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WEEKEND LADDER

A summary of the week’s results

29.07.2016

Week Ending 29.07.2016

Eco Blog

That the world of central banks is making every effort to get prices up is a phenomenon that tests the sensibility of those quite accustomed to cost of living pressures. After the release of the June data, the Australian CPI stands at 1.0% with goods prices barely moving at 0.3%, while services are 2% higher than last year.  The highest growth was from healthcare at 4.5%, whereas communication costs continue to slide, falling 7.2% in the year.

CPI Components: Q2 2016 - Annual and Quarterly Contribution

Source: CBA
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Assessing inflation is far from an easy task. If a household feels that their cost of living is rising at a higher pace, it would be due to a different mix of spending than reflected in the CPI, with the consumption of goods and services outside the data. Naturally, the pattern of spending varies enormously depending on household structure, age demographic and wealth. For the data to have integrity, it has to measure the same items over each survey period. This inevitably dumbs down what can be included. While there are updates to weighting the goods and services, the bulk of the input comes from the Household Expenditure Survey, the last of which was in 2009/10. The ABS is well aware of the time lag between surveys, though naturally, of course, cost constraints mean it is unlikely to increase the frequency. Instead, it has modelled the trends in the quarterly national accounts which cast some light on changes in spending. The impact is nuanced to the so called ’substitution effect’. Consumers will adapt their spending towards lower cost equivalents if there is a price disparity between similar goods or services. The ABS suggests that inflation (as experienced by households) has in fact been lower than measured by the CPI.  When households suggest living costs are rising, they are more likely reflecting their choice to consume more of a good or service, or those that are front of mind, commonly fuel, utility bills and the like.

With the US Fed affirming its official rate (while indicating that another rate rise was likely this year) and Japan disappointing on both the fiscal and monetary side this week, attention turns to the central banks of Australia and the UK. Economists are calling on the RBA to cut rates, given the benign CPI data and a sluggish economy. As the new governor commences his role in coming months, there may be a change in the debate to the appropriateness of the ‘2-3% through the cycle’ inflation rate target. This new phase of global growth and changing household patterns may require a longer-term adjustment to an inflation target. Otherwise, as in Japan, it loses relevance.

Much comment is likely to follow the UK decision on rates post the Brexit vote. Some economists had expected an immediate rate cut early in July, however given the amount of anxiety after the vote, the BoE held steady. Now it faces a dilemma. The bulk of the data would not point to a cut. The release of May unemployment trends (down), credit growth (up) and housing (stable) strongly point to a holding pattern. The subsequent fall in the sterling and possible import inflation lies ahead. But the slump in business and consumer confidence may mean data is put aside in anticipation of weak growth over the coming year.

The following chart, while specific to the UK, is a telling picture of consumer attitudes in many parts of the world.  The financial circumstances of consumers are mostly positive, but their faith in the economy is weak. Interest rate cuts will likely do little to change that.

UK Consumer Confidence Survey for Economic and Personal Financial Conditions

Source: GfK, Barclays
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The looming US election casts a spotlight on global trade and the role of currencies. The economic benefits of global trade are complex and inevitably have been unevenly distributed, but the answer is unlikely to lie in knocking currencies about. After the big moves in currencies in 2015 (arguably a belated adjustment to fundamentals), foreign exchange analysts believed the USD and yen had somewhat overshot their expected trading range on their respective up and downside. The yen subsequently recovered ground and the inaction from the authorities now points to a doggedly higher exchange rate.

Conversely, notwithstanding the emerging economic recovery in Europe, the efforts of the ECB have paid off and the Euro is considered to be undervalued relative to the USD. With political instability and issues in the banking system, it is more than likely to remain there or by many forecasts, move even further into undervalued territory.

Source: ANZ
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The attention inevitably turns to China with its managed range of exchange rates. The CNY has been allowed to depreciate against the USD, but has largely held its value against other currencies. While many assessed the CNY as overvalued last year given China’s weaker economic outlook and easing interest rates, its downward move against the USD has left other Asian currencies facing their local trade competitor with relatively stronger currencies.

USD/CNY and USD/Other Asia

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There are inevitably political and structural issues. While the US may at times accuse China of managing its currency to the disadvantage of local manufacturers, the impact on its neighbours is greater, given their dependence on exports. On the other hand, a stable USD exchange rate takes the attention away from current account deficits and USD-denominated debts of the Asian corporate sector.

And the AUD? There is a near unanimous view that its fair value sits around 0.75/USD, but that the skew is for it to trade below that level over the coming two years. Official rate cuts and soft commodity prices may however battle against the flow of money seeking interest rates at any positive level.

Fixed Income Update

In a NAB conference this week, a presenter stated that, “an average retiree will spend more annually in retirement than when they were working”. In addition, “retirees are generally exposed to a higher level of inflation than the younger generation due to the increasing costs of health services and the fact that they are not buying technology products which are deflationary.” With this in mind, the low interest rate environment makes it even more challenging for self-funded retirees and it is no surprise that the search for yield is increasing the popularity in the riskier sectors of the market.

The current domestic cash rate is at 1.75% and many economists predict it to decline further (perhaps down to 1% within the year). The RBA will remain data dependent such as the CPI figures released this week, which were weak but in line with market expectations. While the figures are not necessarily going to force the hand of the RBA into cutting rates again at next Tuesday’s meeting, they keep the prospect very much alive. The futures market is currently indicating a 58% probability of a 25bp cut next week.

As we have previously noted, Australian interest rates are higher than other developed countries. While our domestic rates have declined, yields have also tumbled in global markets in the last two years. The chart below depicts the movement and proportion of bonds (in the global index) with yields in each range.

Global Government Bonds by Yield 2014-2016

Source: BlackRock Investment Institute
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Negative interest rates in Europe have resulted in outflows from debt securities in that region in the last 12 months. The following chart illustrates this trend.

Source: JP Morgan Asset Management, Bloomberg
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The riskier, higher yield sectors of the fixed income market have recorded higher demand in the last three months including credit products, high yield, emerging markets, subordinated and bank hybrids. The recent improved performance of the domestic listed debt from spread contraction is depicted below, which is an index of the market created by Australian Ratings.

Source: Australian Ratings, ADCM Services
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BBSW is the Bank Bill Swap Rate that many securities within the Australian fixed interest market are priced off. Term deposits, bank mortgages and corporate bonds, including listed debt securities, all use this reference rate to determine pricing.

Evidence has come to light in the last few years that this rate setting has been manipulated and ASIC are taking action against ANZ, NAB and Westpac. This has been well publicised in the press, and it is unclear whether this manipulation has been favourable or at the expense of investors or borrowers. Following an inquiry, the Australian Financial Markets Association (AFMA) came out last week and announced a new methodology for how the BBSW is calculated. According to AFMA this “will support production of the benchmark both under normal market conditions and in a stressed environment.” 

Corporate Comments

Fund manager Henderson Group’s (HGG) first half result was more anticipated than usual given the recent outcome of the British European Union referendum. While HGG’s profit was marginally below expectations, the key focus was more on the outlook statement and how the company has managed to deal with an environment that has changed very quickly.

Investor flows give a good indicator of sentiment towards HGG’s funds and on this measure, these were not as bad as some had feared. As was expected, HGG had large fund outflows in the lead up to and following the Brexit vote. Through July, outflows have now moderated (see chart below), indicating that the worst is most likely now behind it. The news on institutional flows was better; HGG actually recorded net inflows in the second quarter, which followed a level of outflows in the first quarter. 

Henderson Group: EU Referendum Impact on Retail Fund Flows

Source: Henderson Group
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For a fund manager, market movements and relative fund performance are arguably more important. The former will typically have a greater influence on FUM levels given the volatile nature of investment markets, while strong relative performance will help a manager attract FUM from its peers and help it earn performance fees. HGG’s FUM levels actually rose in the six months to 30 June, in part driven by a weaker pound (the company’s reporting currency) and higher equity markets. The second half has also had a strong start in this regard, with global equities rallying. HGG’s relative fund performance weakened somewhat in the first half, although returns remain solid on a three year basis.

Taking into account a more difficult operating environment, HGG is generally performing well, with good cost control and a strong capital position. A further share buyback is expected in the second half. We have retained the stock in our model portfolios, but are mindful of the shorter term challenges facing the company.

Macquarie Group’s (MQG) quarterly trading update was solid, with the company reaffirming its FY17 guidance of steady year-on-year earnings. Compared to other global investment banking peers which have faced earnings pressure, MQG is better insulated from the weaker activity levels that are evident across its capital markets businesses. MQG described the conditions facing these businesses as ‘mixed’, with subdued market conditions in Macquarie Capital and its securities division, while activity improved across its commodities and financial markets trading business.

The group’s annuity-style revenues, driven by the funds management division, continue to show steady growth over time. Combined, these now account for over 70% of MQG’s earnings and are generating a superior return on equity, helping to lift this measure for the entire group.

While MQG will face the headwind of lower performance fees that it earned from maturing infrastructure funds (which were a feature of earnings in the last two years), recent accretive acquisitions will add to the base for this year. We have MQG in our model portfolios.

Fortescue Metals (FMG) rounded out the quarterly production reports of the major iron ore producers this week. The company has done exceptionally well operationally, with a sharp focus on cost reduction in recent periods to help it transition through a period whereby its business was marginally profitable and carried high levels of debt. The recent spike in the iron ore price has allowed the company to repay some of this debt, a task that appeared insurmountable late last year when the iron ore price dropped below US$40/tonne.

FMG has now reduced its cash costs of production below US$15/tonne, a comparable level to larger peers BHP Billiton (BHP) and Rio Tinto (RIO). This has fallen from closer to US$50/tonne just four years ago, with the key drivers of improvement coming from more favourable currency rates, operational and scale efficiencies and a decline in strip ratios (i.e. the volume of material moved to extract the ore). Compared to BHP and RIO, however, FMG would still be expected to earn slimmer margins on its iron ore operations as it produces a lower grade iron ore and thus the price it receives is at a discount to the benchmark price. The chart below illustrates the additional costs per tonne that FMG considers when estimating its breakeven price per tonne.

Fortescue: Breakeven Iron Ore Price

Source: Fortescue Metals
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FMG is no longer a production growth story, although if current spot iron ore prices remain elevated in the medium term the company will generate good cashflows in the next few years. To invest in the stock, however, one would need a constructive view on the sustainability of the recent pick up in the steel market; a view which is shared by few.

Global laboratory services company ALS (ALQ) reported a relatively mixed first quarter update at its AGM, although perhaps a source of disappointment for investors was a lack of any further advancement of takeover talks that has put the company in play. Last month ALQ received a cash offer of $5.30 per share from two private equity groups which the company rejected as opportunistic in nature.

ALS’s quarterly update noted ongoing strong performance in its life sciences division (which operates in the environmental, food, pharmaceutical and consumer products industries), with all business lines reporting higher revenue and earnings. The company’s geochemistry business within its minerals division also showed a pickup in activity. Higher commodity prices (gold in particular) and sentiment lead towards more consistent improvement compared with recent quarters.

The primary source of disappointment, however, was again the group’s oil and gas business, which is expected to record a loss for the half. ALQ continues to adjust to a sector that has a much softer outlook following the large decline in the oil price. With its high-quality life sciences division and its cyclical divisions managing a weak period of activity, we are comfortable with the longer term outlook for ALQ and believe that a small position is appropriate for portfolios.

Monday morning greeted Woolworths’ (WOW) investors with a wide-ranging restructuring plan for its business and a large writedown of assets, along with provisioning for changes.  The cost of redundancies for non-store staff, writing off assets at Big W and closure of loss making stores will total $959m, of which about two thirds is non-cash. The guidance on FY16 profit (to be released in the next few weeks) indicated that the operating outcome would be met, albeit expectations were already low.

Woolworths has therefore taken on some breathing space and cleared away asset overhang. There are some early but only qualitative signs of stabilisation and the key will now turn to in-store execution of the basics. It is worth revisiting the source of Woolworths’ malaise: excess store growth, which disguised falling standards in existing stores; excess margin achieved from aggressive rebate programmes and higher pricing than the competition; and a slide in store presentation as staff costs were made to achieve margins.  It was compounded by the Masters misadventure (which leant on the cash flow from the higher food margins) and a complete capitulation in discount department stores.

For investors, the question is whether it can be fixed, how long it will take and what price to put on that potential outcome. Fixing the business is achievable. Supermarket retailing is often said to be a simple business, true in most ways, but it requires a very fine-tuned execution and store managers have a major influence.  The question is perhaps what ‘fixed’ looks like, as the competitive landscape is different to the past. Lower margins are inevitable. Then it takes time, likely at least two years. However, history shows that once underway, the momentum can build as the fixed costs in the business leverage the profit outcome. 

There are events that may smooth the path. The key ones are closing the sale of the Masters business and the potential unbundling of the liquor/gaming operations.  While some will call for the sale of Big W, there is not much to sell as the stores are leased and, in all likelihood this category of retail will struggle given the three competitors. 

For the moment the worst is likely to be over for WOW shareholders and the patient may look to sit it out. We reiterate that Wesfarmers investors should be careful of excess weight in the stock. If Woolworths is to recover, Coles’ outlook will have to be compromised.

Next week, reporting season gets off to a steady start, with the following companies expected to post FY16 results:

Tuesday: Credit Corp, Navitas, Genworth Mortgage Insurance

Wednesday: Rio Tinto

Thursday: Downer EDI, Suncorp Group, Tabcorp

Friday: BWP Trust

 


 


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