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WEEKEND LADDER

A summary of the week’s results

23.11.2018

Week Ending 23.11.2018

Eco Blog

- In this week’s report we have looked back at the past three decades of equity downturns and the environment in which they occurred to draw out any lessons for today.

Reporting of events, data or trends to justify a view are part and parcel of investment commentary. The quote ‘history does not repeat itself, but does rhyme’ is commonly attributed to Mark Twain, yet there is no evidence he used those words. But he did pen ‘..man’s character will always make the preventing of the repetitions impossible’. In this vein, we have noted comparisons of today’s markets with some of the similar patterns from the past. For ease of reference we have predominantly focused on the data from the US and Australia.

It is unlikely that there is much to be learnt from the period prior to central bank oversight of inflation and floating currencies and therefore we comment on the downturn post 1980.

The 1987 Black Monday crash came off the back of slowing growth and rising inflation, yet economic conditions were otherwise unexceptional. Markets had, however, changed shape. The participants were rapidly moving to institutional from private individuals and P/Es had moved in excess of 20X through rising demand for growth assets and the tax favourable treatment of acquisitions. There were two programme trading strategies considered crucial to the crash. Institutions had taken up ‘portfolio insurance’ in the futures market and ‘index arbitrage’ strategies were popular to take advantage of pricing differentials in the futures versus spot market. These strategies both relied on untested programme trading.

In the week prior to Monday 19 October 1987, the S&P 500 had already fallen 9%. In the middle of the week there was a proposal in the House of Reps to remove the tax break for acquisition funding, which coincided with a large US trade deficit, a fall in the USD and expectations that rates would have to rise. By the Friday, the mismatch in the futures market was evident, redemptions were flooding in and Monday saw markets gap down by over 20%.

The response from the Fed was to provide liquidity across the board. Europe followed a similar path and both regions avoided a recession. US GDP growth was 3.5% in 1987 and 4.2% in 1988.

  • This market event is possible without warning and is not notable in an economic assessment. Based on commentary from investment houses, the most likely source today would be in credit markets where there is little liquidity. Credit rarely sells in a panic, unlike equity, but a sharp widening of spreads would quickly flow into equities. The combination of algorithmic traders, risk parity funds (which keep risk at a stable level and therefore have to sell equity if volatility rises) and ETFs (where there is no problem in the structure, rather in their use as a trading instrument) could resemble the squeeze for the door that took down markets in 1987. In our view, central banks would again provide liquidity to the financial system if required.

The real recession followed in 1990/91, the one ‘we had to have’. In the US, the Saving and Loan crisis peaked in late 1989. These institutions had become the predominant source of lending for mortgages but initially suffered from a lack of deposits due to interest rate restrictions, followed by risky lending. A string of collapses was embroiled in political graft. Then, the oil price rose sharply as a consequence of the invasion of Kuwait.

Locally, interest rates were high (over 15%) in response to stubbornly high inflation. Poor lending practices were exposed, resulting in the failure of a number of smaller financial institutions perhaps the best known being the unfortunately named ‘Pyramid Building Society’. Unemployment rose to 11%.

Equity markets entered a period of weakness of 12-18 months. Our banks required substantial recapitalisation and some large companies failed. Fixed interest, conversely, did well as rates fell.

After a stellar 1993, interest rates went up sharply (and unexpectedly) in response to rising inflation. The result was a short contraction in all asset classes and where cash was the only redemption.

  • This period represents the debt/credit event that commentators believe lies at the heart of most weak investment returns. Today there are a number of potential culprits. US corporate debt (noted in the fixed income section), China’s corporate debt, European banks, and/or Australian household debt could result in a global or regional downturn.
  • Much will now depend on central banks. The US Fed is intent on its rate cycle, though many now believe it will taper this into 2019. China is walking a fine line in its stimulus, while the ECB has to deal with Italy, Brexit and softer economic growth. The RBA, APRA and the banking commission appear to have restrained the appetite for debt in Australia, but the sensitivity to interest rates is high.

The 2000 fall in equity values (or dot com bubble) was mostly a US phenomenon, though came hard on the heels of the Asian debt crisis. The 9/11 attack and high-profile accounting scandals added to the picture. Once again, the US responded with a large and speedy cut in interest rates that many argue culminated in 2008/9.

Effective Federal Fund Rate

Source: Board of Governors of the Federal Reserve System, FRED
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  • In this instance, the overvaluation of stocks in the US was, in hindsight, evident. Today, there are probably more in private equity – large companies with high valuations but persistently negative cash flow – though a few notable stocks where the valuation has to be justified on long term (and by default, unsure) expectations.

In summary, economic conditions today are far from ideal. There is growth, but it is still hanging off rising debt and government support, be it in tax cuts (US) or widespread stimulus (China). The capacity of central banks to ride to the rescue is naturally limited by already-easy monetary conditions. On the other hand, equity valuations are reasonable and it is likely that earnings downgrades are the hurdle to better returns. This seems to us to imply a period of low rolling returns rather than an event.

The relationship between investment markets and economic growth is far from clear, though naturally a recession is not investment-friendly.

Australian GDP QoQ vs. rolling annual returns on the All Ords Index

Source: Bloomberg, Escala Partners
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Focus on ETFs

- October is historically one of the more volatile months in the year. We examine the use of ETFs as a way to smooth out a portfolio’s volatility.  

Inverse ETFs, or short ETFs, are a designed to protecting investors by profiting from a bear market. These ETFs look to profit in a falling market, achieved through selling equity index futures contracts.

The Betashares US Equities Strong Bear ETF (BBUS) aims to provide negatively correlated magnified returns of the S&P 500 Total Return Index. When the S&P500 falls by 1%, this ETF should deliver a 2% to 2.75% increase in value. The other two inverse ETFs, Betashares Australian Equities Strong Bear Hedge Fund (BBOZ) and Betashares Australian Equities Bear Hedge Fund (BEAR), are similar are negatively correlated to the returns of the Australian sharemarket. The difference between these two is that BBOZ generates magnified negatively correlated return. 

Monthly Performance of Inverse ETFs and ASX 200

Source: Morningstar, Escala Partners
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For the most part, both BBOZ and BEAR have achieved their objective over the short term. However, using these ETFs as long-term strategies will generally lead to losses. The reason due to the daily rebalancing that is required from these ETFs which works against a buy and hold strategy as the returns in these ETFs (especially leverage) are asymmetrical. The returns in both BBOZ and BEAR (to a lesser extent) are magnified and whilst the declines in an index from higher levels are compounded, its much harder to make up losses as rebounds don’t return investors back to par as easily. Furthermore, markets generally have an upside bias over the long term, holding these ETFs will naturally lead to losses over the long term.

Cumulative montlhy returns of Inverse ETFs and ASX 200

Source: Morningstar, Escala Partners
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Additionally, these types of ETFs generally have a higher management fee. BBOZ and BEAR have a MER of 1.125% pa compared to 0.46% for all ETFs. Therefore, these higher management fees will dent profits through a higher tracking error. Furthermore, as these ETFs rely on regular rebalancing, they will naturally have a higher turnover, which will also have higher costs.

  • Because of the daily rebalancing that is required, these ETFs are better suited for the short term. Timing the implementation of this tactical strategy is easier in theory than in practice. To reduce the volatility within a portfolio, we would recommend the use of active market neutral or long-short funds.

Fixed Income Update

- Credit spreads widen. We note the composition changes to HY and IG are causing jitters.

- Ongoing Brexit negotiations open trading opportunities for those with a strong view and a decent risk tolerance.

Prior to the last week, it was just equity markets and emerging market debt that suffered as investors offloaded risk. Corporate credit, including the riskier segment of high yield (below investment grade rated companies), appeared resilient as valuations held up. However, of late there has been contagion to credit market pricing, with spreads widened in investment grade and high yield. The average spread on US high yield is now above 3.90%, marking the highest level in 18 months. This is reflected in returns for the sector, with the US High Yield index showing performance at -1.2% this month to date. Investment grade spreads are also trading at levels not seen since April 2017, with the US iTraxx reaching 0.99% (from 0.78% in mid-September) and the Australian iTraxx 0.88% (from 0.71% in mid-September). To add context, credit spreads in the last 18 months had been at their tightest since before the financial crisis, and one could argue are returning to more normalised levels.

US high yield spreads

Source: Escala Partners, Bloomberg
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The tight valuations on credit in the last 18 months had been driven by low default rates from low funding costs and strong corporate profits. This encouraged companies to increase leverage, taking US corporate debt levels to their highest relative to GDP since the financial crisis. The Investment Grade (IG) bond market grew from US$4.8 trillion in 2008 to US$9.3 trillion by June 2018, with non-financial companies contributing $1trillion of debt in two years. Most sectors in IG are at near 10-year highs in terms of leverage.

In addition to the rise in leverage, the weighting of BBB rated issuers as a percentage of the whole investment grade bond market has climbed from 25% to almost 50% today. Using the Moody’s probability of default matrix, BBB rated bonds have an 18% chance of being downgraded within 5 years. Add to this is the growing concern of lighter covenants on corporate loans. While this composition change has been unfolding for years with no rise in default levels or even price volatility, it is becoming more relevant now as global interest rates rise. Pricing of late has reflected these uncertainties. The sell-off in oil prices has also added to the weakness for the high yield energy companies as was the case in 2016.

  • Given default rates have not yet risen, it is likely that spread widening will be contained in the near term as investors buy the higher spread product at attractive levels. However, as global economies slow, the high leverage and lower credit quality will become an issue in this segment. We remain cautiously supportive of high grade credit products until such time.

The sell-off in risk assets has had little impact on Australian ASX listed hybrids (AT1 bonds) with only a marginal increase in credit spreads (10-15bp). In contrast, offshore AT1 securities in USD and GBP have fallen in price, with spreads on average 50bp wider. GBP securities have the added uncertainty of Brexit negotiations which has eroded pricing on this debt over the last year. These bonds had a small reprieve in the last few days after the UK and Brussels agreed a draft declaration for a Brexit deal that is expected to be endorsed by EU leaders this weekend.

Compared to the Australian market, some GBP AT1 securities appear decent value. As an example, a Lloyds 7.625% AT1 with a call in June 2023 is trading at GBP104.21 (down from GBP116.28 a year ago) which returns a yield of 6.55% to the call (4.5 years). This bond is rated BB-/Baa3 by S&P and Moody’s. A similar rated Bank of Queensland hybrid, that is a year longer, trades at a margin of +3.74% (including franking), which is significantly less this Lloyds bond margin of +5.5%.

Notwithstanding, the biggest swing factor to an investment such as this will be the currency movements.

Lloyds AT1 bond price

Source: Bloomberg, Escala Partners
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  • The trade above should only be considered by those that want to express a view that the GBP will strengthen following the Brexit negotiations. While this plays out, the AT1 market offers an interesting relative return for those willing to take on hybrid credit risk.   

Corporate Comments

- CYBG’s full year result was hurt by an additional provision to cover the legacy costs of mis-selling of insurance products along with a softer margin outlook for FY19. Ongoing Brexit negotiations provide a binary outcome for the stock in the short term.

- Conditions for ALS (ALQ) support a sound medium term outlook, with growth from its two core divisions.

- Little-known Trade Me Group (TME) has received a takeover offer. Further companies may become acquisition targets as valuations become attractive across parts of the market.

- Mineral Resources (MIN) defied the sceptics with a deal to sell half of its interest in the Wodgina lithium project.

Through the recent bout of market volatility, any bad news in company announcements has been severely punished. CYBG (CYB), (formerly Clydesdale Bank, the spin-off from NAB) was a case in point as it reported its full year results. The stock had already been under some pressure over as every day passed without a resolution to the Brexit mess, significantly overshadowing positive developments, such as receiving IRB accreditation (freeing up capital) and approval for its value-enhancing acquisition of Virgin Money.

CYB’s full year result was in line with the market’s expectations at a headline level, although was assisted by a low tax rate in the half. The bank has continued to make good progress on its cost out initiatives, with cost guidance for FY19 lowered again, and falling bad debts was a further tailwind for earnings.

However, there were two elements of CYB’s announcement that captured the attention of investors. An additional provision for the legacy costs of the miss-selling of insurance products was taken and it has expectations of a weaker margin outlook, with competition in the banking sector weighing on deposit funding and the pricing of new mortgages. The margin impact was almost entirely driven by the acquired Virgin Money business, which is a disappointing outcome so soon after the transaction.

In short, earnings growth into FY19 will now be lower than previously forecast. Further, the legacy conduct costs have impaired a core part of the CYB investment thesis (at least in the short term), that being one of a return of capital given the improved balance sheet position following the recent IRB accreditation (illustrated in the following chart).

On a single digit P/E and trading at significant discount to book value, there is obvious value in the stock, however the Brexit impasse will continue to pose downside risks (resulting in a binary outcome over the next few months) and be the key driver in the short term.

CYBG Capital Generation

Source: CYBG
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Laboratory testing group ALS (ALQ) reported a solid half year result ahead of its guidance and supporting the view of its participation in the recovery in commodities markets. Top line growth of 15% translated to a 34% increase in earnings per share and a similar lift in its dividend.

While the company is now less exposed to cyclical sectors than in the past, the operating leverage in these businesses remains high enough to have a large impact on the overall group’s earnings base. Global mineral exploration spend is the key indicator to watch, which has continued to improve off the low base formed through the commodities downturn between 2012-16. Organic growth and margin expansion led to a 45% increase in EBIT from this division.

ALS’s less volatile life sciences division importantly reported a stabilising margin in the half after a competitive market had hurt earnings in recent years. The company’s industrial division was the primary drawback of the result where margins did contract, although this was less significant on the overall group given its smaller scale.

ALS: 1H19 Revenue Growth

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Overall, the outlook for ALS continues to be quite sound with an expectation of an ongoing earnings upgrade cycle confirmed with full year earnings guidance. The company’s balance sheet is in good shape, allowing its previously announced buyback to be extended and providing optionality for further bolt on acquisitions that have supported its growth profile. We have the stock in our model equity portfolio.

In a weaker market environment, corporate M&A activity is one way of realising value for shareholders and two transactions this week (involving Trade Me (TME) and Mineral Resources (MIN)) showed that falling share prices can provide opportunities for acquirers and upside surprises for those with attractive assets, particularly when the market selloff is one dictated by changing valuations or sentiment instead of lower earnings.

TME, which has been a company backed by one of our SMA managers, Investors Mutual, received a takeover offer from British private equity company Apax Partners. TME is the market leading online classifieds conglomerate in New Zealand that can be thought of a hybrid of carsales.com, REA Group, Seek and eBay. Despite the similarities to these businesses and its operation in a market that typically attracts few new entrants, the stock had not enjoyed the similar P/E re-rate of its Australian listed peer group.

Meanwhile, MIN jumped after it announced the 50% sale of its Wodgina project and will now form a joint venture with US company Albemarle to develop the hard rock lithium deposit into an integrated lithium hydroxide plant, a more vertically integrated operation that captures a greater proportion of the value chain. The sale price was significantly above expectations, although the initial intention flagged to the market by MIN was to sell a 49% (thereby retaining control) and of a smaller scope than the now-proposed 113ktpa hydroxide facility.

Nonetheless, the deal has been judged as a good one for MIN, which has been weaker through this year on soft spot lithium prices in a well-supplied market. While the company has had limited broker coverage, several institutional fund managers have recognised the implied pricing mismatch in the market if such a deal transpired. The $3.2bn valuation now applied to the Wodgina asset still remains slightly higher than the entire market capitalisation of MIN, indicating that no value is being ascribed to its core crushing business. With its balance sheet in a net cash position, a well-regarded CEO in Chris Ellison and the diversification via its crushing business, MIN screens as the lower-risk play for investors wishing to gain exposure to the electric vehicle/battery thematic.

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