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WEEKEND LADDER

A summary of the week’s results

24.07.2015

Week Ending 24.07.2015

Eco Blog

The US economy continues its somewhat mixed tone. The Philadelphia Non-manufacturing Survey eased in July with the trend to weakening capital spending persisting and pricing power edging back. Some will be due to the energy sector and stronger US$, yet it appears that the Fed will look through these factors and focus on the labour market. To date wage growth is behaving itself with most US based observers of the view the median increase in labour costs of 3% is a sufficiently high level for the first rate rise this year. There are signs the labour market is in fact tightening even further with unemployment claims at 1973 lows.

The weak China July PMI (48.2 versus 49.4 in June) once again spoke to the soft manufacturing conditions in China and a number of US companies have noted soft demand there for goods. The latent risk is that China has a bigger than expected impact on global growth than currently anticipated.

The Governor of the RBA, Glenn Stevens speeches are closely analysed for hints of direction. What was broadly interpreted as dovish was rather a debate on the merits of using monetary policy as a way of supporting economic conditions without compromising long term stability through excess leverage.  On cue, The Economist newspaper this week cited two long term studies on the impact of equity and housing bubbles. The conclusion in both cases is that bubbles with leverage, particularly in housing cause substantially more damage than financial assets.

Post WW2 sample: 1948-2012

Cumulative percentage change in real GDP per capita

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It is therefore no surprise that the RBA and APRA are taking inordinate steps to limit the risks in the banking system to mortgage lending. As we will note in our corporate comments, the latest regulatory step to increase our banks capital reserves came through this week, with expectations further measures in coming years.

The CPI release showed a sharp rebound in petrol prices in the June quarter, contributing 0.3% to the 0.7% after reducing the CPI by 0.4% in the previous period. The RBA’s preferred measure of ‘trimmed mean’ is showing annualised inflation of 2.2%, in line with the RBA target.

Surprisingly the fall in the A$ has had very little impact on imported goods, implying that suppliers and/or retailers are not passing on the full extent of the currency move. The small fall in food inflation also indicates that in this quarter, supermarket chains are likely to have coped with little support from price movement. The largest impost on household inflation is in regulated pricing. Alcohol and tobacco (7.9% weight in CPI) reflects the excise rise and health (weight 5.9%) the increase in private insurance costs. The CPI weights are based on the detail of the household expenditure survey and then adjustments for the sectors inflation itself. One would not be surprised to see a relatively large reweight after the forthcoming survey next year given what appears to be a substantial change in household consumption.  For some, the good news is the fall in holiday travel and accommodation (down a large 5.4% in the quarter) partly due to the shoulder season effect keeping demand soft over these months.

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In New Zealand the RBNZ reduced rates as expected by 25bp to 3%. Further easing seems likely as the growth outlook softens due to slower construction spending and falling dairy prices. The RBNZ is working on the basis its measures (LVR limits etc.) to prevent Auckland house prices rising further do not stand in the way of monetary easing.  Similar to here, rates are unlikely to be an investment hurdle and a lower currency the desired outcome.

Corporate comments

Following the release of the Financial System Inquiry (FSI) APRA announced the first regulatory capital changes for the major banks. The higher mortgage risk weighting was less odious than some expectations, while the time frame to implement is shorter. This is not the end however, as to conform to global Basel 4 banking standards further capital will be required as a buffer. Analysts estimate that the 4 majors will have to raise equity of between $12-14bn to meet the first standards. They are most likely to fully underwrite one to two dividends (issue equity in lieu), though it is possible they may jump the gun and raise capital in a rights issue such as NAB did recently.

The key for investors is that this reduces banks EPS growth to near zero for the next two years, assuming the benign credit conditions continue. It is also therefore counterproductive to raise the dividend, given it simply increases the earnings dilution. Investors today should expect the banks to do no more than dividend returns for at least the coming year. There is some downside valuation risk should interest rates move up,  while on the other hand firstly ANZ followed closely by CBA have already repriced investor loans, lifting the variable rate by 27bp.

We recommend underweighting the index in the major banks while allocating more to the diversified financials. This is not a bear position on the majors, but rather that their weight in index is in our view excessive comprising a highly concentrated, undifferentiated sector.

A record quarter for PNG LNG lifted Oilsearch’s production June quarter report above expectations, cementing its position as the best large cap energy stock in achieving its output targets. The gas price however, down some 35% in the quarter, will weigh on revenue received and the company also guided to slightly lower costs as a small mitigation. Demand across Asia Pac is relatively weak with high levels of supply likely to cap prices in the near term.

Our decision to bunker down into OSH and ORG in our model portfolio has paid off by limiting the damage from the sharp fall in energy prices while maintaining a high quality exposure to this sector.

At this stage there is no obvious catalyst for OSH beyond a higher received LNG revenue. That said, we gain comfort that even allowing for little recovery in the price, the majority of analysts value the company at around the current share price with upside from future developments.

BHP’s FY15 production was in line with expectations, but the guidance for FY16 weaker than anticipated outside iron ore. A combination of falling grades in copper, mine closure and planned maintenance in metallurgical coal and an estimated 5% reduction in petroleum output due in part to a pullback in onshore gas but also field decline. On the other hand the iron ore output is expected to increase to over 250mt, up 13% on FY15.

The group has will also take further impairment charges which, along with the balance sheet adjustment with respect to S32, will total around US$5bn in the August profit release. The fall in realised prices across the commodity spectrum is spelt out in the accompanying table below.

BHP realised average price (US$)

Source: BHP
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Based on current commodity forecasts, BHP’s net profit is set to fall from US$8.0m in FY15 to $US5bn in FY16. The estimated dividend is 124c this year and the question arises whether the board will hold to their progressive dividend policy for FY16 given will have to pay out 150% of earnings. The yield of over 6% may entice some investors, but we feel it’s an inappropriate valuation metric for a resource stock. Instead we hold BHP based on its medium term outlook given this year should mark the low point in earnings. Consensus commodity expectations of a uniform recovery through 2016 may be somewhat optimistic, yet a combination of even a mildly better prices, lower capex and costs and a weak A$ should see the stock claw back ground over the coming years.

S32 first production report post the spin out from BHP. This result sets the ground for what is forthcoming and focuses on assets that under BHP barely rate a mention. The performance since demerger has been weak, though no worse than other resource stocks. The mix of commodities however is somewhat unique. At present the contribution from alumina and aluminium outweigh its other assets and the diversity of commodity exposure should reduce group earnings risk over the medium term.

Source: Deutsche Bank
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FY16 looks likely to be tough on the earnings front given trend in commodity prices, partly offset by the lower A$, but analysts are focused on three other aspects, namely cost reduction, asset sales and potential acquisitions. As the market becomes familiar with the management tone and the last vestiges of holders (including ETFs) which are not natural investors in the company washes out, we would expect the price to reflect fundamentals.  An ungeared balance sheet within 12 months opens up many options, not least corporate activity. We would be reluctant to realise a holding in S32 at the prevailing share price, which is well under the mean estimated valuation of $2.20/share.

Rounding out the major miners, Fortescue achieved an average Q4 price of US$52 for its 165mt shipped. The group however continues to tread a fine line on a cash flow basis and will have to pull out all stops to on mine costs on a wet metric ton (wmt) basis as indicated in its programme below, given that realised prices will be lower once again this year.

Source: Fortescue
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Resource analysts are divided on whether the group can weather the expected iron ore price path. Companies have made adjustments to their mining methods by reducing the strip ratio (lowering the amount of overburden removed) and changing their ore blending. Some view this as deferring the inevitable through this selective approach. Most investors would be aware that FMG is a highly leveraged play on an uncertain iron ore outlook and only appropriate for traders or the very brave.

Echo Entertainment scored a welcome win as part of the consortium to successfully bid for the Queens Wharf Brisbane project. Facing competition in coming years at its Sydney Casino from the new Crown development, it was critical for the group to consolidate its position in Queensland, adding to the Jupiter and Townsville operations. Echo will operate the asset and contribute 50% of the capital with its two partners, Far East Consortium and Chow Tai Fook Enterprises the remainder. Both these parties are conglomerates with widespread interests in property, retail and entertainment. The whole project comprises a casino, 5 hotels as well as multiple entertainment and retail facilities. Costs have not yet been disclosed and the completion date is 2023. Investors had largely factored in this win as was evident in the relatively subdued share price reaction, though recent operating performance has also been good. Given the reliance on its existing asset for some years to come, we believe the P/E of circa 18x is relatively rich.

Macquarie’s AGM confirmed that profit this year would be better than the conservative guidance provided at the final year result. The two key divisions, asset management and corporate finance which contribute 60% of net profit are both in a sweet spot with the currency a further tailwind. The share price however gave ground late in the week as the staff selling window commenced, an indirect reminder that employee compensation is a critical part of the net profit outcome. MQG is trading at close to 2x book value and given the recent rally we would not chase it at these levels.

DUET (DUE) announced an offer for Energy Developments (EDL) for $8/share representing an acquisition multiple of 8.8x EV/EBITDA. DUE has undertaken a placement and entitlement offer to raise $1.57bn. EDL is a supplier of energy to remote locations mostly in long term contracts as well as operating waste gas plants at mines and landfill sites. DUET’s major assets are the Dampier Bunbury Pipeline, United Energy and Multinet Gas Holdings. While the stock attracted interest in recent times and offers a decent yield of 7.4%, the low cash flow cover of this distribution and high debt in our view requires carefully judged entry and exit points for the stock.

Fixed Income Update

This week has seen a bit of normality return to the bond markets. In what was a very volatile end to the financial year, the markets put the Greek crisis, Puerto Rican bad debts and a collapsing Chinese stock market into the past. Volumes, particularly in the European markets, have dropped indicating that the summer break in Europe has arrived.

With these distractions on the side lines (for now!), focus returns to the much anticipated Fed tightening lift off. Performance data from the US is mixed, but the Fed Chairperson Janet Yellen remains upbeat on the economic outlook: “If the economy evolves as we expect, economic conditions likely would make it appropriate, at some point this year, to raise the federal funds rate target, thereby beginning to normalise the stance of monetary policy”. We have heard varied views from the FI funds regarding the timing of the first rate hike (September, December or 2016), however, the consensus is that moving away from the zero bound interest rate environment will be challenging and rate rises are likely to be gradual and measured.  

Regardless of each funds' view on the timing, all are prepared for increased volatility in the bond markets when it does happen. Most remain cautious of adding duration in the US market (so remain short the US benchmark), have narrowed their exposure to emerging markets (which are vulnerable to changes in the US Monetary Policy) and have increased their cash holdings to offset liquidity concerns. (For more information on liquidity issues please refer to last week’s Weekend Ladder).

Divergence in global monetary policy continues, with only the US and the UK angling to increase their cash rate.  As noted this week has seen the Bank of Canada and the RBNZ cut official cash rates by 25bp, which is in line with other central banks who are still easing.

Source: Macquarie Bank, Bloomberg. *RBNZ have cut a further 25bp.
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Locally, minutes from the RBA meeting this week suggested that the bank continues to hold a mild easing bias. While most market participants expect that rates will remain on hold in the short term, the domestic futures market continues to reflect a high probability that we will see another rate cut here within the year.

Source: Escala Partners, Bloomberg
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On credit, the listed hybrid and subordinated debt market has recovered some of its losses from the end of June, with credit spreads tightening in across the curve. However, supply side concern is starting to weigh on the market with the AFR reporting that “Westpac will raise hybrid capital with a $750m offer to be launched in the near future. It is understood the ASX-listed offer will be marketed at a margin of less than BBSW+400.” Market talk is that this deal may get announced as early as next week.

Staying with new issuance, but in the OTC market, this week saw the announcement of an inaugural tier 2 subordinated debt deal by MyState Bank. Predominately funded by retail depositors, this BBB rated ADI is looking to access longer term funding in the wholesale debt capital markets. This 5 year FRN is expected to price at 3m BBSW+450 for an issue size of $30mm.

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