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WEEKEND LADDER

A summary of the week’s results

23.10.2015

Week Ending 23.10.2015

Eco Blog

The prediction of an El Nino event will have mixed fortunes for Australia’s agricultural sector. Unlike hard commodities, many soft commodity prices have been generally stable for some time. Global agricultural prices will react to world demand supply balances, but local prices can be determined by domestic conditions.

NAB’s rural division aggregates its own and other forecasts into the following table:

Australian Price and Production Year on Year Forecasts (as at 20 October)

Source: NAB, ABARE, Meat and Livestock Australia, Profarmer
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In the current season, it is anticipated that the late onset of El Nino and respectable rainfall across WA, SA and parts of NSW, will offset the likely low wheat crop in Victoria, which only accounts for some 12% of the national average. In the widespread drought events of 2002 and 2006, the farm sector subtracted some 0.5ppt from GDP growth over a two year period. Given the fragility of economic growth at this stage, watching the weather will be another feature.

The optimists saw a glimmer of light in China’s Q3 GDP release. Headline numbers were as expected, a tad under the magic 7%, with the usual scepticism on the actual growth. The weakest areas were mining, manufacturing and construction, while services maintained their steady rate of expansion.  Some of the softness in production may lie with factory closures around the WWII commemorations and the after effects of the Tianjin port explosion.

An upturn in activity, however, rests on three strands. The property market is emerging from a prolonged period of negative growth. If this is sustained, it would add substantially to GDP next year, though many will remain mindful of the past excesses in this sector.

China Property Market Activity

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The second sign is the increasing insistence by the central government that local authorities follow through on their programmes. The municipal bond market is gaining traction, serving a number of purposes. It puts a torchlight on local debts, rather than the shadow banking and less-than-transparent leverage that caused much concern in recent years. It tends to be programme specific, allowing the central government to monitor issuance and spending. And it allows the end investor to price the risk of each issuer.

The other contribution to growth will have to come from easing monetary conditions. As we have seen in virtually all other countries, this is a little like pushing a string. Low prices and the availability of debt does not mean companies have any intention of using these funds unless they can see a profitable investment. Nonetheless, this is a necessary condition to prevent tightening monetary conditions post the outflow of capital in recent months.

Another plenary session next week may provide a sense of how comfortable the Central Party Committee is with their progress. While the financial world may fret about industrial data and the like, the party is focused on political stability which comes from improving lifestyles. Clearly growth is a required part of that, but the path there may not neatly fit into investors’ framework.

Trade data from China could also be read both ways. The sizable surplus ($US60bn in Sept) helps offset the pressure on these capital outflows. On the other hand, weak exports indicate that global trade will be a much smaller part of China’s, and probably the world’s, economic focus in the next few years. The charts below show the extent of contraction in China’s trade, both in exports and imports.

China Trade Data

Source: ANZ
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Economists from all walks of life are dragging down their forecasts for global growth in 2016. Naturally, China is a big part, but the earlier optimistic views on the level of GDP growth the US could attain has been another feature. Add to that the inevitably slowing in commodity economies, weaker than expected Abenomics from Japan, political instability in the Middle East, and its hard point to any region bar parts of Europe, which are doing better than anticipated.

In turn, bond yields are soft and inflation is low. The discussion is now centred on further stimulus, rather than tightening. This much was evident in the dovish outlook provided this week by the ECB, which pointed towards an expansion of its current quantitative easing (QE) programme in December. The QE influence on all markets is likely to be sustained for some time yet, and the ECB’s move will further complicate the decisions of the US Fed, as it would lead to a stronger $US and lower inflation.

Adapting from a fund manager’s views on the world, one can segment most countries and industries into three distinctive themes. The first is a new and sustainable one; taking on digital options, renewing energy production and use, and healthcare improvement, for example. The second faces regulation and competition, but with a chance of reforming; and the third confronts excess capacity and potential structural demise. In the equity world, the perfect outcome is to buy the best of the first, value the second correctly and avoid the third.

Taking it into economic outcomes, the consumer is driving the first. Generalising somewhat, household confidence around the globe consistently comes up as just fine. The gloom of the financial downturn appears to be abating. Wealth from housing and financial assets is decent. Labour markets are either relatively good (as in the US) or improving. Wages growth is the absent factor and in some cases (Australia, Canada, the Netherlands, for example) high household debt is a potential problem. Inevitable features such as demographics, rising spending on non-discretionary items, particularly health, and some erosion of welfare benefits are likely to be an ongoing feature and limit consumer exuberance.  This points to a continued search in investment markets to participate in securities and assets which can benefit from these themes. While not every feature is represented, the US, China and India are at this stage the countries with the best consumer outlook.

Country-wise, Europe and Japan would represent the regulation, competition and possible reform. The potential from freeing labour markets and corporations from both imposed and self-constraint could unleash a much better growth outcome for some years. Japan is arguably the test case. Many comment that, notwithstanding the demographics, greater participation by women in the workforce, more flexible jobs and a move away from tenure to aptitude for promotion could be more important than the aging population. Similarly, indications that the corporate sector would be cajoled to release cross shareholdings and latent capital could reinvigorate Japan’s still innovative companies.

At this stage the avoid lies with much of South America and probably Russia.

Where Australia sits is an awkward question that we leave the reader to contemplate.  

Corporate Comments

Super Retail (SUL), having tested the patience of many investors, gave a positive trading update at its AGM. The group has worn disruption to distribution centres, struggled with repositioning its leisure format and faced weak retail conditions. The solid sales figures year to date and indications that margins in two divisions were up, are possibly the early signs that the patient renewal undertaken by management is paying off.

Super Retail Trading Update

Source: Super Retail
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SUL is our preferred position in discretionary retail. Other stocks can have bursts of cyclical upturn, but we believe longer term investors are better off in this company given the range of retail sectors and a conservative approach to debt.

Wesfarmers (WES) delivered another solid result across its retail brands. Food and liquor sales were up 4% (3.6% comparable) with a claim of 1.3% deflation in its prices.  Home improvement remains the standout at 11.6% headline growth, with an 8.2% rate for same stores. Kmart has become a persistent surprise package, with comparable sales growth notching up successive quarters to 8.6% in Q1 this year. Cycling this rate of acceleration will become harder, but likely set the division up as a decent free cash flow producer. Target could follow suit, with its first positive comp growth in a year.

It is hard to fault WES’s achievements in retailing. The investment question is about the price (FY16 P/E of 18X) and the relative maturity of its formats.

BHP Billiton’s (BHP) quarterly production report was mixed, although the company maintained its FY16 guidance across its businesses. The company’s petroleum volumes were down in the September quarter, reflecting the deferral of investment spend in its US shale energy operations and it indicated that this expenditure would be cut further from its previous forecasts.

Reflecting its better competitive position in iron ore, however, BHP is pushing ahead with its Pilbara expansion. Growth in FY16 will be driven by better productivity. This is occurring despite the already well-supplied status of the iron ore market; instead of satisfying global (or China’s) demand growth, these additional tonnes may simply be displacing the higher cost production of its competitors, pushing the cost curve down. While production can have fluctuations based on differing grades, maintenance work or weather conditions, the lack of overall production growth, illustrated in the chart below, shows the company’s focus shift to cost cutting and balance sheet strengthening.

BHP Billiton: September Quarter Production Growth (Year on Year)

Source: BHP Billiton, Escala Partners
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The ongoing weakness in the oil market has been quite problematic for BHP, which followed a multi-year decline in the iron ore price. As we have noted, the falls in these two key commodities has seen the outlook for investors shift from one where additional capital returns were expected (buybacks or special dividends), to its situation where it could be borrowing to pay its dividend over the next two years. BHP has recently been pulling as many levers as is can in order to protect its dividend policy, including a hybrid issue and a proposal to shift capital within its dual listed structure. Ultimately, it will rely on some improvement in commodity markets in order for its current policy to be sustainable.

BHP spin-off South32 (S32) also released its quarterly production report, which was better than expectations, although the company also maintained its full year guidance. For a mining company also stuck in the downdraft of commodity prices (including coal, nickel and aluminium) it has performed well on the cost side of its business, enabling it to reduce its net debt over the quarter. While currency movements have been favourable for S32 through this year (a depreciation of the $A and South African rand), the company has increased its expected overhead cost savings for FY16, highlighting the opportunities that would have arisen since trading as a stand-alone company. We have S32 in our model portfolios as a satellite option to BHP or Rio Tinto with a strong suite of assets across a range of commodities.

M&A activity continued this week in the energy sector, with a bid for Santos (STO) and a merger agreement between smaller Cooper Basin producers Beach Energy (BPT) and Drillsearch (DLS). The latter proposal appears to have some merit, given the operational synergies that could be achieved from combining the two businesses.

In the case of Santos, the $6.88/share proposal does appear to be quite opportunistic in nature (and has been rejected by its board), with the company amidst a review with the aim of strengthening its balance sheet. Throughout the recent weakness, it has been widely believed that Santos has been trading below the net value of its asset base, with the company’s share price weighed down by this large debt burden. The relatively-unknown status of the potential acquirer (described as a direct investment syndicate acting on behalf of sovereign wealth) may, in this case, raise some doubts of a transaction coming to fruition. However, the activity in the sector announced this week and recently (including Woodside’s bid for Oil Search) highlights the confidence of many in the longer-term fundamentals of the industry and the cheap status of assets in the current market environment. A combination of an equity raising as well as asset sales still looks to be the most likely path for Santos when it concludes its strategic review in the coming months.

As was widely anticipated, this week the three other major banks followed Westpac’s (WBC) lead, raising their variable mortgage rates in response to the higher capital requirements imposed by APRA. While Westpac raised its rates by 20bp (basis points), Commonwealth Bank (CBA) has raised its rates by 15bp, National Bank (NAB) by 17bp and ANZ by 18bp. In a broad sense, the changes will approximately offset the earnings and return on equity drag from the capital raised by the banks in the last six months.

While the increase in mortgage rates has addressed one of the issues that we had with the banking sector, we remain underweight banks in our model portfolios on the basis of a weak earnings outlook (which may now be compounded by a slowing in housing lending), the likelihood of a slowing in dividend growth and the potential for bad debts to normalise somewhat, impacting profitability. The moves in the last two weeks by the major banks has increased the possibility of a rate cut by the RBA when it meets on Melbourne Cup day, given the central bank’s focus on end borrowing costs.

AGM season continued this week and was notable for the lack of any significant downgrades across large-cap stocks.

- Amcor (AMC) reported that its first quarter trading was in line with expectations. The company has now completed a US$500m buyback, which will be around 3% accretive to EPS in FY16.

- Spotless (SPO) also reaffirmed its view for FY16 to “materially exceed” its FY15 result. The underlying growth in the market remains a positive for SPO as it complements this with a number of bolt-on acquisitions. Higher-margin Public Private Partnerships (PPPs), in which it has recently added to, provide a good tailwind for earnings growth in the medium term.

- Carsales.com (CAR) reported a positive trading outlook for FY16 from both its domestic and international divisions.

- IAG reiterated its guidance for flat premium growth and a reported insurance margin of 14-16%. The insurer announced last week that it had decided to abandon its proposed investment in the Chinese market, with investor concerns over the risks of entering this competitive market influencing this outcome. The shorter term benefit may be higher shareholder returns, although the decision highlights the difficulties of domestic companies operating in a relatively mature Australian market and the limited options available to them to expand.

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