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WEEKEND LADDER

A summary of the week’s results

27.07.2018

Week Ending 27.07.2018

Eco Blog

- The Australian CPI remains low; consumers believe differently.

- US interest rates came back into the spotlight in the second half on the back of better GDP data. The structure of income and wealth is another feature that forms the backdrop to household behaviour.

There is the cost of living and the consumer price index; they represent quite different features. Consumers tend to base their views on their spending rather than the rise in like for like products or services, which forms the basis of the CPI. Businesses, in turn, have in recent years been able to manage their cost base effectively and do not confront the major drivers of consumer prices such as healthcare and education. Notably, however, is the recent upturn, likely due to commodity prices as has been noted by some listed companies. Market economists are generally right about the CPI, based on the fact that it is on a structured set of weights.

Inflation expectations

Source: RBA
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The June quarter CPI, released this week, was slightly below expectations at a headline of 2.1% or 1.9% excluding volatiles – petrol and fresh produce.  The largest increase was, unsurprisingly for auto fuel, up 16% yoy followed by utilities (+8%) and childcare (+6%). Notable declines were in apparel (-2%) and communication equipment (-9%). These categories have shown low to negative inflation for some time given low cost imports and the fall in like for like electronic product. Other product categories were in a tight range around the headline number.

The fall in house prices has yet to register while rental growth was particularly low, flat over the quarter and only 0.6% yoy. Rents in Brisbane and Perth fell while that for Sydney and Melbourne were the weakest since 2003/4.

It reinforces the potential risk to consumer spending from the investor segment of the housing market when interest plus principle hits home. And this comes on the back of another set of mortgage rate rises in second tier lenders.

  • Recently, risk to the Australian household sector has been a feature of our weekly reports.  A low CPI may give fodder to low wage increases as labour cannot point to living cost pressure.

Increasingly the debate on US rates has turned to how far they can rise. The opinion is that the US 10-year yield is unlikely to exceed much above 3.5%, though there are a few that believe up to 4% is possible. The impact of a 3.5% yield depends on the cause of the increase. If growth exceeds expectations and is supported by an improvement in productivity, investors should be less troubled by the higher yields. In another scenario, growth stays middling, but inflation pops up (the usual culprits of tariffs, higher energy costs and wages), possibly accompanied by a an overly aggressive Fed hike cycle, or a bigger than expected funding requirement due to the fiscal deficit.

The lack of productivity as been a notable feature. Its measure is blunt – output (GDP) per hour worked.  A range of explanations have been given. The simple one is that social media employs a lot of people, but no measurable output. Demographics may be another cause and the growth in employment in services such as healthcare, childcare and education don’t lend themselves to data driven productivity.

It may be that a renewed phase of corporate investment as companies look to sustain their profit margins and cope with rising costs adds to productivity. But the impact is likely long dated and unclear. Much of the spending appears to be retrofitting systems to compete and out of necessity, rather than a major cost reduction. Cost cuts in one area are often matched by a rise in another, usually technology spending. In the medium term any additions to fixed capital also reduces productivity as the output will only be achieved on completion. 

  • The risk is that a rise in growth based on capital spending will be interpreted as pressure on the Fed to raise rates more than currently expected. This US cycle is tenuous given, low employment, rising government debt (plus unfunded liabilities) and political overtones.  A simple embrace of short term growth may not end well.

The persistence of wealth and income inequality in the US (and elsewhere) is judged to underlie the increasingly populist trend in politics. There have been a number of versions of this chart come to our attention in the past month.

High wealth households experienced a moderate fall in net worth in 2008 and are now in a better position that before, meantime the median is still well behind.

Top 10% and median wealth in the US

Source: Haver Analytics, Federal Reserve, Deutsche Bank
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The same pattern is evident for income. The Gini coefficient measures income inequality. A reading of 0.0 would imply no difference in income in a country while a reading of 1 would suggest one person got all the income.  The intricacies are not critical; the trend in inequality is more telling.

All measures show that in the US income inequality is high compared to other in the developed world.

The Gini measure of income inequality in the US

Source: Internal Revenue Service, US Census, Haver Analytics, Deutsche Bank
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Other supportive data include the consistent fall in labour share of output, rise in corporate profit share and low wage growth. The problems with the US may not be as much about import competition but rather that those left behind in the skew have been subject to the internal dynamics of the structure of the economy, lack of bargaining power and social contract with the government.

Investment Market Comment

- After being among the best performing indices in 2017, Chinese equities have come under pressure with the continuous trade tensions between the US and China. However, despite these tensions China still provides steady economic growth and corporate earnings that can be abstract from this issue.

Chinese listed companies trade under three different categories A-Shares, B-Shares and H-Shares. A-shares trade on the mainland exchanges and are quoted in Chinese yuan (renminbi). H-shares of Chinese companies listed on the Hong Kong Stock Exchange trade with a face value of Hong Kong dollars. Also, H-shares are open for trading to all investors, while only Chinese domestic investors and there are still some restrictions on the trading of A-shares.

There are two exchanges on China’s mainland, the Shanghai, the largest, and the Shenzhen exchange. The CSI 300 Index is a market capitalisation index that tracks the performance of the 300 largest A-share stocks in the Shanghai and Shenzhen stock exchanges and represents approximately 59% of the total market capitalisation of the two exchanges. Australian investors can access this index through the VanEck Vectors China AMC CSI 300 ETF (CETF).

Hong Kong is tracked by the Hang Seng, weighted by market capitalization and includes the 40 largest companies traded on the exchange. There are no ETFs that directly track this index, however, the iShares China Large-Cap ETF (IZZ) aims to replicate the performance of the FTSE China 50 Index, which is composed of 50 of the largest stocks (H-shares) traded on the Hong Kong exchange.

Sector Weights – CSI300 v FTSE China 50 Index

Source: Morningstar, Escala Partners
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IZZ has a much greater concertation in financials than that of CETF, with major weightings in China Construction Bank, the Industrial and Commercial Bank of China and the Ping An Insurance Group Company of China. During the recent pullback, top-tier Chinese banks got sold off in the tariff rustle even though they are unaffected. Recent outperformance has been assisted by monetary policy designed to support Chinese businesses in this period as well as the limitations on unregulated lending. It demonstrates that ETFs can result in stock specific opportunities as sellers (and buyers) can have no regard for the potential differentiation in the outlook.

2-year performance of ASX-list Chinese equities ETFs

Source: IRESS, Escala Partners
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Another option for investors to access the Chinese market is through a broad-based ETF, such as the iShares Asia 50 ETF (IAA), which has a 35% China weighting. This gives investors access to the 50 largest stocks in China, Hong Kong, Macau, Singapore, South Korea and Taiwan. Technology makes up a large part with China’s Tencent, South Korea-based Samsung and Taiwan Semiconductor the top 3 holdings at over 30% of the fund.

  • The use of ETFs can be an efficient way for investors to take tactical tilts should certain opportunities present themselves in specific markets or sectors. In this case, the recent pullback in Chinese equities could be a tactical opportunity to take advantage of China’s sustained economic performance, particularly domestic consumption and reform of state-owned enterprises.

Fixed Income Update

- Global bonds move on reports that the Bank of Japan may make changes to a part of its monetary program.

- Fixed income had many challenges in the last financial year. We highlight these and report the performance across the benchmarks.

Two years ago, the Bank of Japan (BoJ) embarked on an explicit price target on its 10-year government bonds (JGB) in which it pledged to keep the yield at around 0%. This has been part of its Quantitative Easing (QE or nonstandard monetary easing) programme where the central bank is the marginal buyer or seller of the bonds to achieve the stated outcome. The aim was to stimulate the economy through low cost funding in the hope of triggering inflation. Other stimulatory measures included a massive corporate bond and ETF buying program and negative interest rates on short term government bonds.  While the measures have not done what they set out to do, that is, lift inflation, there has been an impact on the profitability of the domestic banks.

This week, global bond markets responded to reports that the BoJ is considering making changes to its policy stance on keeping the 10-year yield at around 0% to support the profitability of the banks. This triggered a rate sell off, taking the yield on the 10-year JGB away from its target and above 0.09%. Global bond markets also reacted with the 10-year US treasury yield edging up 8bp on the news. The governor at the BoJ dampened the momentum by insisting this was not the case and that it remained committed to buying JGBs in unlimited quantities to keep the target in place. Nevertheless, markets are now awaiting any indication of changes that the central bank could announce at their meeting next week.  

The prospect of a policy shift by the Bank of Japan has implications for global bond markets. Japanese investors have been large buyers of offshore assets in recent years, including within Australia –as the second largest holder of our domestic government bonds.  Higher yields in Japan has some suggesting that this may reduce the strong appetite Japanese investors currently have for foreign assets. While change is not imminent, the central bank may opt to open the door by communicating that shift in tone in the short to medium term.

  • Any changes to the policy is likely to be a tweak of the existing QE program in Japan rather than any suggestion of elimination. Therefore, global bond yields will likely react, but moves should be contained.

Japanese 10-year bond yield

Source: IRESS, Escala Partners
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We reflect on the performance of fixed income for FY2018 and highlight the headwinds that the sector has faced over this period. As a reminder, a rise in yields causes weakness in bond prices, as does credit spread widening on bonds issued by corporates, banks and those backed by mortgages and loans.

While returns have been somewhat pedestrian, it does demonstrate the low volatility and resilience of bonds and that a positive performance can be generated even in a period of upward pressure on rates and credit spreads.  In summary, the themes that have had a direct impact on the rates market and fixed income assets over the last year include:

- The US Fed raising cash rates (3 times over this 12-month period)

- The reduction in the Fed balance sheet is now underway

- The ECB commenced the reduction in its QE program, which is due to finish at the end of this year

- The pledge of stimulatory fiscal spending policies from the US administration which is funded through the increased issuance of US Treasuries

- Trade tariff discussions

- Credit spreads have widened off their lows

- Declines in Emerging Market currencies and bonds as the USD has strengthened

While interest rates and credit spreads have trended higher, the yield curve flattened, both domestically and in the US. This has aided the performance of long dated bonds. Coupons in the credit markets have cushioned some of the capital loss as spreads moved out, affecting performance for this period. While we do see risks to rates into the second half of 2018, investors should be able to reinvest maturing investments at the new higher levels

Fixed Income Benchmark performance in the last 12 months

Source: Bloomberg, Escala Partners
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We recommend that investment portfolios in fixed income are diversified and given portfolio managers can generate alpha above these benchmarks, portfolio returns are likely to have been be in a 2.5%-3.5% range for FY2018.  

Corporate Comments

- Wesfarmers announced the balance sheet structure for the demerger of Coles. The lukewarm reception was an interplay of the relief at the relatively low debt attached to the supermarkets, but also a reminder of the high dividend payout ratio that hampers capital spending.

- A merged Nine Entertainment and Fairfax media hopes to take growing services, such as Stan and Domain, to a new level compensating for the challenging outlook for traditional media.

- BHP’s speedy realisation of its US shale assets lines it up for capital management.

- The path to recovery for AMP is some way off. The redeeming feature is its capital position.

- New wealth platform service providers got a reminder that the big end of town would battle to retain share.

Wesfarmers (WES) has played a careful hand of cards in its proposed demerger of the Coles supermarket operations, targeted for late November this year. The attention was on the level of debt that this division would assume. The $2bn was lower than expectations to appease concerns that Coles would not be able to refurbish stores and its supply chain to prevent loss of market share.

This was offset by the proposed 80-90% payout ratio. Notwithstanding, the consequence would likely be a likely negative cash flow for the group after required capital spending. The persistence of high payout ratios in the Australian equity market to utilise franking credits and satisfy income is also a persistent risk and drag on earnings growth. Wesfarmers has embraced capital management for some time and seems unwilling to give Coles a refreshed view.

The rationale for the demerger is the maturity of the supermarket sector. Yet Bunnings, WES’s discount department stores, Officeworks and their industrial portfolio are seasoned to the cyclicality of the Australian economy and do not necessarily present as that much better.

Demergers can result in better returns to shareholders from neglected assets. Management often gets a lease of life without the constraints of a ‘parent’, where the capital allocation favours the more interesting operations. In this case new management (new CEO, Steven Cain, ex-Metcash and previously Coles Myer) has yet to disclose how they will address the competitive market, own brands, digital and the online challenge.

  • The balance of reward has shifted to Woolworths as it is in the throws of a refreshed onslaught for market share gains. Yet Coles management will be keen to demonstrate their success and may turn to the inevitable mechanism, promotions, to drive the headline. History shows that ‘pass the parcel’ between these two is inevitable.

1-year performance – Wesfarmers v Woolworths

Source: IRESS, Escala Partners
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The proposed merger of Nine Entertainment (NEC) and Fairfax Media (FXJ) attracted much more mainstream media commentary than from the financial community. Contrary to the supposition that free-to-air TV was on a permanent and possibly fatal slide, NEC has been buoyed by a confluence of positive developments. Firstly, advertising revenues were up in the first half of the year as the return per advertising dollar was judged as attractive with Nine picking up share. Secondly, the group’s extension of its programmes to 9NOW and Stan has paid off, adding circa 30% to total audiences for a show. Stan is considered critical in this merger with the businesses currently a 50/50 JV between the two. Thirdly, is the leverage to profit after a prolonged period of cost pressure.

The addition of Fairfax brings both businesses some opportunity but also another set of difficult operations.  Cost reduction (suggested at $50m over 2 years) and the promise of a larger share of the advertising pie are the biggest opportunities. The core value of Fairfax arguably lies with Domain (60% owned), though the softer tone for the property market may weigh on any advantage gained from this business in the near term.

The outlook for print media is unlikely to change much. Paper prices are up putting pressure on margins and cutting staff further is likely to diminish readership. Shifting readers to online is not easy and undercuts profits.

Whether the combined business can monetise Stan and Domain further remains the key challenge.

Source: Nine Entertainment
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  • The NEC share price fell with the announcement as those that had supported the stock on the growth parts of the business, now have to access new risks.  Most predominant is that NEC is a challenging business to judge in terms of investment options, which fits our view that fund managers are best left to make the case given access to a wide range of view and industry contacts.

On the heels of its production report, BHP has announced the sale of its US shale assets to BP earlier than expected and for US10.8bn, a touch higher than forecast.  Half is payable on completion and the remainder will occur progressively over the following six months without any conditionality. The Chairman stated that the net proceeds (after tax and other costs) would be returned to shareholders with the outcome to be confirmed once the transaction is complete. The residual cloud is the impairment charge of US$2.8bn against the carrying value on the balance sheet.

The transformation of BHP to a capital disciplined company with modest debt has come at a cost for long term shareholders. The previous management walked away in the height of an acquisition and expansion fuelled downturn, leaving the balance sheet under pressure from asset impairment and debt. Today BHP is considered one of the better companies on the ASX in terms of corporate governance. 

  • While the relationship to commodity prices is ever present, the volatility of performance should diminish if the current ethos remains in place. It reinforces our support for a holding in BHP outside the SMAs and other recommended fund managers where the company does not fit their mandate.

AMP has politely been called a ‘work in progress’. Another step came through this week with a downgrade to profit guidance and actions to improve the risk management. The first half profit is largely inconsequential as it was derived under conditions that have radically changed. The large remediation charge ($290m) is also hardly a surprise.  A reduction in fees is another announcement that has been factored into the base case.

The negative share price reaction is likely a combination of the tap down in dividend, with the statement that the interim dividend (due August) will be below the 70-90% payout and that the full year will be at the low end of that range. This has arguably reminded investors that AMP is far from out of the woods.  What the core of the business will be, the fee structure, recommendations from the Royal Commission and potential legal challenges are yet to be determined.

  • Our Martin Currie SMA holds AMP. Based on their work, Martin Currie believe the share price overly discounts the implied likely business that can evolve. AMP does have a sustainable balance sheet with a capital position well above regulatory requirements. If the right management team can convince its customers that the future will look very different to the past then, the valuation already allows for a large loss of revenue.

Investment platform providers HUB24 (HUB) and Netwealth Group (NLW) released their respective quarterly updates over the past two weeks.  HUB24 stated that it had net inflows of $739 million during the June quarter, bringing its funds under management to $8.3b, up 51.2% on the same time last year. Netwealth has previously confirmed net flows of $1.4 billion, which was ahead of analyst estimates. This has helped elevate its total funds under administration to $18 billion at the end of June.

Funds under management

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Specialist platform providers are taking advantage of the current shift of financial advisors from big banks to non-bank advice groups, which are choosing to utilise these platforms in favour of the traditional organisations. Over the last five years the newcomers (including Netwealth and Hub24 along with OneVue and Praemium) have increased their market share from an estimated 0.9% to 4%. This has come at the expense of the platforms that are owned by large banks such as Commonwealth Bank’s Colonial First State, AMP's MyNorth and Westpac's Panorama.

Comparative performance since November 2017

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In an effort to combat this, Westpac announced price cuts to its BT Panorama. Panorama fees have been cut to 0.15% p.a. + $540 admin fee pa with a fee cap once assets reach $1m. The estimate is that it would take a $70 million hit to its revenue with these fee cuts. This commitment from Westpac to its wealth management business comes as the other four big banks are divesting their wealth divisions.

  • Investors marked back HUB and NLW after a stellar run in anticipation of tighter margins given the pricing from Westpac. The big players will be reluctant to see much further erosion of share given the fixed costs of the business.

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