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WEEKEND LADDER

A summary of the week’s results

27.01.2017

Week Ending 27.01.2017

Eco Blog

Inflation has plateaued and basing effects will see it rise in coming months. Yet, price pressure from higher demand looks to be some way off. 

- Global trade has become even more complex given the US move towards tariffs and barriers. 

It has been some decades since a higher CPI is welcomed as a stabilising economic trend. While the data for Q4 2016 was in line with expectations, there was some relief it was achieved. Nonetheless, the headline of 1.5% hardly will move the dial and rate hikes for the moment are off the cards.

Food prices edged up, in part due to the impact of the South Australian storms on the potato crop (a relatively high weight in the food index) amongst other weather-related issues and alcohol and tobacco went through their annual tax-related increases. Property rates rose 4% in the year, while the CPI in utility prices was a more subdued 2.6%; counter to the suggestion that these costs are rising sharply. Child and healthcare are the other two persistent high rise categories, up 8.1% and 3.7% respectively over the year. On the other side of the equation is the ongoing deflation in electronic and related equipment, while holiday costs also measured lower over the year.

It has been some time since Australian CPI was notably below that of the US. Beyond the ups and downs of energy, commodity prices, regulatory and tax impacts and currency, the main determinant of inflation here comes from a reduction in spare capacity in either or both of goods and services. The slack in the Australian economy is predominantly on the wages front. In last week’s note we commented on the rise in part time labour, itself an indication of a sluggish labour market. Domestically, the other area of low capacity is the housing sector, but the CPI does not quite pick up the strength in this market. That said, there are emerging signs that affordability and an uncomfortably high level of investor participation may cap any rise in house prices this year.

Soft inflation, a rising currency and low consumer confidence is not a good start to the year for the Australian economy.

New Zealand is following much of the same pattern. The CPI was 1.3% for 2016, slightly ahead of expectations and for the first time in two years in the RBNZ’s 1-3% range. Tradable goods prices were down 0.1%, while non- tradables rose by 2.4%. The flow-on effect from higher energy prices is already evident, with international air fares up 11.2%.

The event of the week was the US administration’s change in view towards the TPP. The intricacies of the politics and structure of this (and other) trade agreements is open to debate. Nonetheless, the focus is clearly on the impact on Asia and by default, Australia. The US Peterson Institute has estimated the 10 year impact of trade agreements for Asia and is in line with most commentators’ view. The research was based on an all country TPP as envisaged, as well as if Asia did it alone, based on the same principles.

Vietnam is unquestionably the most affected given its export dependence. Conversely, countries such as the Philippines and Thailand were not part of the TPP in the first place.

Impact on GDP 10 Years After Implementation of a Trade Agreement

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The muddy water on the trade outlook has arrived just as data from Taiwan and Korea this week shows a sharp acceleration in exports. Taiwan exports were up 8.3% in Q4 2016, while Korean exports have risen 24% in Jan to date after an 11% rise in December. It is yet to be determined whether the US administration sets up a battle ground against these countries or focuses entirely on China. The US has been a diminishing destination for China’s exports, but remains at a high 20% of the total. What form any trade tariff will take and the possible tit-for-tat looms as one of the bigger risks of this year.

China Trade with US

Source: Kapstream
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But it is likely to be only the first stab at global trade. Mexico’s ‘payment’ for the infamous wall will probably come in the form of tariffs rather than direct payments. In the meantime, the Mexican economy is performing strongly. Retail sales were up 10.6% year-on-year and other activity indicators suggest the economy is likely to grow by 4% this year.

It is hard to make a case that US inflation will not move with the cost increases from tariffs and USD also remain strong, not only due to flows but also the impact on rate expectations.

Fixed Income Update

We have often referred to the low level of liquidity in many fixed income markets, largely due to the regulatory environment of the banks which no longer hold inventory. This has opened up the path for other ways to access debt markets, specifically by a direct relationship between the lender and the buyer. This private market is proving fertile ground for funds which have the capacity to make judgement on the credit quality. It again reinforces that fixed income assets are not all bound by the constraints of low bond yields and fixed rate securities.

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An additional return of 100-150bp can be gained from such private debt securities, in good part compensating for the liquidity premium. In the US, this market has become the norm, with US$270bn in private debt issuance since 2013.

There is no shying away from the risks, but the analysis and experience of credit analysts within larger funds make this a worthwhile endeavour to gain additional returns.

Corporate Comments

BHP Billiton’s production report was in line with expectations and the sustained high iron ore price provides scope for upgrades in coming months.

BlueScope Steel (BSL) has continued on its recent strong record of lifting guidance and has strong short-term momentum.

Brambles (BXB) downgraded its full year guidance ahead of its earnings report next month, with destocking of US inventories the primary driver.

Several mining and energy stocks issued December quarter production reports this week, including BHP Billiton (BHP). BHP’s report was mixed, with a number of divisions slightly weaker than expected (including copper and energy coal, both of which reported a slight fall in production levels). However, on the plus side was a good performance from its Pilbara iron ore operations, with a record half year of production and 4% production growth. While BHP has received a boost from a broad rebound in commodity prices over the last 12 months, iron ore remains key for itself and Rio Tinto and is still expected to account for approximately half of the company’s overall earnings in FY17.

The iron ore price has doubled over the last year, well ahead of what was anticipated by analysts in early 2016. At that point in time, the median forecast by Bloomberg analysts was for a price in the low $US40/t range, essentially flat for the year.

Iron Ore Forecasts and Forward Curve

Source: Bloomberg, Escala Partners
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The key driver for the year was a return to growth in Chinese imports, fuelled by fiscal stimulus. Additional factors that have supported the rally have included reforms by the Chinese government in cutting excess 

steelmaking capacity (leading to improved utilisation and margins across the sector, allowing the steel mills to afford higher input prices) and a slower rate of additional supply from the major miners who dominate the seaborne market; a ‘profits over volumes’ strategy has helped in this regard.

While China’s demand for iron ore is expected to moderate in 2017, at this stage the current spot price remains well above broker forecasts and the forward curve. The base case is thus likely to be further earnings upgrades for the major miners in the short term, which potentially feeds through to higher dividends and/or capital management.

China steel sector rationalisation has also fed through to a better environment for BlueScope Steel (BSL), which issued a further earnings upgrade this week. Necessary cost savings that the company has made across its domestic operations have also played a part, as has an AUD that has stabilised at a lower level after remaining uncomfortably high for several years.

The operating leverage in BSL and the high historical volatility in global steel mill margins has in the past led to a corresponding level of fluctuation in the company’s profitability and that of the highly competitive global steel industry. While the near term picture looks quite positive, it would not be unreasonable to believe that there will be a level of mean reversion in steel margins at some point in the future and there is risk to domestic volumes should the residential building cycle continue to soften from peak levels.

The bull case for the stock would point to strong earnings momentum over the last 12 months following a succession of earnings upgrades, a strengthened balance sheet and a valuation that remains at a significant discount to its global peers (at approximately 40% on an EV/EBITDA measure), perhaps somewhat unwarranted given the structural reduction BSL has made to its domestic cost base. The low quality of earnings across the business, reliant on external factors outside of its control, however, would lead us to conclusion that the stock could only be considered as a short term trading option.

Brambles (BXB) issued a surprise earnings downgrade this week, the first in several years for the pallet logistics company. After reaffirming its full year guidance of constant currency profit growth of 9-11% at its AGM in November, its operating environment has deteriorated to a degree that this will be reduced to just 3% growth in the first half. The quantum of the downgrade was perhaps the most concerning aspect of the update, given what investors have become accustomed to be a relatively stable and predictable business model.

Management cited two key issues that have arisen it the company’s North American business: a deferral of potential customer conversions to pooling solutions such that BXB offers, and secondly a destocking of inventories by US retailers, which has led to reduced revenues and margins. To the extent that the downgrade is based on a short term movement in inventories and does not reflect the actual underlying demand in the US economy, it would be expected that this would be a short term cyclical issue that would correct itself in coming quarters. Nonetheless, the valuation impact would be expected to remain in place given a higher level of uncertainty, with a lower multiple now applied to its earnings.

BXB has some parallels with Amcor (AMC), with both market leaders and dependant on demand that is relatively defensive in nature. The charts below illustrate the end markets for both companies, with food/beverages and other fast moving consumer goods products making up the bulk of their exposures. BXB has arguably introduced some cyclicality into its business via acquisitions in the auto and aero markets, but these remain relatively minor in size.

Amcor (LHS) and Brambles (RHS) End Market Exposures

Source: Amcor, Brambles
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A further key difference is their respective exposures to faster-growing emerging markets – these account for nearly a third of AMC’s sales, while the corresponding figure for BXB is approximately 13%. With lower levels of infrastructure to support its business across emerging countries, BXB is thus more reliant on organic growth and new business wins in developed markets, a factor which appears to have slowed in recent months and which could become challenging given its already-high market share levels.

BXB’s downgrade this week (and similarly AMC’s ‘update’ on its Venezuelan operations in mid-2016) illustrates that the earnings path for many companies is rarely the smooth progression that is often assumed by analysts, despite what has been a fairly strong track record for both. With the longer term investment thesis for both companies remaining unchanged and with both stocks trading on reasonable valuations, we believe that they are suitable core industrial options for an Australian equities portfolio.



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