Week Ending 24.11.2017
- Infrastructure Australia is a state based story, but the revenue to support this spending is likely to limit the potential uplift.
- China, once again, is on the war path to restrict debt. This week it is proposing wide-sweeping changes to its non-bank lending growth.
- European momentum appears unstoppable, inflation and corporate profit growth should follow.
The level of infrastructure construction activity is all too obvious in most major cities currently disrupting traffic and travel in the hope of improving these bottlenecks. The question is how this being funded. The most significant single source of state revenue is GST. Total state taxation proportionately matches the GST component in NSW, while in Queensland government grants/GST are half of revenue and state tax only 24%. WA remains in a net deficit for some years partly due to its much lower share of GST at only 34 cents for every dollar collected in the state.
Notwithstanding the differential mix of revenue from government sources between the states, the growth in these two sources is compromised. Due to changing consumption patterns, GST is falling relative to GDP, while property related taxes are levelling off. The state government can elect to raise taxes from payroll, gaming, motor vehicle levies, but all would hurt their constituents income levels.
Selling assets has been another fruitful source of one-off flows in most states, but the best of these have been realised. The projections are that every state will take on more debt to fund their proposed infrastructure programmes. As we are also well aware, there is inevitable expedient spending lift prior to the elections cycle. Queensland has increased its allocation to health and education, increasing government employee expenses by 6% in the past year. Victoria, with an election due in 2018, exceeded that with a 7.5% increase in employee expenses. The pipeline of public sector construction spending is viewed as compensating for the anticipated easing in housing activity. However, this will be constrained by the increases in state government operational expenditure, which are often hard to peel back once in place.
This week construction work done posted a healthy rise of 15.7% for the third quarter, but the headline included a large LNG increment with the imports for the floating platforms for Prelude and Ichthys.
The charts illustrate the challenge to achieve a rise in the GDP contribution from construction activity. Engineering is destined to revert to its trend once the LNG is in place and, in any event, the GDP impact is neutralised by the net effect once the import data is incorporated. The public sector spending is necessary and welcome, but pales into a much smaller contribution compared to the private sector. Over reliance on housing to bolster activity is also evident.
Construction work done (chain volumes)
- Infrastructure investment is a current equity theme with widespread support. Yet the extent to which it can be sustained and its broadening impact elsewhere may be curtailed by state revenue constraints.
China is back in the spotlight as tightening measures alongside regulatory change are expected to contain GDP growth into 2018.
This week the government released a paper on the ‘asset management business’, or shadow banking. It encompasses unregulated lending, with a high proportion of nonstandard credit assets. In parallel to some other countries, including Australia, it is in response to capital controls imposed on the formal banking sector and low deposit rates that encourages those with savings to seek higher rates elsewhere. It was also as a consequence of targeting high GDP growth while disguising the inevitable growth in debt. The total segment is estimated to be worth 137% of China’s GDP, some of which is standard credit and bond issuance.
The controls will come through a requirement to match the duration of the product to the underlying asset, limiting multiple layers of investment vehicles where each could add to leverage, removing implied guarantees of capital return and restricting the level of nonstandard credit. The impact will take time to take hold but the outcome another positive step towards avoiding uncontrolled credit expansion.
Even investment spending is coming under greater scrutiny. A subway development just commenced in Baotou has been stopped in its tracks as it was deemed to be excessive relative to the population of the area. The Ministry of Finance has released a paper on private public investment partnerships which will see some cancelled given their impact on the fiscal budget.
The progressive slowing in investment growth has been evident for most of this year.
Fixed Investment spending Property sales growth
In 2017 trade and consumer spending has been sufficient to keep the economic engine moving at a relative high speed. In the coming year a greater contribution will be required from the preferred industries such as technology, transport and logistics and services.
- There is a growing view that iron ore prices may fade into 2018 as China changes shape. Conversely, local industries with government support within the new growth framework are likely to be attractive investments in the medium term.
European growth is proving unstoppable with France joining Germany in the manufacturing bonanza. Job creation is at a 17-year high and the backlog of uncompleted work along with supply chain shortages will hamper sustaining this growth rate.
Price increases look inevitable as producer costs eventually move into consumer prices.
Unless the politics in Germany and Spain hit confidence, European data will become all the more interesting in 2018 with a rise in inflation but still cautious ECB.
- While the European stock market has not quite lived up the promise of earlier in the year, the potential for better than expected earnings gains credence. The shift to this region counter balances the high valuations prevalent in favoured US sectors.
Fixed Income Update
- Spreads on risk assets within fixed income widen, with emerging market country debt following the trend of the high yield market.
- We examine some potential implications for fixed income markets from the US tax reforms.
- The RBA governor indicates that the central bank does not expect to be raising domestic interest rates in the near term, while the ECB minutes from October’s meeting are revealed.
In recent publications we have referred to weakening valuations in high yield (unrated bonds or below investment grade), as outflows have been pushing down prices, increasing spreads to bonds. Last week was the third largest withdrawal rate on record for high yield with $6.7 billion in outflows. This follows a strong 12 months for this sector with spread levels testing their 10-year lows. The catalyst, at this point, is largely this valuation point rather than any indication of rising default.
Similar to high yield, government debt issued from emerging market (EM) countries has been in heavy demand this year, but has experienced some outflows of late. For the first time in a year, foreign investors are said to be net sellers of emerging market debt out of Asia. There has been mixed data over the week for the emerging market sector.
On a positive note, Moody’s has upgraded India’s sovereign debt rating from Baa3 to Baa2. In its statement Moody’s said it expects “continued progress on economic and institutional reforms will, over time, enhance India’s high growth potential and its large and stable financing base for government debt, and will likely contribute to a gradual decline in the general government debt burden over the medium term.”. In contrast, Venezuela (although not part of the EM index) was found to be in default by S&P after it failed to pay ~$200 million in interest payments on its sovereign debt.
Issuance in the emerging markets (USD denominated bonds) and high yield sectors was expected to rise prior to the anticipated rate hike by the Federal reserve bank in December, but instead companies in China, Hong Kong and Indonesia are said to have pulled $800 million of planned bond sales. Weak market sentiment is blamed, as spreads have widened out on existing debt. The average spread on USD denominated debt peaked at +355 last week, after trading at +313 only three weeks prior. Even at the recent moves, spreads are still below their 17-year average of + 423.
- As can be seen with the varied performance of Venezuela and India, country selection within this asset class is key and fund managers that are specialised in this area should be used. The Legg Mason Brandywine GOFI fund has long been an investor in this market and has a strong track record of performance.
Spreads on USD denominated Emerging Market debt
The US tax reforms are likely to have implications for fixed income asset valuations. The impact may come from:
- A reduction in bond sales - The tax plans include a cap on interest deductions to 30% of income a year. This could limit the amount of debt companies want to issue.
- An increase in defaults for lowly rated companies with high debt levels - the inability to deduct interest above the cap will weigh on profitability
- A lift in inflation putting downward pressure on bond prices - The lower tax is to designed to stimulate the economy and generate growth which may push up inflation.
- An increase in supply of Treasuries – The government will need to fund the deficit, increasing supply of treasuries and putting downward pressure on prices.
Assuming some of the above plays out, overweight short duration investment grade credit could be one of the better trades allowing resets to higher yields as they emerge.
In a speech this week, Reserve Bank of Australia governor Philip Lowe said “there is not a case for a near-term adjustment in monetary policy”. Low wage growth and low inflation are cited as barriers to raising interest rates, although he did concede that the next move in rates is more likely to be up than down. While the market is still pricing in a chance of a rate hike in the first half of next year, it is more heavily skewed to rate hikes in the last quarter of 2018.
Over in Europe the minutes from the ECB’s October meeting revealed that while alternatives were discussed, most members agreed on the extension of the asset purchasing program (QE) combined with the reduction to EUR30 billion a month. They discussed that an end to the program would be premature given low inflation.
- ALS’s result missed the market, however there remains significant momentum in its commodities-exposed business.
- Monadelphous (MND) has been one of the stand-out contractors on the Australian market through the recent cycle. A pick up is expected in FY18, however headwinds for the business remain.
- CYBG remains on track to achieve its FY19 target metrics following the release of its full year result.
Despite an underlying increase of 18% in earnings per share, ALS (ALQ) missed expectations with its half year result, although the source of disappointment was less typical. The half yearly dividend was also increased by 45%, albeit off a low base following a multi-year contraction in profit. The key driver in the improvement was the group’s commodities testing unit, which showed a 52% increase in earnings on higher revenue, coupled with margin expansion. The division is the more volatile component of ALS’s earnings base given the correlation with exploration undertaken by mining companies and the number of smaller miners raising equity.
The chart illustrates the deep trough following the peak in commodity prices several years ago. Volumes began to recover off a low base in mid-2016 as the resources industry started to catch up on a period of underinvestment. This momentum has been maintained through most of this year, despite the tougher comps that are now being cycled. Additionally, pricing is beginning to improve again, which is having flow on effects to margins. With the commodity prices continuing to provide a supportive environment, this better margin trend for ALS is likely to extend in the medium term.
ALS: Global Mineral Sample Flow
ALS’s core life sciences division, which provides laboratory testing services for a range of industries from environmental to food to pharmaceuticals, was weaker than expected. The division has experienced steady growth and benefited for an extended period of favourable regulatory trends, although competitive pressures in the UK and US markets led to softer margins in the half.
Following the sale of its oil and gas business earlier this year, ALQ has opted to return capital to shareholders via a buyback, which was somewhat of a surprise to investors. The common view was that this capital may have been retained for further bolt on acquisitions in its life sciences business. While the decision may show a level of discipline by the company given stretched valuations in the sector, in the short term it does remove a potential source of earnings growth.
ALS does screen as expensive and is now trading on a forward P/E of 22X (a factor which will also limit the EPS accretion from its buyback). A continuation of the trends in its commodities testing division should result in a commensurate improvement in earnings given the operational leverage in the business allowing the stock to grow into this valuation, although the risk from here is a disruption in the current cycle.
ALS’s confidence in the outlook in resources- related markets was mirrored by contractor Monadelphous (MND) at its AGM, as it noted that it now expected to deliver sales revenue growth of greater than 30% in the first half. This rate of growth is expected to moderate into the second half and the medium term challenge is likely to be through its large exposure to energy markets. MND has significantly participated in the LNG construction boom in Australia (oil and gas accounted for over half of revenues in FY17), and there is little prospect for much activity in the next few years given the well supplied nature of global LNG markets, lower oil prices making few prospective projects economical and the poor capital position of the key players in the domestic market.
NAB spin-off CYBG’s (formerly Clydesdale) result was viewed favourably by the market, with the company making good progress on its cost out strategy. While this remains the focus of the business and was the key driver of a 33% lift in earnings, asset growth was also fairly solid, with 8% growth in mortgages and 6% in SME lending. Similarly to the experience in Australia, bad debts have been well contained, with an impairment charge at 14bp for the year.
CYBG is well on the way to achieving its FY19 cost out targets, with its cost to income ratio falling from a high 75% at its IPO two years ago to a level of 67% for FY17. Its run rate is better than this, with £90m delivered to date, while importantly, it is reinvesting part of these savings back into the business into areas such as digitalisation.
CYBG Cost Savings
The result also marked the maiden dividend for CYBG as a separately listed company, even if the size fell short of forecasts. Nonetheless, increased capital returns may soon become a central part of the investment thesis if the bank is successful in its bid to achieve ‘internal ratings-based accreditation’, which would effectively mean that it would reduce the amount of capital that it holds against its loans (a reversal of the stricter capital requirements recently imposed on Australia’s major banks).
This would likely accelerate the rate of improvement in return on equity (CYBG has a double-digit forecast by FY19 and is halfway to achieving this from the measure at is IPO of 5.1%) and result in additional returns to shareholders. CYBG estimates that £5bn would be freed up through changes to risk weights to its mortgage book. This is a FY19 story, with the currently expected transition timeline October 2018 for its mortgage portfolio and October 2019 across the rest of its book.
While the stock is not without its risks, such as those raised from Brexit and a possible increase in legacy conduct charges arising from the mis-selling of insurance products, the potential for an attractive level of earnings growth in the medium term is in contrast to the more benign outlook for Australia’s domestic banks. With a solid capital position and trading at a discount to book value, the stock is a holding in Escala’s Investor Mutual SMA portfolios. We have also held it in our direct equity guided portfolio.