Week Ending 30.01.2015
The themes of the present economic debates have largely consolidated into two areas. Firstly, can the deflation risk be overcome and what will be the substance behind growth. Central bank easing – now already in 9 countries this year, with Singapore and also Demark the latest to drop through a negative deposit rate – is in most cases a response to very low inflation and in many cases a negative CPI as the substantial turn in the oil price weighs on data. Others will also focus on the race to the bottom in foreign exchange markets as a desired outcome.
The closely-watched RBA meeting next week will see if it feels the pressure to join in. The AUD is doing some of the work, or rather USD strength, but any hint the RBA is on hold may well see some of those ‘gains’ foregone as our cash rate is still multiples of those in most developed countries.
The character of economic growth is unlikely to change much as a direct function of even lower interest rates, here or elsewhere. Cost of debt capital hardly strikes one as the major business concern. However the anchor of low rates and solid to improving asset values is a necessary support for the time being.
Turning to the nature and potential of the Australian economy, there are occasionally tables and charts which can provide insight. The segmentation shown on the following page of the contribution of industries and their importance to employment is useful in that context. The rise in ‘real gross value added’ from the finance industry is a snapshot of the growth in wages in the sector relative to other sectors and the improvement in profitability in banking and insurance; in good part a function of low interest rates and low bad debt and claims experience. Mining remains on the upper end due to the volume contribution, though it may come back in forthcoming quarters given recent price movements and its employment rank is low. Construction (housing and select components of non-residential) has also benefited from low rates and while the RBA would prefer housing prices to taper off (and see a lift in owner-occupier rather than investment), it would also not want this industry to fade through the year.
The key missing sectors in terms of high employment, but low current output, are retail and hospitality. The hope therefore still remains that the combination of decent asset wealth, relatively high savings and the cash flow impact of low inflation, will see the household sector diversify its spending into a broad array of consumption goods and services. Early signs of a pickup in local holiday spending may be a glimmer of light that this transition will emerge.
The NAB Business Survey suggests that the aggregate level of activity is in the doldrums for the time being. Industries such as construction (housing), finance and recreation are in reasonable shape, whereas mining, manufacturing and trade are weak. The apparent improvement in mining (though still negative overall) appears to be a combination of traction on costs (as some resource companies are now reporting) and volume growth.
The Australian CPI for Q4 2014 came in at the low end of expectations. The headline rate of 0.2% for the quarter took the annualised rate of inflation to 1.7%. Excluding volatile items, such as food and fuel, saw it reading 2.2% for the year; barely in the RBA’s through-the-cycle aim of 2-3%. In the quarter, prices of alcohol and tobacco, childcare, recreation and travel rose higher than average, while the cost of fruit and veg, fuel and pharmaceutical goods fell. For the year, the largest increase was in fruit and veg, house purchase costs (not the price of houses per se) and childcare. Conversely, consumers of clothing, utilities, fuel and communications benefited from lower prices than the year before.
The key is that inflation is in the eye of the consumer – it all depends on the mix of consumption, and the CPI can only represent a notional median household.
One month into 2015, has the outlook for the Australian economy or investment market changed? At face value, the pattern of 2014 has followed through, but the impact of much lower inflation and falling interest rates outside of the US is, on balance, positive. On the eve of the profit season, the corporate sector may be a better indicator. Initial releases from some mining companies shows that cost reduction does eventually come about and the impact of lower inflation will also be a positive. The equity market over this year could therefore reflect a bell-bar of companies which surprise on the cost side and those with real growth potential. The laggards may be those that simply await better conditions from external events.
Alongside a very busy few weeks of company profit releases, the economic data is also closely watched to pre-empt the timing of the Fed. Rate hawks will note that the US initial jobless claims were lower than expectations, but bears will focus on the weak durable goods orders. At some point, the US data is likely to show an unco-ordinated transition, as the high investment spending in energy falls away but on the other side, discretionary spending picks up and the cost benefits of lower oil prices feed their way into the system.
As usual, the FOMC minutes were micro-analysed for hints on the timing of the rate decision. It is not too hard to suggest this will be in the second half of the year. For one, inflation is likely to have bottomed by then as the oil price cycles through and food inflation picks up again. Wage rises may start to have an impact with the unemployment rate now low enough to reduce the statistical influence of new, low-cost employees entering the workforce. Overnight (Friday our time), the quarterly employment cost index will be as closely watched as the release of Q4 GDP.
The focus on employment is acute in the various state reserve banks of the US. The chart shows the closely watched Kansas City Labour Market Conditions Momentum Indicator, an amalgam of all the readings on this statistic. It is now at the highest point in 20 years.
US: Kansas City Fed Labour Market Conditions - Momentum Indicator
Ironically, the emergence of higher wages, a retracement of inflation later in the year, a high $US and a rise in the base rate is not ideal for the equity market. This underpins the cautious stance many have on the potential upside to the S&P 500 compared to other regions, where valuations are also lower and financial conditions more sympathetic to a recovery. From an investment viewpoint, we note that an increasing number of global fund managers have eased their overweight bets on the US and therefore we feel a balance of these managers will serve investors well through the course of the year.
The repercussions of the new government in Greece are likely to take time to establish. There will be some key decision points where EU support will be tested. Greece also has a reasonably sizeable value of bonds maturing this year that it may need to reissue. The inevitable outcome may be a grumpy recognition on both sides to give some ground. This will, however, be closely watched by voters in Spain, Portugal and even the UK. While not in the Eurozone, these countries have voters expressing similar sentiments of discontent on incumbents.
For watchers of the quantitative easing impact, it will inevitably be different in Europe than what it did in the US. There, low interest rates helped launch a pool of credit issuance which then proved highly profitable for fixed income markets as rates fell further than expected. In turn, a meaningful part of this debt found its way into equity prices through a large buyback programme that added some 1.5-2% p.a. to US earnings growth.
Conversely in Europe, corporations, particularly small and medium businesses, depend much more heavily on bank loans rather than credit issuance. The health and willingness of banks to lend is therefore likely to play a bigger role and probably take longer to filter through. In equities, buybacks are also less of a feature, though dividend payouts are higher than in the US.
Finally on the QE theme, the conviction on Japan continues to sway between outright scepticism that substantial structural change can also occur, to believers in the emergence of renewed corporate willingness to change and embrace the lower Yen. Evidence is patchy to say the least.
The charts show the pace of industrial production growth (index based at 100 in 2010) in a range of key sectors. While there is some improvement in a few industries, it is not broadly-based enough to be confident that a new phase is emerging. Japan is a major beneficiary of lower energy prices, but also an important signal on the health of industry in general given its export orientation. Though the economy is far less important than before, it remains one of Australia’s most important trading partners.
Japan: Industrial ProductionEnlarge Enlarge
Japan is undeniably also at the pointy end of the potential path of many developing countries: excess debt, over reliance on a few economic drivers (in this case infrastructure building and exports) and high age dependency. Voting is skewed to protect the benefits enjoyed by the aging population. Its economic fortunes therefore deserve wider attention.
Oil Search’s (OSH) quarterly production report showed sequential growth from the PNG LNG project, which has gone through a trouble-free ramp up period and is now performing close to nameplate capacity. A full year contribution from the project is expected to see the company’s production expand by approximately 40% in 2015. Despite this outcome, revenues and profitability could well be lower for the year as a result of the rapid decline seen in oil prices over the second half of 2014. Reflecting on how this is still to translate through the profitability of energy companies, OSH’s average realised price of US$73.64/barrel is at a 50% premium to the current price of Brent oil.
Just a few months ago (when oil was trading much higher than current levels), OSH released the outcomes from a strategic review. A key finding was the potential for OSH to participate in the expansion of up to three additional LNG trains (more than doubling the current production capacity) while also materially lifting its dividend payments to shareholders. While returns from these investments would now expected to be lower given reduced energy price forecasts, at this stage OSH does not anticipate any changes to its strategy. The ability of energy companies to receive an economic return on any new investment (particularly greenfield projects) in the current environment will be becoming increasingly rare, although OSH’s commitment demonstrates the strong position in which the company finds itself. OSH, however, pointed towards reduced capital expenditure in 2015; an unsurprising outcome given reduced cash flows.
We have retained OSH in our model portfolios. Across the sector, we believe that the optionality of its asset base is best among large cap energy stocks and its low near-term capex commitments see it well placed to weather the current weak conditions in global energy markets.
Fortescue Metals (FMG) is another company that has been revising its capex plans in response to declining commodity prices, having recently halved its budget for FY15. The chart below (taken from a presentation in October last year) shows how marginal the group’s operations had become, with an estimated free cash margin of US$7-$12 a tonne, based on an iron ore price of US$85/tonne.
Fortescue: Free Cash per Tonne (based on US$85 Iron Ore Price)
However, the iron ore price has continued to decline since then, further impairing FMG’s cash flow. Offsetting some of this impact to margins has been relief from a lower $A along with fuel and energy costs, which reduce operating and shipping costs. The bounce in FMG’s share price following its quarterly production report announcement appears to reflect a market that may have underappreciated the extent of these changes on its cost base. Nonetheless, FMG remains in an inferior position compared with the larger diversified peers of Rio Tinto (RIO) and BHP Billiton (BHP), with higher costs, lower ore grades and higher debt levels. There is no near-term pressure from debt refinancing given the earliest maturity on its current debt is 2017, however the prospects of any meaningful recovery in iron ore appears slim given the further expansion plans of the major iron ore miners and the slowing of demand growth from China.
Newcrest (NCM) had a rare production upgrade in its quarterly report this week, with its new guidance range 4% higher than previously. The company’s balance sheet is looking less stretched now after a concerted effort to reduce costs throughout FY14, and the recent decline in the $A has undoubtedly had a significant effect on improving its margins. A cloud remains over its Lihir operations and its longer term plans for this asset, however, which are barely break-even in the current environment.
Gold is one of the better performing commodities over the last 12 months by virtue of simply holding its value over this time frame. To date, it has resisted the negative influence of a strong $US, however the prospect of Fed tightening in the second half of this year is a significant risk.
The potential private equity bid for Bradken (BKN) was pulled this week with the company suggesting that difficulties in accessing debt the cause. This is not the first such transaction to unravel and we have tended to steer well away from playing takeovers in portfolios. Last year, Treasury Wine (TWE) and SAI Global (SAI) were unconsummated. Now we have Pan Aust (PNA) and possibly Skilled Group (SKE) also unlikely to be acquired. The safe outcome is for investors to sell stock into a suggested offer, rather than wait for the risk that it does not come about.
A secondary issue is that this may be a sign debt markets are becoming a little more selective on what they will fund. Private equity realised a large number of companies in IPOs in 2014 and need to replenish their holdings as they have an incentive to be fully invested. Debt, however, plays a very important role in achieving the required returns.
Market Focus: US Earnings Season Progress Report
With an equity market that comprises around half of all global equities, results from US companies have a large influence on international equity returns. US companies provide quarterly earnings figures to the market, ensuring a more continuous flow of profitability and outlook commentary. Reporting season in the US commences earlier than Australia, with earnings announcements typically within two weeks of each quarter end and over the following four weeks. This week is the busiest of reporting season, with results from just over a third of S&P 500 companies. Here we look at some of the themes and trends to emerge from results so far.
Earnings Beating Consensus
As is often the case, more companies than not have beaten consensus earnings forecasts. However, expectations have not been high, with earnings per share (EPS) growth anticipated at 4% compared with the fourth quarter of 2013. As the chart below shows, EPS forecasts are typically revised lower in the lead-up to reporting season, however the revisions over the last three to four months have been much sharper than average. Overall, EPS growth expectations for the fourth quarter are almost 5% lower than late last year.
S&P 500: Quarterly EPS Estimates
While most sectors have had their earnings estimates lowered over this time, unsurprisingly it has been the energy sector that seen the most dramatic cuts. This sector only represents 8% of the S&P 500 (which is higher than the 5% weighting in the S&P/ASX 200), yet the overall impact to the market has still been significant given that forecast EPS across the sector has been reduced by nearly 50% following the rapid fall in the oil price. Consumer discretionary companies will, of course, be the ultimate beneficiaries of lower oil, although the translation into improved earnings is not as immediate. So far, guidance issued by companies has been lower than the market’s expectations.
Variation Across Sectors
The 4% EPS growth across the market is a lower figure than recent years, but not all sectors are showing weaker growth figures. IT, industrials and health care are all reporting double-digit expansion, in part due to buybacks reducing the share count. Aside from the slowdown in the energy sector, the financials sector has also been weak following a period of slower trading revenues coupled with legal costs relating to the settlement of a recent currency manipulation case. The outlook for banks is better as these legal costs roll off, although uncertainty remains given the timing of expected Fed rate hikes this year.
The $US has appreciated against most major currencies over the last 12 months, particularly the euro. Nearly a third of S&P 500 revenues are sourced from overseas markets and the translation of these profits will thus be lower compared to the respective underlying market growth. Compounding this is the reasons for the strength of the $US, including recent relative economic weakness across a number of regions. Thus, there is the dual impact of lower demand translated into the stronger $US. Some companies will have hedging in place that will limit this impact, although this will only be delayed if the strength in the $US is sustained.
Net profit margins across S&P 500 companies has risen steadily since a sharp rebound following the GFC and are now at record levels. There are a number of reasons to explain this change, including reduced debt levels and interest rates, constituent changes in the index (e.g. higher weightings for IT companies) and lower tax rates. Nonetheless, any mean-reversion of this trend is currently a risk for the market.
Over the last few years EPS has grown at a faster rate than underlying profitability due to the fact that companies have been buying back stock. With higher debt ratios and a less friendly high-yield market, this may be less of a factor in the coming year.
Of all developed equity markets, the US has enjoyed the strongest returns over the last five years - the S&P 500 compounded 15.5% p.a. over this time to 31 December 2014. Similar to Australia, however, valuations have outpaced earnings growth, resulting in an expansion in P/E multiples above historical averages (particularly if the technology boom is excluded from calculations). We believe that It is unreasonable to expect a similar return profile in the medium term, although we note that equities are likely to remain a preferred asset class for many investors while interest rates remain low.