Week Ending 25.03.2016
With the recent comments on the purpose of superannuation, the spotlight revolves back to the problem of global pension obligations for an ageing population. In Australia the demographics are much better than for the bulk of the OECD, with the share of over 65 year olds expected to be in the high-teens, rather than akin to those shown below (this does however assume immigration and births takes the overall Australian population to 37m by 2050). However, based on OECD data, those dependent on an aged pension in Australia will have a low income relative to that of the working population at 67%.
The chart below shows that for a number of countries the median income for a 65+ year old is higher than that for the working population. Unfunded government pension obligations and inadequate corporate plans are a major challenge for economies worldwide.Enlarge
The impact of this issue will be widespread. Tax rates will have to remain higher than governments like to promise, the retirement age is likely to creep up even more and it would appear likely governments will have to consider options such as asset tests (including the family home) and withdrawal limits in pension considerations.
Government pension payments already soak up over 10% of GDP in a number of countries, mostly in Europe. It is however, cold comfort Australia can get away with only 3.5% of GDP. Of course, pensions are far from the only costs of an aging population. Healthcare costs, rising here by over 5% per annum, is another. As noted, the government pension is not particularly generous in Australia compared to other OECD countries. Yet the issue is rather that the onus is on the individual to make complex decisions on how much is required for retirement and how to invest these funds. Similarly, healthcare costs are increasingly foisted onto the individual.
For the fortunate (and hardworking!), there will be sufficient funds to satisfy the expected lifestyle in retirement. However, this does not apply to most retirees and their influence on financial assets will have a considerable bearing on the flows in and out of asset classes. We note that some superannuation industry funds, particularly those with mostly government employees, are already experiencing net outflows.
RBA Governor Stephens was at pains to provide a balanced view of the Australian economy in a closely watched address this week. From the RBA’s perspective, the unwelcome rally in the AUD has unwound some of the easing achieved from the fall in interest rates. The cause of the upward move in the currency is firstly, due to a perception that the USD had moved too quickly late last year, secondly, the Fed revisiting its ‘dot points’ representing the guidance on the expected official rate in the US, and lastly the sharp move in commodities (iron ore in particular). Stevens intimated that he was expecting the rate rise in the US to take some of the pressure off the currency.
In the short term, the rise in the AUD has eaten up much of the recent improvement in global equities, if unhedged. Yet in the long run (over 10-year period) the difference between hedged and unhedged returns are relatively similar, barring at the extreme points of the exchange rate.
The question is which direction the AUD is now likely to head. The balance of probabilities suggests that it will trade in a range from the current level (circa 76c/USD) to 70c/USD. This is based on the interest rate differential, which suggest it is currently slightly ahead of itself, largely due to the commodity rally.Enlarge
The risks to this scenario lie with the US rate cycle and economic momentum. Recently housing activity has slowed with new home sales falling 7% in February. On the other hand, housing inventory is at its lowest level since 2005. The decline in sales is skewed to the higher end of pricing, indicating affordability was becoming an issue given the low level of income growth that seems entrenched in the US. A similar pattern appears to be evolving in Australia. Wage growth therefore would appear to be a critical factor likely to influence the Fed.
Overall, economic growth itself may prove a determining factor with GDP expected to be weak in Q2 in part due to the rise in inventory/sales ratio. The cause is attributed to patchy retail spending and sluggish manufacturing, some of which is cyclical. Structural inventory issues are also in play. A number of retail models, for example, Bonobos in the US, does not have inventory to purchase in its stores, rather to try on, feel and see. All product is then delivered directly to the customer. This will potentially substantially reduce inventory holdings to a few distribution centres rather than a large number of stores.
The potential for a weak Q2 underpins the expectation the Fed is only likely to move rates again in June/July when it has more data to support such a move. In this case, the USD may remain sloppy through the first half of the year.
However, there are other factors which may also play a role. The Euro may be vulnerable to political uncertainty, deflationary trends and negative interest rates. Conversely, due to the persistence of its current account surplus and large stock of international assets, the Yen is resilient to Japan’s low growth and ineffective monetary settings. The Chinese Yuan is judged as overvalued by between 10-15%. The authorities appear to be aiming for a gentle slide, but another significant outflow of capital may overtake their capacity to resist a faster devaluation.
This makes it a tough call to be dogmatic on the outcome for the AUD. Fundamental considerations can fall victim to sentiment, trading positions and importantly for currencies, the inevitable fact that there are always two. For example, if a trader is of the view the NZD is expected to be weak, it is common to pair it up against the AUD. Similarly, given the liquidity in the AUD, it is a way to express a short term currency view of emerging markets rather than representing a particular opinion on the value of the AUD.
Fixed Income Update
Perhaps the fact that the Australian financial market is equity centric and investors enjoy discussing their latest stock picks at the weekend BBQ is to blame for the relative disinterest in fixed income. Sadly, it is rare to find an investor bragging about their latest bond purchase and how, if all goes well, they should receive 5% p.a and see their capital returned in 4 years’ time. (With interest rates at 2% that may well be worth bragging about!).
Part of the confusion comes from understanding that investing in fixed income is all about capital preservation. With this in mind the question is why there are negative months of performance for fixed income funds? The reason is that bonds are marked to market and reflect where that same bond is trading at that point in time. This performance (or price movement) is only relevant if there is an intention to sell this bond. If not, the only thing that remains relevant is what the yield to maturity on the bond was when it was purchased, and will the issuer still be viable at maturity to pay back the capital. The journey it takes to get there shouldn’t really matter and is only ‘white noise’.
Unlike equities, the fundamental difference with bonds is that the return is known if held to maturity and there is no default. Equity investments always face permanent loss of capital – there is no reason for a share price to ever equal the purchase price. Leaving recovery rates on defaulted bonds aside (and bonds with imbedded calls), it is a binary outcome. The return is either get the yield of, for example, 5% p.a plus capital repaid, or the issuer defaults and the capital is foregone. For floating rate notes (FRN’s) the same applies except that the coupon income will vary with underlying interest rates (as set by BBSW).
For buy and hold investors the price movements on a bond simply represent an ‘FYI’ on where other market participants can buy and sell the bond. If the bond is held until its due date, the price will revert to par (usually $100) upon maturity.
A live example is the recently matured CBAHA senior unsecured FRN. This was a 5 year CBA FRN bond that paid a coupon of BBSW +1.05% priced at purchase at $100. During the 5 year life of the bond investors were paid a quarterly coupon of BBSW + 1.05% and then after the 5 year period the capital was returned. Upon maturity the capital price of the bond was $100 plus the last quarter’s coupon. In this example this equated to $100.40.
Price movement of a 5 year CBA senior unsecured bond – CBAHAEnlarge
However, throughout the 5 year period the price of the bond went up and down reflecting where the market was pricing the security at that time. Two years into the 5 year term the bond was trading down to $98 implying a loss. An investor would rightfully argue, where is the capital preservation on this bond if it is now lower in price? The answer is that the capital is only lost if sold at that point. If not, holding the bond for the 5 year term prevents any loss.
The same principal applies for a fixed income fund, but it is often harder to visualise as this is a pool of bonds maturing at different times. Further, the portfolio managers aren’t always buy and hold investors. For this reason the entry and exit time can skew results. However, theoretically if the investment time frame matches the ‘weighted average life’ of the fund then the return will reflect the ‘average yield to maturity’. Once again the monthly performance of the fund is just ‘FYI’ or ‘white noise’.
It would be remiss to not address the real risk of losing capital. The likelihood of a bond defaulting depends on the credit quality of the issuer. A common determination is the ratings applied by the agencies Standard and Poors’ (S&P) and Moody’s. For those investing in investment grade securities (BBB- and above) the chance of default is very small. Further, when investing in a managed fund that ordinarily has in excess of 200 securities (~0.5% exposure to a single issuer), any real impact in terms of loss of capital is negligible even if there was a default. It is only when investors purchase lower rated (High Yield) product that the chance of default is material (however, bear in mind investors are compensated in the form of higher yields for taking on this risk).
The table below shows the historic cumulative default rates of global bonds given their credit rating as determined by S&P.Enlarge
For investors seeking capital preservation we recommend their fixed income allocation is made up of a large diversified pool of high quality bonds. The probability of default is extremely low and the most likely outcome is that capital will be fully preserved over the course, as well as receiving a modest income that reflects the low risk profile of the portfolio. Naturally, there will be months of under and over performance. Therefore, ongoing performance reports are worth a cursory glance, but the end goal remains the main objective.
TPG Telecom (TPM) reported another solid result this week along with full year guidance for the first time, which was ahead of analysts’ expectations and implied 10% half-on-half growth. Earnings growth of 36% for the half was boosted by a five month contribution from the acquired iiNet business, while earnings per share was slightly lower at 31% following an increased share issue to help fund the transaction. TPG increased its dividend by 27%, reflecting this improvement in earnings, while the group’s cash flow was strong.
TPG EBITDA GrowthEnlarge
The ability of TPG to extract a high rate of synergies within the first six months of iiNet ownership was the key driver for the earnings surprise. While the realised synergies was not quantified by TPG, the sharp uplift in iiNet’s margins indicates that the company is on track to achieve $40m or more in savings in FY16, up to double the rate forecast by the market. TPG has had a strong record of accomplishment in this regard, with a combination of acquisitive and organic growth over many years, and so current estimates of approximately $80m p.a. may prove to be conservative.
Subscriber growth is the other key metric that is driving the improved profitability of TPG, and the recent trends remained quite promising for the company. In the core TPG brand, broadband subscribers increased by 9% over the 12 months, with a large part of these from new NBN plans. With the NBN rollout still in its early stages (NBN plans currently represent approximately 10% of TPG’s subscriber base), we remain of the belief that there is a significant opportunity for the smaller telcos to take market share from Telstra (TLS) through more attractive pricing and a low current representation in regional areas.
Ironically, TPG’s result came on the same day as another network outage for Telstra, the fourth such problem for the company in the last two months. Telstra was the big winner from more significant issues from its competitor Vodafone several years ago, and while there is no suggestion at this stage that Telstra’s issues are on the same scale as those experienced by Vodafone, the risk remains of some customer churn from unhappy customers in coming periods. As we noted recently, Telstra’s mobiles growth has slowed markedly in recent periods and this driver of earnings for the company has subsequently become more challenged. We recently added Vocus Communications (VOC) to our model portfolios and believe that, combined with TPG, are a compelling alternative to an investment in Telstra.
In light of the movement in oil prices, it was unsurprising that Woodside Petroleum (WPL) shelved the proposed development of the Browse assets in the North West. WPL holds a 30.6% interest in the joint venture, alongside Royal Dutch Shell (27%), BP PLC (17%) and others.
The project carried higher risk than other developments as it intended to use a floating platform and undersea technology rather than piping the gas to a land based facility.
While this may still prove to be a delay rather than outright cancellation, there would have to be a high level of certainty on better oil prices (which determine the gas price) compared to today for the project to proceed.
The announcement comes close on the first production from the Chevron Gorgon project and a number of global gas facilities are further adding to supply. It may well be 3-5 years before Browse is on the radar again, putting WPL in a difficult position on its production from existing project which will decline prior to this decision.
Our preference in the sector lies with Oil Search, which has the option of adding brownfield capacity rather than the scale required for projects such as Browse.
Australian LNG projects
Banking analysts are likely to be unpleasantly surprised by the pre Easter updates from the banks both in terms of timing and content. ANZ indicated that it would raise its bad debt provision for resource loans with the implication that there may be more to come in other sectors and regions. Additionally, Westpac held a presentation day flagging emerging stress in consumer loans and tough business conditions.
The sectors share prices reacted sharply, not so much due to these annoucements but the rising probability of dividend cuts. The fact that bad debt provisions are at a low point is not new news and the increase will weigh on profit growth as we have flagged for some time.
The company comments above are a consistent reminder that portfolios need to be refreshed with new ideas to achieve the desired outcome. Traditionally held stocks such as Telstra and Woodside may be facing challenging conditions and we believe there are other selections in their sectors which are better positioned.
Over the past 12 months the top 20 stocks have lagged the ASX200. There are 34 new names in the ASX200 compared to 3 years ago, an indication of the degree of renewal. Even in the top 20 the best performers over a 3 year time frame (in order CSL, Macquarie Group (MQG), Transurban (TCL), Brambles (BXB) and IAG), have not necessarily been well represented in portfolios compared to the likes of BHP, RIO, WPL or Woolworths (WOW), which have had poor to negative returns over that time.
Stock selections in the smaller end of the ASX200 is challenging and prone to reactionary movements. Nonetheless, even with the risk of a few misjudgements, we believe it is important to continue to be prepared to allocate some weighting to a number of these companies.