Week Ending 28.10.2016
• Inflation was up at headline level, though in line on RBA preferred measure. The trend however points to incremental rises into 2017.
• Canada is leading the way on fiscal expansion and may be the base case for evidence this will prove fruitful.
• China’s property market is once again causing concerns. A complex interlinked set of political and economic issues will feature for the coming year.
No economic data is ever as simple as it seems. The headline CPI for the September quarter was stronger than the market consensus at 1.3% (versus an expectation of 1.1%), however the trimmed mean and weighted median were exactly in line. The latter measures attempt to soften the impact from some of the big outliers and seasonal trends.
The table shows most (not all) inputs to the CPI, highlighting the three sectors of greatest rises and falls. Given their volatility, fruit, veg and fuel is usually excluded from the analysis of underlying CPI. A notable feature is that the fall in the AUD has not yet come through in higher import prices. Conversely, most service costs are rising at well above the average. Consumers all live within their own inflationary circumstances, depending on their lifestyle and family structure. Anti-media, bike riding, property owning, vegetarian parents would be faced with a CPI of over 5%.
The underlying CPI is likely to be range bound while wage growth is subdued. Given the latest trends in employment, it is unlikely labour costs will come under pressure in the near term. Import prices may well capitulate to the lower AUD, however there appears to be some implicit alignment to the currency of the country of origin rather the habitual USD. Fuel costs will have a big impact on the headline CPI into 2017 as the fall in oil prices passes through.
The immediate reaction was that a rate cut on Cup day is less than likely, indeed many are reverting to the view that no further rate changes will come through without some additional trigger.
Canada rarely gets much attention in the economic world, yet given some similarity to Australia, it is worthy of comment. Recently, in an effort to lift growth and compensate for the slowdown from commodity investment (the oil sector has been at the heart of a substantial drop in economic activity), the government announced a large infrastructure programme. In turn, that will result in a higher deficit, though its debt/GDP of 94% is middle of the pack in today’s world. The impact of this programme will therefore already be in the making if and when other countries choose to follow suit.
The Bank of Canada (BoC) has sat on an official rate of 0.5% for more than a year, but even now is biased to easing. In a similar way to which the Reserve Bank of New Zealand treats Auckland different to other regions, housing has been impacted by specific measures to address the Vancouver market. Canadian inflation is middle of the road at 1.5%, yet its low GDP, expected to be only 1% for 2016, requires attention. With the infrastructure programme, alongside a child benefit payment, the BoC believes 2% GDP growth is achievable in 2017. Australia’s GDP growth is a step above and if a parallel is drawn, the case for easing here is weak.
China is back in the headlines with persistent concerns about the growth of its private sector debt. On the corporate side, this is partly being dealt with through the emergence of a local bond market, though it is likely to take years for the credit rating structure to be fully formalised. Some express concern that the default process is yet to be tested within the legal system.
But, as elsewhere, it is housing that is attracting the most attention. Mortgage loan growth has shot up, though the focus is very much on tier one and two cities where demand remains high compared to the previous cycle of excess supply in marginal cities.
The government has put in place a number of measures to reign in the property market. Tighter control of developer finance, higher down payments from buyers and restricting the number of purchases by each family unit has started to reduce the pressure. Once again, China faces the same issue as in many other countries in that it wants to temper housing, but not the other parts of the credit cycle, particularly business lending. Within the political and economic cycle, economists are suggesting China will tighten its monetary policy by mid next year, subject to conditions at the time.
The reform agenda will then come to the fore, with the important handover of political power in the top echelon. Balancing the requirement for stable employment with social improvements in health, pensions and pollution control, encouraging a shift upwards in technology and keeping the workhorse of infrastructure productive within the diversity and size of China is arguably the most complex task of any government at this time. As an article in The Economist pointed out this past week, the uneasy relationship between central authorities and local governments only adds to the challenge.
Fixed Income Update
In this follow on from last week’s publication, we discuss:
• The change in the shape of the Australian yield curve and the impact for investors;
• The recent fall in volatility for US treasurys
• New bond issuance in global markets
Bonds are little changed over the week, with the market finally taking a breather from the significant spike in yields over the last 8 weeks. The week began with yields softer (prices higher), however, the higher than expected CPI figures retraced those gains.
We have previously discussed the steepening of the yield curve in Europe, the US and Japan. The cause is a combination of ‘yield targeting’ (in the case of Japan), likely interest rates rise (the US) and embarking on fiscal stimulus (England and Japan). However, in the last two months the Australian government bond yield curve has outpaced its global peers (in terms of basis point moves) with the curve shifting up and becoming steeper (particularly in two to five year maturities). In addition, it has extended out following the issue of an inaugural Australian Commonwealth Government Bond (ACGB) with a 30 year maturity.
Australian Yield Curve Change - Last Two Months
While the main driver has come from offshore trends, the outlook for further rate cuts by the RBA is diminishing, adding to the momentum. For investors of fixed rate bonds, this translates to a downward revaluation in the price of bond holdings, but for portfolios and fixed income funds with cash to deploy, the higher yields are welcomed, as the steepness of the curve gives funds the ability to pick up carry as the bonds ‘roll down the curve’. Floating rate notes (e.g. bank hybrids) will be broadly unchanged, as the BBSW rate has only shifted marginally, although the recent spread tightening in credit sectors (because of some of these factors) has aided valuations.
In addition to the aforementioned movements, the US election is looming. Despite all of this, the one month implied volatility for US treasuries (US Government bonds) has fallen to its lowest level since December 2014, as measured by the Bank of America MOVE Index. Whether this is a function of central banks keeping volatility low, or a ‘wait and see’ situation for markets given the upcoming election, is yet to be judged.
Bank of America MOVE 3 Month Index
In terms of supply, there has also been a slowdown in bond issuance in October. Just $49bn of new bond sales have been completed in the US, Eurozone and the UK, a drop from the $89bn of debt sold in the same period last year. The slowdown comes in what has otherwise been the best year for corporate bond deals in almost a decade, with more than $2tn of debt sold this year as companies lock in record-low borrowing costs.
This week saw Austria join in the growing trend of issuing long-dated bonds, with a 70 year, 1.5% bond raised this week. This follows issuance by the governments of France, Belgium, Spain and Italy, which have collectively raised €14bn of 50-year debt this year, and two 100-year bonds by Belgium and Ireland. It indicates that investors are expecting low inflation for a very long time, with the 1.5% yield below the European Central Bank’s long term target for inflation.
• National Australia Bank (NAB) marginally beat consensus expectations, with the bank holding its dividend after it was able to improve its capital position.
• Macquarie Group’s (MQG) first half was strong considering that the bank was cycling a strong comparable six month period.
• AGMs and trading updates again surprised on the downside, with AMP the highest profile casualty today.
• Sales figures from Wesfarmers (WES) and Woolworths (WOW) highlighted the high competition in the supermarket sector.
• JB Hi-Fi (JBH) again reported solid sales numbers, although the challenge ahead for the company is the integration of The Good Guys stores.
National Australia Bank (NAB) kicked off the banking reporting season with its first results following the various divestments it has made over the last 18 months, including the headache that was its UK Clydesdale operations. Cash earnings growth of 4% was viewed as a good outcome and delivered on the market’s expectations, however, a decline in earnings per share of 4% was less impressive. Much of the focus, however, was on whether or not NAB would hold its dividend, with some pressure to do so given benign credit growth, a high current payout ratio and ongoing regulatory pressure to hold additional capital. In the end, it was stronger organic capital generation that allowed the bank to sustain the current dividend payout for the six month period, thus ensuring that the discussion over dividend sustainability for the company will continue into next year.
Of NAB’s result, there were the usual positives and negatives to be gleaned from the numbers. The positives included the better outcome on the group’s capital position; a solid performance on bad debts (with a charge of 16bp for the year); an improving business bank result; and a surprise fall in the bank’s cost base, with costs falling 2% for the half. Rising costs has been a challenge for the sector, particularly from technology and compliance-related expenses over the last decade. A move to capitalise some of this investment spend instead of expensing (effectively delaying the flow through the profit and loss statement) meant that the sustainability of falling expenses has been met with some healthy scepticism.
Among the key negative points was ongoing relatively benign revenue growth of just 2.5% and a flat outcome in the second half. A competitive environment and rising funding costs have not helped, with net interest margins down slightly for the year. As illustrated in the following chart, however, some of these funding pressures have been receding in recent months.
Banking Funding Costs
The outlook for the banks still remains relatively soft and there is still a number of risks over the next few years. The possibility of a higher regulatory capital impost is still in the picture and for NAB, an increase in bad debts to levels of its peers could also pose problems. In the short term, however, the banks may continue to benefit from investors seeking yield, with the rotation out of so-called ‘bond proxies’ (REITs, utilities, infrastructure) continuing over recent weeks.
Macquarie Bank (MQG) also operates on the same financial reporting periods as the banks and posted a solid first half result today. While earnings were down slightly for the half, a 19% lift in the group’s dividend was a positive surprise. Despite the increase, the 62% dividend payout ratio for the group is at the low end of its targeted range.
As usual, there were several moving parts to MQG’s result. The period included a much lower contribution from performance fees in its infrastructure funds and a drop in interest and trading income in its securities division, however was boosted by falling impairments and a significant gain on the disposal of its risk insurance business.
On balance, MQG’s annuity-style businesses (which represent approximately 70% of group earnings) have continued to perform well, while the more cyclical capital markets facing divisions have lagged. While the best of the company’s earnings upgrade cycle that it experienced over the last four years may be behind it, the lift in its annuity earnings base, level of international earnings and reasonable valuation make it a good diversifying option in the financials sector.
AGMs through this week again provided further trading updates from a range of companies, which on average were somewhat weaker than expectations.
- An update from Bega Cheese (BGA) reminded the market of the regulatory risks for the several stocks that are looking to tap into the large opportunity that is the food export market to China. BGA has partnered with Blackmores (BKL), the glamour stock of the market in 2015 (and has since suffered a halving in its share price this year), to develop and manufacture nutritional foods, including infant formula. BGA this week warned investors that sales had been weaker than expected, blaming a tightening in Chinese import restrictions earlier this year. In hindsight, the update was maybe not overly surprising given that BKL had made similar comments two months ago (which were reiterated at its own AGM this week). The valuations across this theme have become much more reasonable since the beginning of the year, reflecting a more appropriate pricing of risk, although there remains some near-term uncertainty.
Forward P/E of Food Companies
- Star Entertainment’s (SGR) first quarter update was softer than anticipated, although notably the company was cycling a particularly strong quarter from last year and the business has faced capital works disruptions in its Gold Coast and Sydney casinos. In light of the recent news regarding the detainment of employees from Crown Resorts (CWN) in China, SGR confirmed that its VIP high roller business accounted for 16% of total EBITDA in FY16 and had shown ‘satisfactory’ volumes in the first few months of FY17. We believe that the recent fall in SGR’s share price following the CWN news implies an overly pessimistic outcome for its VIP business.
- Regis Healthcare (REG) reaffirmed its guidance for EBITDA growth of at least 15% for the year and that there will be minimal earnings impact from the Federal Government’s changes to residential aged care funding. Following similar comments from Japara Healthcare (JHC) last week, the issues behind the recent downgrade from Estia Health (EHE) appear to be company-specific.
- An update from AMP saw the stock sell off after it reported another deterioration in its life insurance business. The division has been problematic for AMP for several years and had, until recent, shown signs of stabilisation. Ominously, AMP referred to the issues as “structural in nature”, with actual claims experience continuing to run ahead of estimates. In response, AMP is introducing a new reinsurance arrangement to lift its coverage, although this transition will take time to implement. Unfortunately for AMP, uncertainty in superannuation legislation contributed to net cash outflows in its wealth management division, which has been the core driver of the group’s profitability.
Wesfarmers' (WES) share price took a hit as the first quarter sales results brought home the degree of competition in food retailing. Even in its other businesses, the trends indicate that cycling the high comp store growth of recent years is becoming difficult. The Coles supermarket data was the focus. The group suggests food deflation has eased (in line with the CPI highlighted earlier) yet the overall low rate of food inflation suggests that packaged grocery prices are hardly moving. The bigger issue for Coles is that the low comp shows that real revenue growth (comp store plus deflation) has taken a measurable step back. Some of the fall may be due to one-off factors, such as the strike at the Victorian distribution centres in July and a slow start to seasonal summer fruit due to weather conditions. However, the past pattern has been broken, with a higher level of uncertainty to weigh on sentiment.
Wesfarmers 1Q Retail Sales
While the outcome for Bunnings may have been affected by the closure of Masters and its inventory realisation, there is the looming potential that Bunnings comps will ease off as the housing cycle runs its course.
In the now-combined department store business segment, evidence that Wesfarmers can get acceptable growth from both Kmart and Target remains to be proven and should not ignore the attempt to regenerate Big W as well. We argue that this discount store format is overcrowded, given the changing offer in retailing today. Even within the category, the range is being curtailed. Target has experienced a 10% loss in revenue from removal of its toy sale without any sign that other products can fill the gap.
A ‘less bad’ Woolworths and persistent Aldi points to a tough time for supermarket sales. Cost leverage therefore implies flat margins at best. Any further price pressure will spell trouble. Unhelpfully, WES management also guided investors to a breakeven first half result from its resource division, notwithstanding the rise in coal prices.
The market voted with its feet and the share price fell 9% this week. The stock now trades on a mid-17X P/E for 2017 with a 5% franked yield. Given the P/E is still relatively elevated, there has to be some confidence in the yield. The high payout of near 90% is partially supported by dividend reinvestment and if any of the businesses requires cash flow support, even this may be compromised.
Woolworths’ (WOW) sales figures did support the contention that its supermarket business has bottomed in terms of sales, though there will need to be evidence of the degree of damage to margins before the base is set. The group reported comp store growth of 0.7% for the first quarter of FY17, but with a messy mix comprising of a rise in the number of transactions offset by fewer items in the basket. Surprisingly, WOW claimed fresh food deflation, in sharp contrast to the CPI data. WOW’s liquor sales growth eased back as this sector matures and market shares settle down.
Management is coy about the outlook, stating the obvious that the Christmas season will determine the profit for the half year. Only then is it likely profit forecasts can be made with higher certainty, given the risk that margins can yet prove worse than expected.
JB Hi Fi (JBH) gave a better tone to retailing at its AGM, with 8.3% comp growth in the first quarter. The company has been the star of the sector this year, but with the integration of The Good Guys ahead and possible moderation of demand, the market seems comfortable to let the stock mark time for the moment.