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WEEKEND LADDER

A summary of the week’s results

27.10.2017

Week Ending 27.10.2017

Eco Blog

- A lift in global capital spending looks imminent.

- US tax changes are expected to be pushed through in coming months.

- Australian CPI was below par. As usual, a few items stand out, yet the aggregate remains below the RBA target.

One of the features absent in the current growth cycle is a pickup in corporate capital spending. This is despite the improvement in company cashflows. Some have funded buybacks (a phenomena common in the US) and an increase in dividends. Consumption spending will not be sustained unless capital spending also comes to the party and the indicators are promising. Orders and shipments in the G3 (US, Japan, Eurozone) are accelerating.

G3 Capital Goods Orders and Shipments

Source: JPMorgan
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To further support the theme, manufacturing and construction employment has only recently started to improve, implying more labour is being added to meet demand. Meantime, capacity utilisation is getting closer to the previous peak.

In Europe, the most recent PMIs (an indicator of activity) show manufacturing still on an accelerating path, while the services component rate of improvement has levelled off, partly ascribed to the unsettled political aspects in Spain that has disrupted tourism.

With US growth now middling in global terms, there are two potential accelerants. The first is wage growth. Economist have puzzled over the lack of wage traction, notwithstanding the increasingly tight labour market and skills shortage. Some suggest that the lags in economic behaviour are longer these days, which would concur with the time it has taken for interest rates to impact on corporate investment and consumption growth to resume. There are increasing signs that the long-awaited rise in household income is going to emerge, and with employment close to full, the aggregate impact on the economy would be high.

The second is the potential for tax changes. This is messy territory and the political landscape is likely to complicate matters. Nonetheless, some adjustment is expected to emerge, though the implementation may be pushed out to 2019.

The corporate sector is lining up to take its share. Simplistically, domestic companies paying full taxes should benefit, even with a small change. Actual tax payments vary considerably between and within sectors. Using the MSCI as a benchmark, healthcare and consumer stocks are positioned to get a free kick, though that will not to apply to the big pharma stocks domiciled in Europe (as some moved with the infamous tax inversion, where an acquisition changed their head office location, often to the 12.5% tax regime in Ireland).

MSCI USA effective tax rate by sector: average 2007-2016

Source: Factset, Amundi Research
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Financials are a special case. The low average tax rate of the past 10 years is mostly from the deferred tax credits from losses during the downturn. Local regional banks are generally full tax payers.

But the benefit is preconditional on getting to a 25% rate, a big step from the statutory 38.9% (Federal and State).

Aside from the top rate, there are other measures that, if implemented, will be important. Repatriation of cash held outside the US has been a persistent theme, given it is around $2.6tr. Many are less optimistic about what this money will do. In the tax relief offered for the same purpose more than ten years ago, companies undertook buybacks and increased dividends, while capital programmes barely budged.

Other proposals include full expensing of domestic capital spending with the offset of giving up interest deductions. Companies would elect which path they wished to go down.

The concept of a ‘border adjustment tax’ has been put aside; instead there is a clear shift to unwind trade agreements. The outcome for the corporate sector is again clouded. Many large corporations have globalised their supply chain and enjoyed tariff-free movement of goods. However, there are smaller companies that may enjoy the protective measures of tariffs, which is likely to put upward pressure on inflation.

Personal tax cuts will get the headlines. As currently proposed, it will be a small cohort of wealthy individuals that will have outsized gains. Here there is likely to be adjustments, given the proximity of the 2018 mid-term elections.

The final peg will be the deficit. Loosely-based comments that growth would compensate for tax cuts are unlikely to find favour amongst the Republican heartland. This week, the FY2017 budget deficit was reported at US$665.7bn, $80bn more than 2016. The table shows the problem. Revenue growth is well below GDP and tax cuts without restructure will exacerbate the problem or force large spending cuts into the so-called discretionary areas.

US Government Budget Summary

Source: Haveranalytics
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Australian CPI came in at 1.8% for the September quarter. As expected, electricity costs rose by 9%. Healthy eaters benefited from a 11% fall in vegetable prices and telco services also eased 1.5%. The offset was in international holidays (up 4%) and a small increment in house occupancy costs. 

Core inflation remains below the RBA bandwidth at 1.9%. Rate hikes become complicated with a decent labour trend, but no evidence of pricing pressure. That won’t be helped by the Q4 CPI data, which will include structural changes to reflect spending patterns. The implication is that the RBA is unlikely to say much about rates until it gets a better reading in 2018, unless it sees more risk taking in the housing market.

Fixed Income Update

- European bond markets rally on the back of dovish commentary by the ECB, despite a wind back in the QE program.

- The bank of England on the brink of their first rate rise in 10 years.-

- Tight supply in the Australian listed market facilitates what is expected to be a successful new Suncorp hybrid issue.

As expected, the ECB will reduce its monthly quantitative easing purchases from January next year to EUR30bn per month. In what Mr Draghi described as a “downsize” not a “tapering”, the central bank also announced an extension of the program until September 2018, although adding that the program is “not going to stop suddenly”. The central bankers will continue to spend €60bn a month on buying government and corporate debt through to the end of this year before halving their purchases.

The key EU interest rates were kept at 0% and the deposit facility at -0.4% with forward guidance being that this level of rates will stay for “an extended period of time, and well past the horizon of the net asset purchases”. This suggests no rate rises next year with the bank assessing that the euro area recovery is reliant on the continuation of accommodative monetary policies. The market interpreted this part of the commentary as dovish, leading to a fall in European sovereign bond yields as bond prices lifted slightly across the region. The biggest basis point moves were in Germany, where yields on the 5-year Government bund fell from -0.25% to -0.32%. 5-year Italian bond yields dropped 5 basis points, while the French debt fell 4 basis points. Risk markets including equities responded positively to the announcement.

Basis point moves on 5-year government bonds post the ECB meeting

Source: Iress, Escala Partners
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Staying in Europe (can we still say that?), the Bank of England is on the brink of raising rates for the first time in 10 years. Better than expected GDP figures out this week, showing growth in the UK of 0.4% in the third quarter, saw UK GILTS (government bonds) sell off as yields rose. Bond yields across the curve are now trading at their highest levels since before the Brexit vote, with the futures market predicting a 93% probability of a rate hike at the November central bank meeting next week. This is up from 80% just days earlier.

Movement in yield on 5-year UK Gilt in the last two months

Source: Iress, Escala Partners
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Locally, following on from the Bendigo and Adelaide bank hybrid issued last week, Suncorp announced a partial roll over of the SUNPC’s (call date in December), with a new 6.5-year preference share at a margin of BBSW+ 3.65-3.85%, and a minimum issue size of $250m. The reduced size of this Suncorp transaction, which is only 45% of the maturing $560m SUNPC’s, together with the Bendigo bank hybrid will result in a net reduction in market supply on the ASX. The redemptions in 2017 currently exceed new issuance by $3.9 billion, with this latest deal likely to be the last new issue this year. Spreads are therefore expected to remain tight in this asset class as the shortage in supply weighs on markets and keeps prices firm.

Corporate Comments

- Wesfarmers’ (WES) supermarket sales were below expectations with the implication margins will remain tight. A below par Target and UK Bunnings did not help.

- JB Hi-Fi (JBH) noted slightly weaker sales trends, although remains on track to meet its full year guidance.

- Star Entertainment (SGR) has emerged well from the challenges that casinos sector has faced in the last 12 months.

- Fletcher Building (FBU) issued an additional earnings downgrade.

-ANZ’s result was supported by reduced costs and bad debts.

- Macquarie (MQG) surprised on the upside with its first half result, although this was driven by cyclical factors.

Reality headbutted hope, with fears that Coles was entering an intense battle for market share being realised in Wesfarmers’ (WES) Q3 sales release. Headline growth of 1.3% and comparable sales of 0.3% indicate that the loss of share in recent times is far from over. The CPI release for the September quarter showed a fall in vegetable prices (which will partly explain the figures), but otherwise Coles has no choice but to grind away at lower prices and better stores, both of which will cost margin in the coming periods. Further, feedback suggests they are losing supplier support as demands for lower prices and more deals weigh into this relationship.

The tone could not be rescued by the ongoing strong performance of Bunnings and Kmart. Investors anticipate that by now and have looked to a recovery at Target, as well as indications that the new UK Bunnings operations are making headway. Target failed to gain traction, with sales slipping another 6.4%. The UK was also behind expectations, recording a 17.5% slump in sales.

Consumer spending overall is sluggish and won’t assist WES as it comes to terms with the competitive shift. Regaining share had been critical for Woolworths (WOW), yet this stock fell in sympathy as investors judged that the supermarket sector remains unfriendly for profit margins.

Wesfarmers First Quarter Sales

Source: Wesfarmers
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JB Hi-Fi (JBH) reported moderating sales trends at its AGM with 6.2% growth in the JB Hi-Fi business (comparable growth of 3.2%) and 3.1% for the acquired Good Guys division (comparable growth of 2.4%). The outcome was broadly in line with expectations given the company was cycling a strong figure last year and had sufficient confidence to confirm its full year sales guidance. The lumpy nature of key product releases (such as the upcoming iPhone X) also has the ability to distort the shorter term picture.

The stock has lost some ground despite reporting a solid result in August, although much of the retail sector has struggled in this time. With Amazon expected to commence trading locally in coming months, the noise around the expected impact that the global behemoth is likely to remain at the forefront of investors’ minds. While we acknowledge the risks that Amazon poses and the likely price discounting that it will trigger, we believe that this is already captured in an 11X forward P/E for a business that we view as one of the highest quality within the sector.

Casino operators Star Entertainment (SGR) and Crown Resorts (CWN) both provided trading updates at their respective AGMs this week. The last 12 months has been a difficult period for the sector, which has been characterised by a decline in VIP high roller activity following the revelations that several CWN employees had been arrested in China and charged for gambling promotion offences. While CWN has been the most affected by the drop off, the fallout was evident across the other casinos that offer VIP services in Australia. The arrests also accelerated CWN’s exit from its international strategy that was once linked to the high growth Macau market to instead focus on its two domestic casinos in Melbourne and Perth, as well as its Barangaroo development in Sydney.

SGR’s trading for the first quarter was positive, with normalised revenue growth of 4%. The momentum has improved in its business following the completion of capital works despite some softness in domestic discretionary spending. Volumes in its VIP business were actually in line with last year, although SGR’s win rate (which can be volatile) was lower. In contrast, CWN reported that main gaming floor revenue was ‘slightly up’ on last year, however, VIP turnover was down a further 17%.

With CWN also exposed to the softer WA market through its Crown Perth operations and the ongoing reputational damage suffered by its VIP business, our preference in the sector remains SGR. The opportunity to share in the dollars flowing from the growth in Chinese tourism in Australia – the most recent estimates from the Australia China Business Council forecast a tripling in tourists from the current figure of 1m each year within the next decade – is a core part of the investment thesis for the stock.

Fletcher Building (FBU) dealt another blow to investor confidence in listed engineering construction companies, with an additional downgrade triggered by losses in its building and interiors business unit, which have arisen from two problematic contracts. This includes the $NZ700m New Zealand International Convention Centre, which is under construction in Auckland and is not expected to open until 2019. Remediation actions are in place following an external review of the division, although FBU’s admission that there is “unknown and unquantifiable risk” remaining, the possibility of further bad news will likely hang over the stock in the short to medium term.

The reporting season of the major banks commenced this week with a result from ANZ that was slightly below par. At face value, the 17% increase in earnings per share appeared to be a solid result, however, this masked softer underlying trends. Profit growth was primarily driven by a combination of a focus to reduce its expense base, in addition to a further fall in its bad debts expense (which is itself a cyclical component of earnings). Consequently, the bank elected to leave its dividend unchanged, which was rebased at a lower level in FY16.

As with the broader domestic banking sector, revenue growth remains soft amid weak industry credit growth. This is particularly so for ANZ, which has continued on its path to rebalance its portfolio away from its lower-returning institutional book, while also divesting non-core businesses. These assets sales have created an additional earnings headwind for ANZ (approximately $300m in FY18, or approximately 4% of its full year profit).

The shorter-term upside, however, for shareholders is that the group’s capital position is now looking very solid, having already lifted its CET1 ratio above APRA’s new target range. The focus is thus likely to turn to capital management initiatives (which would probably be in the form of a share buyback given ANZ’s lack of franking credits) and provides a point of differentiation from the other majors, with a possible announcement in the first half of 2018.

ANZ: FY18 Impact of Recent Divestments

Source: ANZ
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Macquarie Group’s (MQG) balance sheet is also in good shape, which allowed it to announce a $1bn buyback as it reported its first half result. Its earnings were ahead of expectations, with 15% growth on 1H17 (and an 8% increase in its dividend), although the surprise was largely due to factors that are unlikely to be recurring in nature, being a lower tax rate and a spike in performance fees from its funds management business. The strong result allowed MQG to increase its full year guidance for earnings from ‘flat’ to ‘slightly up’ and is likely to result in consensus upgrades for the year.

Reflecting mixed conditions across its business units, earnings growth was limited to its more annuity-style businesses (Asset Management/ Corporate and Asset Finance/Banking and Financial Services), while its capital markets facing divisions (Commodities and Global Markets/Macquarie Capital) had a lower contribution. Weaker market volatility and softness in M&A activity has led to a more benign environment across these more cyclical divisions, although they presently have lower relevance to the group given the growth in the rest of MQG’s business. We have MQG in our model portfolio as an alternative option in the financials sector, with exposure to more attractive offshore markets than the major banks.

Macquarie Group 1H Profit Contribution

Source: Macquarie Group
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