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WEEKEND LADDER

A summary of the week’s results

28.09.2018

Week Ending 28.09.2018

Eco Blog

· Japanese economic growth is far from embarrassing. The industrial sector is holding up and tourism is a new growth industry. The equity market is considered good value as more Japanese corporations improve their governance.

· Brazil is approaching a critical election. The equity market is doing relatively well given the challenges.

· The US mid-terms may have market related implications. There are signs the USD strength is waning which would support the performance of other regions

If Australian investors are heartily tired of politics, chin up, there is more to come.

Earlier this month Japan’s Liberal Democratic Party re-elected PM Abe for a third term. If he remains in place until the year-end he will be the second longest serving PM since Katsura (who ruled from 1901 to 1913). More important is his agenda. Politically he has indicated his desire to renew the 1947 constitution to refine the clause on a defence force, in part also seen as an expression of the changing relationship with the US.

Economically, he may revisit the ‘three arrow’ plan of monetary stimulus, fiscal support and reform. The monetary position is expected to remain in place, though the stated aim of 2% inflation is unlikely to be a major focus as the CPI sits at 1%. On the fiscal side there are outstanding changes to tax via a rise in the GST, partly to fund early childhood education. Similarly, to encourage more Japanese to enter or stay in the labour market, the working age for private sector workers may be raised to 70 and the mandatory retirement age for the public sector lifted from 60 to 65.

The repercussions of the trade spat are already evident in data. This week, the Machine Tool Builders Association reported total orders up 5.1% yoy to the end of August. Domestic orders were particularly strong at +20.5%, driven by auto and industrial machinery. Conversely, overseas orders fell by 4.6%, entirely due to the collapse of smart phone related equipment, while those for other products to Europe and the US remained strong. Overall economic growth is expected to be slightly above 1% in the coming year. This is not a particularly notable number, yet it is in the context of a falling working age population and persistent low inflation. The number of people considered as of working age – 15 to 65 – has fallen from its peak of 87m in 1995 to 74m today.

Japan GDP

Source: Focus Economics
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A key feature of recent years has been the major increase in inbound tourism. Notwithstanding the disruption from storms that closed Kansai airport, foreign visitor numbers are up 13% calendar year to date and likely to annualise at 30m. Asia dominates at 86% of the tourists. Shopping is therefore a major activity, with retailers reporting 30% increases in tax free sales.

From an investment point of view, Japan has provided Australian investors with a decent return. It is important to note the underlying index. While the Nikkei is often cited, this price weighted index is rarely the benchmark, given it does not adjust for free float (important when there are many large shareholders that limit liquidity) and stock weights can move in big swings based on the share price. The Topix is the appropriate local index and is relatively similar to the MSCI Japan that form the basis for global investors.

- Over the past year, the Topix is up 9% and the fall in the AUD/JPY rate has added 8% to local returns. The index is broadly spread, with industrials at 21%, consumer discretionary at 20% and information technology at 13%. Toyota is the largest weight at 4.3%, followed by Mitsubishi Financial at 1.9%. We recommend a modest allocation to Japan via the Platinum Japan Fund. While it has lagged the index in the past few months, its long term track record is strong. The index P/E is approximately 13X and the yield is a respectable 2%; a function of the slow but steady progress towards improving capital management.

Off the radar is Brazil, where the electorate face a somewhat unpalatable array of policies for the October 7 election. The battle grounds are on the future of state enterprises, such as the state banks and Petrobras, pension reform and dealing with the fiscal deficit. While the economy has some obvious weaknesses, it has, along with most emerging economies, a much-improved outlook compared to ten years ago. The sovereign debt position is solid and overall debt levels are relatively contained. In 2002, 41% of debt was linked to the exchange rate; today the figure is only 8%.

Brazil is not alone in facing a pension system that cannot be sustained, yet it is politically difficult to change.

Brazilian Budget Expenditures

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For a population of 212m and a country with endowed natural resources, Brazil joins many others in South America as failing to live up to its potential. GDP growth is expected to be soft this year at 1.4%, recovering from a deep recession in 2015/14, while some forecast a rise to the 2.5% range for the coming few years. On a positive note, inflation is reasonably contained at 4% and the official interest rate (Selic) at 6.5% has been stable.

This paints a somewhat gloomy picture, yet within the emerging markets (EM) index, Brazil is outperforming, a reminder that the domestic economy does not necessarily match the equity market. The Brazilian Bovespa index is flat year to date against the negative performance from the broader EM index.

- For global investors, Vale is an alternative to BHP and RIO as an exposure to iron ore. Brazilian banks are also in portfolios, as they are deposit funded and tend to conservative lending standards. Ambev is an America-wide beverage company with a solid record. The country has a 6% weight in the EM index.

Last, but not least, is the US mid terms set for 6 November. From an economic point of view, it will matter in terms of the likely policy initiatives in the second half of the term for this administration. If the Republicans hold the House of Reps and the Senate, more of the same is probable, though there are not a lot of new items on the agenda. An emboldened trade initiative may follow.

If the Democrats gain the House (highly unlikely to get across the line for the majority in the Senate) the trade policy may be watered down, particularly if pro-market Republicans then feel more comfortable to challenge the current direction. There is general agreement amongst observers that an infrastructure spending burst is unlikely due to the growing deficit. Few deny that the US is in dire need of infrastructure renewal. So far, there has been a reluctance to move to private partnerships and much of the required spending (road, bridge and local infrastructure) would not lend itself to private ownership. While possibly self-serving, the Department of Transport assess 25% of US bridges as obsolete.

Source: ASCE Infrastructure Report
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Ironically, given the boost from the tax cuts, the economy does not need further stimulus. More spending would lead to higher interest rates and hasten the inevitable retracement.

- The mid-term elections have taken on a heightened importance for investment markets.  We would expect little from the S&P until after the event. The direction of the USD is key and many forex commentators do believe it is set for a period of softness given overextended positioning. That, in turn, would be helpful to turn around the underperformance of non-US markets.

Focus on ETFs

· Index providers are undertaking a major sector reshuffle to reflect the evolution of the technology, media and consumer industries.

Three of the eleven equity sector classifications (GICS) have changed shape, with the telecommunications sector rebranded as communication services and now including companies from the consumer discretionary and information technology sectors.

Within the S&P500, the weighting of technology falls from 26% to 21%, while communication services and consumer discretionary will both encompass around 10%.

S&P 500 Sector Weights

Source: Bloomberg, Escala Partners
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Apart from a surge in trading volume, the S&P500 seemed to have gone through Friday’s rebalance unscathed. This is likely a result of pre-emptive moves since the February announcement where the required rebalancing within major ETF providers would have been designed to limit any impact.

However, there will be implications for investors following sector index ETFs as the nature of underlying assets, potential growth and dividend yield is likely to have changed.

The sector that went through the biggest overhaul was telecommunications. In its old form the sector consisted of 3 telecom companies. Now it has been expanded to include internet software and services, media and entertainment stocks. Over the past year, consumer discretionary and information technology have been the best performing sectors, having risen by over 30% compared to the S&P500’s 17%. Both these sectors benefited from the influence of a handful of companies that have transitioned to the communication services sector.

One Year Performance of Communication Services Companies Based on Previous Sector Designation

Source: Bloomberg, Escala Partners
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Growth names such as Alphabet (Google) and Facebook will make up 40% of communication services and will shift what was a traditional defensive play to a more cyclical sector, with a considerably different risk-return profile. These moves result in a major decline in the dividend yield of the former telecom sector, which, prior to the reshuffle, was yielding around 5.5%. Now with the high concentration towards tech companies that traditionally do not pay dividends, the yield is 1.7%. The valuation of the sector also rises significantly from a price/earnings ratio of 10.7x to 18x, similar to that of the S&P 500.

P/E Ratios of S&P 500 and Reshuffled Sectors

Source: Bloomberg, Escala Partners
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For Australian investors there are no locally listed sector-based ETFs that are affected by these changes. The only tech sector-based ETF listed on the ASX is ETFS Morningstar Global Technology ETF (TECH) that uses its own classifications, unaffected by the GICS changes. In the US, most investors are likely to move to Communication Services to retain a similar profile.

- Whilst the market was largely affected by Friday’s shifts, the MSCI is still to undergo its changes to global indexes. How investors now chose to express their views on tech related growth companies should become evident in flows over the coming weeks.

Fixed Income Update

· The Fed raised interest rates by 0.25% for the third time this year. Forward guidance from the Fed’s dot plots was unchanged

· A speech by the president of the ECB moves European bond yields higher.

· US high yield posts strong performance, as correlations break down between this sub sector and emerging market debt.

· Collingwood eye off the (equal) top spot on the permiership leaderboard, but will their statistical conversion rate prevent them from doing so?

The Fed’s September meeting was the focus this week. While the rate increase was fully priced in, it was the future path of interest rates that was in focus. The FOMC dot plots were unchanged with a fourth rate hike lined up this year and three more in 2019. US treasury auctions in the lead up to the meeting were met with lacklustre demand, as investors prefered to sit on the sidelines rather than buy fixed rate bonds. Two and five year notes were offering the highest yields in 10 years, but this failed to entice investor appetite. The $37bn two year bond at 2.829% had the lowest level of demand (as measured by the bid-to-cover ratio) since December 2008. The exception was the auction of a 2yr Floating Rate Note Treasury (where the coupon goes up with rising interest rates) which was well bid, with non-prime dealers taking 57.5%, the highest level in 10 months.

- The bond market is still underpricing the Fed projections (dot plots) for interest rates. The risk is therefore to an upward shift in the yield curve (a price fall of fixed rate bonds) if the Fed delivers on the pathway.

Across the pond, the president of the ECB, Mario Draghi, spoke in the European parliament, signalling that the central bank is confident of meeting its inflation target in the next few years given strength in the European jobs market.  This had markets predicting that the ECB would withdraw some of its stimulus, potentially ending its Quantitative Easing (QE) programme at the end of this year. Further, the probability of the ECB raising interest rates next year has increased, with bond futures assigning a 62% chance of this September next year, up from 47% earlier in the week.

Yields across Europe have subsequently lifted. The AAA rated German bond is perhaps the best reflection of central bank pricing given it doesn’t have any ‘credit’ priced in, unlike other countries in the region where political and economic woes have pushed out bond yields (eg Italy, Portugal). German bond prices have fallen across the curve, with the yield on the 5 year sovereign testing levels close to 0%. This bond yield rose above 0% for six weeks at the beginning of this year before falling back into negative territory and one would have to look to 2015 to see it hold a positive yield for a sustainable period.

Five Year German Bund Yields

Source: Iress, Escala Partners
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The tariff trade wars and strong USD, together with negative news out of Turkey, Argentina and Russia have caused Emerging Market debt and currencies to fall this year. Often correlated and vulnerable in a ‘risk off’ period are high yield bonds, which have broken this link in recent months. While the one year rolling returns are only slightly positive and the asset class has exhibited heightened levels of volatility, high yield has posted decent returns since the beginning of this financial year. Better than expected corporate earnings, a strong equity market and reduced supply have supported valuations. The global high yield index is up over 2% since the beginning of July (annualised at 8.5%), with September a strong contributor thus far.

US Global High Yield Index

Source: Iress, Escala Partners
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- For access to the high yield market, we recommend the JP Morgan Global Strategic Bond Fund. In a meeting this week with their London-based portfolio manager, they communicated conviction in an allocation to this sector within fixed income. They note strong fundamentals, good revenue growth, higher interest cover ratios, reduced leverage and low default rates to support valuations.      

Corporate Comments

· Nufarm (NUF) has been a victim of the Australian drought and a diversified geographic asset base failed to save it from a capital raising this week to repair its balance sheet.

· Sims Metal Management (SGM) became one of the first large cap companies to downgrade its guidance. While the cause may be somewhat temporary, risks remain from trade, tariffs and a weakening pricing market.

Agricultural chemicals group Nufarm (NUF) bowed to the pressure on its balance sheet, announcing an equity raising alongside its full year results. The equity raising has followed a difficult year with the drought in Australia (the driest autumn in 100 years and very dry winter on the east coast) impacting the company’s domestic business and triggering two profit warnings. Further share price pressure came from a successful lawsuit against competitor Monsanto that questioned the safety of the weedkiller glyphosate (this product represented 12% of NUF’s gross profit in FY18) and an EU ban introduced on a common insecticide due to the harm it was causing to bees.

Adding to investor concerns was volatility in currency markets (given the company’s exposure to Brazil and Argentina), issues posed by the introduction of US and Chinese tariffs, as well as trade developments following the upcoming Brexit.

NUF’s full year result was slightly below expectations, with the company’s underlying earnings declining 28% as higher interest costs detracted from an already weak operating profit. Several one-off items led to a reported loss for the 12 months, the most significant of which was an impairment of its Australian division.

The growth in the business was primarily across its international operations, with a solid result from Europe, North and Latin America, reflective of market share gains in these geographies. Earnings in Europe were further enhanced by recent acquisitions. However, while NUF was helped by its global diversification, its domestic result was still the significant drag on profit. The drought led to lower demand for crop protection, increased competition, high channel inventory levels and a more than halving of its EBITDA margin. The knock-on effect to its cash flow was even more visible, with a spike in working capital largely responsible for a net operating cash outflow for the year. 

Nufarm: Average Net Working Capital/Revenue

Source: Nufarm
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On the outlook for FY19, the company’s guidance is for limited relief from these ongoing headwinds, with only a ‘partial earnings recovery’ forecast in Australia. Reflecting the numerous short term risks, the stock is now trading at a reduced earnings multiple of 13X and a reasonable discount to its recent average of approximately 16X.

The numerous issues probably outweigh what could be an opportunity to gain exposure to a positive underlying long-term demand story for crop protection at a cyclical low point in the cycle. This is in addition to the optionality that exists in its portfolio, with products such as omega-3 canola adding to what has been an increasing proportion of sales from more valuable patented product. The weakness in NUF’s share price may also potentially open the door for M&A given the recent consolidation that has transpired in the sector and the more isolated nature of NUF’s key domestic market exposure.

Metals recycler Sims Metal Management (SGM) is another company that has come under a cloud following the rise in trade tensions throughout this year. The stock lost ground after downgrading its guidance for the first quarter less than a month after providing a forecast at its full year results; a conclusion that one could draw is that the business has limited visibility in its earnings.

The downgrade primarily related to its joint venture SA Recycling and the current weak zorba (an aluminum scrap metal) market conditions which have arisen as a result of China’s evolving environmental policy and the introduction of tariffs, which has impacted demand for lower grade products. While SGM is seen as a net beneficiary of such policies in the long term given its strategy and capability in upgrading its plants to extract higher margin products, this is a work in process and hence disruptive to earnings in the shorter term.

SGM has done a commendable job in recent years in lifting the returns on its business through a self-help program and has benefited from strong pricing, resulting in higher margins despite reduced volumes. A refreshed strategic review is imminent and comes at a time of increased trade uncertainty and potentially a peaking in scrap pricing in the current multi-year cycle. A relatively high fixed cost base could pose a challenge in this environment. In its defense is a solid balance sheet, with the company in a net cash position.

Sims Metal: Return on Capital

Source: Sims Metal
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