar tale of a stretched supply chain, input costs running at their highest rate in three years and inevitable job vacancies given the low unemployment rate. Additionally, the Yen has not been friendly for export demand.
The CPI in Japan has hit 1%, but excluding energy and food, remains well below the BoJ target, even though wage growth is at its highest since 1998.
The mystery of missing inflation continues as a heated topic.
US wage growth is averaging 2.9%, but not accelerating in line with the traditional economic model based on the Phillips curve. At the current level of unemployment, a greater level of pressure should have emerged. Even for high skilled jobs with shortages frequently nominated by corporates, the pace of wage growth is subdued.
12-month moving averas of mediam wage growth
Locally, low wage growth is the rationale for the RBA to stay put for what might soon be a record of two years. A notable development is the widening divide between the public and private sector. In 2017, public sector employment increased by 7.6%, compared to the 2.6% of the private sector. As we have noted, the NDIS accounts for a large proportion, but other sectors such as education and administration have also seen a robust level of job growth.
Public sector wage growth has also exceeded that of the private sector by a decent margin. In fact, absent the mining boom, it has been typical, even allowing for bonus payment in the private sector.
Public spending in aggregate has been a large supportive factor for the economy in the past three years, averaging 4% per annum, compared to the household sector running at 2.4% per annum. To fund that, households have run down their savings while the government sector has benefited from the increase in jobs, bracket creep and, at a state level, property-related taxes. Altogether it does not add up to much of a base from which to build economic growth. Compound that with a likely tightening of credit for the household sector, as the banking royal commission highlights the sloppy standards applied to extending debts to individuals.
- The thematic positioning in the equity market against domestic consumption in Australia is in contrast to the potential that is represented by most global regions where domestic demand is on the rise.
Investment Market Comment
- Looking into the composition and concentration risk of the financial sector.
Portfolio diversification is generally viewed from an asset class level and then at a regional or sector level within equities. However, it is equally important to look at the composition of each sector. Within the current definitions are 11 sectors and each will have its own unique dynamics and concentration risk. An appreciation of the structure will give context to some of the risks and exposure within the equity portfolio.
GICS sector weights in the All country index
The IT sector has been well and truly covered in recent times, with our weekend note last week touching on the implications for the sector last week in the upcoming GICS shuffle. At present two of the FAANG stocks, Amazon and Netflix, do not contribute to the IT sector’s returns as they make up nearly 25% of the consumer discretionary sector.
The next biggest sector in the MSCI ACWI, the financial sector. This, unsurprisingly, consists of mainly of banks, investment funds and insurance companies.
Financial sector weights
Compared to other sectors, the stock concentration risk is relatively low with the top 10 holdings making up just under 30%. Warren Buffet’s investment company, Berkshire Hathaway, is the largest at 5.2% and Commonwealth Bank ranks 12th.
The performance of the largest companies is shown in the table. It is notable that companies with regulatory issues (Wells Fargo and CBA) have been the weakest over the past twelve months.
Despite the low level on concentration risk at a stock level, there is a large bias towards large-cap US banks and the banking industry. Therefore, most of the revenue generated by the sector comes from mortgages and loans that are leveraged to a rise in interest rates. The returns of the above holdings may therefore have a high correlation.
Fixed Income Update
- The US Federal Reserve raised rates by 0.25% this week. However, it is the increased Treasury issuance over the last few weeks that is driving up short term yields while rates on the long end responded to Trump’s new trade war with China.
- On the back of a recent covered bond issuance by NAB, we discuss the composition of these little-known securities and their benefits for banks.
As expected the Fed raised interest rates by 0.25%. The market had already fully priced in this outcome, yet rates fell following the announcement as Chairman Powell’s comments were perceived as mildly dovish. The forward guidance of two more rate hikes in 2018 remained unchanged and committee members were divided on their views for 2019. This lead markets to interpret the commentary as lacking conviction on the tightening of monetary conditions.
Through the week short dated treasury yields rose to their highest level in 10 years with the 1-year rate reaching 2.08%. As the Fed’s move was already accounted for, the main reason is said to be the recent surge in issuance by the US Treasury as they seek funding for the tax reforms. To fund the budget deficit Treasury issued $111bn in new t-bills in February, together with capital raising through longer dated bonds. This trend has continued into March and the increased supply has resulted in a higher cost of capital given competition with corporates for short term funding. The news of Trumps new tariff on some of China’s imports at the end of this week has eased rates on the long end as investors look for safe haven assets. However, short term funding rates still remain relatively elevated.
- Australian banks will also be affected by the increased funding costs in the US. They typically tap into offshore markets to obtain better rates than what they could achieve domestically. As the economics erode, we should expect to see more issuance domestically and the higher funding costs potentially passed on to customers.
Treasury yields driven up by Fed policy, high issuance
A little discussed security in the fixed income universe is the covered bond, which was only legislated in Australia in October 2011. These bonds are typically issued by banks and are secured against a pool of assets, most commonly residential mortgages. They are similar to asset backed securities, however the main difference is that the issuer is responsible for paying the bondholder, and the assets are only used in a default, as opposed to an ABS/RMBS structure whereby the assets are relied on to pay the bondholders and the issuing bank no longer carries the liability. Covered bonds remain on balance sheet for the issuer versus a RMBS structure which are off balance sheet transactions.
Given the collateralisation, covered bonds rank ahead of senior unsecured bondholders in a liquidation, but behind depositors. The securitisation enables the bond to have a higher credit rating than unsecured debt and therefore a lower cost of funding for the issuer. The Australian banks are ranked AA- by S&P, but these bonds have a 3notch uplift giving them a AAA rating.
The Australian regulators have limited these securities to 8% of the total bank assets, although currently issuance is well below this level. With the higher credit rating, these bonds are a good alternative funding source for banks during periods of market stress, such as in a financial crisis and banks have remained under the 8% cap for this reason. Contrary to this while still remaining under the ceiling, NAB issued one of these bonds earlier this month which marked the first instance by a major bank in nearly a year and the first one by NAB since 2014.
- APRA regulations ensure that the banks are well capitalised. The introduction of covered bonds into the Australian market in 2011 gives another tool for the banks to fund themselves during dislocated markets, further supporting the credit worthiness of our banks.
Issuance by Australian banks
- TPG Telecom (TPM) upgraded its guidance for the full year, although this was mostly driven by short term factors. Mobile growth will be critical to the company’s longer-term success, with capital spend restricting shareholder returns in the interim.
- Brickworks (BKW) reported a strong half yearly result, however demand in its end markets is at a cyclical high.
TPG Telecom (TPM) reported its half yearly results with a slight upgrade to its full year profit guidance, although this failed to impress investors. Much of this was due to the fact that the key driver of the upgrade, being delays in the rollout of the National Broadband Network (primarily relating the suspension of HFC broadband connections), remains an inevitable and unavoidable challenge for the company’s broadband margins in the medium term. Thus, while the margin reduction equated to loss of around 5% in EBITDA for the half, this is expected to accelerate into FY19 and FY20.
TPG Telecom: EBITDA Bridge
While this issue is now well known, of concern from the result was a noticeable slowdown in subscriber growth in both consumer broadband and across its mobile customer numbers. Historically the company has had a sound track record of organic subscriber growth, particularly in its core TPG brand (although iiNet’s middle price point offering has recently seen it underperform), with its low price plans the primary selling point in winning market share from the larger incumbents. The sharp slowdown in customer growth in this half is likely a function of both a maturing market and the high level of price competition among the key players to secure their customer base as the NBN transition continues.
Like Telstra, TPG faces an earnings hole to plug within an NBN-world, yet the company has ambitious plans than its much larger peer to address the issue. TPM is currently a bit player in the mobile sector, although is making a significant investment in building its own network in Australia and in Singapore. As such, the company is going through a high-capex period, which will result in limited dividends within the next couple of years.
There are risks around achieving a satisfactory return on this investment and it is the view of several analysts that its forecast spend will be insufficient to build a network that can viably compete with the likes of Telstra and Optus. Nonetheless, to us it highlights the longer-term focus of the company’s chairman, founder and significant shareholder David Teoh, and willingness to make calculated investment decisions rather than appease the shorter-term dividend interests of many shareholders.
It remains too early to call whether this investment will be a success or otherwise, however the short-term driver for the stock will be arresting the recent slump in subscriber growth and cost cutting efforts to offset lower NBN margins. Trading on a forward P/E of 16X, at face value the stock looks to be fairly priced, although noting that this is yet to fully incorporate its earnings profile once the NBN rollout is complete.
TPG’s result is also keenly watched by shareholders in Brickworks (BKW), (Australia’s largest manufacturer of bricks) which this week reported an 18% increase in earnings in its core building products division. The connection is via Brickworks’ legacy cross-shareholding in Washington Soul Pattinson, which has a 25% stake in TPG. BKW’s shareholder structure has been an impediment for some prospective investors in the company (a point which has led to attempts by institutional shareholder Perpetual to merge the two entities), although it also provides a useful window into the state of the Australian housing industry.
We have previously noted the elongated nature of the current property cycle in Australia, which has been supported by record low interest rates. While we have now passed the peak in construction, it is also probable that the downside for building materials companies will be limited. This is primarily due to the fact that the recent construction boom has been driven by apartments as opposed to detached dwellings, with the latter more materials-intensive on a per unit basis.
The following chart on detached building approvals illustrates that this category, while at cyclical highs, is not at extremely elevated levels. Nonetheless, building materials demand is forecast to peak in FY18, which will be a headwind for BKW’s earnings in the medium term. Additionally, the company will be required to absorb higher energy costs, which will impact its margins. A potential risk in the medium term could be a restrictive housing lending environment which may materialise in the wake of the ongoing royal commission into the banking industry.
All of these factors and risks are reflected in BKW’s forward multiple of 13X, which is significantly below that of the broader industrials sector. Among listed companies with exposure to the Australian housing market, we have preferred those that are closely aligned with a more favourable demand outlook, such as US housing (James Hardie and Boral) and Australian east coast infrastructure capex (Boral and Adelaide Brighton).
Detached housing building approvals