Week Ending 29.03.2019
- Low wage growth and low inflation hatched out of the past decade now haunt financial markets.
To understand the cause of these trends, government data sources are expanding their remit to capture more than the standard survey formats on which they have relied for decades. Both in the UK and US, the statistics bureaus are including alternative sources such as scanning data, credit card transactions and, for difficult to measure sectors such as healthcare, insurance claims. The first cut of this data has tended to imply inflation is more variable than the traditional CPI, however as more sources are added from complex sectors, it is expected to reduce the overall price variation.
The RBA is also focused on the wage and inflation puzzle and in a recent paper worked its way through the influences on the labour market by referencing data outside the traditional metrics from the ABS.
The first is that labour conditions are considered to be strong and improving. There is a relatively broadly spread, albeit that the bias has been towards healthcare and household services, which are typically mid to lower wage jobs.
Private survey data accessed by the RBA indicates that employment intentions remain robust. The central bank is of the view that there is evidence wage growth will come through, albeit slowly. Minimum and award wages are expected to create a floor, with state governments having upped the ante on pay rates for many employees off the back of recent elections.
Another factor has been the low rate of job churn. The RBA business liaison programme suggests that firms are reporting difficulty in finding suitable labour, but have yet to turn to wages as a way to entice job change. Yet, as the charts show, this is close to a tipping point. Previously, such a trend has results in wage growth of 4%, which compares to the present growth rate of 2%.
The RBA has delved further into other aspects of disposable income. Non labour income has been particularly weak. Most comes from social assistance (we have previously noted that welfare redistribution is now negative in real terms), rental and investment income and earnings of unincorporated businesses. To be fair, one of the reasons social assistance has been falling is due to the transfer from household income via benefits to government consumption that funds the NDIS. This is an accounting issue and has partially distorted the data.Enlarge
Other factors are rental income which has also been weak, rising in low single digits and falling in cities such as Perth. The drought has also inevitably reduced farm incomes, represented in unincorporated businesses. Finally, the RBA is at pains to point to the stealth in tax revenue growth. On average, as a rule of thumb, for every 1% increase in household income, tax payments rise by 1.4%, absent adjustment to tax brackets. In the past year, tax payments have risen by 8%, more than double the growth in gross household income. Aside from bracket creep, the level of deductions and offsets has fallen and, where applicable, capital gains on property sales have risen substantially. The RBA concludes that this nexus between labour, household income and the housing market are crucial for the broader outlook.
This week, the budget will be thrown into the picture. Typically, fiscal measures are in response to rising unemployment. This time it will not be the case, but is nonetheless widely considered appropriate to address the rising proportion of income that is taxed. The easy decision would be to bring forward proposed tax cuts. The consensus implies a circa $8-10bn boost to household income in 2019/20. Assuming a 2% saving rate (the current level and based on the propensity to spend of the relevant income groups) it could add 0.4% to GDP growth.
But the main thrust of the budget should be a way to revive confidence in both the business and household sector. In this context, the debate on rates cuts is less centred on the impact on the price of credit, than the signal it may provide to economic participants. This could go either way; a cut may be perceived as concern the RBA has turned bearish on the outlook, or that the RBA is willing to be active in supporting activity and the cost of capital. Similar arguments apply elsewhere. A reversion to mortgage-supported house price rises may make households feel better, but runs against the unresolved problem of high household debt.
Where there is agreement is that large scale infrastructure projects have considerable capacity to create jobs while also boost productivity in the longer term.
- The outlook for the Australian economy remains finely poised. A short term boost to income will have minor consequence unless there is firmer resolution to provide policy stability. We remain cautious on the outlook for Australian equities in general. Our recommendations for this asset segment are focused on the broader outcomes of our asset allocation. Local credit market present fair value.
Focus on REITs
- The demand for rental housing will continue to rise while the availability of homes and affordability of homeownership will remain low. This could allow for residential REITs to perform well.
Residential REITs make up over 15% of the FTSE EPRA/NAREIT Developed Index, the third biggest sector. These REITs own and manage various forms of residences, including multifamily/apartment buildings, student housing, manufactured homes and single-family homes. The biggest subsector of the sector is apartments, which was one of the stronger performers in 2018. This was a result of decelerating supply growth and has led to strong demand for rental apartments for multifamily REITs. Multifamily occupancy has been extremely stable over the past 15 years compared to other REIT sectors. Subsequently, net operating income has continually improved.
US REIT Sector Performance
The best apartment markets occur when home affordability is low relative to the rest of the country. Furthermore, multifamily operators analyse the population and job growth trends to estimate supply and demand in a region. This results in differentiated multifamily REITs strategies and territories of concentration. In addition, operators focus on quality and affordability. Standards vary by market, and each category is defined in relation to its counterparts. Currently, Class B and Class C apartments (lower quality) have lower vacancy rates then Class A (upper end).
- We recently added Quay Global Real Estate Fund to our APL. Multifamily/apartments make up over 22%, a significant overweight compared to the FTSE/EPRA NAREIT Developed Index.
Fixed Income Update
- We discuss the recent inversion of the US yield curve (10 year to Fed Funds), and the likelihood of this indicating an upcoming recession based off previous cycles.
- Dovish central banks lead bond prices higher, resulting in more negative yielding bonds across the globe, particularly Europe.
A yield curve is charted by plotting the yields of ascending maturities of government bonds and bills. Typically, it is positively sloped, but as forecasts for growth slows, short-dated interest rates can rise above longer-dated interest rates.
The US yield curve inverted last Friday, with the 10 year bond yield falling below the Fed Funds Rate for the first time since 2007. The inversion was largely led by a steep bond rally (falling yields) on the long end of the curve as the market priced in a pause in the Fed’s rate hiking cycle following dovish rhetoric from the central bank on the outlook for growth and potential for rate rises. The 10 year bond yield has fallen ~0.3% in March, while the short end has been anchored after the central bank kept interest rates on hold. The shape of the yield curve attracts attention as an inversion has preceded the last seven recessions.
10 Year Treasury Yield - Fed Funds Rate
While one adopts caution given current pricing, it should be noted that an inversion does not always lead to a recession. There have been periods where an inversion has occurred, but it has reverted into positive territory without a recession following (e.g. 1997, 1998, 1995, 1985, 1986 and 1966). Further, where it has resulted in a recession, it was typically at least 12 months from first inversion to recession and, in most cases, much longer (up to three years). At other times, the curve has stayed inverted for a long period of time (e.g. Sep 1978 till Sep 1981).
- This is relevant for investment portfolios, as it shows that while this week’s inversion may be an indicator of a recession, it is not likely to happen imminently (history would suggest in one to three years time) and there is plenty of time for the economic outlook to improve and hence a recession avoided. As a footnote, the yield curve in the domestic market is still not inverted. We do note that even more so than in the US, an inversion of the Australian yield curve has a very weak, if any correlation with upcoming recessions. Notably, Australia has not had a recession in 25 years, whereas the curve has been inverted multiple times over that period.
The recent dovish rhetoric from the Fed has also reverberated across European markets. Bonds have rallied, pushing the yield on the German 10 year government bund into negative territory. While this benchmark bond has flirted between positive and negative since the ECB implemented a below zero cash rate in June 2014, it is the first time it has turned negative in 18 months. This takes the total amount of debt trading with nominal yields below zero to over $10 trillion, up from a low of $5.7tn in early 2018.
The obvious question is, “Why is there is still demand for European bonds when investors lose money holding them?”. For the most part, investors buy the debt because they have little choice. Insurance companies are required to hold the bonds to match assets and liabilities. Many mutual funds track the index that includes these bonds. Others buy with the view that yields will decline further and they will hence benefit from the capital appreciation.
- While holdings of European bonds are limited in the funds that we recommend (on the view that they don’t offer value), the recent bond rally is of interest, as it confirms the dovish tone of global central banks in response to a low growth, low inflation and low interest rate outlook. These macro themes shape the positioning within portfolios.
- Wesfarmers (WES) has lobbed an opportunistic takeover proposal for rare earths miner Lynas (LYC) which has already been rejected.
- Coles’ (COL) increased investment in improving its online offering is necessary, although is more required to maintain its position rather than grow the top line.
- Westpac’s (WBC) announcement of client remediation provisions is one of several expected by the major banks this year, which will weigh on earnings and dividends.
Wesfarmers (WES) provided the surprise of the week when it announced a proposal to acquire rare earths miner Lynas (LYC) for $2.25/share. The offer has been viewed as quite opportunistic in nature, given that LYC’s share price has been hurt by uncertainty surrounding an extension to its operating licence in Malaysia, where the company processes ore that has been shipped from its Mt Weld mine in Western Australia. WES’s proposal is dependent on the operating licence issue being resolved and a fair assessment would be that LYC would have, all things being equal, traded higher upon a resolution.
Rare earths are a long term play on rising demand driven by the global take up of electric vehicles. Further, the Mt Weld asset is viewed as one of the highest quality outside of a market that is dominated by China. While LYC might appear to be a somewhat unusual pursuit for WES, the company’s history is in value creation via buying and selling assets as a conglomerate, though its current portfolio is dominated by the retail sector (Bunnings, Kmart, Target, Officeworks and a stake in Coles). WES ultimately had some success in improving the Coles business, although critically, the company’s return on capital was consistently poor due to the top-of-the-market price paid for the acquisition. That mistake appears unlikely should it prove successful in acquiring LYC given the cyclical low state of the rare earths market, however at this stage, LYC has refused to engage with its suitor.
Wesfarmers' Historical Acquisitions/Divestments
Meanwhile, Coles (COL) had a positive announcement this week as it entered an exclusive partnership with UK group Ocado to improve its online and home delivery operations. Ocado is an online only supermarket operator that specialises in next day delivery via automated customer fulfilment centres and has partnered with other supermarket retailers in Europe and North America with similar deals.
Grocery delivery from online orders is an issue for the major supermarkets as it is a small but growing segment of the overall market off a low base (for COL, it represents less than 3% of sales), however is margin dilutive given the high costs of fulfillment. The Ocado partnership will help to bridge this gap given increased automation and increased scale. However, it would appear a difficult task to close the margin gap completely, particularly given the fees that will be payable to Ocado and the issue of low population density within the Australian market.
Coles Online Sales
Further, while the capital investment is fairly necessarily given changing consumer preferences, it is more likely to cannibalise its existing customer base rather than providing an organic growth opportunity for COL and the broader sector. Smaller retailers who cannot afford this investment are the most probable losers in this environment, although potential market share gains for the COL and Woolworths are limited. We believe that this capex spend, along with an expected increase in store refurbishment spend in coming years, could restrict the free cash flow available for the group’s payout ratio in the medium term.
The fallout of the Royal Commission continues to hamper the earnings of the major banks and one area that is expected to extend for at least the next 12 months is client remediation costs. Westpac (WBC) was the latest to reveal costs expected for FY19, announcing a $260m provision, which adds to the $400m in similar charges taken in the last two financial years. While these provisions are now generally accounted for in consensus forecasts, there is a possibility that estimates are on the low side and hence this poses downside risk for earnings over the short to medium term. As a guide, bank provisions for client radiation were an approximate 5% drag on the sector’s earnings for FY18, which may well be higher this year. While capital ratios are generally viewed as robust, it is shaping up as a further year of flat dividends, with possible dividend cuts (NAB is viewed as most likely to cut its dividend at this stage).