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WEEKEND LADDER

A summary of the week’s results

28.07.2017

Week Ending 28.07.2017

Eco Blog

- Absent any major change in the economic pattern, we look at the typical forward indicators for guidance on the remainder of the year.

- Currency markets have once again caught most by surprise. The logic is there, but that does not mean its predictable now.

In the northern hemisphere summer lull, financial news also takes a holiday and one could be forgiven for thinking that an algorithmic repeat button has been initiated as everyone heads to the sun, only reordering words in economic releases. There is no discernable change in the pattern; European growth seems fine, the US is in a stable range and developing economies are still producing decent trends. As a sample, this past week US house sales rose while prices fell, durable orders were up, while initial jobless insurance claims are up, but still at near record lows of 1.4%. Germany’s business conditions survey reached an all-time high in terms of the number of firms with expanding output and the pickup in global trade has been sustained, reflected in export data across Asia.

Is there is a predictive capacity in any indicator that would suggest another trend is to emerge? The most common data that are purported to be leading indicators are based on indices -  the financial conditions index, PMIs and the widely-cited Citi surprise index.

One that is considered representative of the US economy is the National Financial Conditions Index (NFCI) which measures risk, liquidity and leverage in money, debt and equity markets, as well as in the traditional and “shadow” banking systems. Positive values of the NFCI indicate financial conditions that are tighter than average, while negative values indicate financial conditions that are looser than average.

Chicago Fed National Financial Conditions Index

Source: Federal Reserve bank of St Louis
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The current reading should not surprise. Investment markets are providing ready access to capital, credit spreads are tight and the US$ has eased. There are no obvious warnings bells, beyond anxiety on the valuation of investment assets, which is not captured in such an index.

Goldman Sachs produces a similar measure for emerging economies. Falling inflation, easing interest rates, bountiful equity markets and investor demand for EM credit make for very attractive financial conditions. Assuming China tightens only a little and the improvement in balances in other parts of the diverse set of developing countries holds pace, the risks to EM come from a dislocation in China, a trade blow up or a sharp change in risk appetite.

Source: Goldman Sachs
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The PMI (purchasing managers index) is an amalgam of survey-based responses from manufacturing companies on whether they are experiencing expanding or contracting trends in orders, inventory, supplier deliveries, production and employment. Supporting the contention the US economy will pick up momentum into the second half of the year is the positive and rising reading on its PMI this July.

In Europe, it has been the big jump in the PMI Index over the past year that supported the upward revision of growth for the Eurozone. In recent months, it has hit a speed wobble, though this is ascribed to constraints on capacity, especially in Germany. Uncompleted orders are at a six-year high and the employment indicator has not faltered.

IHS Markit Eurozone PMI

Source: Markit
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The Citi Surprise index, compiled from the difference between actual data releases against expectations, took a sharp dive in the US earlier in the year, coming off the halo of the election. Perhaps that was less of a surprise after the weak GDP data in Q1 and the fall in bond yields. This index has a high correlation to the bond market, itself a prognosis on economic health. Therefore, it is not another surprise that the Citi index has ticked up recently, once again reflecting the better GDP expectations for this half the year and the rise in bond yields from the recent trough.

Source: Federal Reserve Board & Citigroup
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Citi’s Euro and Emerging Market surprise indices are also as expected, with Europe holding up at high positive reading and that for emerging market showing accelerating growth.

If these indicators are validated, economic growth should be more than decent in the second half of the year. The outstanding issues remain central bank policy impacts and politics. For the latter, the US debt ceiling debate and tax reform are going to concentrate the post-holiday minds. Early indications are that the combined tax and debt plan will attempt to focus on ten year plans reminiscent of the Bush era and that the notion of a ‘border adjustment tax’, which would have penalised imports, has been dropped as unworkable.

In Europe, France will need to sustain traction in reform and co-ordinate with Germany towards a tighter fiscal union. The latter issue will come after the German elections on 24 September and depend on the makeup of the coalition government. Meanwhile, China with its National Congress in November, will have to convince financial markets it can manage its high private debt alongside its unremittingly high growth ambitions.

As we have noted, economic growth and investment markets are not well correlated. But the outlook paints a picture where corporate profit levels can be sustained and valuation becomes the key decision.

We commented on the sharp move in the AUD in previous weeks. To surmise, it’s all the USD’s fault, reflecting the sharp change in consensus from earlier this year. The US did not move into a new growth phase, Europe did not collapse, rates did not move more than expected, commodity prices recovered and global trade had a decent bounce. Within the financial sector, bond buyers have embraced the Australian market for positive yield and easing regulatory restraints on US banks has added US dollars into the system.

The view is still that the AUD will cap out at around these levels against the USD, while the fair value rate has nudged up to the mid from the low 70c range given the now slightly-hawkish RBA and a vastly improved current account. The assumption is that the rise in US rates will do the trick. It is often said that currency forecasts are there to make a fool of market; if it happens again now, it won’t be the first time

Fixed Income Update

- The local bond market digests the CPI figures, the speech by the RBA Governor Lowe and the US Federal reserve banks rate decision.

- ANZ make an announcement regarding its outstanding ANZPC hybrid security.

- A new style of bond, targeting investors with a social and or environmental conscious gains traction in June.

Despite the potential for some market moves this week, Australian bond prices were relatively stable with yields on the long end unchanged while slightly lower on the 3-5-year part of the curve. The release of the CPI figures, the speech by RBA Governor Lowe and the FOMC rates decision failed to move the domestic bond market.

The FOMC kept rates on hold, but the accompanying statement talked to the gradual normalisation of rates and the expected reduction in the Fed’s balance sheet. Despite expectations of more rate rises, the market interpreted this as somewhat dovish and a rates rally followed though once again the magnitude was small.

This week ANZ announced it is considering a buyback of the ANZPCs with a call date of 1 Sept 2017. Below is an extract from the announcement, with a final decision to be made after the 15 August. 

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The last few years has seen the rise of new styles of bonds that link the proceeds to environmental and socially responsible investments. The best known are issuers of ‘green bonds’ raising money for varied environmental projects, for example, wind farms or low pollution factories. The issuers include banks, corporates, government entities and religious institutions.

In the same vein, there have been some other additions to the bond market. In the second quarter of 2017 growth in the number of ‘social bonds’ more than doubled over 2016. These types of bonds fund social issues, including crime prevention, the supply of clean water, homelessness, access to education and helping disadvantaged children. The cash flow to support the yield and principle repayment is commonly from a government or such organisation that believes it will save money overall if the incentive is changed to meeting the obligation.

Social bond issuance

Source: Dealogic, Financial Times
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While the market is still small for these style bonds, further growth is predicted. The benefits for issuers is that it enables them to reach new investors specifically those with a mandate for a socially responsible overlay. However, while the funding costs often comes into line with the issuers’ normal cost of funds, there is the pressure of ensuring the funds performs according to that mandate. Detailed financial monitoring and reporting on the projects is expected adding to the cost of the security. As the market grows, the expectation is that a standardised reporting system will develop. Last month, the International Capital Market Association launched a set of social bond principles aiming to ease the work for individual issuers and give greater comfort to investors, opening up these new style bonds to market scale.

A variation on the social bond, the end of June marked the launch of the first-ever pandemic bond by the World Bank raising $322m across two securities. The structure of these 3-year bonds are such that investors will receive a regular coupon unless a catastrophic infectious disease takes hold, in which case the bondholder will lose some capital. The larger bond covers pandemic influenza and diseases such as SARS and is priced at US Libor + 6.5%, while the second bond paid Libor + 11.1% to cover viruses such as Ebola and several types of fever. Both bonds were said to be more than twice oversubscribed and priced tighter than the initial indication.

Corporate Comments

- Macquarie’s (MQG) quarterly trading update had few surprises, with guidance unchanged despite an increasing tax burden.

- Earnings trends have been softer into upcoming reporting season. Double digit earnings growth will be largely driven by a sharp rebound across the resources sector.

Macquarie Group (MQG) provided its usual quarterly trading update at its AGM, with no change to the company’s guidance to profit for FY18 to be “broadly in line” with FY17. Presently, MQG’s guidance is consistent with the market’s expectations, which has assumed flat year on year earnings. This has followed several years of fairly strong profit growth, indicating that FY18 will be a year of consolidation.

Notably, MQG’s guidance is inclusive of the impact of the recently announced bank levy, with MQG among the five banks that will be affected by the new tax. MQG has estimated the annualised cost of the new tax at $66m pre-tax based on its FY17 profit, which equates to approximately 2% of its total earnings base. As guidance maintained despite this, the update was judged as incrementally positive.

MQG is also subject to APRA’s new capital requirements, which we discussed in last week’s publication. The bank is in a strong position, with a CET1 ratio of 10.9% as at 30 June, above the new minimum requirement.

On the outlook and first quarter trading, MQG reported that the first quarter was stronger than last year. The group’s annuity-style business (representing 70% of earnings) have performed well, although performance fees (typically variable from year to year) are down. The capital markets facing businesses (30% of earnings), leveraged to cyclical factors, have seen improved trading conditions.

We have held MQG in our model equity portfolio as an alternative to a large weighting in the domestic banks, which face a greater number of headwinds. After strong share price rally in the last 18 months, coupled with a tapering earnings profile, there is arguably now less upside, with the stock now trading close to its average P/E multiple of recent years. Should the $A retrace back to its previous trading range, however, MQG stands to be a beneficiary of this call, given almost two thirds of its income sourced offshore.

Individual market news was otherwise rather limited this week, in what is typically a quieter period in the lead up to full year reporting season. The Australian market has navigated through earnings ‘confession’ season (the period of May to July when companies often revise their guidance) relatively well this year, with fewer downgrades across the period compared to recent years. June saw a slight uptick in updates, although this included a few announcements that were instead upgrades, including IAG and Flight Centre.

FY17 is expected to show relatively healthy year on year earnings growth in the mid-teens range. The headline number does include a significant rebound in resources profits, forecast to approximately double. The turnaround in this sector has merely offset some of the decline from prior years after a multi-year fall triggered by excess supply and poor capital allocation decision that resulted in large write-offs.

Excluding resources, profit growth across the rest of the market should be around 5%, an improvement on the slight decline recorded in FY16, although a below-par outcome.

Dividend growth across the market is likely to be fairly muted, acknowledging a prevailing high payout ratio across most companies. Again, the upside is expected to come from resources, only 12 months after the knife had been taken to dividends that were unsustainable.

Forward earnings trends across the three key sectors of the market – industrials, banks and resources – shows that a cautious approach is warranted. The chart illustrates that the uplift that was sustained until the March quarter has since faded. Resources earnings are now forecast to decline through FY18, while the negative direction for banks reflects the introduction of new taxes and a regulation-driven slowdown.

Change in Forward Earnings Growth by Sector

Source: Bloomberg, Escala Partners
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Industrials, too, are expected to face additional headwinds into FY18, with retail and housing-related companies potentially most at risk. If the recent $A strength is sustained, then this will pose an additional risk to earnings estimates for some stocks and sectors. Healthcare is an obvious casualty – the decline from $US parity a number of years ago has, until this year, been a major positive driver for translated earnings. The upside potentially resides with companies that can leverage a pick-up in government infrastructure spending, although gaining a clear exposure to this thematic through individual stocks is somewhat problematic.

A trickle of companies kick off reporting season next week and the bulk of companies scheduled to release results in the second half of the month. Next week’s expected results days are as follows:

Monday: Northern Star

Tuesday: Credit Corp, Navitas

Wednesday: Resmed, Seven West Media, Rio Tinto

Thursday: Seven Group Holdings, Downer EDI, Suncorp

Friday: Tabcorp, Crown Resorts

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