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WEEKEND LADDER

A summary of the week’s results

29.06.2018

Week Ending 29.06.2018

Eco Blog

· A downward revision in US first quarter GDP growth was notable for weakness in the household sector.

· China is the latest trade target for the US, leading to a decline in the renminbi. Tariff-led inflation may result.

· European PMIs were more promising in June, halting the slide of early 2018.

· Weakness in the AUD has been driven by the recent shift to risk off in investment markets.

· Domestic credit growth has continued to moderate, driven by APRA’s macroprudential measures.

US Q1 GDP was revised down in its final reading to 2.0% (the Bureau of Economics provides an initial estimate with two further updates as detailed data comes to hand). The main areas of weakness have been personal consumption and inventories, while business fixed investment remains strong. The first quarter has become notable for its softness in recent years and expectations are that the second quarter will largely make up the perceived shortfall. Nonetheless, the modest rate of consumption growth consistently reinforces the relatively weak position of the household sector.

Confidence levels have reached highs, though currently levelling off, yet spending has remained constrained. Notably, confidence in the under 35 age group is now 11% lower than a year ago.

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The clock is ticking on wages as the only realistic route to the participation of households in this robust US cycle. To date, the reverse seems to be occurring, with the widely followed Atlanta Federal Reserve Wage Tracker data indicating that the trend to 4% wage growth in late 2016 has now faded to 3%. This week’s release of mortgage data (-12.5% year-on-year) and existing home sales (-2.2% year-on-year) also point to a subdued consumer.

Businesses appear to be able to limit wages while corporate profitability is up sharply based on the GDP data. The case can be made that business investment will focus on productivity and systems updates rather than necessarily pay more for labour. Capital spending, as a measure, can be deceptive as some systems are accounted as operating expenses rather than capital.

At face value, the US economy looks set to deliver expectations of GDP growth around 3% this year. But many debate its character, driven by fiscal stimulus with increasing government debt (the budget deficit is likely to be 5.5% of GDP in 2019, the highest since 1978 bar the 2008 recession), persistence in the income divide and potential disruption if the trade battle becomes even more intransigent.

· US growth is almost certain to be robust this year and the equity market had rewarded the potential EPS increase. Momentum and growth remain the focus of investment markets and the certainty in the US is offsetting other concerns.

For China, trade is clearly a major dilemma. The visible impact has been the fall in the renminbi, though USD strength is a global feature. China seems to be taking a cautious approach. On one hand, it has been relaxing the ‘reserve requirement’ of its banks (effectively a capital ratio) but also noting that it must retaliate to some of the proposed US measures. It may also lean on the services sector, such as education, or place hurdles for US companies looking to expand into China.

The US administration will have to decide where to draw the line, both on the potential disruption to US businesses that have ingrained their operations with China and those that do sell into China. In turn, it appears China will take the long-term view and focus on building its internal industries and those associated within broader Asia such as the One Belt and Road initiatives.

A possible step might be reducing the holdings in and buying of US treasuries. At an investment level it may make sense given the potential for a capital loss as rates rise, but, in reality, China does not have a lot of choice as European bonds are unattractive and few other regions have sufficient volume to absorb surplus capital.

· Investment markets have been quick to sell down China equities in response to the increasingly inevitably trade issues. On the other hand, there seems to have been no increase in inflationary expectations in the US as tariffs will have to be passed through to goods pricing.

The Purchasing Managers’ Index (PMI) data for regions give an early indication of economic activity ahead of official readings, with a figure above 50 representing expansion. European PMIs have been noticeably weaker through the first half of this year, although some pull back was expected following the high readings recorded towards the end of 2017. Capacity constraints from labour and raw materials have been cited as an issue for manufacturers, while some cyclical factors have also played a part, including the weather.

June showed a stabilisation of the weakening trend of 2018, although there was contrasting performance between the manufacturing and services sectors. Services improved off an 18-month low recorded in May, while manufacturing again eased, with the outlook somewhat at risk given escalating trade tensions. The surveys also indicated a higher level of pricing pressures continuing to emerge from both a raw materials (particularly oil) and wages perspective which therefore has implications to the inflation outlook. The latest PMI reading perhaps suggest a better rate of growth than that forecast by the ECB, leaving the central bank on track to end its quantitative easing programme later this year.

European PMIs

Source: Bloomberg, Markit, Escala Partners
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Several factors have combined in recent months to push the AUD to its lowest level in two years against the USD, although most are global in nature and not directly related to domestic conditions. The risks around trade appear to be a dominant driven in recent weeks. While tariffs announced to date should only impact growth at the margin, the sentiment towards trade-exposed currencies like the AUD has been negative.

A short-term bout of USD strength as speculative positioning unwound from late April has added to the pressure, while moderation in growth in some regions (such as Europe) has reduced investor risk appetite. Interest rate 

differentials have also pointed towards AUD weakness. The Fed has stayed on script and is likely to add two further hikes to its tightening cycle before the year is out, while locally there is nothing to suggest that the RBA is going to move any time soon, despite its declaration that the next change in rates is up. Providing some level of support has been robust commodity prices, leading to a strengthening terms of trade, although this could possibly fade into the second half of the year.

A rebound in the AUD is likely predicated on a resumption of synchronised global growth with the attention again turning to the funding of the US twin deficits. If this occurs, there is the potential for dispersion of performance against a basket of other currencies resulting from an acceleration of interest rate normalisation around the world, with our domestic cycle lagging. Significant downside risk could potentially emerge, however, if there is a ramp up in the trade tit-for-tat, although the consensus call remains weighted towards the former view.

Meanwhile, domestic credit growth again fell below expectations this week, supporting the notion of the RBA remaining on hold and indicating that APRA’s macroprudential measures and an increased focus on lending standards is having the desired effect. A 0.2% month-on-month increase in credit was the slowest pace in more than five years, with the expansion in housing investor lending of 2% over the 12 months was the lowest on record. 

Australian Credit Growth

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Fixed Income Update

· The strength of the USD has caused weakness in emerging market currencies, with many trading at all time lows.

· The US yield curve is at its flattest in 11 years. We examine the factors driving this whilst recognising the need to monitor these moves.

This year has marked a challenging start for emerging market (EM) debt. The USD has strengthened, a consequence of the widening interest rate differential between the US and other developed market (DM) countries as the Fed stays the course on raising interest rates. In addition, capital has sought out the ‘safe haven’ dollar in the face of trade wars and political unrest in Europe. Emerging market currencies have suffered as a result. The JP Morgan Emerging Market Currency Index has fallen almost 10% this year following a peak in January, with many individual countries close to all-time lows.

The countries most affected are the sovereigns with large current account deficits and who are highly in debt such as Argentina, Turkey, Brazil and South Africa. Comparatively, Asian countries have held up reasonably well, although the escalating trade tensions with China may weigh on the whole region moving forward. It should be noted that many EM central banks have responded to the dollar strength by raising rates, which should provide some reprieve.

Emerging Market Currencies Against USD

Source: Iress, Escala Partners
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· Given the sell-off in EM currencies, this is potentially a good to time to increase exposure to this sector. However, we acknowledge there may be some further weakness as the US-China trade talks play out. Investors should be prepared to tolerate volatility, as EM debt is one of the riskier sub-sets of fixed income. A diversified exposure through the Legg Mason Brandywine Global Opportunities Fund is our recommendation.

The US yield curve is now at its flattest level since late August 2007. The difference between 2 and 10-year Treasury yields fell to 32bp this week, as the 2-year yield rose while the 10-year drifted down. Debate continues whether the curve will become inverted, which could potentially signal a recession.

The yield rise on 2-year US treasuries is understandable. The elevated level reflects the rate rises by the US central bank, together with the increased treasury issuance in this part of the curve as the US Government funds its promised fiscal spending and tax cuts. More surprising is the stubbornness of long-term bond yields, which have been slow to rise, suggesting traders and investors are concerned about long-term growth and benign inflation. This may be the case, but aiding a flat yield curve is simply the demand for long-dated treasuries from both pension and insurance companies with long term liabilities to match, together with the use of the US 10-year bond as a hedge to risk assets.

The growing interest rate differential between the US and other developed markets will also keep US treasuries well bid. The European Central Bank has shifted in a dovish direction and, coupled with the recent blow out in Italian debt, has capital seeking the perceived safety of German bunds. The spread between 10-year US and German yields has reached its widest level in almost 30 years, making US Treasuries a more attractive option.

US and German 10 Year Government Bond Yields

Source: Iress, Escala Partners
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· We note the supply-demand dynamics playing out across the US yield curve, which is affecting the shape. However, the flattening of the curve is still a signal worthy of monitoring.

Corporate Comments

· The major banks continue to transition towards simplifying their operations and divesting smaller business units. Commonwealth Bank (CBA) has followed this theme with plans to demerge wealth management, although the bank will leave it to shareholders to decide whether they remain as investors in the separated entity.

· The earnings of Metcash (MTS) have been supported by a cost out program and realised synergies in its hardware division. The outlook is for much of the same in FY19, with a soft sales growth profile offset by the upside from a share buyback.

The strategy alignment of the major banks continued this week as Commonwealth Bank (CBA) announced that it would demerge its wealth management and mortgage broking businesses. CBA had previously flagged to the market its intention to pursue an initial public offering of Colonial First State Global Asset Management, although the divestment will now be via a demerger (whereby CBA shareholders will receive shares in the separated entity) and include a wider range of business units, including its wealth management platforms.

Wealth management has been quite a disappointing line of business for the major banks, who have, by and large, failed to capitalise on the structural growth opportunity available in the sector. The failure of the banks to achieve success in cross selling their wealth management offering to the vast customer bases has led to the earnings of these businesses only representing a fraction of their overall earnings base. Further, it is likely that the Royal Commission has accelerated the decision to sell these businesses, with increased scrutiny and oversight of the vertically integrated model the probable outcome going forward.

The demerger path, as opposed to the IPO path, was perhaps of some surprise to investors. While shareholders will now receive an in-specie shareholding in the separated company (with initial estimates of its market capitalisation expected to be around $6bn on an earnings base of $500m), the expected benefit to CBA’s balance sheet will not materialise. Further, CBA will lose approximately 5% of its earnings base and there are thus implications for its dividend going forward. In a low earnings growth environment, all things being equal, it would result in a step up in CBA’s dividend payout ratio if the bank elects to maintain its dividend.

The demerger is expected to also be dilutive to CBA’s return on equity (more so compared to its peers) and so there is also the likelihood that its ROE premium compared to the majors may continue to close. This, coupled with a higher reliance on mortgage lending (which is facing pressure following a regulatory crackdown and a peaking housing cycle) is the key reason typically cited for the preference of the other majors over CBA in fund manager portfolios.

Major Banks: Contraction in ROE and Price to Book Ratio

Source: Bloomberg, Escala Partners
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Metcash’s (MTS) full year result was largely in line with expectations. Underlying earnings growth of 11% for the 12 months was, at face value, a fairly good outcome given the headwinds faced by the company. The composition of the growth profile and the outlook, however, raised some questions for investors.

MTS’s core wholesale food distribution business (predominantly IGA stores) again showed the difficult competitive and deflationary environment of the supermarket sector, with a 3.6% decline in food sales (ex tobacco) over the 12 month period. Further challenging the business into FY19 will be the loss of a key contract in South Australia, which accounted for just under 4% of MTS’s supermarket sales in FY18 and there are risks that other retailers follow suit. The group’s hardware division (includes Mitre 10 and Home Timber and Hardware) was the key driver of earnings, although stronger on the back of a high level of realised synergies from acquisitions.

Metcash: Wholesale Food (Ex-Tobacco) Sales Growth

Source: Metcash, Escala Partners
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A successful cost out program has underpinned the earnings turnaround for MTS in recent years and while these targeted savings were extended further over the next year, the primary issue for the company is returning to organic growth beyond this profile. In the interim, an undemanding valuation and strong balance sheet is key to the investment case, which has led to a high level of expected earnings per share accretion from an announced $125m off-market buyback. MTS’s weak competitive position makes it an unlikely candidate as a core long-term portfolio holding, however value managers have, until recently, done quite well from the stock from the successful implementation of its strategy.

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