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WEEKEND LADDER

A summary of the week’s results

25.05.2018

Week Ending 25.05.2018

Eco Blog

- Global growth should again become synchronised into Q2 with an acceleration in the US and revival in Europe. Oil prices and politics are the likely culprits that can spoil the trend.

- Investment spending may be the key to US wages as jobs in manufacturing and construction come to the fore.

- USD strength is widely believed to be temporary.

Notwithstanding the noise of weekly data flow, the consensus is firmly of the view global economic growth is intact and more likely to show stronger numbers in coming quarters. This is on the back of the small retracement in Japanese GDP in Q1 and the weak PMIs for Europe, which translated into the quarterly GDP for Germany easing from a 0.6% rate in Q4 2017 to 0.3% in Q1 2018.

German private consumption was solid following the recent wage negotiations, which resulted in employee compensation rising 4.6% yoy. Government spending, inventories and foreign trade were softer in the quarter, more likely due to seasonal effects than a fundamental retracement. Nonetheless, it would appear that 2017 will have been the peak for Europe in this cycle and while decent enough GDP growth of 2.2% is forecast for 2018 (versus 2.5% in 2017), the upgrades of last year are no longer prevalent.

For all the conflicting trends in emerging economies, the view is that the aggregate growth is sound. China has largely cemented its profile via the reset of its policies and recent easing in credit restraint. Trade is clearly a potential trigger point, but it appears the US may temper any meaningful implementation until after the mid term elections in November.

That brings one back to the US and how the economic momentum is unfolding. The consumer has been slow to react to the tax breaks, while corporate investment invariably takes a while to crank up. The forward plans for capital spending have rarely been this high across a range of surveys and even if some are unrealised, the effect is likely to be significant.

US capital spending

Source: Deutsche Bank, Federal reserve banks, Bureau of Economic Analysis
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  • Equity sector leadership is rotating to the tune of changing global growth. We are mindful of increasing cost pressures, leverage to capital spending and rising rates. We look to the recommended managers to justify their positions accordingly.

The potential risks are a spike in oil prices (most likely geopolitical rather than demand) and uncertainty created by trade or other policy factors. Over and above the level of demand, forecasting oil prices is a messy mix of politics (Iran), self-induced (Venezuela and OPEC), shorter term supply out of the US and speculative positions.

Claims are that oil company capital programmes have been overly curtailed as shareholders seek near term rewards versus longer term investment. Current assessment of the likely trajectory for oil prices is mixed, unsurprising given the potential for several unrelated events. An uptick in global growth and sticky supply is likely to pull in financial traders and could see the oil price move above the comfort level.

The point at which petrol/gas prices start to undermine spending is purely judgement. Some suggest that the US consumer is reacting to both rate rises (as the long term bond yield sets the mortgage rate) and energy costs.

What will matter as much is the flow on effect to inflation. The long-awaited wage growth is also in the wings. While the US growth came from consumer spending, wages where subdued given the skew to services. If manufacturing and construction jobs follow the investment spending thesis, average wages are likely to rise more strongly.

Emp Growth Low vs Non-Low Wage Sectors

Source: Thomson Reuters Datastream, BLS, TS Lombard
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The recent USD strength has been another feature that is affecting financial markets. At face value, the rise in US rates should imply a stronger dollar, yet as we have pointed out, flows into the USD have been weak due to the hedging costs. Further growth in Europe and EM were attracting investment flows. By the beginning of this year the overwhelming consensus that the USD would be weak had resulted is significantly extended short positions. As the tone changed, these have been reduced, resulting in USD buying. The view is that this USD strength is short lived. If European growth picks up again and oil prices stabilise, the currency could retrace some of its recent gains. Longer term the large twin deficits, the current account (trade and capital flows) and fiscal deterioration, limit the USD upside.

US Twin Deficits and Exchange Rate

Source: Manulife
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The trade imbroglio may take a back seat in coming months. With the impending US mid term elections, the administration would not want China to revisit agricultural restrictions or raise the heat given surveys show that small business is concerned about the costs of tariffs. As it is, the headlines may imply China is rebalancing its exports. Electronic products are the largest component of the goods deficit with the US. Slowing mobile sales and lack of new releases will impact exports, while imports can grow as China moves further towards its goal of value-added technology.

These issues are though playing right into the longer-term China theme to develop its own industry. China buys around 58% of the world’s microchips, while only producing about 4%. Taiwan and Korea are large and highly regarded in this industry and, given their dependence on China, have been pushed to share their technology, as growth within China has outweighed concerns on protecting their IP.

  • EM investing, increasingly dominated by China, requires a long term view. Currency and oil prices, amongst other influences, can at times dominate. 

Investment Market Comment

- Commodity ETFs offer various degrees of exposure to numerous commodities such as oil, agricultural and metals.

Traditionally it has been complicated and expensive for investors to get direct exposure to the performance of commodity prices. However, ETFs aim to replicate the price movement of commodities through holding the physical asset (a rare case) or using derivativities. Additionally, an ETF can invest in a portfolio of commodity equities or replicate the performance of an index. These different methods are going to come with different risks.

There are two main types of ETFs that can accommodate the theme -  physical and synthetic. As the name suggests physical ETFs hold the actual securities of an index or the physical commodity, whilst, a synthetic ETF is designed to track the performance of a commodity or index through use derivatives such as futures or swaps. This is achieved through the ETF provider agreeing with a counterparty to buy or sell the commodity equivalent at a pre-determined future date and price. These ETFs can be considered riskier as the counterparty could default on its obligations under the swap agreement. Additionally, synthetic ETFs commonly have higher tracking errors relative to the commodity spot price. This is the result of the constant need to roll contracts which leads a deviation from the spot price. In addition, higher fees are associated with synthetic ETFs.

Gold ETFs have been the most commonly used commodity ETFs as it has traditionally been thought of as safe haven during volatile times. There are five gold ETFs available on the ASX, three that physically hold gold bullion and two that follow gold miners. Both of the ETF Securities physical GOLD ETFs are unhedged and consequently track the price of gold in AUD terms, whereas, Betashares hedges its US dollar exposure back to the Australian dollar. As a result, an investor is required to take a view on currency when deciding on one of these. These funds own gold bullions, therefore, they should follow the gold price very closely and give investors a true exposure to movements in the gold spot price less fees. As the below chart demonstrates Betashares Gold Bullion ETF has a higher tracking error, which can be associated with the cost of hedging.

Gold ETFs growth against Spot Gold Price

Source: Bloomberg, Escala Partners
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VanEck and Betashares each offer an ETF that aims to track the performance of companies in the gold mining industry. Betashares gives a hedged exposure to global gold miners (ex-Australia), whilst VanEck is unhedged. Both funds will also invest in companies with silver exposure and therefore these are not true gold exposures. Unsurprisingly the performance of these ETFs can diverge from performance of the commodity given that there is a company and share price rather than direct commodity exposure.

Perforamnce of Gold-themed ETFs

Source: Morningstar, Escala Partners
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The most efficient way for an investor to gain exposure to the performance of the gold price is to invest in an ETF that holds the physical commodity rather than equities or derivatives related to that commodity. Other commodities do not lend themselves to physical replication. Stock based ETFs should also provide better leverage to price movements given companies profits are highly sensitive to commodity prices.  

Fixed Income Update

- Italian bonds sell off in light of political change with safe have assets such as German bonds being the beneficiary.

- 2-year US treasuries look attractive when considering the potential movement in yields.

Political turmoil in Italy resulted in a volatile week for Italian government bonds. The yield on the Italian 10-year benchmark government bond bumped up 0.20% in a single day and is now up 0.65% since the beginning of the month. Investors have responded by withdrawing money from Western European bond funds.

The newly formed coalition of the anti-establishment Five Star Movement, and the far-right League party raises concerns about the prospect of Italy leaving the euro and a budget blow out. Proposed new policies include raising welfare and cutting taxes, which would increase Italy’s debt burden. As it stands public debt in Italy is already at 132% of GDP which is the highest in the eurozone, after Greece.

While the sell-off in bonds is significant, it has been cushioned by ECB buying Italy’s bonds and as owners of ~23% of outstanding debt. Further, foreigner's outside the Eurozone (who are perhaps more reactionary in their selling decisions) only hold about 25% of Italy’s sovereign debt, a 20 year low. 

The divergence in economic performance and political stability across Europe has bond yields on individual countries trading at very different levels, despite the same interest rate policy set by the ECB. The variance is akin to a ‘credit spread’ on the country’s sovereign status. By way of example, German and French bonds trade tighter than ‘riskier’ sovereigns such as Italy, Spain and Portugal. However, the spread offered between the regions narrowed due to the ECB’s bond program which had investors buying up peripheral European debt in a ‘carry trade’ as these bonds had the buying support of the ECB and still paid a premium above countries such as Germany and France. This recent bout of political uncertainty saw the margin between German and Italian bonds widen to its highest level in 6 months, as investors sought safety in German bonds.

Spread between German and Italian 10-year sovereign bonds

Source: IRESS, Escala Partners
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  • Recommended global bond funds have take differentiated views on the Italian situation. Pimco remains underweight Italian bonds against the benchmark, a position it has held over the last few months as spreads narrowed between German and Italian bonds. In contrast, JP Morgan played down the political risk and suggest it may become buyers of Italian debt at these new levels.

A normal shaped yield curve is positively sloped, as investors get paid a term premium for holding longer dated bonds. This higher premium acts as a buffer to protect investors against upward movements in yields which push down the price of the bond. When analysing risk/return, investors can do a simple breakeven analysis, by calculating the basis points (bps) yields would need to rise within one year before the decline in the price of the bond offsets the annual coupon and results in a zero annual total return.

The US treasury market is viewed as without default risk and strong liquidity, which if held to maturity would preserve capital whilst generating an income. However, throughout the life of the bond the price will fluctuate. Rate rises by the Fed and the unwinding of the balance sheet have done just this, as the 10-year US bond sits at near 3% today compared to a yield of 2.25% a year ago. This has resulted in a mark to market total return loss of ~-4.6% in the year. By using the breakeven analysis mentioned above, one can determine how much further yield pressure the Treasuries can sustain before a potential net loss. At present, a US 2-year bond yields could rise 132 bp (1.32%), a 5-year 60bp (0.60%) and a 10year 35bp (0.35%) before this occurs. The flattening of the yield curve (as shorter dated treasuries yields rose at a greater pace than longer dates) have made the former more attractive from a risk/return perspective if using this analysis.

Current breakeven analysis on US treasuries for a given maturity

Source: Bloomberg, Escala Partners
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  • It should be noted that this is only one consideration as investors evaluate the likelihood of yields rising for a given maturity on the curve. Future economic growth, inflation, central bank policies, currency, supply/demand dynamics and the shape of the yield curve, amongst other things, are additional considerations.

Corporate Comments

- James Hardie’s (JHX) earnings beat was of relatively low quality given a tax benefit, although the company got a tick for addressing issues it has recently experienced in its North American operations.

- Aristocrat Leisure (ALL) is presently one of the glamour growth stocks of the market. M&A success and market share gains in its core product have led to significant operating leverage in recent years and the short term outlook is for a continuation of these trends.

- M&A was again in focus this week, with the rejection of two takeover proposals for different reasons. Santos (STO) shareholders are yet to see the full benefit from a higher oil price environment, while Healthscope (HSO) remains in a difficult position and somewhat dependent on a higher offer emerging for the group.

- Wesfarmers realises UK assets and takes large loss.

James Hardie (JHX) this week delivered a full year result ahead of expectations, albeit of questionable quality given a favourable taxation outcome of approximately US$10m for the period. In the 12 months, the company’s underlying net operating profit increased by 17%, with growth in both its North American and international divisions driving the result.

For JHX, the key development in the last six months has been the turnaround in its core North American business after experiencing some manufacturing difficulties in the past nine months. Consequently, the EBIT margin had dipped several percentage points to below JHX’s targeted 20-25% range.

In the second half of the year, however, the lifting of capacity constraints, an increase in pricing levels and a reducing in delivered unit costs led to a material improvement in earnings. Margins rose again, despite the headwind of rising input costs, a factor which we have noted has recently impacted many manufacturers. In the fourth quarter, JHX’s two key costs, being freight and pulp, both increased at circa 20% over the 12 months

James Hardie: Quarterly US Input Costs

James Hardie: Quarterly US Input Costs
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With better operating momentum into FY19, a supportive market environment (steady growth in US housing starts) and the expectation of further market share gains for the company, the medium-term outlook for JHX remains sound. Delivering on consensus mid-teens EPS growth will help to justify a forward P/E in the low 20s range, somewhat more appealing than other high growth options that have experienced significant multiple expansion over the last 12 months. We have the stock in our model equity portfolio.

Poker machine developer Aristocrat Leisure (ALL) has also been a widely-held growth stock among fund managers with this bias, although the significant gains it has made in recent years have been more driven by a rising earnings profile as opposed to escalating valuation measures. The company again easily beat consensus expectations in its half year report, delivering growth of 33% for the six months.

Aristocrat Leisure Earnings Bridge

Source: Aristocrat Leisure
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There have been several aspects behind the increase in ALL’s profitability, with the key driver being market share gains in the important North American market, which overall has experienced limited growth in this time. ALL have been reaping the benefits from investment in core product development which has led to market-leading games that have proven to be more profitable for its casino customer base and hence lifted demand.

The other factor that has provided leg of growth has been a series of acquisitions in the social gaming and casino space which has made ALL the number two player in the social casino market. The market here is going through a significant growth phase, assisted by smart phone penetration and increasing data speed and allowances and there is material scale benefits from being one of the larger players.

The parallels with ALL’s primary poker machine development business are quite similar, in that success is dependent on the development of popular games and the monetisation of this customer base. Arguably, however, the competitive advantage and sustainability of this particular business for ALL is not as strong, given weaker barriers to entry for app development and the relatively short shelf life of individual games.

The outlook for ALL is predicated on much of the same drivers that have been behind its recent growth and is therefore largely dependent on further market share gains in its pokies business (within a fairly soft market environment) and ongoing growth in its newer digital division. The company presently retains solid momentum on both fronts, which could potentially be broken by a competitive response from its peers. On the back of this result, the company is likely to be retained as a conviction position among growth managers, although it remains a more challenging proposition for investors with an ethical view of their investments.

This week also saw the failure of two proposed M&A deals, with Santos (STO) and Healthscope (HSO) both rejecting proposals that were on the table. In the case of Santos, the rebuff was somewhat understandable. After surviving the worst of the downturn in energy markets (helped by two large equity raisings along the way) the company has been transformed following a successful campaign to cut costs across its business and repair its balance sheet. STO is now well placed to cash in on the robust oil price environment, although management’s attention is likely to turn to balancing the excess capital generated with either production growth opportunities (that may not be economic if the oil price weakens again) and shareholder distributions (the company has not paid a dividend since HY16).

The former has not been on the radar for some time (the slide below is from STO’s recent full year result), although it would represent a change in strategy and in all likelihood change the investment thesis for the stock. In the absence of STO’s suitor returning with a more attractive offer, investors are banking on either a continuation of the recent oil price strength or success in a transition to a growth bias for the company.

Santos Strategy

Source: Santos
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Healthscope, meanwhile, rather heroically rebuffed the advances of two separate takeover proposals, while at the same time issuing a further earnings downgrade for FY18. Despite the rejection, HSO shares only declined slightly this week, reflecting the modest control premium of the offers and indicating that there is a high degree of expectation in the market that a higher offer for the company will eventuate. With pressure on near term earnings given weak hospital conditions, the outlook for HSO investors looks very much like a binary outcome: either the completion of a takeover deal at a higher offer, or failing this, a derating over time as the challenging market returns to the front of mind.

Wesfarmers (WES) capitulated early on its misadventure into the UK home and hardware retailing sector. It will sell the Bunnings business here (BUKI) and take a loss of GBP200-230m, in addition to the writedown earlier this year and ongoing operating losses.

While the stock price indicates muted relief, the management judgement of this poor outcome will weigh on any other decisions to diversify industry or geography.

The attention will now turn to the outlook for Coles Supermarkets given the intention to spin off this division and the potential growth of the other components. The stock is likely to be range bound until investors take a distinct position to the value of these entities.

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