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WEEKEND LADDER

A summary of the week’s results

25.01.2019

Week Ending 25.01.2019

Eco Blog

- This year, if not this decade, is beholden to the frustration that growth is seen as below par. The two key economies, the US and China, inevitably cannot find common ground. Corporations will have to consider politics and policy in their strategic direction.

- Consumer behaviour has clearly changed and property assets with specific tenants, or where they can be adapted, are being supported compared to traditional malls. This supports the contention that a blanket rule on the merits or otherwise of a sector is rarely appropriate. 

A slowing growth meme has gripped financial markets since the third quarter of 2018. Some months later the analysis is more reflective and hones on two distinct issues.

The first is that the US policies of this administration have not done as much as expected for economic growth. Many will point to the tax cuts, but the evidence is that the corporate sector has rolled along in capital spending rather than take a dedicated reallocation of cash flow towards projects. In practice, many large corporations (particularly the tech companies) did not pay the statutory rate of tax in the first place, while small businesses have been hampered by lack of qualified labour that appears to have limited their capacity or desire to expand.

Source: Federal Reserve Board/Haver Analytics
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The household sector did not get the wage growth some anticipated and instead proved sensitive to interest rates, particularly in the housing market. Existing home sales are now at a three-year low, though there are signs that the fall in bond rates has renewed interest in housing. Another contributor could have been the tariff troubles across the Americas and China that pulled some jobs into the US, but also resulted in a fall in business confidence, as cited in surveys through the year.

The prognosis is that US GDP growth will resume its normal run rate of around 2.5% in 2018 (though the shutdown is estimated to possibly represent up to a 0.5% drag). This is far from problematic and certainty better than that of other developed regions, but not at the 3%+ level that the optimists had expected. Corporate profits are being adjusted accordingly.

The second factor that deserves attention outside the spotlight of daily news is global trade. The focus has been on the US/China battleground, as the changed agreements with Mexico and Canada are seen as resolved and inconsequential. China represents roughly 50% of global GDP growth and without China and its counterparties (including Australia), the pace will clearly take a big step backwards.

Wind back to where China now sits, regardless of the US deficit problem. The demographic benefit has faded and its debt levels are higher. After the long tailwind of export trade based on low cost, productive labour, it would, in any event, have needed to restructure its economy. This has precedent in the so-called Developing Economy Low Income Trap. Once an economy has exploited its labour market or commodity resource, it has to move to something else. China reached this point while also dealing with bad lending and investing practices, otherwise known as ‘shadow banking’. 

The current government, not unreasonably, viewed a move into value-added product, its emerging internet based sector and a broader connection across regions (the One Road One Belt theme) as the next step. The US, on the other hand, saw the trade deficit with China as something to fix. That would require China to lift its import of US value-added product and limit the transfer of proprietary technology.  This impasse will not be resolved by tariffs. The US has to live within its means and retain the benefit of low product prices and China cannot depend on exports nor the transfer of intellectual property at no cost.

Inevitably, it has another aspect in the politicking on both sides, a surprisingly similar pattern. Both leaders have anchored themselves to public opinion, not always what is in the longer term interests of the country. The weight then falls on the populist agenda rather than how and why economic growth and development can unfold.

  • Patience may be required to achieve the investment returns expected from good companies that can abstract themselves from this powerplay by focusing on consumer and business trends. Valuation sentiment is likely to give an uneven ride and the pattern will require constant adaption to both policies and structural changes in demand.

Retail is continuously attempting to adapt to the revolution of the e-commerce business model. As a result, retail property struggled last year with the exception of REITs that own free-standing street-based retail, which were amongst the top performers of 2018. In the US, free standing retail produced a total return of 13.9% in 2018 compared to shopping centres and regional malls of -14.5% and -7%, respectively.

The tenants of REITs that own free-standing retail properties generally provide non-discretionary products/services, such as pet stores, discount formats, gyms and restaurants. As an example, Realty Income Corporation’s biggest tenant is Walgreens. Consequently, they can identify demographic trends for tenancies compared to the boarder base required for a shopping centres. Shopping centres have been challenged by declining sales, store closings and bankruptcies from major retail chains. Since filing for bankruptcy in October Sears has closed nearly one third of its stores.

The gap between the quality of assets in the retail sector is widening. An example comes from one of the world’s biggest retail landlords, Simon Property Group, which has been transforming its shopping centres into mixed-use centres, with non-retail elements like offices, hotels and entertainment options. Locally, Vicinity Centres announced a $37m decline (0.2%) in the value of its portfolio this week. This mainly came from its regional, sub-regional and neighbourhood centres, while their flagship portfolio increased in value.

Fixed Income Update

- Emerging market sovereign debt and leverage loans both start 2019 strongly as sentiment favours riskier subsectors of fixed income.

Growth cycles between the US and emerging market (EM) economies were out of sync last year, fuelled by government fiscal spending and tax cut boosts in the US, while China’s policies, election upheaval (Mexico and Brazil) and economic woes in Argentina and Turkey weighed on the EM region. The result was falling local currencies as the USD strengthened, putting EM central banks in a tough position. Some (India, Indonesia, Malaysia and Mexico) responded by increasing interest rates to stop the currency from falling further. In many cases it was done in the absence of inflation. Slowing growth and tightening policy were a bearish combination for EM assets.

A recent change in Fed policy takes the pressure off the USD and is supportive for undervalued local emerging currencies. This year a risk-on sentiment in markets has extended to the EM region, with inflows into many bond funds. New issuance levels have also got off to a good start, with 2019 being the third best on record for EM USD-denominated issuance levels.

We see the value in this sector, notwithstanding the recent rally (the index is up 2.25% YTD). While country selection is imperative, high real yields are on offer in places that have a strong fundamental outlook (e.g. improved fiscal position, low inflation, high growth and young demographics). In many cases, yields are trading at close on double historical levels.

EM USD Bond Index returns YTD

Source: Escala Partners, Bloomberg
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We note that EM government debt has grown rapidly in the last few years and remains at levels well below developed countries. EM debt/GDP is 48% (vs 109% in developed markets) and also heavily skewed towards some countries such as Brazil and Hungary. Debt levels will likely prove to be a headwind for certain countries, and unsurprisingly funds favour countries with low debt levels. 

  • EM assets are still underweighted in global portfolios. We expect a rebalancing this year as investors see the value in this sector. Legg Mason Brandywine GOFI Fund provides exposure to EM debt.

Another riskier sub sector of fixed income that has got off to a strong start this year is the leveraged loan market. After falling 2.5% in December, the worst month since August 2011, the index has rebounded, returning 2.6% so far in January. 

Leveraged loans are secured loans of lower rated, smaller companies that might struggle to issue in the high yield market. They have been in the spotlight in recent months as concerns mount on the move to lower covenant protections for the lender. These may be the amount of leverage within company, level of cash or liquid assets on hand and maintaining interest coverage ratios at acceptable levels. By taking out these protections, it is now estimated that 80% of the market is covenant-lite.

The turnaround so far in 2019 can be attributed to the tapering of interest rate expectations in the US (these are floating rate products and it relieves the cost of funding on the underlying borrowers) and valuations following last year’s price falls. Market participants also note improvements in the credit quality of new issuance. According to a portfolio manager at Eaton Vance that specialises in leveraged loans “to get a deal through the market now, it is going to have less leverage, tighter documents and a higher coupon”.

  • We note that this sector may rally into 2019, although we expect volatility to remain heightened. Current low default rates are aiding the sector (at 1.6%, below the historical average of 3.1%), but any meaningful tick up will revisit the bearish trend. Bentham Global Income Fund does invest in leveraged loans and has an excellent track record, though inevitably is vulnerable to the sector’s movements.

Corporate Comments

- Challenger (CGF) and Sims Group (SGM) added to the profit warnings of the market this week, foreshadowing a higher level of earnings risk heading to half year reporting season.

Challenger’s (CGF) downgrade to its earnings guidance (of ~8%) took the market by surprise, although in hindsight should have been better anticipated given the weak investment returns of the December half. CGF’s core business is in issuing annuities, whereby it essentially pays investors a predetermined rate and takes on the investment risk to earn a spread above this figure. While it has a relatively conservatively invested portfolio (primarily in fixed interest assets), large swings in equity markets and/or credit spreads can impact the short-term performance. This proved to be the case in the first six months of FY19; weaker performance in its absolute return portfolio and lower performance fees from its funds management division reduced its ‘normalised’ profit, while the ‘statutory’ figure included larger losses from equity markets and wider credit spreads.

Challenger: Life Investment Portfolio

Source: Challenger
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On one hand, the market’s response to the downgrade could be viewed as overly harsh; after all, market volatility is not unusual and the lower starting base as at 31 December provides an improved probability of better investment returns in the medium term. On the other, it highlights the core issue that Challenger faces, that being balancing the risk in its investments and offering a sufficiently attractive return for investors to maintain its margins; a task which has become harder in a lower growth/interest rate environment.

The bulls on CGF point towards the untapped and growing demand for annuities, which is being assisted by superannuation reform. However, we note that CGF’s P/E derate over the last 12-18 months has only brought it back to a similar range of 2014-15 and that there is some short term risks with a new CEO who may look at rebasing expectations in the upcoming reporting season.

Also downgrading earnings this week was metals recycling group Sims Metal Management (SGM), with a sharp share price drop on the day followed by a recoup of around half of the losses by the end of the week. Sims has been impacted by higher competition as well as uncertainty regarding trade wars and tariffs. An example is Turkey’s price position in the market following tariffs imposed by the US.

Aside from the macro concerns that are likely to persist through much of 2019, SGM has gained support from some investors on the success of its own initiatives that have focused on improving the return on capital. This is coupled with a respectable valuation and sound balance sheet, although the company is subject to cycles which can overshadow the achievements by management.

  • We have noted a pick up in ‘profit warnings’ or negative earnings revisions in recent months, which bodes for a more difficult upcoming reporting season. The chart below shows that this has returned to a more normal level. The typical risk areas cited are for companies exposed to the domestic consumer or housing sector, although warnings from Challenger and Sims show that the potential for disappointment is broader. On a positive note, domestic valuations have adjusted following the December quarter market correction, hence diversified portfolios should still be better placed for improved returns this year.

ASX 200: Earnings Revisions

Source: Thomson Reuters, Escala Partners
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