Week Ending 29.05.2015
For those who do not live and breathe financial issues, the movement in bond yields across the globe (which we have referred to in past weeklies) is seen as portending the inevitable rise in rates over the coming year. Given these markets are generally used to predictable, low volatile outcomes, disruptive patterns have awoken bond scribes.
One issue that has perplexed economists is that the huge rise in monetary injection through quantitative easing (QE) has not resulted in an inflationary outcome; indeed recently there has been more concern on deflation. Inflation is traditionally the key data influencing interest rate expectations and therefore bond markets. This recent rise in bond yields has possibly come at the low point of inflation.
As some investment managers however point out, there has been substantial inflation in asset prices (both hard assets and financial instruments); a monetary initiative has met its match in a financial phenomenon rather than the ‘real’ world of goods. Perversely, one can further take the view that this has reduced spending as investors have been rewarded, yet feel insecure enough not to spend against their wealth, while those that rely on deposit rates have been left wanting. Given high levels of debt, particularly in the household sector of some countries (of which Australia is a prime example), even the low cost of debt capital is not enough to encourage them to add to that burden. The cost of debt is only one element; the gross dollar amount in some cases is front of mind.
If the consequences of QE does indeed become CPI-style inflation, the investment world would have to adjust rapidly. As we have noted on a number of occasions, wages is the watch point on this front. Germany, the UK and US are the most likely trigger points. Germany?! Well may you ask. As an example, the rail union has negotiated a 3.5% wage rise this July, to be followed by 1.6% in July next year. The inflation rate in these countries may tick up somewhere between 0.5% - 1% from present levels later in the year based on current trends. While this seems almost irrelevant here given that our inflation has had much great variation over the years, the relative move in other countries will be higher than expected and bond markets at current low rates are likely to prove much more sensitive than in the past.
The following charts show the Australian CPI range over the past 20 years. Headline has varied up to 4%, while tradables (mostly goods) has an even wider dispersion.
The correlation between the 10 year bond yield and inflation is clear from the chart below. The spike in inflation with the introduction of the GST in 2000 was naturally ignored by bond markets. The recent trend of much lower wages growth could well subdue inflation for some time, reinforcing the view that interest rates will rise more slowly than in the past and peak at a lower, stable rate.
Australian 10 Year Bond and CPI
To reinforce the point, the US shows the same pattern, even though QE has been a key determinant of the bond market. The case can be made that US rates could move up quite sharply if a hint of inflation comes through.Enlarge
As we have noted before, the influence of bond prices is widespread and not isolated to fixed income assets; indeed, the impact is even greater in other asset classes. Equity market sectors have historically shown distinct trends in response to bond yields. Cyclical goods and services, industrial and technology sectors outperform healthcare, utilities and financials. The rationale is not hard to establish: rising rates should imply better economic conditions and investment spending; conversely defensive and interest rate sensitive sectors do well when the interest rate curve is flat. Whether this trend follows the same pattern given the current economic cycle and still unique interest rates will test the equity investment community over the coming year or two.
Focusing therefore back on recent data, Australian capital expenditure expectations is closely watched as a good indicator of the likely trend in investment spending. While the fall in mining investment is unsurprising (circa 30% down into 2015/16), the non-mining side was very disappointing, implying that spending will drop by 10% in 2015/16. The RBA’s efforts to encourage non-housing related investment has not found fertile ground to date. Another interest rate cut is unlikely to achieve that, and while possible, it appears more likely that rates will simply be on hold for a longer time. Comments from the deputy governor of the RBA suggested that companies should adjust their required rate of return on the basis of this rate setting.
The entrenched thesis that US rates will rise later this year and trigger a further fall in the $A/$US is still within grasp. Conspiracy theory has noted that Janet Yellen, as Chair of the Fed, will break tradition and not attend the usual Jackson Hole economic symposium in late August. Given it will be close to the date of the September FOMC meeting, she would not want to be asked about a rate rise if it were planned for that time. The $A rallied briefly with the rise in bond yields and somewhat poor data out of the US. A number of forecasts moderated their downside for the $A, suggesting it might well range trend in the 75-80c mark. Currency forecasting is fraught with danger, but we do note that the $A in particular has a habit of overshooting its assessed ‘fair value’ and therefore downside to below 75c is just as probable.
China is in the same boat as Australia, with easing financial conditions having little impact on growth while driving a frenzy of hyperbole in the stock market. While not at the same level, it would not be hard to parallel the lift in residential prices here and leverage in the investor segment to the Shanghai Index.
ANZ, amongst others, creates a series which combines rail volumes, trade flows, electricity generation and imports (amongst others) into a Real Activity Index.
ANZ China Real Activity Index
The recent launch of big plans for infrastructure and business will take time to make a contribution and it is likely China will have to find other initiatives to boost short term growth or accept that GDP is unlikely to reach the 7% goal for this year.
US data remains somewhat listless, with home sales up a bit, yet jobless claims are flat. Tonight, the revised Q1 GDP figure is expected to come in even lower than the original estimate of 0.2%. Another reading on consumer sentiment may also confirm that the household sector is ‘alright’ but not excited.
Meantime, Europe will get attention as Greece runs into its next repayment. In the great literary tradition of the country, this negotiation looks like running right to the wire, with both sides claiming non-negotiables, yet surely recognising that there has to be give and take on both sides.
Aristocrat Leisure (ALL) beat expectations with its half year result, continuing on with the recent momentum in its business. The primary driver of the company’s improved result, however, was a large acquisition it made in the second half of last year (Video Game Technologies, or VGT), with earnings per share boosted by the limited equity funding of this deal. VGT has performed well since being acquired and has given ALL a more reliable recurring earnings stream (now estimated at close to 50%) compared to what had historically made up the bulk of its earnings, namely less predictable product sales from poker machine platforms.
While the VGT acquisition has so far tracked well against expectations, it has also been the improved performance from ALL’s product portfolio that has driven the company’s earnings in recent years. ALL has been able to take market share from its competitors through this time and a continuation of this trend in the medium term should translate into solid profit growth for the company.
Ultimately, however, this trajectory will only be sustainable if there is a pickup in the conditions in the group’s key US market. As ALL illustrated at its recent investor day, the installed gaming base in the US has been flat for several years now, reflecting a relatively weak environment where casinos have been reluctant to invest. ALL is also branching out into online gaming, particularly through the development of apps for phone and tablets. At this stage this is not contributing in a material way to ALL’s overall earnings, although it is a fast-growing segment that we will watch with interest.
US Gaming Operations: Installed Base and Casino Capex
AGL’s investor day was the first chance for its new CEO, Andrew Vesey, to present his strategy for the company. Central to its targets in the medium term is reducing costs and increasing the group’s free cash flow. By FY17, AGL is targeting the one-off benefit of $1bn in asset sales and a $200m reduction in working capital. This raises the prospect of increased returns to shareholders, thus giving the share price a temporary boost. In addition to this, AGL is looking to generate additional recurring savings of $200m p.a. through lower capex and operating cash costs.
AGL is one of the largest players in the retail energy industry and the company is adapting to the significant change that is affecting it and its peers. Electricity demand has been declining over the last few years, particularly from large industrial customers, although AGL is more optimistic of a return to positive growth over the longer term as population growth offsets declines in per capita consumption.
While much has been made of the threat of rooftop solar generation on AGL’s business, to date the impact has been minimal (see chart below, listed as “Rooftop PV”). AGL is, however, getting ahead of the curve to combat this longer-term trend and has recently initiated its own solar power purchase agreement (SPPA). A SPPA is a contract whereby a customer has a solar power system installed at no cost in exchange for purchasing a supply of solar energy for the period of the contract – essentially it allows customers to avoid the high upfront costs associated with a solar installation. Economical energy storage solutions could be an opportunity or catalyst for this market to grow, although predicting this rate of technological change is inherently difficult.
AEMO Forecast East Coast Electricity Demand (TWh)
AGL noted that the competition in the retail energy industry has remained high, with an increased number of players, elevated discounting levels and high churn rates. While Origin Energy (ORG) is also exposed to these same variables, it remains our preference in the sector due to its strong gas position and the imminent cash flows it will begin to receive from its APLNG project.
Suncorp (SUN) also held an investor day as it looks beyond its existing simplification program. Similar to AGL, a low revenue growth environment has led it to focus on the costs side of its business to generate earnings growth and an improved return on equity. SUN is looking to achieve an additional $170m in efficiency benefits from its new ‘Optimisation’ program through better claims processing, procurement, technology and efficiencies in motor vehicle and home repairs. If it is able to achieve its targets it will reduce the group’s cost to income ratio from 53% to 50%.
While hard to quantify, SUN has recently been reinvesting the benefits from its current cost out program into its business in order to improve its top line in an industry that has faced increased competition. Through passing on some of these savings to its customers, it has improved its insurance renewal rates, while also maintaining its margins. From a dividend yield perspective, SUN remains attractive, particularly compared to the major banks. Inclusive of expected special dividend payments, it trades on a forward yield of 6.8% (or 9.7% on a gross basis), compared to the big four banks which are in a range of 5.1-5.8% pre-franking.
Suncorp: New Efficiency Target
ALS (ALQ), a company which we recently added to our model portfolios, reported its full year result, which was in line with its pre-released guidance. Divisionally, there appeared to be few surprises in the numbers. Its minerals division, which provides testing services to the mining industry and thus is leveraged to global mining exploration expenditure, has been the chief source of earnings pressure over the last three years.
While the forward visibility in this business is low, part of our thesis for commencing an investment in ALQ was on the basis that the risk of further significant earnings downgrades was reducing as it showed signs of a more stable environment. This looks to have played out in the second half; although full year revenues were down 14%, the half-on-half figures appear to have found a floor in the last 18 months.
ALQ: Minerals Division Revenues
ALQ’s oil and gas business, however, is more at risk in the medium term given the recent weakness in the oil price. Management reiterated their confidence in the long term prospects of the division, however revenues and margins are widely expected to be lower in FY16. For the March quarter, while experiencing a 15% quarter-on-quarter revenue hit, it has managed to outperform its peers who have experienced a revenue loss of some 20-30%.
Outside of its resources exposure, ALQ’s businesses continue to perform well and it again recorded solid cash conversion of its profit. The core life sciences division is well diversified, both geographically and across a range of industries, including environmental, food and pharmaceutical. A lack of formal guidance may have disappointed some investors, but we note that the company has typically not given this until its AGM in July. Our investment view on ALQ is unchanged following its result.
OzForex (OFX) reported its full year result, which was largely in line with expectations. The focus, however, was on the company’s cost base, which has risen at a faster rate than many may have anticipated as the company stepped up its investment expenditure. This meant that continued strength in the company’s top line was not fully reflected in underlying earnings, which were flat half-on-half.
OFX is one of many new disruptors in the banking industry, seeking to take advantage of weaknesses in the legacy operations of more established players. Through its online platform it provides competitive rates for foreign exchange transactions and it is exposed to positive structual thematics in terms of the growth in international transactions through a digital medium. While our major banks have offered a relatively predictable dividend income stream over time, we believe that Austrlian equity portfolios would benefit from smaller positions in companies such as OFX. In our own model portfolios, we have recommended investments in FlexiGroup (FXL) and Veda Group (VED) to achieve a similar outcome.