Week Ending 23.09.2016
• The Fed and BoJ did not disrupt markets this week. For the US December is lining up as a high probability for a rate rise while Japan is attempting a new ill-defined path forward.
• Global trade may be at risk if the US election prevents or even retraces ground on agreements. The chance of tit for tat measures should not be discounted.
Even the experts struggled to paint a coherent picture on the potential impact from the latest efforts by the Bank of Japan (BoJ). Rather than a hoped for analysis on monetary policy, the BoJ stated it would anchor its 10 year bond rate to 0% and announced a barely credible commitment to overshooting a 2% inflation target. The difference to the prior policy was the removal of a quantitative benchmark and implies that the BoJ balance sheet has greater leeway to expand. In practise there is not much in this as the BoJ has already bought a substantial amount of available Japanese Government Bonds (JGBs). While there are inevitably nuanced outcomes that may be relevant for rates and currency traders, the predominant reaction has been that there is no evidence any meaningful economic improvement that will emerge from this policy meeting.
Instead, the likely repercussion is that the style of quantitative easing enacted over the past eight years is now being put to bed. Central banks have no choice but to maintain large and probably open-ended balance sheets, but the simple dogma of establishing the scale and time frame of asset purchases is expected to shift towards stating a goal without a prescriptive path to that desired outcome. This will require investment markets to assess the attitude of the central bank rather than rely on specific rules. Markets are therefore likely to be even more reactive to data than before.
The only change at the US Fed’s meeting this week was in the projections. To remind, each member indicates their forecast of rates at the quarterly meetings, which are then shown in a dot matrix without identifying any individual. Unsurprisingly, the forecast trend is lower than it was in June, while there are few economists that are venturing towards the 3% longer run rate suggested by the Fed. Nonetheless, it implies only three members expect rates to be on hold by the end of the year. The likelihood of a December hike is currently priced in at about 60%.
Federal Reserve Dot Plots
The potential path for equity markets over the coming year or two can be construed from the jigsaw of the central banks. Bar the US, interest rates are most likely to be flat or within a very tight range. That implies that rate sensitive sectors – banks, utilities, infrastructure and REITs - will move in a wave pattern, reflecting the broadening and contraction of spreads and shape of the bond curve. Elsewhere, ever-expanding valuations cannot be relied upon and low economic growth suggests a highly selective approach is required.
With the impending US election, the discussion on trade pacts has come to the fore. Currently, the US has two free trade commitments, but another three are awaiting ratification. At this stage both of the presidential candidates are indicating they will not follow through on these agreements.
One hopes that both sides have learnt a smidgen from the historical perspective of the 1930s. The infamous Smoot Hawley Act introduced import tariffs on 20 000 products and subsequent retaliation which was the final straw in weak economic conditions, resulting in the deepest recession in modern history.
A second possible outcome would be specific tariffs or restrictions on products from China and Mexico, both commonly singled out as hurting the US manufacturing sector. This again would be negative for global growth, however, depending on any quid pro quo, may be troublesome rather than disastrous. Repercussions may be higher inflation given that tariff costs will flow through to prices, implying a change in the expected cash rate.
The greater risk is if China plays hard ball and finds a reason to curtail the flow of products regardless of tariffs. We have seen the impact of its desire to limit overseas purchases of infant formula as an example. High profile goods could well find that there is some regulatory or other restriction placed on their entry into China. Naturally, this could escalate into something a lot more problematic.
The best one can hope for is that there is no change. It would mean the trade agreements under consideration will not be ratified. The high hopes the Australian government had for the TPP given our export-oriented economy would come to naught. The political bias at this time makes such endeavours impractical.
A consequence of the US vote and the forthcoming European elections in 2017 may have a much greater impact on investment markets than might otherwise have been the case. Brexit may have lulled some into the conclusion that they are more about lights and colour rather than having a meaningful impact. Rather, it is the time it takes for things to change and even Brexit can be expected to be an important issue for the UK and probably Europe as well.
Fixed Income Update
• Credit securities are, for the moment, revelling in the stable yield environment.
• Long term negative real rates are not as uncommon as you might think.
The actions (or inaction) of the Fed and BoJ saw credit indexes strengthen, with no imminent danger of unexpected rate movements and the continuation of modest economic growth, seen as the sweet spot for credit markets. Notable has been the stronger performance from energy and material credits, which are now pricing in the combination of an improvement in corporate cash flows due to cost cutting and better commodity prices. For those with a risk appetite, purchases on the heavy selling of late 2015 into early 2016 have been well rewarded. It is a reminder that fixed income is in many cases a better option for buying on weakness, as the reversion in spreads is more certain than a recovery in equity values.
Reflecting on the earlier economic comments with respect to the uncertainty regarding the US trade pacts, it may be that emerging markets (EM) are already toying with the possibilities. Alongside high yield, emerging country debt has been fruitful demonstrating the risk-on characteristics in both segments and some correlation with commodity markets given the reliance of key countries on resource prices. Nonetheless, EM has also been a beneficiary of the desire for yield, the stability of exchange rates in recent months and the prospect for fundamental economic change in countries such as Brazil.
Emerging Market Credit Spreads vs Developed Market High Yield and Investment Grade
This is particularly pertinent for Australian investors given the bias to local equities. Portfolios inevitably have a high correlation to commodity prices (even though that might be indirect) and to emerging markets. Alternative fixed income returns from other developed markets remain an important way to add stability to portfolios.
It is worth taking the ongoing discussion on negative rates in Europe and Japan in a longer time frame. The table below shows real (adjusted for inflation) government bond rates over the past 75 years. Negative real rates were common from 1940-1970 due to low nominal post war rates followed by heightened inflation. Only when central banks took on the mandate to slay the inflation dragon did rates become positive. Why then should one not allow for the possibility interest rates in real terms could be zero to negative for a few decades to come? Even putting aside the quantitative easing, perhaps all that needs to be on offer is to maintain the real value of money and no more. In a world of aging demographics and ‘excess’ savings, that is a real probability.
Real Annualised Government Bond Returns by Decade
• TPG Telecom disappointed with its FY17 outlook, although we believe that the smaller telcos will still perform comparatively better than incumbent Telstra (TLS) as the NBN is rolled out around Australia
• Macquarie Group (MQG) reiterated its full year guidance for flat year-on-year earnings after cycling a tough comp
The mid-cap telco sector, which has been a source of strong earnings and share price returns for a number of years, had a setback this week following the release of TPG Telecom’s (TPM) result. TPM’s FY16 result was in line with its guidance and the forecasts, however the outlook for FY17 was below expectations.
While there was a large negative reaction due to the company’s guidance, there were several positives to be gleaned from the FY16 result. TPM reported underlying earnings growth of 46%, which was driven by an eleven month contribution from the acquired iiNet business. EPS growth was slightly lower at 39%, with iiNet predominantly funded by debt. Similar to the previous acquisitions, a high level of synergies have already been achieved from the iiNet, helping to lift the EBITDA margins in the division from 18.0% to 23.5%. TPM’s existing consumer and corporate business again exhibited a good level of profit growth, with the core TPG brand generating consistent consumer broadband subscriber growth.
TPG Consumer Broadband Subscribers
As noted above, the primary concern from TPM’s result was the company’s guidance for the next 12 months, which pointed towards an underlying earnings growth rate of 6%. This would represent a step down from the levels which investors have become accustomed to and appears to be primarily driven by the increased access costs that it (and other telcos) face for NBN broadband plans, resulting in an expected fall in profit margins. While this will be offset to a degree by the higher price of NBN plans compared to those that utilise Telstra’s legacy copper network, the competitive environment is still likely to reduce the industry’s ability to recoup the cost and result in margin compression.
To date, this has failed to have an impact on TPM’s consumer broadband margins (which were broadly flat in FY16), with the NBN only representing a small proportion of overall subscribers (see chart above) given the slow progress of the rollout. This will accelerate in the next few years, however, and so the risk remains that this could turn into a significant earnings headwind in the medium term.
While this was a known issue in the sector, the consensus view was that TPM would still be able to generate solid earnings growth from multiple sources. These included the ongoing synergies to be extracted from iiNet, market share gains given the strong value proposition of the core TPG brand and the rollout of its fibre to the building (FTTB) network. The FTTB will effectively compete with the NBN across approximately 500,000 apartments in capital cities and will allow TPM to capture an additional wholesale margin on its network.
TPM’s share price has fallen more than the expected weaker earnings growth would imply, with a large P/E de-rate. This in part was a reflection of its strong track record of earnings delivery and meeting or exceeding the market’s expectations, along with the high premium that has been attached to perceived quality stocks in the current environment.
Nonetheless, we remain of the view that TPM and Vocus (VOC) are better placed to deal with the transition to the new NBN environment compared with Telstra (TLS), which will lose the earnings attributed to its copper network, as well as face market share risk given the relatively even playing field for all telcos. TLS will also likely face pressure to maintain the current high dividend payments to shareholders once it ceases to receive NBN compensation payments from the government.
VOC currently screens as the value play in the sector after retracing in recent months despite posting a solid result last month. While VOC has a higher level of integration risk following a series of large acquisitions, it is not as exposed to the margin pressures noted above as it had less infrastructure on the older network and was predominantly a reseller of Telstra’s services. This much was noted by the company in an update to the market this week (which confirmed ACCC clearance of its Nextgen acquisition), with VOC confirming that average gross margins had been constant for its newer NBN plans.
Macquarie Group (MQG) provided a trading update to the market this week, maintaining its full year guidance to be ‘broadly in line with FY16’, with the usual caveats of market conditions and foreign exchange impacts. The company has been in a multi-year earnings upgrade cycle which is showing signs of maturity, however achieving flat profit growth for FY17 would be a respectable outcome given that the company is cycling a tough comp with earnings in FY16 boosted by performance fees in some of its unlisted funds.
Since the financial crisis, MQG has reduced the level of cyclicality in its earnings base through growth in its ‘annuity-style businesses’ to over 70%. The table below shows that these divisions are presently doing well, while its capital markets facing businesses are mixed. MQG currently trades on a forward P/E of 13X, higher than its average of the last five years, but is arguably justiifed given this transition to recurring revenue streams.
Macquarie Group 1Q17 Update
Specialty retailers Kathmandu (KMD) and Premier Investment (PMV) released their year end results. Kathmandu’s share price performance resembles the picturesque mountains of its marketing material. The share price reached $3.40 a few years ago before succumbing to altitude sickness due to the highly leveraged nature of the business model and spent near two years in the valley of $1.20-1.40. This result, largely preannounced, has recovered ground, though it would be a brave investor to allow for a long term stable outcome. KMD is vertically integrated and therefore can achieve gross margins of around 62%. It has been reducing the high dependence on promotional periods, but is still a very seasonal business. Better sales through this year and the closure of the loss-making UK stores saw a 60% improvement in profit for FY16, though the second half was more modest at 10%.
Local store coverage is mostly complete and the group hopes to achieve sales through its small international business where it will rely on ecommerce and possibly franchised stores. As a small cap it does not attract the attention of those seeking high growth and that is reflected in the expected 11X FY17 P/E and yield of 6%.
By contrast, Premier Investments has a smoothed profile due to the number of brands that can offset the weakness in each other. The mature stores, such as Just Jeans, Jay Jays, Portmans and Jacqui E, together are the driver of cash flow while the growth is in Smiggle and Peter Alexander. Both these are establishing in overseas markets, particularly Smiggle.
The Australian specialty apparel sector is highly competitive and any product or price misjudgement is punished. While PMV has had a good year, it would be inappropriate to capture that in a valuation multiple. The growth from Smiggle and Peter Alexander therefore become critical to support a P/E of over 20x. PMV has net cash of some $280m and this year elected not to pay a special dividend even with excess franking. An acquisition to supplement the group’s growth ambitions may be on the cards.