Week Ending 29.09.2017
- European PMI Indices were strong again in September, leading to further confidence for a solid GDP print.
- Germany’s election result over the weekend will challenge future reform in the euro area.
- Solid domestic employment data continued this week with the release of job vacancies for the August quarter.
The release of the Eurozone Purchasing Manager Index (PMI) for September supported the notion that the region’s economic growth momentum will continue into the fourth quarter of the year. PMIs are typically used as a leading indicator of GDP growth and are constructed based on survey responses about business activity levels from a broad selection of companies. A reading above 50 is typically a sign of economic expansion.
The September PMI readings for manufacturing and services both rose, also leading to an increase in the composite index, which was much better than expectations of a fall. It has been the manufacturing sector which has been the primary driver of the Eurozone recovery, with this sub index at a six year high. Manufacturing has defied expectations of a potential slowdown as a result of the appreciating euro through this year, although this was cited as a concern among manufacturers.
Markit Eurozone Manufacturing PMI
Geographically, the two core economies of Germany and France were the key contributors to the rise in the composite PMI, with both countries recording impressive increases. The rest of the euro ticked down slightly although remained close to the average of this year. Also within the data was pricing indexes, which showed a lift in input and output prices, a reversal of the more recent trend. However, further evidence of this becoming more established is a likely prerequisite for the ECB to become more hawkish on its tapering intentions.
The outcome of Germany’s election last weekend was poor for investors hoping for a higher degree of euro integration. While Merkel’s CDU party suffered a sharp drop in its vote compared to 2013, the centre-left SPD opposition party did likewise. The SPD leader subsequently has ruled out forming a ‘grand coalition’ with the CDU, which has been the basis for German government for eight of the last 12 years.
Germany: Vote of Major Parties
With the CDU’s reduced vote, it will now require the support of two of the minor parties to form a coalition government. The most probable scenario appears to be an alliance forming with the Free Democratic Party (FDP) and Die Grünen (the Greens), the so-called ‘Jamaica coalition’ given the respective colours of the parties are the same as that country’s flag.
With FDP policies including support of Grexit and limiting euro area fiscal integration, further reforms that have been proposed by Merkel appear to be less likely. Additionally, the entry of the far-right AfD party into the Bundestag for the first time will also broaden the political debate.
The most immediate impact has already been noticeable in currency markets, with the euro falling 2% since the weekend, although the uncertainty could persist for several weeks as negotiations take place.
Domestically, economic news was light again this week. Job vacancies posted a fifth consecutive rise in the August quarter, which has corresponded with the recent strong run in employment growth. In a sign that conditions may be improving in mining-exposed regions, Queensland and WA were among the highest growing for job vacancies for the quarter.
Fixed Income Update
- Yields remain at two-month highs as the likelihood of a US rate rise in December gains traction.
- Central bank is activity expected to set the scene for the next quarter, with tightening monetary conditions in America and Europe.
- “Winners rotate” in fixed income sectors. With 37 years between a premiership win for the Tigers and 19 years for Adelaide, one is destined to rotate to the top.
Bond yields remain at their highs of the last two months. Rates sold off leading into the Federal Reserve meeting last week and have been trading in a tight range following. Yields were softer at the beginning of the week as geo-political concerns made headlines again. Offsetting this, has been upward movements in response to speeches by Federal Reserve members, including Janet Yellen. The tone from the speakers remain hawkish with comments including:
- That inflation trends are expected to be transitory and that the Fed can continue to withdraw stimulus, although at a cautious pace.
- That policymakers need to be careful of “moving too gradually” on monetary policy despite “significant uncertainties” over inflation.
- Caution against waiting too long to raise interest rates again, indicating that another rate rise may be on the cards before the end of 2017.
The futures market has increased the probability of a US rate rise in December, now priced at 68% up from 63% last week. The short-dated T-bill strip has shifted upwards to reflect this change.
Movement in short dated US treasury bills over the month
There is a lot of Central bank activity globally at present and coming up over the next month, in what is looking like a co-ordinated approach to tightening of monetary conditions.
- The US Federal Reserve Bank – likely to raise rates in December and begin tapering their balance sheet in October, albeit at a gradual pace.
- The Bank of England – recent hawkish rhetoric, with a reversal of the post-Brexit rate cut a strong possibility, perhaps as early as November.
- The Bank of Canada – meeting on October 26th, in which they may undertake their 3rd rate hike.
- The European Central Bank – at their next meeting on October 26th the governing council expected to communicate the next round of QE tapering from early 2018.
Diversification across fixed income sectors is recommended as ‘winners rotate’. While investors are often tempted to buy into sectors following a successful year, this instead is potentially the best time to sell and take profit and re-allocate into underperforming asset classes. While this is one theory, picking the timing of outperformance is always a challenge, supporting the benefits of diversification.
Like fixed income, the AFL teams’ finishing positions also rotate each year. Time for the Tigers to rotate into the winning position?
Fixed Income Sector Returns and AFL Team Finishing Positions
- Premier Investments (PMV) has spruiked its growth strategy with its full year results, however its more mature brands are struggling to match the performance of Smiggle and Peter Alexander.
- The major banks are expected to have little earnings impact from the decision to remove foreign bank ATM fees, although political pressure remains on the sector.
- Origin Energy (ORG) has divested its unconventional oil and gas business. Further restructure is an option for the company to realise value.
Premier Investments (PMV) has been a favoured stock for analysts covering the retail sector. The stock was marked down, however, following the release of its full year results, which showed a 6% increase in underlying profit, while shareholders were rewarded with a 10% rise in dividends. More media attention was generated on its intentions with regards to Myer (MYR), of which it acquired an 11% stake earlier this year.
Much of the company’s focus has been on its two key brands which cover the diverse markets of stationery and sleepwear – Smiggle and Peter Alexander – which again recorded solid growth figures, underpinned by new store openings. Smiggle, in particular, is undertaking an ambitious store rollout strategy that involves expansion of its UK base and, more recently, into new European and Asian countries, with a $400m sales target by FY20. Peter Alexander is confined to Australia and New Zealand, although similarly has plans to expand its store numbers by more than a third in the next three years.
Smiggle Sales and Store Growth
While there is a positive story to tell in PMV’s success with these two brands, much of its core portfolio again posted weaker results, with negative like for like sales across a number of these more mature divisions (which include Portmans, Just Jeans, Jay Jays, Dotti and Jacqui E), limiting total group like for like sales growth to just 1%. The issues facing these stores are a mix of cyclical (weak retail environment with subdued wages growth and poor consumer sentiment) and structural (increasing competition from international retailers entering the Australian market and online) in nature and managing their recent decline is the challenge for management. The decision to close their flagship Just Jeans and Portmans stores in Bourke Street Mall next month is reflective of the widening expectations of landlords and tenants in this environment. A turnaround or stabilisation in this core portfolio is likely a hurdle for investors to take a more positive view on the stock.
The decision by the major banks over the last weekend to abolish ATM withdrawal fees for customers from rival banks is the latest example of their efforts to improve their image given the higher level of political scrutiny the sector has been facing.
For several reasons, the move could cynically be viewed as an easy option to improve the perception of the industry. First and foremost is the fact that ATM cash withdrawals in Australia have now been declining every year for the last five years (a fall of close to 30% from their peak) as consumers increasingly switch to other forms of payment. As such, while there will be an expected earnings impact (potentially up to 0.5% of overall bank profits), this source of revenue was already in decline because of the trend.
Additionally, there will now be less incentive for the majors to maintain a superior ATM network to their peers, thus likely resulting in an ongoing saving in capital investment. Nonetheless, in the short term it will add to other politically-driven decisions that are affecting the sector, including the new bank levy.
ATM Withdrawals in Australia
Origin Energy (ORG) announced that it had agreed to sell its conventional upstream oil and gas business, Lattice Energy, to Beach Energy for $1.6bn. The intention to divest the assets was flagged to the market late last year, although what was unknown was whether it was going to proceed as a trade sale or via an IPO process.
The price that ORG achieved was in line with expectations and, unsurprisingly, will be used to strengthen the group’s balance sheet. The decision is potentially the first step in what would be a much more significant asset split. This would separate its interest in APLNG from its domestic integrated energy business; a compelling argument can be put forward due to the discount that ORG currently trades to its nearest listed competitor AGL Energy. A further period of balance sheet consolidation is more likely on the cards before this prospect is considered.