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WEEKEND LADDER

A summary of the week’s results

27.04.2018

Week Ending 27.04.2018

Eco Blog

- Domestic inflation remains subdued and has provided little impetus for the RBA to make any move soon on monetary policy. Goods deflation continues to drag on the overall data.

- The RBA is monitoring the transition from interest-only to principal and interest housing loans as macro-prudential measures have the desired effect. At this stage, the impact on aggregate household disposable income is expected to be modest.

Australia’s March quarter inflation print was again slightly below that forecast by analysts at 1.9% with little in the data to suggest a change in view. While inflation has slowly crept higher in the last two years, headline CPI has now been below 2% in 13 of the last 14 quarters dating back to the September quarter of 2014.

As is typical, there was a wide variation in the inflation figures across the various groups, resulting in dispersion for how each household is affected. In a broader sense, the gap between non-tradeables (or services) and tradeables (goods) widened further, with the latter currently in a deflationary cycle. More recently, this has occurred despite some weakness in the Australian dollar.

Australian CPI: Tradeables and Non-Tradeables Inflation

Source: ABS, Escala Partners
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The most significant contributors to the CPI this quarter included education, medical services and utilities such as electricity, with an obvious ‘regulated price rises’ theme through the data. Goods prices that were a drag on inflation included computing media and services, furniture, and clothing and footwear. Retail pricing has slipped over the last year, which bodes poorly for not only listed companies but the economy given the dependence on the sector.

Despite the strong run of employment growth through 2017 wage growth has been relatively subdued and provided little pressure in pushing inflation higher. With employment tapering in recent months, it is hard to see this being a significant factor in lifting inflation back towards the RBA’s targeted 2-3% range through the rest of this year.

One current risk in the economy that the RBA has been conscious of for some time has been the high levels of investor and interest-only lending in the Australian housing market. The current state of interest-only lending was addressed this week by Assistant Governor Chris Kent and how this is likely to affect household incomes going forward.

To provide some background, in the last few years APRA has introduced several measures in an attempt to reduce some of the more speculative investor behaviour and the risks to the broader economy in the event of a correction in the housing market. This has included a tightening of lending standards (i.e. ensuring higher buffers of around 2% above the benchmark rate), limiting the growth of investor lending to no more than 10% p.a. (this imposition was lifted this week) and then finally, restricting interest-only lending to 30% of new loans written for each bank.

In order to manage this transition, the banks raised interest rates on these forms of loans, encouraging borrowers to switch to principal and interest repayments; this has had the desired effect fairly quickly, with interest-only loans falling from ~40% to now below 20% of new loans written. For the Australian economy, the risk was therefore that this increase in repayments would have a material impact on household cashflows as the switching occurred. By the RBA’s calculations, this would amount to approximately $7,000 p.a. for the average interest-only borrower.

There is around $120bn in interest-only loans scheduled to roll over into principal and interest loans for each year over the next three years (this is based on the assumption that interest-only periods typically expire after five years). With this information, the RBA then calculated what the average impact this switch would be to the cash flows across all households holding interest-only loans, which amounted to less than 0.2% p.a.

The RBA expects that other factors will mean that this 0.2% figure is at the upper bound of expectations. Built up savings (including existing offset accounts), the ability to refinance or, in some cases, the sale of the property (particularly for investors) will all help to smooth the impact during the transitional period.

Nonetheless, while the aggregate effect may be somewhat limited, some individual borrowers (particularly owner-occupiers who have borrowed recently on high LVRs) will face challenges in switching. The central bank’s belief is that this group is small, although it is monitoring the asset quality of the banks closely through this period.

Additional Mortgage Payments: Share of Household Disposable Income

Source: RBA, Securitisation System
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  • The switch from interest-only to principal and interest mortgages may not have a significant effect on aggregate household incomes, but it still provides a further reason for the RBA to adopt a cautious approach to rate hikes (the consensus call remains for on hold for the rest of 2018) given low wage growth, high debt levels and constrained household budgets, with inflation evident in more essential services. Lower credit growth will be visible in the upcoming reporting season for the banks and lending standards could possibly be tighented further following the Royal Commission, further putting the brakes on credit growth in the economy.

Investment Market Comment

- The defensive and yield-sensitive Real Estate Investment Trust (REIT) sector has underperformed over the past 12 months.

REITs are traditionally considered to be a defensive sector of the equity market, offering an attractive yield to investors and underlying asset value growth in a declining interest rate environment. However, in the last 12 months, REITs have come under pressure. Rising bond yields have taken their toll and, in combination with the structural issues among retail REITs, have led to the underperformance of the sector in this time.

As with many sectors in the Australian sharemarket, there is concentration risk among domestic REITs. The three biggest REITs (Scentre Group, Westfield Corporation and Goodman Group) make up nearly 50% of the index. Additionally, retail REITs make up nearly 50% of the sector. The structural issues faced by retailers due to online disruption have been well publicised. Losses in some of the largest retail REITs, including Scentre Group and Vicinity, have offset gains from Westfield, which received a boost to its share price after a $32bn takeover bid last December. Conversely, industrial REITs, such as Goodman Group, have benefitted from an increase in demand for distribution hubs from online retailers.

REIT ETF Sector Exposures

Source: SPDR, VanEck, Vanguard & Escala Partners
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There are five REIT ETFs offered to Australian investors: three domestic and two that have a global universe. SPDR and Vanguard replicate the performance of the ASX 200 and ASX 300 REIT sectors respectively. The VanEck ETF has a rules-based index methodology, focusing on liquidity with a concentration risk overlay of each security having a maximum weighting of 10%. The performance has similar between the three funds, with all of them underperforming the broader market.

Monthly Performance of REIT ETFs

Source: SPDR, VanEck, Vanguard & Escala Partners
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The recent rise in global bond yields has seen prices in global REITs lag in January and February before a slight recovery in March. Despite this, global REITs have materially underperformed their Australian peers in recent years. The SPDR Global REIT ETF has over 55% allocated to US REITs, which has had one of its worst starts to a year since 2009. Higher interest rates have dominated the headlines; earlier this year the US 10-year bond yield exceeded Australia's for the first time in 18 years.  Whilst this occurred, US REITs were sold off. One property type that has been less affected by this has been hotel REITs, which can acclimatise quickly to this environment by increasing their prices.

Performance of US v Australian REITs and Spread between Australian and US 10-year bond rates

Source: IRESS, Escala Partners
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While higher rates may reflect the realisation and expectation of better growth and hence better earnings potential for REITs, the ability of the sector to capture this upside is perhaps more limited compared to other participants in the economy.

Another potential impact on the price volatility of REITs is the rapid growth of ETFs in recent years. In the past, ETFs made up under 10% of the major REITs’ share register. Following the continued growth in ETF flows, the representation is closer to 20%. Investors trading ETFs on a more regular basis could mean that the underlying assets, in this case REIT securities, will also see an increase in trading. This has the potential to exacerbate the volatility of what should be a fairly stable asset class.

Fixed Income Update

- The yield on the US 10-year treasury has reached the elusive 3%, which sees investors with differing views on whether to add duration into portfolios.

- Netflix has issued a new 10 ½ year bond despite falling prices of existing debt.

After months of flirting with this target, the US 10 year treasury has finally reached a yield of 3%. At the beginning of the year, it appeared likely that the Australian 10 year ACGB would be the first to reach this milestone. However, at the end of January, Australian rates stalled while the US pushed higher. The result was that the Australian-US 10 year government bond spread turned negative for the first time since 1984. (i.e. US 10 year treasury yields became higher than the Australian 10 year government bond rate).

Historic spread differential between the yield on the Australian 10-year ACGB and the US 10-year Treasury

Source: Bloomberg, Escala Partners
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Now that this technical level has been reached in the US, investors will be considering whether to add duration into portfolios. A few months ago, one of the largest bond managers in the world, Pimco, disclosed that they would be buying long dated bonds once the US 10 year hit 3%. It also seemed likely that pension funds were waiting for yields above 3% to increase their bond allocation.

Pimco’s decision to extend duration (by buying long-dated fixed rate bonds) is to pick up a term premium above short-term rates. For this to be attractive, sufficient spread needs to exist between short and long-term rates to compensate investors for taking on the risk of rates rising. The objective is to lock in a higher rate for term, which will remain elevated to short term rates as the bond moves closer to maturity. This is known as rolling down the yield curve.

However, in the period since Pimco made the initial announcement that they were a buyer at 3%, much has changed. The yield curve has flattened following a rise in short end rates by ~150bp, making this term premium (the difference between long and short term rates) less attractive. Further, signals from the Federal Reserve Bank are that committee members are in favour of three more rate hikes in the US this year, which, if this comes to fruition, will lift short term rates even higher. 

  • While Pimco and others are said to still find the 3% yield attractive, we hear differing views from other bond managers. In our view, the relatively flat yield curve offers little incentive for investors to take on meaningful duration risk at this time. 

The move higher in US rates has also affected fixed rate corporate bonds that are benchmarked against the 10 year treasury. The price of a bond issued by the world's largest online television network, Netflix, has fallen to $94 after being issued at par ($100) in October last year. While credit spreads have increased marginally wider (which also impacts the price), the majority of the price fall is due to the move in treasuries.

Price fall of a 10-year fixed rate bond issued by Netflix in October 2017

Source: Bloomberg, Escala Partners
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Netflix returned to the market this week by selling $1.9bn of senior bonds, which was the company’s largest dollar-denominated bond issue. The deal was said to be upsized from a planned $1.5bn and priced at a yield of 5.875% with a maturity in 10 ½ years. Netflix are rated below investment grade by the rating agencies at B+, due to the negative cashflows of its business. This is despite the continued growth of the company, which added 7.4m subscribers in the last quarter, its strongest start to a year since the company became public in May 2002. The proceeds of the bond issue are said to be used for general purposes, which may include production and development of new content and potential acquisitions.

Corporate Comments

- Boral (BLD) downgraded its guidance this week on a mix of weather-related and operational issues. A better full year result may be required to restore investor confidence, although the robust macroeconomic and company-specific earnings drivers of the stock remain.

- Wesfarmers’ (WES) sales were mixed ahead of the expected demerger of Coles.

- Brambles’ (BXB) quarterly sales were largely as forecast, although the near-term question mark is the margins in its business given the emergence of cost inflation.

Late April to early May can be perilous time for investors as companies give various ‘trading updates’ to the market on how they are tracking to either their full year guidance or the market’s expectations following the completion of the March quarter. This was the case this week, with announcements from several large industrial companies.

Boral (BLD) had a somewhat disappointing release to the market as it pared back its operational forecasts for FY18. The issues raised were largely consistent with the weaker aspects that we highlighted at its half year result in February, including plant operational issues in its US operations. Additionally, factors outside of its control (such as the weather) have been unfavourable for the company, with BLD stating that this has impacted its earnings in North America and in the Queensland market.

BLD noted that there will be some offsetting factors to these, including property sales (although these are really one-off and not recurring in nature) and a lower expected tax rate; the benefits to the company from tax reform in the US will be noticeable this year and next.

While the announcement this week is a setback for the company, the medium-term outlook remains positive, with multiple drivers of earnings growth. Firstly, BLD remains on target with the material synergies from its acquisition of Headwaters in late 2016. Secondly, its exposure to the US housing market is a positive, which has been on a recovery trajectory for some time (although housing starts remain below the long term average). Finally, while its Australian business has pockets of weakness (Western Australia was highlighted this week) and the housing construction cycle has peaked, there is excellent demand coming through from infrastructure projects on the eastern coast and recently announced price increase for key products is supportive of this view.

While the stock has suffered ~13% drop in its share price this week, this looks to be a fairly significant reaction to only minor consensus downgrades. BLD now trades on a FY19 P/E of just 14X, below that of the industrials index with a better earnings growth profile. We have the stock in our model equity portfolio.

Wesfarmers’s (WES) quarterly was mixed with the focus on Coles as the company prepares to demerge the business. Coles has been losing the sales battle with Woolworths for almost two years now, with a marked deterioration in its comparable sales growth from a mid single-digit range to barely 1% p.a. While sales growth nudged higher in the third quarter it was below the market’s expectations and was against a backdrop of cycling a much easier comp.

Presently, the consensus view in the market is that Coles is unlikely to make significant price investment ahead of the demerger and thus supermarket price deflation will reduce through this period (providing support to margins) amid a more rational market environment. Price deflation of 0.7% in the March quarter was lower than that of recent times, however additional data points will be required to gain more comfort that conditions are improving.

Coles Comparable Store Sales Growth/Price Deflation

Source: Company reports, Escala Partners
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WES’s other retail divisions reported mixed numbers. Bunnings continues to power ahead, posting 7.7% like for like growth (although remains susceptible to a cooling housing market and has had a free kick from the closure of Masters) and Kmart was again solid at 6.8% growth. Target, however, remains under pressure (-2.6%) and the sizeable question mark on its Bunnings UK expansion was not helped by a double-digit decline in sales.

Also with its usual quarterly sales update was Brambles (BXB) who reported constant currency sales growth of 5% for the nine months. Given the depreciation of the US dollar relative to its other operating currencies (particularly the Euro), reported sales growth of 10% was achieved. The results were largely as anticipated by the market, with respectable growth achieved in its core US and European CHEP markets. Asia-Pacific was the key point of weakness, although this had been foreshadowed following the loss of a large RPC contract with Woolworths.

Brambles: Sales Revenue for First Nine Months of FY18

Source: Brambles
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While BXB was consistent with its practice of not disclosing margins or profitability with its trading update, it is probable that it will report a deterioration in margins at its full year results in August. This is a result of the cost pressures in which the company has recently reported, with accelerating increases in lumber and transport noted in the US and Europe. Given the limited ability of the company to pass these straight through to its customer base the earnings outlook for the company is somewhat impaired, despite a generally positive economic environment.

BXB typically screens well on quality metrics, with a leading market position, high return on equity and substantial barriers to entry. Following the emergence of short term challenges for the stock we removed the position in our model portfolio, although there may be value for more patient investors given its more modest forward multiple of 17X.

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