Week Ending 29.01.2016
With the headline inflation rate coming in at 2.1% for 2015, economists have turned to minutia in analysing possible trends. Tradeable goods inflation ticked up at year end, possibly indicating some flow through from the weaker AUD. Most services are achieving higher prices, led by childcare (+8.2% for the year), education (+5.5%), health (+5.3%) and property rates and services (+4.6%). These rising costs are likely to explain the relatively soft trends in household consumption, as most of the services are judged as ‘essentials’ rather than discretionary. Low food inflation, at only 0.4% for the year and falling fuel prices do not therefore translate into a perception of higher buying power.
Wage growth in the private sector is running at 2.1% (as at September 2015), the lowest since the measure began in 1997. This sits awkwardly with the high rise in services inflation as noted above, but can be explained by the rise in part time employment and sectors such as accommodation, retail and cafes. Implicitly, there is even more pressure on spending with low wages inadequate compensation for the structural rise in costs. The dispersion in segment inflation is unusually high. Using broadly defined categories there is around 9% inflation differential between the lowest and highest segments. Based on the past, one side will give – either low inflation goods prices will rise or high inflation services have to come down.
The release of RBA credit aggregates reminds one of the imbalance towards housing investment lending within the banking system. Based on the RBA data, which includes all lending institutions, 36% of outstanding credit is investor loans. In the UK, the Bank of England has worried about their proportionate share of 16%. Locally, the proportion of lending to business is down to 33%, implying there is better leveraged opportunities in passive housing assets rather than business growth. Few would argue that this outcome is productive for the economy.
The persistence of weak US manufacturing data is starting to trouble some economists. New orders for durable goods fell 5% in December, taking the overall year down 3.3%. The lumpy nature of transport numbers (essentially aircraft), which fell sharply, was not the only culprit. Electrical machinery and computer orders also declined in the month.
US Durable Goods
On the positive side, the household sector and employment appear largely untouched at this stage by any sense of gloom. For 2015, single family home sales were up 14.6% and prices a moderate 3.8%.
Currency markets remain tetchy, awkwardly balanced between the consensus trade of a strong USD, yet, as noted, a possibly fading US economic growth. Conversely, market commentators want to believe the ECB will deliver further easing at its next meeting in March, yet concede that European data, outside some weakness in the German export sector, has to date not been disappointing. In between the two sits the UK. A rate rise is lightly pencilled in for late this year or early next. Nonetheless, GBP is off sharply in recent weeks. The cause appears to lie with oil state money, often banked in the UK. Budget deficits are forcing these countries to realise financial assets. Further, the purchases of property assets by these nationalities has also taken a dip and therefore their buying of GBP to settle transactions is reduced. Adding to the pressure is China, which in part due to the legacy Hong Kong relationship, held a somewhat unusually high level of GBP bonds. The final nail is the ongoing relationship between oil prices and GBP, even though the fortunes of North Sea oil have long faded.
It paints a picture that exchange rates are not under control of the central banks to the extent that they would like. On the other hand, it has once again raised the issue that selling of bonds by foreigners may not be as disruptive as some predicted. Local demand appears to readily absorb the flows at this stage.
This year to date, the weakest currency against the USD has been the Mexican Peso, caught by its energy link and FX trader positioning to go long the USD/MXN as a way to express interest risk. With the economic data in Mexico improving, many are closing this position.
Currency Movements Versus USD Year to Date
These moves are a reminder that currencies, like most financial instruments, have many possible influences and accurate forecasts of cross rates are fraught with danger.
Fixed Income Update
Central banks had their day in the sun again this week. Following on from the ECB indicating that it may expand its quantitative easing program, Draghi pledged in a speech on Monday night that the bank would take necessary measures to strengthen their economies. The result was that short term German government yields hit new record lows, with German 2 year bunds (bonds) dropping to a low of -0.45%, while five-year yields hit -0.24%.
Negative yields, where investors pay governments to hold their money, have been a reality since the Eurozone crisis began. Investors rejected the idea of negative yields in April last year. However, rates are now even lower, with global turbulence and a flight of capital into safe haven assets such as bunds, together with continued stimulus by the ECB. The chart below depicts the yield on the 5 year German government bund over the last 12 months.
5 Year German Government Bund Yield
The Federal Reserve Bank was next, leaving rates on hold this month (as expected). Financial markets have been slowly pulling back pricing in future rate hikes, so the announcement was no surprise and the treasury market moved very little. The futures market is now only pricing in one rate hike by the Fed this year. The probability of a rate rise in March has fallen to 20% this week, down from 51% at the beginning of 2016. The rapid change in expectations is usually data dependent. Any hint of better than expected growth or inflation would see a sharp reversal in the futures market.
In credit markets, participants trade credit default swaps or CDS, which is a derivative contract that provides a means of protection against credit risk. It is akin to buying or selling insurance on a particular issuer. When referring to the credit risk of the market as a whole, we often look to the Australian iTraxx index, which calculates the average spread or margin for a five-year credit default swap over and above the benchmark bank bill swap rate (BBSW). The index includes 25 investment grade Australian issuers which are weighted equally.
The further falls in metal and energy prices this month have driven out the CDS levels on BHP bonds to their highest premium in 7 years. The company is now more expensive to ‘insure’ than 21 other members of the iTraxx index, including the likes of Woolworths and Qantas, which have much lower credit ratings.
BHP is on review for a downgrade by Moody’s, but currently holds an A1/ A+ rating (Moody’s/S&P). The Australian iTraxx is now trading at a spread of +146, whereas the BHP CDS is priced at +245. This is the biggest differential since the financial crisis of 2008.
In a light week of market announcements, Oil Search (OSH) was the last of the major energy companies to release its fourth quarter production report. The company’s full year production in 2015 was 52% higher than that of 2014, primarily due to a full year contribution from its interest in the PNG LNG project. The PNG LNG project produced above its nameplate capacity for the third successive quarter, allowing OSH to exceed the upper end of its forecast guidance range for the year.
Revenue, of course, was lower in the quarter due to the ongoing weakness in oil prices (with LNG prices linked to oil) and thus should be lower again in the current quarter. Importantly, as the company notes, OSH’s production is cash flow positive even at current oil prices. For 2015, OSH has guided towards production costs of approximately $US10/boe (barrel of oil equivalent), along with a further US$5/boe for other operating costs and a (non-cash) depreciation and amortisation charge of approximately US$13.50/boe.
While OSH remains profitable in the current environment, it nonetheless is still looking to conserve capital given a much lower free cash flow outlook in the short term. It could be reasonably expected that its 2016 capital budget will be reduced while oil prices remain low, thus potentially pushing out the approval of any further developments in PNG, including a third train brownfield extension of the existing project.
With an element of this optionality most likely imputed in the current share price of OSH, this delay may have a slight impact on OSH’s value, although the important factor is that these options remain available to the company when markets improve. OSH remains our preferred energy sector exposure, with the best mix of quality of current assets (low cost), future development options (and the prospective returns from these) and ability to weather the current volatility in energy markets.
Laboratory services company ALS (ALQ) has also been weighed down by the oil price of late and this much was evident in its quarterly market update. Its third quarter earnings were within its previously stated guidance range, albeit at the low end. As we have previously noted, the company’s energy division is not overly material in terms of its revenue exposure (16% at its recent half year), but is susceptible to greater volatility in the short term based on underlying commodity price movements.
Following the recent sharp fall in oil prices, revenue was thus significantly lower in the most recent quarter. Its minerals division, which has been relatively resilient in the last 12 months, also showed a slight fall in revenue, although recorded improved margins.
Pleasingly, ALS’s non-cyclical divisions continue to perform well, with good growth in particular in its life sciences division along with a solid margin outcome from its other divisions. While the outlook for its resources divisions is somewhat clouded, the longer term investment proposition for the company remains, with its strong market positions, defensive growth characteristics of its core divisions and management’s track record of value-enhancing acquisitions. The costs that ALS has taken out of its resources division will also assist with margin growth when conditions in these markets improve. We have the stock as a smaller position in our model equity portfolio taking a longer term view on its mix of businesses.
With the performance of the domestic equity market largely dictated by international macro events in the early part of 2016 as well as reporting seasons in the US and Europe, next week our own reporting season kicks off. From a top down perspective, earnings growth is expected to be weak, although again largely weighed down by the resources sector.
Ex-resources, consensus for the industrials and financials sectors is for earnings growth of approximately 5% in FY16. As dividend payout ratios are already high, overall dividends may in fact fall given the widespread cuts expected in the resources sector.
The ASX 20 has a significant influence on the overall market’s expected growth given the high index weighting attached to these companies. As the chart below illustrates, the few stocks forecast to deliver double-digit growth for the year (QBE, Brambles, Westfield and CSL) are boosted by a weaker dollar, with materially lower earnings expected from resources stocks and Woolworths.
ASX 20: FY16 EPS Growth
While the overall earnings outlook is fairly benign, there are still likely to be pockets of strength. Anecdotally, the retail sector has enjoyed fairly solid trading over the Christmas holiday period. Tourism-exposed stocks should report good conditions, although the overall representation of these in the index is quite low. Housing-related companies will again be the beneficiaries of a solid domestic market, while the transport sector should be assisted by lower oil prices.
A positive development in recent months has been a lack of profit warnings issued by large cap companies, although we note that many companies have been hesitant to issue guidance in the first place. As ever, the market will be dictated by outlook statements and the steps taken by management to drive earnings growth in the medium term. The following table lists the expected reporting dates in February of large cap stocks.
February Reporting Season Calendar