Week Ending 28.04.2017
- Fiscal reforms have proven to be a headache in many countries and equities cannot (yet) be priced on expectations of positive outcomes.
- Australian inflation remains at the low end of the RBA range with nothing pointing to any price tension that may take the rate higher.
- The direction of commodity prices, together with interest rate differentials, usually have a big bearing on the AUD; not this time as they head in opposite directions.
The fiscal agenda is now well and truly taking over from exceptional monetary policy as the topic de jour in financial markets. After the incapacity to get agreement amongst US Republicans on the repeal and replacement of the Affordable Health Care Act (AHCA), the one pager on tax reform left more questions than answers. The new administration increasingly needs a win to validate its election stance and May looms as a big test.
There is talk of reintroducing the AHCA repeal next week, but few commentators believe it will pass through. A ten year budget programme, also due in May, could shed more light on the proposed tax changes. At face value, the proposal to drop the personal tax rate to 35% from 39.6% is likely to be accepted, along with an increase of the standard deduction to $24k from $12.6k for couples. What is more contentious is that state and local taxes lose their deductibility, which may cause some friction with Republican state representatives that rely on those taxes. Nonetheless, these changes leave a very large hole in the budget, given personal taxes are the primary source of revenue.
The proposed reduction of the corporate tax rate to 15% is a big ask and there was little clarity on what would happen to a host of deductions many companies enjoy, which results in an effective tax paid by US corporations closer to the low 20% range compared with the statutory 35%. The method and rate at which foreign earnings could be repatriated was also left unclear, while most pundits argue that corporations have had many years of cheap, tax deductible funding and don’t need the cash that sits outside the US for capital programmes. Finally, the border adjustment tax, flagged as a way to raise income by taxing cheaper imports, is effectively dead in the water, with little support from any sources.
All up, the biggest question will be the impact on the US deficit. That, again, depends heavily on the assumption of GDP growth. An optimistic 3% p.a. over 10 years would limit much of the blowout in the deficit, but that assumes GDP gets a ‘terrific’ boost that most believe is unlikely against the headwinds of demographics and industry transformation, as well as the perplexing lack of productivity growth.
Now the hard works starts, with some tax legislation to be put to a vote in the second half of the year and implementation only in effect from 2018.
The US equity market will have to rest on its own laurels rather than enjoy a free kick from the new administration for the remainder of the year. So far, the reporting season for Q1 has been acceptable, though the rally in the S&P 500 over the past few months has again seen US stocks go well above their historic average valuations.
Locally, the upcoming budget will face a parallel challenge. Tax cuts appear less likely but rearranging the way spending is accounted for is intended to indicate that a rise in government debt by investing in infrastructure can be good for the long term. Whether foreign buyers of Australian bonds and rating agencies view it in the same light is yet to be seen.
Headline inflation crept back into the RBA range of 2-3%, but the weighted and trimmed measures remained mostly unmoved. In the first quarter of the year, adjustments to tobacco and alcohol excise and one-off rises in education are notable features. Transport costs have unsurprisingly ticked up due to the increase in the oil price over the past year. Outside of these, there is little price traction. Housing includes imputed rent and utilities and some may be surprised to see a moderate 2.5% annualised rise in these costs. The reality is that cost in some categories such, as energy bills, get swamped by the weighting of others, reducing the impact.
In the forthcoming quarter, Cyclone Debbie may impact fresh food prices, at the headline rather than the RBA’s core measures. Indeed, it is hard to see inflation settling above 2% without stronger demand, or a fall in the AUD.
The drivers of the AUD have been tracking an unusual trend in the past year, with commodity prices rising, yet the interest rate differential to the US easing away. Historically the trends would be different and rising commodity prices signal an improving Australian economic cycle and therefore rising interest rates. This time, we have been on an easing cycle relative to the US, yet enjoyed the commodity upswing.
Rate Differentials Versus Commodities
The implication is that either rates here should rise, or that there is low expectation that the commodity cycle has much further to run. The market is heavily skewed to the latter view, with a fall of 20% in iron ore prices in the past quarter an indication the market may be proven correct. The AUD therefore appears to be range bound for the time being, awaiting a trigger to shift direction.
Currency forecasts have a habit of catching out consensus. The hugely skewed view to a stronger USD over 2017 has softened away, suggesting to some it has seen its peak, or that it may stage a late rally before retracing into 2018. For equity allocations, some hedging against high weights in the US and conversely, unhedged Euro exposure can capture that theme.
Fixed Income Update
- The spread between French and German government bonds has been volatile in the last few weeks as the first round of the French elections took stage.
- Central bank policies in Europe remain in the spotlight, with the ECB president giving support for an accommodative stance.
- Netflix has issued credit in the European market for the first time.
- ANZ has announced the redemption of its ANZHA subordinated bonds.
European markets drove market sentiment early this week, following the first round election results in France and the anticipation of an announcement on the timeline and implementation for US tax reforms. Both were considered bearish for bond markets (although the actual US tax reform announcement underwhelmed) and yields on global bonds rose across the curve (bond prices fell) as a riskier tone took hold. This reversed the rally in bonds in the previous weeks as money flowed into safe haven assets in response to geopolitical concerns.
It appears that the French election was directly responsible for rattling the European bond market in the prior weeks, with French bond prices weakening and the spread between the 10 year French government bond and the 10 year German bund ballooning out to 80bp. Over the last 12 months this spread has averaged 30bp and this recent widening reflects the perceived increased risk between the two sovereigns. The spread snapped back 30bp to a 50bp differential following the first round election result.
French/German Bond Yield Spread
The ECB meeting also took place this week, with the ECB president emphasising improvements in European growth, but subdued inflation. While he took the opportunity to note his support for accommodative monetary policies, many experts still expect that as growth continues this year there may be some wind back on these policies. Views differ on whether the ECB will begin by tapering its bond purchasing program (QE) or abolish its negative interest rate policy (NIRP) by lifting interest rates into positive territory. Despite the pressure from Germany on a pullback on QE, other good reasons for addressing interest rate levels first include:
- Negative interest rates are bad for bank profits;
- The US Federal Reserve Bank are raising rates, which will widen the interest rate differential between Europe and the US. In turn, this could put downward pressure on the Euro, and highlight the trade surplus at a time of tension in the trade balance with the US;
- Quantitative Easing has been very supportive for peripheral bonds, and the ECB may be reluctant to take this away given political uncertainty; and
- The ECB raised rates twice after starting their QE program. It may be prudent to reverse the policies the same way they began.
In the event of any reduction in either the bond purchase program or the accommodative monetary policy, we would expect that bond yields will track higher in Europe, which would put downward pressure on bond prices. This will be one that markets will be watching closely throughout 2017, although given this week’s rhetoric, it could be a slow game.
Staying in Europe, this week saw the first ever EUR bond issuance by Netflix. In this case, it seems that the well-recognised global streaming company could achieve favourable terms for its new bond, over and above what is standard for a below investment grade-rated issuer. Netflix falls into the high yield sector given its S&P rating of just B+. Investors normally demand a covenant that prevents the company from raising more debt than what the company can sustain, but this was absent from the deal. Despite this, the 10 year fixed rate EUR bond (with a coupon of 3.625%) was oversubscribed and the deal was upsized from $1bn to $1.3bn. This bond ranks alongside other Netflix deals that have taken place in the US high yield market.
Domestically, ANZ announced last Friday that they would be redeeming all of its ASX-listed $1.5bn ANZHA subordinated notes. There has been no talk of a replacement deal. There are very few subordinated bonds in the listed market, with most issuers preferring to print these deals in the OTC (Over-The-Counter) market due to the efficiency in which they can market and close a deal compared to the listed market. These hybrid securities, the lowest ranking debt on the capital structure, make up the majority of issues on the ASX market as the ability to utilise franking credits is skewed towards retail investors.
- BHP Billiton’s (BHP) quarterly production report was weak and the spot pricing upside for its earnings is dissipating.
- Sovereign risk has emerged as a problem for our gas exporters, particularly Santos (STO).
- Computershare (CPU) is set to benefit from a more supportive interest rate environment, which may mask the softer underlying performance of its business.
- Lendlease (LLC) is well placed to participate in increased infrastructure spend in Australia.
- Spotless (SPO) has rejected its takeover offer from Downer EDI (DOW), however, remains in a weak position. Tatts Group (TTS) looks increasingly likely to merge with Tabcorp (TAH).
- Wesfarmers (WES) sales point to difficult and competitive trading conditions
BHP Billiton’s (BHP) quarterly production report was soft, although largely as expected. The group’s copper division had lower production following industrial action at the Escondida mine in Chile, while Cyclone Debbie interrupted metallurgical coal production in Queensland. Western Australian iron ore was also impacted by wet weather, leading to an 11% decline in production quarter-on-quarter. Production guidance for FY17 was subsequently lowered for each of these commodities. While many factors are short-term or cyclical in nature, a lack of significant growth projects coming to market has meant that these are now the predominant driver of quarterly changes in group production.
Recent weakness in commodity prices and, in particular, iron ore, has reduced the upside ‘spot pricing’ scenario that was underpinning its share price recovery. While we believe it is the best way to gain exposure to a broad range of commodities with a quality asset base, the prospect of additional capital returns has reduced somewhat in recent months.
Sovereign risk became front of mind again for investors this week as the Federal Government announced measures designed to ensure adequate supply of domestic gas for Australia. The policy would affect the LNG operators that are net exporters (i.e. they have insufficient reserves to meet their requirements and thus have to purchase additional gas from other market participants) and would result in export restrictions if required.
The two listed companies that are most exposed to the policy are Origin (ORG) through its APLNG venture with ConocoPhillips and Santos (STO), with its interest in GLNG (partnered with Petronas, Total and Kogas). While the policy is still to be finalised, the initial view is that STO has the most to lose given GLNG’s weaker resource position compared to its peers. As we have recently noted, AGL Energy remains best placed to capitalise on Australia’s energy crisis from its strong generation asset base, however, following a sharp rally in the last six months, much of this positive news would appear to be factored into its current share price.
Computershare (CPU) held its annual investor day this week, reaffirming its full year earnings guidance, the midpoint of which would represent a modest 3% year on year increase. CPU earns margin income on cash balances held on behalf of its customer base, and part of the presentation was dedicated to detailing the impacts that the changing interest rate environment will have on its earnings.
Nearly two-thirds of CPU’s cash balances are exposed to interest rate changes (they either earn a spread or no interest on the residual). Of this amount, just under half is directly exposed to interest rate moments, with the remainder hedged through either fixed rate deposits or interest rate swaps (typically short term in nature). In summary, the impact of higher interest rates will be gradual over time, rather than the immediate boost that some may have anticipated. In addition, while the key currency exposure is the USD, the British pound and Canadian dollar are also significant, which may be reinvested at a lower rate as hedges roll off. Nonetheless, FY17 is expected to be the bottom of the current cycle, with this headwind (see chart below) turning into a tailwind into FY18. As a guide, CPU noted that a 1% increase in the interest rate on the group’s exposed balances would translate into a $55m uplift to EBITDA – an approximate 10% uplift to earnings.
Computershare: Margin Balances and Income
While the improvement in margin income and a cost-out program provides a solid medium-term base for earnings growth for CPU, the longer term challenge is addressing the soft organic growth rates in its core global registries business. The company has had mixed outcomes from acquisitions it has made to expand its product offering, including into mortgage servicing. The stock is likely to remain an effective interest-rate hedge (particularly to rising global rates) for an equities portfolio, although its structural challenges make it difficult to recommend as a long-term holding. We have QBE Insurance in our model equity portfolio as a similar exposure to this theme.
Lendlease (LLC) also updated the market on the outlook for its Australian engineering division. The rotation from monetary to fiscal stimulus is likely to be beneficial for LLC and its engineering competitors in Australia, with large projected spend across major road and rail projects. In the medium term, an annual revenue target of $4bn looks achievable for this division, and while its 5% EBITDA appears optimistic compared to what it has historically achieved, realising this would help to protect its earnings as domestic apartment construction peaks. NSW has led the way in infrastructure spend in recent years, with increasing spend from Victoria and Queensland projected in the medium term.
Australian Major Transport Construction Pipeline
There were further updates on live M&A deals with week, with Spotless (SPO) and Tatts Group (TTS) both responding to takeover offers. Given SPO’s previous statements regarding the opportunistic nature of the proposal, it was unsurprising that the Board rejected DOW’s cash offer of $1.15/share. SPO noted that it had had discussions with other parties to create bidding tension, however these had failed to reach any agreement. SPO’s current position thus appears to be weak, given the poor performance by management and its defence reliant on executing its turnaround strategy. With several hurdles still to be cleared before a deal is completed (and unhappy shareholders on both sides), our recommendation remains that SPO shareholders sell into the share price strength.
The private equity consortium that had tabled a rival proposal for Tatts Group (TTS) has also had its offer rejected, with TTS continuing to prefer its recommended deal with Tabcorp (TAH). While the consortium’s cash offer provided a higher level of certainty for the deal, we were of the view that the retained equity interest in the merged entity, a shorter regulatory approval process, along with the suspension of dividends for the consortium’s offer, favoured the original TAH offer.
Wesfarmers’ (WES) quarterly sales release contained ominous tones, with growth easing in all businesses outside Officeworks (which itself is on the block to be sold). While the timing of Easter has affected the quarter, the trend is all too obvious. Most importantly, supermarket comparable sales are now barely positive, even though prices are largely stable, and the growth at Kmart has taken a big step down while Target has yet to find its feet.
Wesfarmers Third Quarter Sales
Things are not about to get easier. Competition in supermarkets will remain fierce while waiting for a participant to stumble, typically on allowing prices to grind up to protect profit margin, or dropping store standards to reduce costs. The excess space allocated to discount department stores is clearly evident, especially given the market penetration of international retailers and the likely impact of Amazon.
WES is staring at a potentially flat net profit over the next few years. At at 16-17X P/E and dividend yield of 4.5% (with downside if asset sales do not come through or capex has to lift), the investment case is increasingly marginal.