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WEEKEND LADDER

A summary of the week’s results

30.06.2017

Week Ending 30.06.2017

Eco Blog

- The worry factor in financial markets remains high in the face of reasonable trends outside of wage growth and inflation and out of sync with consumer confidence.

- After trading in a narrow band, the question is whether the recent break in exchange rates is heralding a change in pattern. In turn, this feeds into the dilemma for the RBA.

The second quarter looks to be running out in a puff of smoke. Global economic activity is growing at a reasonable pace, yet there are many indicators that cloud the momentum. Most prominently is the lack of wage growth and inflation, now an imbedded topic de jour for the economic contingent. If this is determined to be a structural feature (demographics, skills, trade etc), then the case can be made that interest rates should be lifted to a notional ‘natural rate’ that is in keeping with these slower conditions. Perhaps the focus should therefore be on other indicators rather than just these two.

US consumer confidence (the long running Conference Board Consumer Index) has hit its straps with the 35-year cohort registering their highest index level since 2000 and all with age groups in net positive territory. We can only conjecture on why that is the case. It could be the jobs market in the information economy, it could be that wage growth is improving as the well-regarded Federal Reserve of Altanta Wage Tracker shows under 25 are achieving a median 7.4% increase over the past year. Even living at home or in a rented apartment may take the pressure off the weight of mortgage burden (while ignoring the growth in student loan liability).

A change in attitude in this cohort could go a long way to sustaining the US economic expansion. If household formation rises, mortgages and babies follow. Mortgage demand has eased in May but remains up 7% year on year. There was some clamp down on refinancing to cover other debts and spending. The mortgage rate (15-year) is remarkably stable currently at 3.48% versus 3.54% in 2014. Compared to Australia, the loan size is within reason and price increases at 5-6% is considered to be about right in maintaining the wealth effect.

Source: Mortgage Banker Association/Haver Analytics
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It is hard to find data that points to more than the natural ebb and wane of activity. Therefore, the forthcoming government policies (healthcare and tax being the primary) and any unexpected interest rate move are the two possibilities that could derail things in the coming months.

The (in)accuracy of financial forecasts is a common point of discussion, none more so than the graveyard of currency predictions. This may be due to the nature of the foreign exchange market, where speculative and positioning volumes dominate those related to trade and hard asset flows by a factor of four. There is no central clearing market or governing body and the size of the position can be as big as you like. And of course, it’s a purely relative relationship between currencies, unlike other financial instruments which have absolute valuations.

This week the deputy governor of the RBA, Guy Debelle, addressed some of this in the official launch of the FX Global Code which has come from an effort to clean up some of the misbehaviour that had become endemic in foreign exchange markets. The initiative, started by the Bank of International Settlements (with the committee chaired by Debelle), also included the trading institutions, but ultimately has to rely on a code of conduct rather than the capacity to regulate these markets. It does not suggest that the market is distorted, but rather that shorter term movements may, for good reason, have no relationship to the long-term rate.

On the other hand, the relative valuation methodology is not dissimilar to other markets in comparing inflation, interest rates, economic policy and financial flows. Earlier models of purchasing power parity (PPP) or the Economist Big Mac index, have given way to judgements on the impact of current accounts and capital flows.

For the moment foreign exchange trades are rallying behind global growth.  Some trades are the result of an unwinding of short positions in the Euro, as the perfect storm of better than expected political outcomes and growth eroded the almost unanimous views of a stronger USD based on rate hikes and ‘Trump trade’. By default, the USD is weakening, not as a signal of concern on growth for the US, but due to flows elsewhere. That is likely exacerbated by the view that the ECB will lighten off on its quantitative easing later this year.

However, if the tightening of liquidity really does transpire into the second half, the tables could well turn back in favour of the USD, especially if that is accompanied with greater volatility in financial markets.  

The forward markets refuse to engage in any debate and are assuming exchange rates remain roughly where they currently are. Most economists lean towards a slightly stronger USD, but also suggest the USD is somewhat overvalued. Those apparent conflicts can prove right. Currencies can be assessed as persistently over or undervalued….and then move quickly. The sharp fall in the AUD/USD in 2013 and move in the USD/Euro in 2015 are a case in point.

Australian Dollar Trade-Weighted Index*

Source: ABS, RBA, Thomson Reuters, WM/Reuters
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The impact of currencies on investment portfolios is most obvious through the hedged or unhedged global equity weighting, as fixed income is predominantly hedged. Yet that belies a much greater influence. In fixed income, exchange rates play an integral part in terms of the direction of bond markets. Equity performance, particularly in the ASX200, is often determined by views on the movement of the AUD.

The recent strengthening of the currency could become a bigger issue were it to persist. The RBA is invariably caught up in the implied tightening of financial conditions brought about by AUD rallies, right at a time when it is hoping that business activity levels pick up. While there is a suggestion a rate hike could be forthcoming, any persistent strength in the AUD is an implicit hike and, along with the moves in mortgage rates by the banks, is more than likely enough for the RBA unless there is much better evidence the labour market and wage growth is improving.

Fixed Interest Update

- Global bond prices fall on the back of a ‘less dovish’ speech by ECB president Mario Draghi as the market prices in a winding back of the European Quantitative Easing (QE) programme.

- The recent flattening of the US yield curve marks concerns for some experts, while others point to imbedded structural differences from previous market cycles.

There were some significant moves in bond markets this week following on from the speech by ECB president Mario Draghi. He stated that “deflationary forces have been replaced by reflationary ones” in reference to strength in the Euro area. With respect to the bank’s policies he added that “the central bank can accompany the recovery by adjusting the parameters of its policy instruments — not in order to tighten the policy stance, but to keep it broadly unchanged”. These comments gave cause for the market to start pricing in the gradual exit of the QE program. Draghi’s comments also suggested that the central bank may be looking at raising interest rates.

Even though this has been under discussion for some time, the market still had a notable reaction, with European bond prices falling across the curve. German, Italian and French 10-year govt bond yields rose 0.13%-0.17% immediately following the speech and traded 0.20%-0.25% higher by the end of Thursday. Rates on the 5-year government bonds in these countries also jumped, up by 0.20%. Most notably out of these three nations, the Italian government bonds have had a bigger reaction to this change in sentiment given the support that the quantitative easing has for bonds in the peripheral countries of Europe, i.e. Italy, Spain and Portugal.

Yield movement on the Italian 10-year government bond

Source: IRESS, Escala Partners
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Australian bond prices also fell on the news. The yield for the Australian 10-year note gained 0.25% over the following days, taking it to a five-week high. While the pricing on short dated (0-3 years) domestic government bonds tends to be driven by expected policy decisions by the RBA, the long end of our curve is often driven by global factors. Despite this, the yield on the 3 year bonds are also up 0.13% over the week.

The US market also followed suit, with the yield on the US 10-year Treasury, reaching higher than the level when the Federal Reserve raised interest rates earlier this month. This lift in yield on the long end may help to dampen concerns regarding the shape of the US yield curve which had some market participants expressing fears that the recent flattening of the curve is a pre-curser for a US recession. 

Despite the fact that the US Fed has raised rates at 3 consecutive quarterly meetings and looks set to continue their tightening trajectory, there has been a significant flattening in the US yield curve. The rate rises have been pushing up the short end, particularly the 2-year maturities, while the bond yields on the long end (10-30 years) have been falling, driven by waning inflationary and growth expectations.

The spread differential between the 2 and 30-year treasury yields fell to a 10 year low this week of just 137 basis points, edging back to 146bp at the end of the week. This is down from over 200 basis points late last year. A flattening of the yield curve, that leads to an inversion, tends to be used as an indication that a recession is looming.

The flattening of the US Yield curve in the last 7 months

Source: Escala Partners, Bloomberg
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Based off historic trends, one would expect to see the yield curve invert coinciding with a recession, or for bond yields on the longer end to significantly rise. There is a view yields would need to lift by 50-70bp on the 10 and 30-year bonds to return the curve to ‘normal’.

However, things are different this time around and there are a number of arguments that suggest that interest rates will stay low and the curve may remain flat for a prolonged period. While changing demographics and increased debt levels since the financial crisis are expected to have large implications for monetary policy settings long term, there are some immediate trading dynamics which are keeping bond prices high and yields low. These include:

- The continued impact of global central bank policies, with the net effect that there are buyers of US treasury bonds over those in Europe and Japan as they search for some yield given rates are higher in the US than in these regions. Increased demand for US treasuries over other bonds in the developed world has helped keep bond yields low on the long end.

- This year, China has increased its purchases of US treasuries. In 2015 and 2016 China was a net seller of the USD and US treasuries in an attempt to defend its currency. However, in recent months it has not needed to do this as USD strength abated. This has led to a build-up in foreign reserves and buying of US treasuries.

Yuan and China's holdings of US Treasuries

Source: Bloomberg, AFR
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Corporate Comments

Link Administration (LNK) has become a higher risk/reward proposition following its offshore expansion and equity raising this week.

- IAG will receive a boost from reserve releases in FY17, although it is likely that this will only be a short term lift to earnings.

- Viva Energy (VVR) has followed recent REIT equity raisings and expanded its own portfolio of service stations.

Link Administration (LNK) received broad investor support this week after it announced the acquisition of UK-based Capita Asset Services for $1.5bn. The acquisition represents a material change in Link’s geographic exposure, moving from a predominantly domestic Australia and New Zealand business to one with more than a third of its revenue generated by the UK and Ireland.

Capita operates in similar divisions to Link’s core funds administration and share registry businesses. In addition, the acquisition will add new business lines in debt servicing and trustee services. The deal is to be funded by a mix of debt and equity (the institutional component of the capital raising conducted early this week) and will increase the leverage on Link’s balance sheet.

Link has paid a relatively full price for Capita, yet the transaction appears to be timed rather opportunistically – taking advantage of the weakness in the pound, a seller that needed capital, and an ability to conduct an equity raising at a valuation that trades at a healthy premium to the market (despite a recent de-rate). While the price paid appears to be on the high side, the transaction has been sold as highly accretive to earnings per share, which is prior to any synergies realised by Link.

At face value, the deal looks attractive to Link, although the risk profile of the company has also risen. Australian companies have had a chequered history expanding into offshore markets and the Capita integration will need  to be managed alongside the ongoing integration of Superpartners. Additionally, the high recurring revenue streams (~90%) of Link’s Australian business will be somewhat diluted by the Capita business, which has only approximately half recurring revenues.

On a more positive note, the revenue profile of the acquired businesses appears to be better than the flat outlook for Link’s existing domestic businesses (FY17 revenue has been guided to be in line with FY16). This is likely to become a greater focus for investors as its expected synergy savings roll off in the next couple of years.

Capita Asset Services Revenue Profile

Source: Link, CAS
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IAG gave a late financial year bonus to investors, announcing that larger than expected prior period reserve releases (5.0% of net earned premium, up from an initial estimate of at least 2.0%) would help to lift its full year margin guidance by 3.0%. Reserve releases occur when an insurer reduces the expected claims liability on its balance sheet because of a change in assumptions or better claims experience.

In this instance, IAG has pointed out that long tail classes (i.e. the claim can possibly be paid out years after the premium is received) such as compulsory third party car insurance, liability and workers’ compensation have performed favourable relative to expectations. Low inflation, particularly wage inflation, has been one of the key drivers of this outcome, with wages growth having fallen from a rate of 3-4% five years ago, to approximately 2% today.

This is clearly a low quality, short term cyclical driver of earnings for IAG (and will likely see an uptick in the final dividend) and thus few would be capitalising this margin rise into IAG’s future earnings. Reserve releases are typically a feature of profits for insurers, although notably IAG generally assumes a 1% of net earned premium release per annum. While IAG has averaged closer to 3% over the last few years, a mean reversion at some point is inevitable. Moreover, reserve releases in the future will gradually accrue more to Berkshire Hathaway following IAG’s quota sharing agreement formed two years ago.

IAG Reserve Releases

Source: IAG
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Underlying factors should be of more interest to investors, including premium growth, competition and better cost management of short tail claims, such as natural perils, home and motor insurance. To this end, some more favourable trends were evident at its half year results, with premium rate increases and a possible shift in the commercial cycle in Australia. Nonetheless, while IAG’s earnings volatility has reduced following its quota sharing deal, its P/E is now higher relative to the ASX 200 than at any point in the last five years, indicating that caution is warranted in investing in the stock at this point.

IAG: P/E Premium/Discount to ASX 200

Source: Bloomberg, Escala Partners
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Following the recent capital raise and acquisition by Dexus, service station owner REIT Viva Energy (VVR) raised equity for the purchase of an additional eight properties. VVR’s portfolio consists of Shell service stations and Coles Express stores, and typically have long lease terms and low single digit fixed rental increases in what is a fairly defensive sector, albeit run on thin margins.

Aside from the usual interest rate risk associated with the REIT sector and the single tenant risk for VVR, the longer term challenges for the company include potential environmental laibilities that may arise and how quickly the transition to alternative fuel sources for vehicles evolves. VVR trades on a forward yield of 5.9% and, like much of the REIT sector, a slight premium to net tangible assets, indicating some level of capital risk for investors.

Metcash (MTS) full year results came as a relief to its shareholders. Servicing the independent supermarket sector remains its primary business, notwithstanding the acquisition of the Home Timber Hardware (HTH) operations, accounting for 60% of its EBIT.

EBIT in the food supply business was flat, a reasonable achievement given sales ex tobacco (which are not profitable) fell by 4.6% on a 52-week basis. Cost savings buffered the competitive low inflation environment, though the full extent of Aldi’s expansion into SA and WA are yet to come through. The case can be made that the market share of the convenience and independent supermarket sector which differentiates its offer on a store by store basis, has now reached an equilibrium, albeit one which will not devolve from ongoing price tension.  

The liquor and hardware sectors slot into a similar industry structure. Convenience plays a big role and as long as prices are within reason, the sales may be able to grow in line with sector demand.

After ten years of negative share price performance, the turnaround in 2015 has been sustained. The stock is now trading at circa 11X earnings with most forecasts assuming the profit level will remain largely flat. Management are guiding to a 60% dividend payout, implying a yield of 5-6%. Aside from the industry dynamics, the key to MTS is the balance sheet. A good part of the damage in the past came from the leverage. There is now a focus on cash flow and debt ratios. These will underpin the yield, though there is a case a buyback would be much more to the advantage of shareholders.

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