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WEEKEND LADDER

A summary of the week’s results

23.06.2017

Week Ending 23.06.2017

Eco Blog

- The big picture debate on what comes next for economies and the financial system rests on central banks and inflation. First indications of how this will evolve will become evident in the second half of the year.

- China A shares made their way into the MSCI Index. This forms another important step in the inclusion of China into the global financial system and will increase global research on these companies. Indications from the banking regulator also point to efforts to reign in wayward investments.

The somnambulant influence of the northern summer has set in, with directionless markets and lack of a new macro theme. From an investment market perspective, the consensus is heavily skewed towards overweighting equities versus bonds, but with an increasing sense of unease that this is mostly following flows. In an effort to be correct, the accompanying comments are that the risks of a downturn or economic recession are rising. Place your bets at, say, a 30% chance of a recession in the next two years and one can claim victory either way – right as it did not occur (70% probability), right as it did (a high enough probability at 30%). For most part, this seems to be based on the maturity of the cycle, rather than a smoking gun to trigger this downturn. Nonetheless, the signals from the bond market, yield curve and credit spreads are primed to accommodate a slowdown in economic trends rather than the uplift most had expected. Persistently low inflation is upheld as evidence that growth is too slow to cause any capacity resistance. Yet perversely, equity markets and higher risk credits are looking forward to solid earnings growth.

Aside from a disruptive geopolitical event, a meaningful trade war or similar policy misstep, the credible risk lies with the path of central bank purchases. If one needed convincing that investment markets and quantitative easing measures have been correlated, the charts for the global pattern paint the picture.

Source: Citigroup
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At a simple level, central banks have achieved what they intended, diverting flows into private capital markets at low cost. The ECB and BoJ have cumulatively bought all net issuance by their governments from before the financial crisis. Savings looking for return inevitably had to turn to other asset segments. This is hardly a revelation, but at times the short term momentum and noise in markets misses the large scale impact of this unique structural situation. Locally, we see the marketing of term deposit ‘alternatives’ as evidence of the pressure investors are under to reach for returns that cannot be gained from traditional havens.

The potential for this eight-year support mechanism to go into reverse, regardless of how slight, is therefore the issue for the coming six months, and probably the next few years.

Post the June Fed rate hike, the proposed balance sheet reduction by limiting reinvestment from maturing Treasuries drew no response from the bond market, indeed, on the day yields eased due to weak retail sales. The full impact of reduced monetary support therefore needs the helping hand of something else, most likely an element of fiscal success from the US administration. This has become complicated by the debt ceiling, which needs to be dealt with by late August. The combination of tax cuts and spending sits uneasily in the Republican camp. 

Outside these policy issues, inflation is still the one economic metric that is likely to shift opinion. Much has been written about the refusal of US inflation to lift its head, notwithstanding tight labour markets and an apparent rise in wages. Shelter costs (housing and housing related) accounts for some 40% of the CPI. The irony is that low interest rates have induced decent supply, particularly in apartments, and therefore rentals are softening. Perversely, therefore, a rise in interest rates may see some inflation come through. A similar argument could be made for goods, where China’s repetitive stimulus and unwillingness to deal with bad debts has encouraged capacity and excess supply.

Pimco, well known for their secular forums, makes the case that there are two potential outcomes. A protracted period of low growth and low inflation (and low investment returns) while economies would be vulnerable to any disruption without a buffer. The second is for rising rates, which could well become the seed to the downturn, but then there would be the capacity to signal support through rates. Neither make one glow with appetite to take on more risk in investment portfolios.

The inclusion of 222 China A shares (each at a partial inclusion factor of 5%) in the MSCI index from 2018 is a small step towards an inevitable structural change in the regional balance towards China and more than likely, India, in the coming decades. The incremental nature of the move belies the end result. Developed country representation will fall, and in the MSCI Asia Pacific index, Australia will be a loser in terms of weighting along with Taiwan and Korea. In the Emerging Market index, the addition builds on the current China representation through the other designations (H shares, overseas shares, Red Chips).

Source: MSCI
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Assuming China’s financial markets behave according to plan, it is more than likely the inclusion will progressively widen and deepen. This will go hand in hand with more analysis of these stocks, many of which are unfamiliar to investors accustomed to seeing the likes of Tencent, Alibaba or China Mobile in their portfolios. It is also likely to dampen the volatility and irrational valuation in the market as institutional investors introduce greater discipline to pricing.

An aspect that has also garnered attention is the undue importance of the MSCI and its methodologies. Some asset managers such as Vanguard have moved to using other indices such as the FTSE for their passive funds to reduce the higher fees MSCI charges and untie the constraints imposed by the MSCI. As an example, the MSCI Emerging Market index will now have 1,116 members, up from 845. The FTSE Emerging Market index has 3,972 members.

Following this move, it may have been a coincidence that the supervisory director of the China Banking Regulatory Commission (CBRC) was quoted as suggesting asset managers and trust companies may be regulated to limit leverage and that some of the large internationally acquisitive companies would have their ‘systemic risk’. These companies have been prone to buying assets that, at face value, have no relationship to the company’s operations. Effort to limit the adventurous nature of financial market behaviour in China is essential for longer term stability.

Fixed Income Update

- Moody’s downgrades the Australian banks. However, it is not expected to significantly impact on the funding costs for the majors.

- Demand for new issue bonds remains strong, with some more risky deals coming to market.

- A narrowing of spread between the Italian and German 10-year government bonds indicates a lift in investor confidence for the Eurozone.

This week, ratings agent Moody’s downgraded many of the Australian banks, following on from Standard and Poor’s two weeks ago. Moody’s reduced the long-term rating on the four major banks to Aa3 from Aa2, putting them in line with Standard and Poor’s. The announcement cited concerns surrounding house prices and household debt levels in an environment of low wage growth.  Other smaller banks were also downgraded including Bendigo and Adelaide Bank, Members Equity Bank Limited and Credit Union Australia Limited.

To assess the impact that this downgrade is likely to have on the cost of funding for the banks, a good indicator is the movement in spreads in the Credit Default Swap (CDS) market. A CDS is a contract between two parties, whereby one buys protection or ‘insurance’ against a default of an underlying corporate or bank. It is a means of protecting against credit risk of a single issuer. For example, the outward movement for CDS on a 5 year CBA bond is indicative of an increase in the spread (above the risk-free rate) of the ‘insurance premium’ or cost of the CDS contract on a 5 year CBA bond. If CBA was to issue a new 5-year bond then market participants would use the CDS market for CBA to determine at what rate they should be apply to a new bond. Therefore, the CDS market determines the cost of funding on new debt deals.

Following the downgrade by S&P at the beginning of June, the CDS on CBA moved out, before retreating back in the following two weeks. The Moody’ downgrade has once again seen the CDS market trade wider.  However, the increase in the banks cost of funding following the downgrade is still well contained.

Credit Default Swap (CDS) spread movements on a 5 year USD CBA Bond in the last month

Source: Bloomberg, Escala Partners
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Demand for corporate bonds remains robust, with a decent pipeline of recent new deals which we understand are mostly well oversubscribed. Recent domestic issues that confirm this strong appetite include Aurizon, Volkswagen and Bank of Communications, all of which had excess demand.

In offshore markets, a couple of new and unusual bond deals of note have been making headlines:

- FWD Group in Asia issued a subordinated, zero coupon, perpetual bond.  While the bond was priced at a discount to par, it does seem like a moot point given it has no maturity. However, many investors somehow priced in the potential value in holding a bond that has no end date and doesn’t pay a coupon, as it was oversubscribed.

- Another indication of the strong demand in corporate bond markets, was the recently issued 100-year bond by the Government of Argentina. As a reminder Argentina defaulted on its outstanding bonds in 2002, and after a 10-year dispute with creditors, it was only allowed to re-enter the global credit markets last year. The country does not have an investment credit rating by any of the agencies. Despite this, it came to market with this ultra-long bond paying 7.125%, which was said to have over $10 billion in orders for $US2.75 a billion deal.

- Russia sold more than $3 billion in sovereign debt on Tuesday this week, in its first bond sale since returning to the international debt markets last year. The deal attracted $6.6 billion in demand, implying the order book was more than 2x oversubscribed.

The above deals are evident of the strong demand for corporate bonds at present. We are mindful of the availability of these riskier types of bonds, and seek to use bond funds that don’t take on undue credit risk and search for true value.

The pricing difference between German and Italian government debt has, in recent years, become an indicator of investors’ confidence in the eurozone. Political instability in the region has dominated the first half of 2017 with elections taking place this year in the Netherlands, France, Germany and potentially Italy. Macron’s easy second round win in the French Presidential elections, together with an improving economic outlook, has calmed concerns, and this has been reflected in the spread differential between the 10 year Italian government bond with that of Germany.

This spread peaked at 211 bps in April this year, but has contracted in the last two weeks taking the spread to 164 bps. Despite the narrowing, it is still well above its lows in 2015 of just below 100 bps.  

Spread differential between the 10 year German and Italian government bonds

Source: IRESS, Escala Partners
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Corporate Comments

- QBE’s downgrade was disappointing, yet the stock is an effective hedge against further increases in interest rates.

- South Australia’s new banking tax is immaterial to the earnings of the majors, although is a further negative for sentiment.

- Tabcorp has taken a further step towards its takeover of Tatts with competition approval this week.

- The capital raising and acquisition of by Dexus Property may be a sign of excessive valuations in the property sector.

QBE Insurance’s trading update this week saw the stock sold down, with a  forecast cut in the combined operating ratio by 1.0% to a range of 94.5% to 96.0% for the half and full year. The combined operating ratio of an insurer is essentially the percentage of claims and expenses of premium income, i.e. an operating ratio below 100% represents a positive underwriting result.

QBE’s reduced underwriting profitability was due to several factors in its emerging markets (EM) business, including a higher level of claims, an increased frequency of medium sized claims in Asia, weather related claims in Latin America and adverse experience in legacy portfolios in Latin America. As a result, the company advised that its combined operating ratio for emerging markets was expected to be 110% for the half.

Other parts of QBE’s business were judged to be performing well, including Australia/New Zealand, Europe and North America. In addition, QBE noted that the return on its investment portfolio was expected to be at the top end of its previously guided range, providing some offset to the weaker underwriting result.

While some of the issues that QBE noted look to be one-off in nature (such as weather-related claims and those from its legacy portfolio), others will require further clarification to determine whether they will be ongoing. QBE’s large global operations would certainly increase the likelihood of some problem area at any given time, although a lack of any positive underwriting surprise in other regions to offset its EM exposure is disappointing. A soft premium inflation environment may also make it difficult for QBE to recover these losses through increases in premium rates.

With a recent history of negative earnings surprises, QBE deserves the discount that it trades on relative to its international peers and the large domestic insurers, IAG and Suncorp. Nonetheless, most parts of its business are improving, assisted by the operating cost reductions that it has been achieving and a stabilising environment in its key regions. The company is also yet to commence its $1bn on-market share buyback announced in February. With significant investment earnings leverage to rising US interest rates, we remain of the view that the stock is an attractive hedge to this key negative risk to most listed equities.

QBE and Bond Yields

Source: Bloomberg, Escala Partners
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The banking sector received further bad news from this week, with South Australia following the Federal Government’s liability tax on the majors amd imposing a similar tax in the state’s budget. The additional levy, which will represent South Australia’s share of the national economy, will have a relatively immaterial impact to the earnings of the majors, accounting for approximately 0.2% of banking profits.

Two more significant risks, however, are likely to result from SA’s actions. In an environment of tight budget constraints, there is an increasing probability that other states will introduce a liability tax, which could effectively double the taxation impost of the Federal Government. Secondly, the regulatory discount applied to the sector should be expected to increase further. Notably, a similar tax introduced in the UK has been raised several times in the ensuing years.

We remain cautious on the banking sector despite the sell off and subsequent derating that has occurred over the last month. Benign loan growth, regulatory headwinds and bad debts at cyclical lows, will continue to challenge the banks in the medium term.

Tabcorp (TAH) got the green light from the Australian Competition Tribunal for its proposed tie-up with Tatts Group (TTS) with the provision that the company divest part of its gaming machine monitoring business. The approval will allow TTS to vote for the proposed merger scheme, which is expected to be held in August and implementation shortly thereafter.

The primary attraction of the TAH-TTS combination has been the expected synergies that should be realised from the merger, estimated to be at least $130m in the first full year of integration. This number has though been viewed as being at the high end of most sell side analysts’ forecasts, leaving little margin for error for the group over the next 12 months.

TAH also provided a trading update for FY17, with guidance almost 10% below the market’s expectations. Revenue growth is forecast to be relatively soft at approximately 2%, in line with the company’s December half result. It appears that margins have taken a hit from an increase in expenses, partly attributable to investment ahead of the TTS merger, ticking up to 23% of revenue and higher than recent periods.

Aside from achieving its integrating cost targets, the medium term challenge for TAH is likely to be addressing the faster rate of wagering turnover growth of its domestic competitors, which are growing share at the expense of TAH’s retail outlets. While the TAH/TTS merger will result in an attractive portfolio of defensive assets, its low-growth outlook and forward P/E of almost 20X leads to the conclusion that the stock looks to be fairly fully priced.

Tabcorp: Opex/Revenue Ratio

Source: Tabcorp
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Dexus Property (DXS) was sold down after it announced a capital raising and acquisition of two properties in Sydney. The office REIT has outperformed the property index through this year, no doubt aided by its lack of exposure to retail, which has fallen on consumer spending concerns. The Sydney office market (DXS’s primary exposure) has been strong and may continue so in the short term. However there is an expected increase in supply coming that should soon start to impact rents. Trading at a healthy premium to its asset backing and in a sector linked to interest rate movements, we believe that yield hunters are better served looking elsewhere.

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