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WEEKEND LADDER

A summary of the week’s results

27.11.2015

Week Ending 27.11.2015

Eco Blog

In one of the lightest weeks of economic news, even Governor Stevens of the RBA told an audience to ‘chill out over Christmas’. One assumes he is hoping financial markets take whatever the ECB and Fed deliver in the forthcoming weeks in their stride. With the main aim of the RBA now on keeping a lid on the currency, he might be debating the diverging path of these two behemoths of the financial world with respect to this outcome.

Many argue that the US$ has already baked in the rate rise and that, conversely, some US$ weakness might ensue as the Fed members recast their longer term rate expectations. The infamous dots will likely be revised downwards. To remind, the dots represent each of the Fed’s voting members view on where rates should go. Financial commenters spend an apparently inordinate amount of time guessing which dot belongs to whom based on their speeches.

Fixed income manager Pimco, for example, has nominated the dots from the September meeting as per below.

FOMC Participants' Predictions of Fed Funds Rate

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With the financial markets uniformly of the view that the pace of rate hikes will be slower and that the final ‘longer run’ will be lower than the current dots, it will be of note to see whether the Fed members will follow the opinion of financial participants.

This may see some confusion as fixed income markets decide how to price in an uncertain pace of rises through 2016. In turn, that may put some short term pressure on the US$.

The other side will be the decision by the ECB next week. Simplistically, the Euro should weaken with more easing. On the other hand, investors are likely to buy Euro assets based on this supportive monetary policy measure. That could see the Euro prove to be stronger than expected.

Of course, neither of these scenarios may come about; they are part and parcel of the ongoing debate on what case can be made for a range of outcomes. It may well mean that financial markets abide by Stevens’ call to ‘chill’.

Taking a broader view, Stevens reflected on some of the large thematic changes affecting global and Australian specific conditions. Some of the influences he noted were:

· Major demographic changes, with falling working age populations across much of the globe. This is particular notable in China, with India’s working population expected to overtake it within the next decade.

· The impact of global debt over the past 10 years and the diminishing impact of global trade.

· Disinflation in goods markets and low wages, in contrast to elevated valuations for fixed assets.

China and India Working Population Projections (bn)

Source: United Nations, Escala Partners
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The somewhat downbeat tone found a glimmer of light in the emerging world, but much of the emphasis appears to be a reality check on the returns from both financial and property assets within Australia.

In 2012 the head of the ECB, Mario Draghi, placed into history the promise of ‘whatever it takes’ to improve the economic outcome in Europe. At that time, Europe was going through its initial Euro crisis and sovereign bond yields in the Mediterranean had blown out. The actions of the ECB achieved their goals and history may well judge them a success given the recovery in southern Europe. However, the potential for deflation and recurrence of Euro issues with Greece, saw the ECB start a round of bond buying in March this year, paced at €60bn a month.  Some weeks ago, Draghi alluded to further easing and it is widely expected the buying in other financial assets may become part of the programme.

As always, the success of these initiatives is hotly debated. Certainly, European bank lending has been somewhat unresponsive to easing. This is hardly a surprise given that the banks are still restricting debt. As we have therefore previously noted, the aim of further asset purchases may be to assist in this recapitalisation of the banking sector through the very low costs of issuance that can piggy-back off the programme. The second motivation is to keep the Euro under pressure, but as we have mentioned, this may in fact prove counterproductive.

One of the major challenges into 2016 will be the efforts by countries to manage their monetary policy and currency aims without the inevitable counterparty effect. The US would like to raise rates without the US$ moving in unison. The ECB would probably prefer holding to its current programme, but feels compelled to work with the financial sector and on behalf of a currency outcome. Japan is also stuck in a groove, with sizeable easing having little impact on economic activity. Meanwhile, many emerging economies are battling falling growth. While they will thus benefit from lower exchange rates as a result, this will however expose their US$ denominated debts to this currency move.

While this paints a rather unattractive picture, it is with the backdrop of relatively resilient economic growth in many countries where the capacity to manage a path through may be understated.

Fixed Income Update

As expected, the hawkish minutes by the FOMC and their upcoming December Fed meeting has been driving yields higher at the front end of the US treasury curve. The US rates market is now pricing in a 74% chance that the Fed will raise rates next month.

Domestically, the chances of an imminent rate cut has all but disappeared. Australian government bond yields are up this week, and our yield curve is now slightly positive as 3 year ACGB’s (Australian Commonwealth Government Bonds) are now trading with a yield of 2.11%. This is the first time 3 year bond yields have held above 2.11% since May this year. On the long end, the 10 year Australian government bond yield has been relatively stable, trading within a 10 basis point range of 2.90% since the 9th of November. The current yield curve is illustrated below.

Source: Bloomberg, Escala Partners
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Credit markets appear to be comfortable with the upcoming Fed hike, with many risk assets holding up well. Our hybrid market (considered a risk asset) has remained stable this week with most securities staying in a tight range. This has been the case in spite of the announcement this week of increased supply in this sector with the launch of a new $400m hybrid security by Macquarie Group.

Staying with risk assets, the fall in the oil price continues to weigh on the emerging market (EM) sector, with most of their currencies remaining at their lows despite a slight bounce in October. Also coming under pressure in November has been the high yield (HY) sector in the US and Europe, which has struggled in the last couple of weeks following a stellar performance in October. 

The US high yield sector has a significant number of issuers from the energy sector which remain under pressure. Contagion across the broader HY universe has put upward pressure on credit spreads. However, the margin differential between low CCC rated (mostly energy) companies and their better-rated peers in this sector is at its highs. The chart below depicts the premiums (credit spread) above Libor (the London Interbank Offered Rate; a benchmark rate that banks use for short term loans) that the HY sector is paying for the varied credit quality, as determined by the ratings assigned by rating agencies.

High Yield Rating Brackets

Source: Bank of America Merrilll Lynch Indices
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Translating this in terms of performance, The Bank of America Merrill Lynch index of BB rated debt has returned 2.4% since the year began. In contrast, the index of CCC rated groups has declined 6.2%. The chart below shows the performance of the index in the last 3 years.

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The fundamental credit risk of the corporate bond market has not deteriorated in the last few months, however now investors are receiving a higher margin above the risk free rate for lending money to these issuers. Actual default rates remain at historic lows, but the market is pricing in a potential spike in defaults, largely driven by concerns around the energy sector.

It remains an unknown as to whether investors are adequately compensated for the growing risk of illiquidity of these securities. However, increased credit spreads certainly does improve the risk adjusted return for credit products which could also be in part factoring in an illiquidity premium.  

As the liquidity debate continues, the good news is that fund managers are working harder to achieve some potentially constructive outcomes to reduce this risk. These include pushing back on the banks to provide a buy price for bonds when they purchase a new issue (facilitating a switch), and refusing to participate in bond deals that only have one lead manager (on some deals the lead managers are the only ones that will show a bid price if an investor needs to sell). Consensus is that a market will eventually evolve outside of the banks with fund managers trading directly with each other.

Another positive is the funds that have increased their liquidity bucket (who are holding larger amounts of cash) are becoming more innovative with how they maximise returns for this significant part of their portfolio. The use of derivatives and diversified jurisdictions have boosted yields on cash, reducing the drag on performance caused by their large cash balances.

Corporate Comments

Transurban (TCL) capitalised on the recent strength in its share price to undertake an equity raising to partly fund the purchase of Brisbane’s AirportlinkM7 via a consortium which includes AustralianSuper and the Abu Dhabi Investment Authority. The consortium (called Transurban Queensland) had bought into the Brisbane toll road market when it acquired Queensland Motorways in April last year.

The acquisition made sense for Transurban, given the adjacency of AirportlinkM7 to this existing network of assets. The asset had previously been the core of listed entity Brisconnections, which collapsed after pre-float traffic expectations proved to be overly optimistic. The purchase price of $1.87bn (which represents just over 50% of the build cost of the road) thus needs to be viewed in this context and the multiple paid by the consortium (28X EV/EBITDA) is in line with other transactions in the sector in recent years. The concession on AirportlinkM7 is long-dated with 38 years remaining and extends TCL’s average weighted concession length across its portfolio to 29 years.

Transurban: Brisbane Network

Source: Transurban
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The expectation for TCL will be to lift the current EBITDA margin on AirportlinkM7 from its current rate of 70% to greater than 80% (in line with the rest of TCL’s portfolio) through the consolidation of corporate functions and technology, procurement savings through TCL’s larger maintenance contracts and improvements in tolling and customer management. Since acquiring Queensland Motorways, TCL has shown an ability to realise margin growth from these assets, with margins expanding from 71% to 75% in the first year.

The optionality of these deals is one of the harder aspects of TCL’s valuation and is arguably required to justify the company’s current share price. Following this transaction, there are now clearly fewer acquisition targets available to it in the Australian market, although the ability to participate in further growth in new toll road opportunities or the expansion of its existing asset base will be key to its ongoing success.

Laboratory testing company ALS (ALQ) also surprised investors with an equity raising to accompany its half year result. While not specifically referring to any acquisition in particular, the additional capital will be used to fund the ongoing growth in its life sciences division (primarily environmental, food and pharmaceutical testing) as well as reducing the company’s debt.

Acquisitive growth has been a feature of ALS’s growth over the last decade, many of which have been small given the fragmented nature of this market. Many of these acquisitions have been in the life sciences division, an industry that has shown high, predictive growth rates. Combined with depressed conditions in ALS’s cyclical exposures, such as mining, oil and gas, the non-cyclical component of the company’s overall earnings mix has been steadily rising. ALS’s earnings mix has also shifted towards offshore over the last decade, with overseas profits representing 75% of its total in the last six months.   

ALS 1H FY16 Earnings Mix

Source: ALS
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ALS’s earnings for the first half of FY16 also reflected these more recent trends. Its life sciences division grew its top line by 15%; sales from its industrial division fell by 5% with a greater fall in earnings due to a fall in margins; the smaller energy division was impacted by the steep fall in the oil price over the last year; while the minerals division reported similar earnings to last year. The latter two divisions represent the ongoing risk to ALQ’s overall business at present, although we gain some comfort from more stable conditions emerging in its minerals exposure, despite the further weakness experienced in commodity markets. We remain of the view that ALQ is suitable as a small position in a share portfolio given the high quality of its core business and the reduced level of downside risk in the cyclical elements of its exposure.

The recent strong momentum of Aristocrat Leisure (ALL) continued with its full year result. A 79% increase in earnings was boosted by the company’s purchase of VGT in mid last year. Despite the strong result, the company lifted its final dividend by just 12.5% to 9cps.

While a stronger $US also contributed to the increase in profit, ALL’s underlying operations are performing well and the company’s growth has been driven by market share gains (most notably in the key markets of Australia and the US), driven by the investment it has made in recent years in its product offering.

With most key markets described by ALL as flat to declining, the ability for the company to sustain this growth trajectory may be more challenged, particularly if its competitors begin to lift their game. The last few years has seen a bout of consolidation in the gaming machine industry and bedding down these acquisitions may have taken a priority for ALL’s peers.

More promising for ALL is an increased level of recurring revenue in its business (improved since its VGT acquisition) and the fast growth that its digital division (online and mobile gaming) again recorded. Success in this latter category may be important to the longer term success of ALL. Despite some potential risks to its medium term outlook, the stock currently trades on a forward P/E of 20X. Within the gaming sector, we have recommended investments in Tatts Group (TTS) and Star Entertainment Group (SGR) (previously Echo Entertainment).


 


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