Week Ending 30.09.2016
• The consequences of low interest rates are likely to define financial markets for some years. While Australian private portfolios have no direct link to pension obligations, the impact of the asset allocations of these major market participants will substantially determine the demand, and therefore the returns, of asset classes.
Investors are increasingly aware that low interest rates will have a significant impact on long term portfolio returns. Negative sovereign yields and tight nominal yields in any relatively secure credit has chased money into risker assets or, in the case of institutions, towards fixed assets with low but stable returns.
There is, however, another important issue at stake. Pension schemes around the world are underfunded as the likely return is measurably short of their obligations. To simplify, the discount rate, which should reflect the long term returns, has to fall and that means more needs to be put aside to pay the liabilities in the future. So what does that have to do with an individual who does not expect to rely on support from others? There are two issues to consider. Firstly, the behaviour of the majority of investors will determine the direction of any asset class and secondly, governments will have to confront this dilemma.
An example of the US system is shown below. Current state based plans assume a 7.6% annual return and 2% inflation to meet their requirements. JPMorgan has modelled a 6% return. Neither are compelling. The higher return (rolling 30 year) lulls one to believe that this will be sustained. History shows it will not if inflation is higher or growth is lower.Enlarge
There are no solutions, rather choices. Higher taxes are the most obvious. Higher debt is also likely but with the interest rate suppressed by central banks. Neither are attractive for investment returns. An ironic conclusion is that higher interest rates may be part of the answer.
The importance of the eventual level of US rates is likely to become the key issue over the coming years. Liability investors (such as pension funds) will work hard to avoid getting caught out by holding too much long duration into a rate rise which would undermine their efforts to get the required returns and the flexibility to invest into higher yielding issuance in coming years. The argument can be made that it may be necessary for pension funds to hold riskier assets to make up for the shortfall from bonds. The charts below show the asset allocations across developed markets and the mix of defined versus contribution schemes.Enlarge
In developed countries there has been a progressive move from stock market equities into fixed assets, private equity and other alternatives. This is not because they necessarily will provide a higher return and, in the case of most hedge funds, they have not, but they do smooth the outcome.
As funds have to pay out to aging demographics, the fixed asset allocation will be a challenge to manage given that it cannot easily be realised. It is therefore hard to imagine the equity component can fall further.
Pension Asset Allocation: 1996 - 2015
In emerging markets (EM) the pension allocation is mostly skewed to fixed income, with equities representing around 20-30%. This is likely to rise and provide support for EM equities in the long run.
The drenching received across much of Australia this spring is likely to have mixed fortunes for the agricultural sector. Prices in many commodities are up this year, however output growth is muted. The all-important wheat sector is the converse with global supply looking strong this year and thus pushing down prices.
Some of the detail in specific products reflect trends. For example, local production of chickpeas has followed a remarkable surge in pricing due to high demand from India.Enlarge
Grape prices too have a strong fashion flavour. Grenache is matching the perennial favourite, pinor noir.
Finally for those hoping these rains will ease, the BOM La Nina watch update suggests the weather will return to ‘normal’ by the end of spring. The good news may be that La Nina rarely lasts more than a year.
Fixed Income Update
• Most fixed income portfolios carry a meaningful exposure to the financial sector. The risk in interest rates is not the only one. Regulation and behavioural issues are as prominent.
• The US mortgage backed market is back in favour, with a range of options for global managers.
More often than not the discussion on fixed interest is on movement in rates and the influence of economic data. There are, however, company specific or sector events that also will have a significant impact on investment returns. The most obvious was the fall in the oil price a year ago and consequent dislocation in the high yield sector which had funded much of the recent energy expansion.
Less obvious is the impact of corporate governance. In the US, Wells Fargo, long upheld as the most stable US bank and largely untainted by the financial crisis, was found to have succumbed to misleading behaviour brought about by aggressive targets on ‘cross selling’ product to customers. Not only has the share price taken a hit, but the cost of funding its balance sheet has ticked up. This factors in the higher risk the bank now faces, given possible regulatory ramifications. Further, revenue growth is likely to be impeded by a change in management strategy. Wells Fargo has enjoyed lower funding costs that its peers, who have greater complexity in their business models.
The table below shows the move in CDS spreads (a reflection of funding costs by pricing in default risk) in September. While a small change, that of Wells Fargo has more than doubled its peer group and with bank margins tight, it can ill afford any such outcome. Financial sector debt is typically a high weight in most fixed interest portfolios. Corporate governance issues are usually limited to the organisation, for example the Volkswagen emissions scandal, but in the financial sector there are often industry wide repercussions.
The risks in the Australian banking sector are possibly even higher as they follow similar business models and have very similar exposure to credit risk. In the event of any unexpected issue, naturally the equity would take most of the hit, but hybrid and debt markets would not be unscathed. Limiting excessive exposure to financials is key within Australian portfolios.
Another side of the US banking coin is the securitised mortgage market, the source of much of the pain back in 2008. Now, conversely, these represent attractive investments for investors looking for yield. Along with the substantial improvement in house prices, higher employment and greater oversight, residential mortgage backed securities (RMBS) in the US have been a winner this year. As the pool of mortgages matures, it usually benefits from lower LVRs and an established pattern of payment by the home owner. The table below illustrates the options in the US RMBS market for a global fixed income manager with varying pricing across years and risk.
• Coal prices have staged a remarkable recovery over the last two months, however most analysts question the sustainability of the rally. Nonetheless, there exists upside risk to earnings forecasts for several large cap companies, including BHP Billiton, Rio Tinto, South32 and Wesfarmers, should prices remain elevated and take time to adjust.
• AGL Energy’s (AGL) AGM resulted in further clarity on its FY17 guidance, while the announcement of a buyback helped to lift its share price.
Amidst the broad-based commodity price recovery that has occurred over the last six months, the most spectacular rise of the more common commodities has been in the coal market, particularly since the beginning of August. This has been particularly notable given that global coal demand is below peak levels of a couple of years ago.
Several factors have contributed to the spike in prices (see chart below), including some disruption to supply from poor weather in Queensland and an increase in demand from stimulus-led activity in China. However, the primary factor, ironically, has been production cuts in China. In April, the Chinese government introduced measures to support the domestic coal industry and address the global supply glut by reducing the number of working days at Chinese coal mines from 330 per year to 276.
Hard Coking and Thermal Coal Prices ($US/t)
All coal prices have risen, including coking coal (or metallurgical coal, used in steel-making), and thermal coal, which is used in power generation.
Coking coal has seen the most significant move in prices, with China’s domestic production accounting for a significant proportion of global supply. China’s steel mills have had improving profitability, which has allowed the industry to absorb higher prices (in a similar manner to iron ore). The metallurgical coal market had previously experienced a price spike in 2011 when flooding in Queensland affected the production levels of a number of mines. Australia accounts for more than half of the seaborne market, with most metallurgical coal mines located in Queensland.
For coking coal, the jump in imported prices into China now materially exceeds the domestic price (which have still risen substantially), a situation that hasn’t been in place since the aforementioned Queensland floods. The seaborne spot price is also now well above the cost curve, indicating that even higher cost miners are achieving attractive margins. With a significant amount of supply shut down over the last three years, sustained high prices would inevitably see this quickly return to the market.
How long the market takes to adjust may ultimately come down to any further changes in Chinese policy, particularly if production controls are relaxed following the recent price gains. While this has a high level of uncertainty attached to it, changes could result in a rapid reversal of the recent run up.
So, which ASX stocks stand to benefit the most should the current pricing environment persist for longer than expected? There are several large cap companies that could potentially see earnings upgrades in coming months as analysts update their models with revised coal price assumptions.
Of the two big diversified miners, BHP Billiton (BHP) and Rio Tinto (RIO), BHP has better leverage to cokingl coal. Both miners disclose their sensitivities to earnings from changes in their core commodities. Compared to the prices that BHP achieved for coking and thermal coal in FY16, current spot prices (if sustained for a 12 month period) would result in an approximate US$5.5bn increase in EBITDA, a 45% increase on the group’s combined EBITDA for FY16.
Rio Tinto has a greater dependence on iron ore and the earnings uplift is not as significant. Compared with FY15 (the company operates on a calendar year basis), current spot prices would still result in an almost 20% increase in core earnings over 12 months.
BHP spin-off South32 (S32) is another company with coal exposure, however thermal coal has greater importance at more than four times the production in thermal coal compared with coking coal. Given its higher cost operations, the uplift to earnings is large. Current spot prices could add nearly US$1bn to EBIT over 12 months, compared with the group’s total EBIT of US$365m for FY16.
These days Wesfarmers (WES) is predominantly a retail company, with Coles and Bunnings the primary drivers of earnings. While earnings from its coal operations have fallen materially over the last few years as the coal price has declined, the large price swings from commodity markets still add an element of cyclicality to the overall profit picture. WES produces
arginally more coking coal as opposed to thermal coal, however less than half of its coking coal sales are of the premium hard coking coal type, with semi-soft and PCI coking coal sold at a discount. Nonetheless, current spot prices would result in an approximate $600m increase in EBITDA over a year, which would represent a notional 13% increase on the group’s underlying EBITDA for FY16.
The above figures show that there is considerable upside to earnings across a number of coal miners should the recent rally last. Of course, the assumptions are based on spot prices persisting for a full year. Few are anticipating this outcome and the upgrade to consensus numbers is unlikely to be as great, given that current broker forecasts would already have factored in a rise in coal prices for this financial year. Nonetheless, at this stage the sector should be the subject of earnings upgrades in coming weeks and months.
AGL Energy (AGL) provided further clarity on its earnings guidance for FY17 at its AGM this week, with the mid-point of the wide range representing 8% underlying earnings growth. This is despite the previously disclosed fall in margins that is expected to flow through from its gas portfolio. With its larger power generation asset portfolio, AGL looks set to benefit from an improving wholesale electricity market over the next few years as the supply/demand balance tilts in its favour and a degree of continued market rationalisation. The realisation of this benefit is less clear, however, given the roll off of its existing hedges that it has in place.
While the group’s guidance was largely in line with expectations, the bounce in AGL’s stock price was more likely due to changes to its dividend policy (now targeting a 75% payout ratio) and the announcement of a share buyback. Though this does little to achieve long-term growth, returning additional capital to shareholders has been a popular way to give support to a company’s share price in this weak earnings growth and low interest rate environment. In addition, it was thought that the capital may have been set aside to fund a bid for some of Alinta’s assets, which is now likely off the table. On a forward P/E of 16X, similar to the broader market, AGL screens as reasonable value given its expected medium term earnings profile.