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WEEKEND LADDER

A summary of the week’s results

25.07.2014

Week Ending 25.07.2014

Eco Blog

While the CPI came in at the higher end of the RBA range and the A$ strengthened in response on the assumption a rate cut is increasingly unlikely, banks have cut their longer term mortgage rates. First CBA, followed closely by NAB and WBC, reduced their 5 year fixed mortgage rates.  This appears to reflect a view on longer term interest rates with ‘lower for longer’ now the universal mantra. The banks have also extended their funding, locking low rates into their cost of capital.

Fixed Mortgage Rates as at 24th July

Source: Bank reports
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Competition in the mortgage market has increased as participants outside the four major banks look for a slice of this sector. Given low credit demand elsewhere in the economy, banks will aim to protect their share of lending. Housing is rarely out the news at present either as a risk to the financial sector due to high loan to value ratios, or as one of the few pockets of strength in the economy, with housing construction activity forecast to be robust over the coming year as approvals work their way through the system.

Both locally and in the UK, central banks, regulators and treasury officials are increasingly concerned that households are unprepared for rate rises, and will be unusually sensitive to any increase as income growth is slow. In all likelihood therefore, central banks will be very clear on their language to prepare markets for rate rises and introduce incremental steps with great care.

Inflation followed much of its usual pattern in the second quarter of the calendar year, with pass through of excise and tax in alcohol and tobacco and the persistence of relatively high cost increases in education and health. 

CPI by Major Category, Year-end % Change

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The RBA is highly unlikely to do much, faced with conflicting direction from its key metrics: inflation at the higher end of its 2-3% band; housing price rises and financial leverage more elevated than desired; yet a currency that is resistant to the usual signals of weakening commodity prices and likely narrowing of interest spreads.

A number of economists have looked at the potential for inflation to break out of the RBA band and have come to the conclusion that it looks extremely unlikely at this time. A meaningful change in the currency is therefore dependent on global interest rates, specifically that in the US.

New Zealand is also faced with, according to the RBNZ governor, ‘unjustified’ currency levels. Intervention by selling NZ$ is mooted, and perhaps the possibility is enough to sideline traders as the NZ$ did fall post these statements. But with a cash rate at 3.5%, NZ will continue to be attractive to carry traders.

The initial reading of the July PMI in China (index at 52 up from 50.7) was much better than expected and at an 18 month high. In turn, this also tends to support the A$, given the perceived link in momentum between Australia and China. In many ways this association is less valid than the past decade. Iron ore demand has been connected to China’s fixed investment decade. With that economy progressively moving away from capital investment and Australia’s export growth shifting to LNG, the correlation should break down.

Europe continues to send out mixed signals. Consumer confidence is weak and falling, possibly due to concerns on the geopolitical tension in the region. Conversely, business activity as measured by the PMI bumped up in July, led by Germany and the emerging recovery in the Mediterranean region. If industrial production data confirms this indictor, Europe looks to be set for a better third quarter after a weak second quarter.

On the other side of the Atlantic, US jobless claims fell to 284k, the lowest number since February 2006.

As the US economy tracks on its erratic recovery, secondary benefits emerge. State and local government taxes are improving, which should see some hiring re-emerge. This part of the government accounts for some 14% of non-farm payrolls, whereas the federal government only employs around 2%. Tempering this trend was a fall in new home sales. The contribution from housing to the US economy appears to be fading, possibly reflecting the low wage growth and interest rate expectations.

As the inevitable end of quantitative easing in the US looms, the debate is shifting to the pace of potential rate rises in 2015 and the way the Fed intends to manage its very large balance sheet.

At the start of this year expectations were that the US economy was set for circa 3% GDP growth and that the bond market would respect this through rising yields. Instead bonds have rallied due to a raft of influences: the US weather induced slump, weak data from China, easing by the ECB, soft inflation, low growth in bank credit. With the imbedded tendency to follow trends, many now contemplate that these lower bond yields will be sustained and have allowed their investment portfolios to take on duration risk again. The other consequence has been a big move into high yield debt in an attempt to maintain income flows.

The chart shows the movement of global investment flows in the past year. Equities have steadily attracted funds, even though there has been caution expressed on valuations. Debt funds lost momentum in late 2013 as rates increased, with money market (MM) funds the beneficiaries. However, investor appetite for income and growth is not satisfied in this asset segment and flows returned to higher yield bond securities. This highlights an issue for markets. High yield is a relatively small component of bond markets. As individual investors rotated to these debt securities and funds in that asset segment are required to participate, the cumulative effect has pushed high yield to where few see any value. 

Global Investment Flows

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In all likelihood, an unexpected level and pace of change in bond markets will once again have a significant influence on investment markets over the course of the coming 12 months. The risk is that participants try to time their move in positions at the same time. Debt securities (using that term rather than fixed interest as an asset class to include floating rate) is possibly the most challenging of investment assets at present. Historically, low volatility and respectable returns offered a buffer to equities. Today the only way to achieve low volatility is in the relatively unattractive yields of investment grade credit. Higher yields are achieved by taking on more risk, which works against one of the main purposes of asset allocation to debt. In its defence however, debt security return is substantially more predictable than equity. The major subjective valuation element is in the spread. By contrast, equity valuation is more art than science and the combination of unpredictable earnings (versus known coupon in fixed interest) and the valuation applied to those earnings will inevitably see volatility return to equities. 

Company Comments

BHP Billiton (BHP) delivered a very solid quarterly production report, with both the key iron ore and metallurgical coal divisions exceeding the company’s guidance for FY14. The group’s Pilbara iron ore result was the highlight, with volumes growing to 225 Mt for the 12 months (after a particularly strong second half), and expected to expand further to 245 Mt in FY15, ahead of the market’s current forecast. BHP’s petroleum division, which is a key differentiator compared to Rio Tinto, downgraded its forecast growth for FY15. However this commodity will account for a large part of overall production growth in the next three years as it expands its US shale gas operations.

The company also updated its averaged realised prices for the financial year, and the table below shows why its combined focus on production growth and cost reduction/productivity improvement is important in the current environment, with the majority of commodity prices weaker over the course of the year. At present, consensus forecasts show a 3% decline in profit for the company in FY15, largely a symptom of recently downgraded iron ore price assumptions.

Source: BHP Billiton, Escala Partners
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With production higher than expected in the fourth quarter, analysts upgraded the company’s full year profit forecasts, and thus the probability of a share buyback being announced at its results next month has also increased. BHP has the additional catalyst in the non-core commodities (alumina/aluminium, manganese and nickel) in its portfolio, with the possibility that these may be spun-out into a new company.

Newcrest’s (NCM) quarterly was a mix of good and bad, as it flagged a further asset impairment of up to $2.5bn, primarily relating to the company’s takeover of Lihir Gold four years ago. Lihir had already been written down to the tune of $3.5bn just 12 months ago – a significant reduction on the $10.5bn acquisition price. At the time of acquisition, NCM had a targeted production of 3.75Moz in FY14, or equal to 37% growth over the four year period (8% compound growth). FY14’s actual production of 2.40Moz, or a 12% decline over the four years, shows the impact of poor operational performance as well as a move to conserve cash as the gold price dropped.

Despite an improved production result in FY14 and a cost reduction program that has reduced its “all in sustaining costs” by 29% over the last 12 months, Lihir, which is the company’s largest mine by volume, remains very much a marginal producer in the current gold price environment:

Source: Newcrest Mining
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With the performance at PNG LNG for the quarter already reported by Santos (STO) last week, there were few surprises in Oil Search’s (OSH) production report. Production levels more than doubled from the previous quarter and will rise further in coming quarters as the project ramps up. Increased attention will now turn to an expansion of the PNG LNG project – with gas fields in the area having a high liquids by-product and the potential to leverage off the existing infrastructure, an expansion would likely have sector-leading returns on investment, particularly compared to others in the Australasian region. We have OSH in our model portfolio, however the upside on the stock is perhaps a little lower at present after solid share price returns over the last few years. 

Macquarie Group (MQG) gave a trading update at its AGM this week, which was mildly negative. While the company confirmed that its FY15 result is expected to be in line with its profit in FY14 with “the potential for a better result if market conditions improve”, its first quarter profit has been below that of the prior quarter and the first quarter of last year. A flat performance from the company’s annuity-style divisions (funds management and banking and financial services) combined with a lower profit contribution from its capital markets facing businesses led to this outcome.

Part of this disappointing first quarter result can be attributed to the timing of transactions, due to the lumpy nature of M&A activity. The current low volatility environment across most markets is also impacting trading activity, and this looks to be evident in its equities business in Australia, and the strength of the Australian dollar would have also been a drag on earnings. We note that the company’s guidance for flat year on year profit in FY15 takes into account the fact that FY14 included a large one-off contribution from the group’s sale of Sydney Airport securities, hence the underlying growth is much stronger. With the outlook for M&A deals picking up, supported by a low interest rate environment, momentum in its domestic lending business and the likelihood of robust performance fees as its various unlisted infrastructure funds mature, we believe that the medium-term outlook for Macquarie remains sound.

Insurance Australia Group (IAG) upgraded its expected insurance margin for FY14, citing several factors. These included a favourable claims experience from natural perils, indicating less frequent extreme weather events in the first half of this calendar year. On the investment side of the margin equation, credit spreads have narrowed further in the half, allowing the company to book larger gains then expected on its fixed interest portfolio.

Both of these, however, are both clearly cyclical elements of the insurance business, and hence few are willing to extrapolate these outcomes too far into the future. While the concentrated nature of the domestic insurance industry has generally resulted in fairly solid returns for the major players, the more pressing issue for these companies is a lack of top-line growth, which appears to have slowed further in the second half of FY14. With IAG’s upgrade more attributable to market factors as opposed to company-specific issues, the positive implications for Suncorp Group (SUN) were also recognised by the market this week, with the stock rising in unison with IAG. Although we do not have an overly positive view on the potential for earnings growth in the banking sector, SUN has been one of our preferred exposures through its ability to turn around its core banking business and the potential for further special dividend payments in coming results due to the strength of its capital position.

Sector Focus - Reporting Season Preview

With August’s reporting season almost upon us, we review what investors are expecting and looking for from the market.

As we have discussed in recent months, on aggregate, earnings growth across the market is expected to be better than recent years – if the current forecasts are achieved, then it would represent the best outcome since the GFC. Unlike most years, where forecast growth starts out as overly optimistic and is revised down as the year progresses, downward revisions have been fairly limited, albeit they accelerated a little in the last two months on softer commodity prices and as a few retailers gave profit warnings.

As the table below shows, all sectors are expected to record earnings growth, although there is considerable variation across the market. Materials lead the way, with the large index components BHP Billiton, Rio Tinto and Fortescue Metals. Cost cutting, currency and volumes are the key variables driving this growth, although the outlook for FY15 is more muted, with less assistance from the first two factors. The large healthcare stocks are also expected to show robust earnings growth, reflecting both a more favourable currency outcome through the year and the relative quality of stocks in the sector.

Consumer staples looks to be the key sector where earnings growth will be much lower than the market – this is dragged down by stocks with company-specific issues (Coca-Cola Amatil and Treasury Wine), along with subdued conditions in the grocery sector.

S&P/ASX 200 - Sector Summary

Source: Bloomberg, Escala Partners
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Despite the variance in FY14 earnings expectations across the various sectors of the market, total sharemarket returns were much more even across the board. Consumer staples was the only sector to fall short of double-digit total returns, while the yield focus of the market was again evident with strong returns seen in financials and utilities, notwithstanding the limited earnings growth exhibited by these sectors.

The Australian dollar has strengthened against most major currencies since early this calendar year, yet on average the currency has been much lower over the course of FY14 – 11% against the US dollar and 15% against the Euro. This clearly has a fairly significant impact on a number of companies and sectors when their earnings are translated back into the domestic currency, in particular the major mining companies, many of the large listed healthcare names and a few select global industrials. At present, fx forecasts show that this experience is unlikely to be repeated in FY15, and thus will not provide the same tailwind to earnings growth.

While earnings growth has been solid, it is improbable that this will result in similar growth in dividends. There are several reasons for this. For one, payout ratios across the market are already at elevated levels (>70%), leaving little scope for management to raise this further without reducing already low capital expenditure budgets. Secondly, the key sectors which are contributing to earnings growth (mining, energy and healthcare) have a greater focus on growing capital returns, with dividend payments generally a secondary consideration. In the case of the large-cap diversified miners, both have a progressive dividend policy, hence year-on-year growth is often limited. Strengthening balance sheets is likely to be a higher priority, particularly for the resource sector. Investors, however, are likely to see more upside from capital management initiatives (i.e. special dividends and share buybacks), with BHP cited as a likely candidate in this basket.

Current expectations for FY15 are starting from a lower base at this point in the year. Forecasts for the materials sector are flat at this stage, however the contribution from LNG projects coming online is evident in energy, which picks up the resources baton. At this stage, growth in the earnings of industrials will be a combination of below average revenue growth and cost reduction programs, many of which are already in place. An extension of the low point in the bad debts cycle will be critical in allowing the banks to achieve current forecasts, as credit growth also presently remains weak.

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