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WEEKEND LADDER

A summary of the week’s results

29.04.2016

Week Ending 29.04.2016

Eco Blog

Down, down, prices are down. Australian CPI fell by 0.2% in the first quarter of the year, taking the annual rate of inflation to 1.3%, touching on its lowest level in decades. Soft price momentum is widespread across most categories as measured by the ABS.

Goods product prices fell across the board, showing the combination of competition in food, global trends in apparel and lack of new products in audio-visual and electrical items. The seasonal impact of a fall in fresh produce prices and the unsurprising impact of lower fuel costs added to deflation. Services inflation had been relatively resilient, but now there is a distinct indication that weak wages growth and pressure on costs in some sectors is translating into softer trend there too. Notably, the ABS measure of housing costs has taken a downward leg. Not only are house prices levelling off, but rental growth has hit a 20 year low, coming in at an annualised rate of 1%.

The only categories showing much in the way of price increases are those that are, to some extent, set by authorities and governments. Pharmaceutical prices rose on the PBS adjustment, postal charges have been lifted and education and childcare were both up around 3%, reflecting the start of the calendar year.

Australian Non-tradeables Inflation

Source: ANZ
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Is this enough for the RBA to cut rates? For May, it is an awkward question, with the RBA meeting within hours of the budget. The bigger question is whether a rate cut will have any impact on inflation. The key remains wages, and in an environment of changing labour demand, lower interest rates are unlikely to do much to encourage employment nor result in the ability to raise prices. The RBA is more likely to react to the stubborn AUD, but even currencies are misbehaving.

Japan has experienced that in full this week. Inflation has been unmoved by the monetary policies that has seen the Bank of Japan enact negative interest rates and asset purchases. This time it chose to do nothing, and saw the Yen rally strongly. The last CPI reading came in at -0.1% without any glimmer that the somewhat ambitious target of 2% inflation could ever be reached. Once again, wages are the biggest issue. Japan typically undertakes spring or ‘shunto’. This programme goes back to the 1950’s, which saw a combined effort by corporations and labour to negotiate wage rises to an acceptable level. About 62 large companies still apply this system in March and April and agreed to an average 2.19% wage rise for 2016/7. While this may appear encouraging, it is the lowest in three years and has had no meaningful impact on inflation. A contributing factor is the growth in part time labour as incrementally more women are employed and over-65 year olds delay retirement. Contrary to some expectations, developed Asia has some of the oldest workforce participation ratios.

The direction for Japan is clouded. For some time there has been the view that the Japanese economy will deteriorate rapidly given the pressure from debt, a weakening competitive global trading sector and slow household consumption. While it is easy to make a case for such an outcome, to date the evidence shows that it has been able to drag out these trends without a major economic event. 

The wordsmith’s analysis of the FOMC (Federal Open Market Committee) suggested the Fed has edged closer to a rate rise, with some of the cautionary language on global conditions taken out of this release. A stalemate between weak GDP and low inflation, versus the clearly decent labour market trends, have the Fed on a metronome decision mode. Rightly or wrongly, whatever eventuates will have a big impact on markets.

In contrast to expectations, the divergence of global economic growth has not come to pass. With the weaker trend out of the US, slowing growth in China and flat-lining in Japan, Europe is holding its own somewhere in the middle of these regions. Italian consumer confidence has improved significantly, Spanish employment momentum has been persistent, German employment growth in the first quarter was the strongest in eight years and credit growth remains on an uptrend. If it were not for the persistence of very weak inflation, the European recovery would be considered successful.

German Employment Growth

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It remains to be judged whether we have entered the ‘new normal’ pace of economic growth, or whether this is a transition. The direction of this transition is up for debate as well. Some argue that we are in the last stages of an economic expansion as policy tools are exhausted. Others believe that better growth still lies ahead if only the credit multiplier were more effective and fiscal policy credible.

Fixed Income Update

Risks to Australia maintaining its AAA credit rating have again made headlines following comments from the rating agency, Moody’s. They expressed concerns on the “narrow set of options” available to meet “the objective of balancing the budget…”, which is a factor in Australia maintaining its current credit rating.

The implications of a ratings downgrade should, in theory, be higher yields, falling government bond prices and increased funding costs for Australian Federal and State governments. However, history has shown that this is not always the case. In fact, in recent bond market history, downgrades in the US, UK and France were all followed by a fall in yields.

US 10 Year Government Bond Yield Following Ratings Downgrade

Source: Bloomberg, Escala Partners
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Despite this being topical, any change to our rating is likely to be some way away. The rating agencies would first apply a negative watch and any ratings downgrade is not likely to eventuate before 2020. Further, research has suggested that any downgrade will only apply to Australia’s foreign rating and not the domestic rating, yet Australia’s government currently has no foreign currency debt. A downgrade of one notch to AA+ is expected to be well tolerated as it still reflects a strong credit and ability to repay debt obligations.

The average maturity of bonds has extended over the last few years, with issuers taking advantage of the low interest rate environment. This week saw the print of a ‘centennial’ bond in Europe, where the Belgium government issued a 100 year bond with a fixed coupon of 2.3%. It was a private placement to one buyer. This follows a similar deal done out of Ireland a month ago and suggests that at least this buyer expects Europe to remain in a low inflation/low growth environment for many decades to come.

Staying with innovation in the bond markets, there are talks of changes to the securitisation market with the launch of a bond backed by mobile phone contracts in the US. This market already exists in Japan, and is driven out of a desire to fund the upfront costs that mobile companies are paying for handsets. These handsets are usually paid off as part of a consumer’s monthly package, and it is these cashflows that will be used for securitisation.

Mobile phone subscribers continue to grow, which could see these become the third largest consumer securitisation market, behind only the established sectors of auto loans and credit cards. The chart below illustrates the growth in subscribers in the last 15 years.

US Mobile Subscribers

Source: FT
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Domestically, weaker than expected inflation figures released on Wednesday have the market looking for further rate cuts in the coming months. The futures market is now pricing in a 48% probability that the RBA will cut rates in May, up from 14% prior to the release.

Corporate Comments

UK-based fund manager Henderson Group (HGG) received some investor support this week following a trading update for the March quarter. Investment flows are a critical indicator that is closely tracked for fund managers, as this is a key determinant in profit growth. While a fund manager can influence inflows, typically through strong performance, overall investor allocations to particular asset classes also play a key role in the asset growth of all fund managers.

At the company’s full year results in February, HGG had noted a slowdown in FUM flows in the early part of 2016 as equity market volatility picked up amid a market correction and as investors sought the relative safety of fixed income assets. While many markets have recovered the losses and are close to (or better than) flat for the year, equity flows have not recovered as expected. Across developed markets, European funds have had among the weaker flows, although the region has been stronger in recent years.

Flows into Equity Funds

Source: EPFR Global, Deutsche Bank
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In this context, a slight drop in institutional money and net inflows into higher-margin retail products was a good result for HGG. Market and FX movements were in the company’s favour for the quarter and more than netted off investor outflows. With HGG’s controllable factors remaining strong, including fund performance and flows relative to the market, the company is one of our preferred diversified financials exposures. We note, however, the short term risk of the upcoming Brexit vote, to be held on June 23. A vote for the UK to exit the European Union is likely to weaken the pound and thus the share price returns for Australian investors. Currently, the ‘stay’ vote has maintained its lead over the ‘leave’ vote and so the odds favour the status quo.

After making progress restructuring its business, as well as positive momentum with its sales figures, Pacific Brands (PBG) fell into international hands this week, with US-based Hanes Brands winning support for a takeover of the company. The takeover price of $1.15/share represents a significant premium from where the stock has traded over the last year, although is still below its post-financial crisis high.

PBG owns prominent underwear (Bonds, Berlei and Jockey) and bedding (Sheridan) brands. The company has faced a tough environment and inconsistent sales over a long period, particularly from discount department stores, which have looked to promote private label product. While the $A has rallied in the last few months, the depreciation of the currency over the last few years is likely to continue to encourage international companies (particularly those based in the US) to take advantage of more attractive FX rates to purchase Australian assets.

After the recent setback of losing their claims on compensation for losing poker machine licences, Tabcorp (TAH) and Tatts Group (TTS) received better news this week when the Federal Government announced its response to the O’Farrell Review into illegal offshore wagering. The key recommendation that was positive for TAH and TTS was a crackdown on unlicensed overseas gambling operators and upholding the current ban on online in-play or live sport betting. This includes closing loop holes which had seen some bookmakers circumvent the existing rules through what is known as a “click-to-call” service.

While estimates are varied as to the size of the in-play market, it is thought to account for approximately 5% of turnover and has been growing quickly. TAH and TTS had not offered click-to-call to their customers given the question marks of its legality and the risks this might impose on their wagering licences, and so the new restrictions should assist the local operators in winning back market share.

Cochlear (COH) held its first investor day in several years this week, with the company highlighting an increase in marketing activity as it looks to achieve its aim of more annuity-like revenues from process upgrades as opposed to just device sales. R&D investment is critical for the company and is behind an expected four new product launches over the next 18 months.

Cochlear again noted the vast market opportunity for the company and low (~5%) level of overall market penetration. These estimates of total population that require hearing devices is not particularly new news; the challenge that Cochlear has long faced is how it actually taps into this potential. Flat unit sales over a number of years is evidence that it is struggling to make inroads, although this followed a damaging product recall in 2011. Despite this recent patchy earnings record, the stock has continued to trade on an elevated P/E multiple of 29X. It is for this reason that, of large-cap health care stocks, COH has been the least favoured by analysts for some time, with CSL, Resmed (RMD) and Ramsay Health Care (RHC) rated higher.

Stockland (SGP) provided a trading update to the market, with the company continuing to see strong sales in its residential community developments. While some may have interpreted this as evidence that the housing market is holding up, Stockland’s projects do not span all sectors of the market, including apartments, where there has been a greater proportion of investor activity. We have LendLease (LLC) in our portfolios which is exposed to the apartment market. We note, however, that LLC has achieved a high proportion of pre-sales which underpin cashflows in the next few years and that the company also has a broader global property exposure.

Next week is a busy one for the Australian market, with a major investment conference being held in Sydney, which has historically been a forum for companies to disclose trading ‘updates’ to the market. Banking reporting season will also be upon us, which will be heavily scrutinised given the weakness across the sector over the last year. Earnings per share are expected to be flat to slightly down across the major banks, with asset quality to be a focus given an expected rise in bad debts from corporates.

The natural question to arise from this is the sustainability of current dividend levels, particularly if the bad debts cycle were to somewhat normalise, and in light of the potential for even higher regulatory capital requirements.

Assessing consensus forecasts from brokers that supply data to Bloomberg, ANZ and National Australia Bank are most at risk of a dividend reset in the near term (see chart below, which shows how broker dividend forecasts have been cut over the last six months), whether it be next week or when full year results are reported in November. Additional capital raised through dividend reinvestment plans is likely to be the preferred option for the banks to continue to build their capital base.

Reporting Next Week:

Monday – Westpac

Tuesday – ANZ

Thursday – National Bank

Friday – Macquarie Group

Major Banks: Consensus FY16 Dividend Growth

Source: Bloomberg, Escala Partners
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