Week Ending 25.11.2016
• Are we about to see the bottom of Australian GDP growth as our terms of trade take a meaningful lift due to rising commodity prices?
• New Zealand highlight the global long term challenges for all economies: pensions and healthcare.
• Stronger Eurozone and UK data may signal the end of low interest rates.
It is hard for the citizens of the south eastern states to feel the economic glow of higher commodity prices. The transmission mechanism of resource dependence comes through a number of channels. Nominal GDP is the most aligned, as the export sector is typically the swing factor, compared to the relatively stable trends from the household and government sector. In the most recent cyclical upturn, wage growth accelerated to 5% p.a. in 2007 (and contributed to an uplift in inflation, hence the high nominal GDP print) given the demand for labour from resource companies and flow on effect across other employment sectors. Company profits also featured, not only directly, but through the public sector, which redistributes the terms of trade via tax cuts and transfer payments.
In the adage of history rhyming but not repeating, the 70% rise in iron ore prices in the past 12 months, along with big moves in metallurgical coal and base metals, has economists debating the potential impact of the terms of trade on the broader economy in the current environment. It comes at a time when the September quarter GDP is expected to be barely positive. Wage growth is at an all-time low since measures started and fiscal pressure doesn’t lend themselves to government largesse; indeed the opposite is occurring. Further, the rise in commodity prices is unlikely to see much in the way of new investment, rather companies are still focused on cost reduction. What therefore will be the rhyme?
In the coming months, it is possible the AUD will be resilient and could move back to the high 70c/USD. The US rate hike is fully factored in and therefore unlikely to trigger another move in the USD. In any event, many believe the USD to be overvalued against its cross currencies. In the scenario of improving terms of trade, local interest rate cuts will be off the table with some economists discussing the option of a rate rise in late 2017 – expect this to gain ground. Budget repair talk can take a back seat with higher than expected revenue flow, but the government may be tempted to put forward a corporate tax cut. Global pressure to lower taxes will presumably come to bear. The problem is that these terms of trade events are temporary, but the legacy of spending or tax changes will be entrenched.
Investors should be cognisant of this potential short cycle. It requires a higher level of risk and willingness for tactical investment to participate.
The New Zealand Treasury Department has taken to confronting its citizens with long term dilemmas. After congratulating themselves on a budget surplus and low (12%) debt to GDP, the department poured cold water on this data by suggesting an exponential explosion in debt to 150% of GDP by 2060 if current spending and revenue trends continue. The culprits are not hard to identify. Unfunded superannuation is to double as a percentage of GDP and healthcare costs are not far behind. The global case for a complete change in thinking on these two areas is never far from the top two problems in the world.
Are interest rates really about to change direction? The US path is set; it’s a question of by how much and when. But even elsewhere the pattern could be set.
European economic data has been quite strong. The composite PMI suggest the Eurozone is expanding at its fastest pace this year, with rising order books and even prices inching higher. These two signals are key, pointing to some longevity in the upturn and the end to deflationary pressure. The strongest gains are in Spain, Italy and Ireland.
This comes ahead of the ECB meeting on December 8, itself only a few days before the Italian referendum on its Senate structure. The ECB has to decide on the extension of its QE programme at that meeting and there are rumblings it may reduce the scale or time horizon of this monetary easing. Implicitly that is a form of tightening.
Even the UK, widely expected to be cutting rates due to the perceived impact of Brexit, is facing unexpectedly strong data. The chart shows the ‘snail trails’ of UK interest rate expectations since 2009. There always was the view rates would rise 12 months or so from whichever time one was at, the only thing that changed was the level. Just as the most recent line – Oct 16 – implies no rate rise, or in fact a rate cut, it may well be that the previous forecasts come true!Enlarge
Fixed Income Update
Downward pressure on global government bond prices continued over the week. However, with this comes opportunity. We summarise some trading ideas and positioning that a few global bond funds have implemented recently.
• Buying long-dated bonds (extended duration) in the Australian market
• Holding Mexican peso-denominated government bonds
• Long USD currency exposure
• Increasing positions in Italian government bonds
The last few days has seen a further push up in global bond yields reflecting supportive data out of the US. As discussed in previous publications, the Australian market has followed the offshore pattern given global inflation has likely bottomed and potential tapering of quantitative easing (QE) out of Europe and an expected imminent rate rise by the FOMC influenced bond investors. This trend continued over the week, putting further downward pressure on bond prices and lifting yields.
5 Year Australian Government Bond Yield
While these moves have resulted in poor performance for long duration (fixed rate) bond funds with little credit premium to buffer the fall, it has also opened opportunistic trade ideas and positioning to funds that have a flexible mandate and can seek out value.
An example is some recent activity by domestic fund managers in lengthening their duration in the Australian market (e.g. adding exposure to longer-dated fixed rate bonds and locking in the higher bond yields on offer). The drivers of the recent sell off in bonds has been predominately a US and European story and our market has been moving in sympathy. Near term data such as GDP growth is expected to be weak and the yields may therefore retrace. With this in mind, fund managers are of the view that the market is currently over extended and short term value has returned.
The depreciation of the Mexican peso and the subsequent rise in interest rates following the US election result has caused a significant lift in bond yields across all maturities. The chart below highlights this shift, with some bonds trading at a 1% higher yield compared to pricing at the beginning of the month. This, coupled with the lower peso, arguably makes taking exposure in Mexican bonds compelling, if one is of the view that these moves are sufficient to cover the risks. Commentary from some of the global fund managers is that they are adding or maintaining exposure to Mexican bonds.
Mexican Yield Curve Change
Other opportunistic positioning that we have seen from global funds include:
• A long bias toward the US dollar, given the Fed is on the brink of raising rates in December, with the likelihood of more rate rises in 2017.
• An overweight to Italian Government bonds. This is based on a view that the market has been too aggressive in its sell off of Italian bonds compared to the rest of Europe. The upcoming referendum on constitutional reform is pricing in a ‘no vote’ which some believe is an overreaction as QE by the ECB will continue to be supportive for Italian bonds.
• Boral (BLD) was sold down by investors after announcing a significant acquisition in the US, funded largely by an equity raising.
• Oil Search (OSH) held an investor day and continues to make progress towards an eventual expansion of the existing PNG LNG project.
• Rio Tinto (RIO) again emphasised its new ‘value over volume’ mantra, which could translate into a step up in shareholder returns in 2017.
• Woolworths’ (WOW) AGM had more interest given the numerous problems that the company has faced in recent years, although the value of the company will likely be determined by the margins that it can achieve once sales growth is restored.
This week Boral (BLD) announced a company-transforming acquisition of US building and construction materials company, Headwaters. The acquisition is primarily funded by a $2bn capital raising (of which the institutional component was completed yesterday), making the most of a share price which has enjoyed the cyclical tailwind of the Australian housing market over the last few years. The forward earnings multiple paid (10.6x on an enterprise value/EBITDA basis) looks to be relatively full for the touted strategic rationale of diversifying BLD’s existing business away from Australia and the complementary nature of its fit with the company’s existing operations in the US.
The price paid appears more reasonable once BLD’s proposed synergies are considered, with the company targeting an annual run rate of $100m within four years. While the majority of these synergies relate to cost measures which are fairly easily identifiable, a quarter are expected from cross-selling or revenue opportunities, which may be harder to achieve.
Boral: Targeted Synergies
BLD forecasts that the deal will be earnings per share accretive (on an underlying basis) within the first year of ownership, yet the fall in the share price since the stock resumed trading suggests that investors are less than convinced. BLD has had a poor track record of earnings from its current operations in the US and few Australian companies have successfully grown by acquisition in the US market. Further, the integration risks for BLD are elevated by the fact that Headwaters itself has been heavily acquisitive, making no less than 11 acquisitions in the last four years alone.
While completing the acquisition will increase BLD’s exposure to the improving US housing market and an infrastructure market that could be boosted by an increase in fiscal spend, over half of the company’s revenues will still depend on the Australian market and hence a maturing domestic housing cycle.
We retain a preference for James Hardie (JHX) in the sector, which is more of an organic growth story, has a strong track record of earnings growth and has a product that has been taking share in the US market.
Oil Search (OSH) held an investor day, focusing on the growth opportunities in PNG that are expected to be developed over time. The company and its partners in the country are taking a measured approach to LNG expansion, given that the market remains well supplied into the next decade. While this may be the case, the long lead time between investment decisions and first production in the LNG sector would still necessitate such a decision in the next few years.
Achieving integration between the two large undeveloped gas resources in PNG and utilising the existing infrastructure at PNG LNG will be key to reaslising attractive returns from this investment. The potential exists for a further doubling of OSH’s LNG production into the next decade.
In the interim, OSH is in a comfortable position, both from the strength of its balance sheet and from a cash costs perspective (US$28/barrel of oil, including operating and sustaining capital expenditure, principal and interest repayments). While OSH has less upside leverage to an improving oil market than some of its domestic peers, we believe that it represents the safest exposure to the energy market with attractive expansion opportunities.
Despite a more supportive operating environment emerging from the ongoing commodity price recovery this year, Rio Tinto’s (RIO) new ‘value over volume’ mantra was reiterated at an investor day. In essence, this means that the major diversified miners are now giving greater weight to the potential price impact that adding additional tonnes to the market might have, rather than be concerned about maintaining market share. This is perhaps reflective of the broader mining industry having learnt from the investment mistakes of the most recent commodity boom, with RIO referring to ‘industry-leading’ volume growth of 2% p.a. over the next decade.
RIO also outlined an additional US$5bn productivity improvement target over the next five years. A large part of this is expected to be driven by increased utilisation as a result of a higher level of automation across its mines. With little of these savings appearing destined for capital expenditure, the likely use would be to further strengthen the group’s balance sheet and increase returns to shareholders, whether it be via share buybacks or additional dividend payments.
RIO noted that, using average prices of the recent September quarter (and prices have trended higher since then), 2017 operating cash flow would equate to approximately US$10bn, a significant step up from the US$3.2bn in operating cash generated in the first half of this year.
Like many stocks in the resources sector, RIO’s share price has made a significant recovery over the course of this year. While there is a well-held consensus view that prices will trend lower over the course of 2017 as stimulus in China is withdrawn and the possibility of previously mothballed supply returning to the market, current spot prices on a number of key commodities remain in excess of those currently assumed by analysts. This implies a high expectation of earnings upgrades and thus share price support in coming months. Our preferred stock in the sector is BHP Billiton, which has a more diversified portfolio of assets and is hence less reliant on iron ore.
In the past, shareholder interest in a Woolworths (WOW) AGM has been rare, given that a supermarket should be a stable, predictable business. How times have changed. The analyst community was keen to hear if the early signs of a revival of sales was being sustained (apparently so, though the pace is patchy) and how the group would deal with Big W, its petrol retail business, its failed efforts to get any meaningful online presence and the potential for the gaming segment to be spun out. None of these have easy answers. The value of the group is likely to eventually come down to what margin it will enjoy once it has sales growth back to around the level of nominal domestic economic growth. Gaining market share is another chapter altogether, with Aldi clearly intent on taking share and Coles unlikely to give up anything without a fight. Whether Metcash customers (its stores) are the inevitable source of share for all will get some colour when it releases its results next week.