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WEEKEND LADDER

A summary of the week’s results

29.11.2018

Week Ending 30.11.2018

Eco Blog

· The extent of the economic cycle is the hot topic of the day. New data will have to emerge to support the case that the growth achieved in 2018 can be sustained. Debt remains the major hurdle.

· US/China watchers have a busy weekend. Further support for the China economy is in the wings, while the impact of trade in the longer term and its intentions to create a domestic technological base will occupy the headlines this coming year.

· A wider view of Australian capital spending paints a more optimistic picture than the traditional focus on mining and housing. 

The reality of a slowing economic cycle into 2019 has been the biggest driver of the equity market in the past two months. Now the Fed has joined this view, judging that conditions already point to a moderating tone for the US. We have noted the downturn in housing and the lack of a meaningful uplift in investment spending or wage rises post the tax cuts (most of which appears to have gone into buybacks and owner cash flow). Most await even more stimulus from China to emerge on the rationale the slowdown there is much deeper than acknowledged. Recent European data has been very weak too, though expected to return to its low base trend into 2019.

Talk about the end of the cycle is valid. While the time is just a number, it is inevitable that a capitalist cycle develops, extends and matures. Based on history, this period has been long, with central bank control of inflation and growth resulting in lengthier cycles, on average, over the past two to three decades. Australia is an iconic case in point, having not undergone a technical recession for 20 years.

Source: MFS
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Elongated cycles have tended to come with more and more debt, a function of low and contained interest rates (which, amongst others, has resulted in the large rise in US corporate leverage) and a shift in household behaviour towards larger and more spending on housing, student loans and consumables. Tightening monetary conditions will shine a spotlight on the pockets of poor leverage. In the longer run this is a healthy development, insofar that capital allocation should weed out the weak, but through the process there is an inevitable pullback.

The best outcome would be for the US to go through a ‘soft landing’; just enough on the accelerator via a shift to real investment spending while moderating the rise in interest rates; just enough wage growth to add to real income while inflation stays range-bound given its structural measurement that emphasises goods and housing coupled with falling energy costs.

- The bearish tone on the US economy may prove to be excessive. The household sector could revive if mortgage rates stabilise and real income rises due to low inflation and higher wages. A note of caution is that this may not underpin another S&P 500 rally as other factors (for example the data privacy issues in IT) and softening margins come into play.

China’s pulse will matter more in the short term. If the outcome from the weekend’s G20 meetings does ameliorate the pressure on trade, the urgency will dissipate, but the data will still look weak into 2019. The question is how China can do the opposite of the US while also confronting its own debt burden.

Here the optimists hope that it is centered on reform rather than a blunt splash of cash. On the financial side, there are signs of liberalising capital flows, external participation in credit markets and transparent bond issuance by local government rather than state-based lending. Yet, others believe that, if anything, the current government is looking to consolidate its power than free up the economy.

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The battleground between the US and China on technological development and advantage looks set to continue. History buffs have commented on the close parallel with the mechanisation of textile production in the industrial revolution. Britain held sway for some time, but others (it is accepted that Samuel Slater copied the process) saw the opportunity to take the technology to the US and create its own industry. The US may stall and frustrate China’s intentions, but is unlikely to change the outcome.

There is also some debate on how trade will redistribute itself with the imposed restraints. On the assumption that the consumption of affected goods will not change, it is likely to mean that some products will be redirected, that excess capacity will come about if new local facilities are established (suppressing global prices) or that consumers will simply pay the higher price for the goods. The end result will take longer to assess than that revealed in any near term data points on China’s exports.

- Many underestimate the impact China has on global growth through demand for goods and services. All investors have a vested interest in how the next year or two unfold. The equity market is swayed by sentiment at present, but by most accounts has highly appealing select company thematics and valuations.

Australian investment spending is not as one dimensional as one might assume. Non-mining capex rose by 13.5% in FY18, expanding in all industries outside of retail trade. Much capex is missed in the traditional surveys as these do not measure research and development or intellectual property. Further, the ABS data does not include industries such as health, education or agriculture, which make up over 17% of the total.

The charts are indexed and therefore do not reflect dollar spending, but demonstrate the growth in many sectors over the past few years. Utility capex, mostly in renewables, has been a recent standout. Another growth sector is the spillover from the public sector infrastructure underway. It is estimated that for every $1 from the public sector, another $0.5 is added by requirements from private spending.

Source: CBA
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The combination of population growth, services exports (predominantly education), health services and structural changes (such as in the utility sector) are often ignored as a driver of growth given the emphasis on mining and housing. Each, however, does require policy support and continuity, currently somewhat absent.

- Mid cap stocks are the likely source of investment options to capture some of the broader aspects to the economy. A highly selective approach is required. Other investment sectors such as non-bank lending and private equity are alternative ways to participate.

Focus on ETFs

· ETFs aim to track the performance of an index after fees, therefore higher management fees are associated with higher tracking errors. Consequently, investors with longer time horizons have increasingly focused on the cost of their investments to improve total return.

For Australian-listed ETFs, the average ETF management fee is 0.46%. For more traditional index-following ETFs such as the iShares S&P 500 ETF (IVV), fees are as low at 0.04%. As the table below illustrates, the ETFs with the lowest management fees are those that replicate large and liquid indexes. 

source: Morningstar, Escala Partners
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Betashares recently released the BetaShares Australia 200 ETF (A200) at a record low 0.07% p.a. management fee. Whilst the name suggests that the fund follows the ASX 200, it tracks the Frankfurt-based index provider’s Solactive Australia 200 index. Despite the lower management fee, this fund is unproven as to how well it can track the index. Therefore, we prefer the iShares Core S&P/ASX 200 ETF (IOZ), which has been around for a longer period and has a substantial fund size whilst still offering management fees under 0.15% p.a.

For ETFs that replicate actively managed funds or more complex strategies (such as leveraged ETFs) fees are as high as 2.00% p.a. It should be noted that amongst these more expensive actively-managed ETFs are those that are simply managed funds disguised as ETFs. Therefore, along with the higher MERs compared to that of passively managed funds, they may also have performance fees attached to them.

As ETFs aim to track the performance of an index after fees, the higher the management fee, the higher the tracking error. Consequently, investors with longer time horizons have increasingly focused on the cost of their investments to improve total return.

The fee war between ETF providers has been more prevalent in the US. Early this year, Fidelity Investments introduced two core equity index mutual funds covering the US and international markets without any management fees. Over recent months, Vanguard Group, Schwab and BlackRock iShares have all been discounting their respective ETFs. IVV, VOO and SPY (which all follow the S&P 500) is a good example of the fee war that is occurring between providers. Investors have been moving out of the biggest ETF in the world, the SPDR S&P 500 (SPY.US), which charges 0.09%, in favour of the Vanguard S&P 500 (VOO.US), with a 0.04% fee. SPY lost approximately 7% in assets during the first half of 2018, whilst the S&P 500 was up 2% for 1H18.

In Australia, the relationship between fund flows and fees is nearly non-existent. The main reason for this is that there are 180 ETFs that follow nearly 150 benchmarks. Hence, the majority of ETFs are not competing with each other over fees as they have different offerings. 

1-Year Fund Flows versus Management Fees

Source: Morningstar, Escala Partners
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- ETFs have come to be known as a low-cost alternative to gaining broad market exposure. However, aside from management fees, investors need to also look other costs involved with investing in ETFs and their potential impact on performance.

Fixed Income Update

· Credit spreads on European Investment Grade (IG) bonds widen as the end of the ECB’s QE program looms.

· We highlight the view of one of the largest global bond fund managers who view EM debt as a buying opportunity. 

· The RBA are set to remain on hold and we question whether it has missed the boat to raise rates in this growth cycle. In the US, the Fed chairman suggests interest rates are ‘just below neutral’. 

In the last 18 months the ECB has bought ~€175bn of corporate bonds under the QE program. Additional bond purchases are expected to end this December, with the central bank only replacing existing bonds as they mature. The buying criteria stipulated that bonds needed to be investment grade quality, while its bid was also at the tightest level in the order book. The reality of the removal of this large buyer is expected to weigh further on corporate bond pricing in 2019, despite the end of QE being well telegraphed. 

European investment grade (IG) corporate bond spreads have, in anticipation, already widened after reaching their tightest level in ten years in January. In the last month the rise in spreads was sharp; a combination of the looming end of the program, further Italian debt weakness and a general ‘risk off’ sentiment in global markets. To be fair, this spread move has not been isolated to Europe, as the US and Australian IG credit indices have also weakened.

European Investment Grade iTraxx

Source: Bloomberg, Escala Partners
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- The common theme amongst portfolio managers is to be underweight European credit. Spread widening and higher bond yields are the likely outcome as the reality of the ECB’s impact works through markets next year. That said, the ECB are unlikely to raise official interest rates any time soon, with recent rhetoric alluding to this.

Emerging market (EM) currencies have come under pressure this year as the USD strengthened. Strong growth in the US led to the rise in the currency and treasury yields at the cost of many in the emerging region. Bond funds that invest in this sector are showing negative performance on a rolling 12 month basis. One such fund that has exposure to EM is the Legg Mason Brandywine GOFI Fund, and its returns have reflected this downturn.

While acknowledging that portfolio managers are known to talk their own book, the GOFI fund managers have a high conviction on debt from emerging markets that offer high real yields. 

They view select EM countries poised for economic growth and prosperity as they undergo fiscal reform, expand infrastructure and diversify their economies. Many note the success of many EM central banks and governments in reining in inflation, building reserves and turning current accounts positive. Additional to this is favourable demographics, with many emerging countries having a young dynamic labour force, which bodes well for infrastructure improvements. A longer-term trend has been the increased liquidity and accessibility of EM bonds and the positive trends in credit quality (reflected in credit ratings) over the last 25 years. EM countries with an investment grade rating now account for ~70% of the index vs 2% in 1993.

Emerging Markets Current Account Deficits

source: JPMorgan
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- The current market backdrop makes investment in fixed income a challenge. However, we do agree that the undervalued currencies in EM appear to offer a pocket of value and are likely to bounce as the US gets closer to neutral rates. Notwithstanding this, the noise will continue in the short term, especially given this weekend’s G20 meeting (which may see China and the US battle on trade) and Mexico’s presidential inauguration. We expect any recovery to take time and investment should be on the basis of a 3-5 year time frame with volatility likely.

As the domestic housing market cools, it is unlikely the that RBA will move on interest rates any time soon. In fact, some suggest that the central bank may have missed its chance to raise rates in this growth cycle, as indications of global pressures build and some forecast an economic downturn in 2020. APRA’s macro-prudential changes to restrict interest-only mortgages and the higher funding costs of the banks as bank bill swap rates reset higher (which have been passed onto mortgagees) have added the equivalent of a 0.25% rate hike without the RBA moving the needle in over two years. The futures market is pricing the probability of an upward change to the cash rate at 46% by November 2019, down from 80% four weeks ago.

With the cash rate at 1.5%, this leaves little room for the RBA to cut rates were the Australian economy to soften. This has some suggesting that fiscal policy, rather than monetary policy, is more likely to be used as a tool to stimulate growth if required. With the current government forecasting a budget surplus for next year, it is hard to disagree.  

The rates market got a lift as we neared the end of the week following a speech by the US Fed chair that suggested rates were just below the ‘neutral rate’. While next month’s FOMC meeting is still expected to deliver a 0.25% rate rise, the number of hikes is uncertain for 2019, with the market expecting less than what the FOMC’s dot points would indicate. The treasury yield curve shifted ~5bp lower falling the speech.

Corporate Comments

· Seek’s (SEK) AGM reaffirmed its FY19 guidance. Profit growth is expected to lag revenue growth in the short time as the company goes through an investment phase.

· Aristocrat Leisure’s (ALL) full year result fell slightly short of expectations, although the stock remains an attractive growth option in the market.

· Coca-Cola Amatil’s (CCL) outlook for 2019 set the scene for another challenging year with several headwinds with which to contend.

GM season continued at a slower pace through this week, with trading updates that largely reaffirmed previous guidance given to the market. This included Seek (SEK), which, like several other stocks in the ‘high-growth’ basket, has been sold off since late August on fears of rising interest rates.

Seek has been somewhat of a polarising stock in the market of late. On one side of the fence is the group that believe its core Australia/New Zealand job ads business should be attached a lower multiple given the cyclical link with the domestic economy and after a period of solid employment growth. Additionally, one could point to the other key issue, being the company’s step up in investments; which extends from the Australian division with data analytics and improving the efficiency of job matching for recruiters, to its international investments in similar job ads companies in typically less developed countries (China’s Zhaopin, of which Seek is a 61% owner, now has higher revenues than the Seek ANZ business), to its more recently created division that invests in a range of early-stage venture businesses (a selection is illustrated below).

Seek: Early Stage Portfolio

Source: Seek
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Those with a more positive view would highlight that its reliance on the Australian job market is less so these days, with a rise in ‘premium’ ad growth providing a margin opportunity, while the expansion in its international businesses has now meant that the Australian division now only accounts for just over half of EBITDA. Further, an investor with a longer term focus will stand to benefit from Seek’s current high level of investment. While shorter term profit growth is slower (and below the robust forecast revenue growth of 16-20%), a strong management team deserves to be backed for the value created in expanding and diversifying its earnings base, particularly over the last decade.

Valuing this optionality in its business maybe somewhat challenging, although is unlikely captured in simple one-year P/E ratio measure. The stock’s characteristics see the company placed as a core holding in the Selector growth portfolio.

Aristocrat Leisure (ALL) is another growth company that has benefited from an investment over several years and helped to give it an edge in a fairly competitive gaming machine market. This is best represented by the group’s design and development spend, which has tracked at an average of 11.4% of revenue over the last four years and translated into an increasing market share, particularly in the core North American market.

Aristocrat Leisure: Deisgn and Development Investment

Source: Aristocrat Leisure
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The company’s full year result, which showed a 34% rise in underling earnings per share, fell slightly short of expectations, although was still a sound outcome against the backdrop of the benign growth on offer in the broader industrials sphere. Underpinning the result was the 16% earnings growth in the Americas gaming division, particularly in the participation market (which offers operating leverage for ALL on the back of the strong performance of its titles).

After undertaking a series of acquisitions in the last few years in the fast-growing mobile gaming market, the results in this newer division were less impressive, although the integration of these businesses is now largely complete. The performance of the sector is typically reliant on bringing new titles to market and this timing can impact shorter term trends. Further investment was also flagged here, which may hinder margins into FY19.

Overall, while some minor earnings revisions have followed this result, the outlook for ALL still looks quite promising, predicated on a rising proportion of recurring revenues, positive casino surveys indicating further growth in its Americas gaming division and the added diversification provided by mobile gaming. With the stock now rebased at a lower level in the recent equity market correction, it remains one of the more attractive mid-large cap growth stocks based on its valuation and forward EPS growth profile.

In an otherwise quiet week of company announcements, Coca-Cola Amatil (CCL) provided the negative surprise that has been a feature of the last two months through various AGMs and trading updates. Similar to SEK and ALL, CCL has stepped up its capital expenditure over the last two years, however, based on its outlook statements for 2018 and 2019 (the company operates on a calendar financial year), the benefits are yet to materialise in the form of a better bottom line.

While not providing specific financial guidance, the statement that “2019 will be another transitional year for the group” was clearly interpreted as a potential earnings decline into next year (while consensus had expected profit growth) and another year whereby the company would fall short of its mid single-digit EPS growth target. Among the issues faced by CCL include weak volume growth in its core Australian business (with price investment required to stimulate sales), costs pressure provided by rising oil and aluminium costs, and the uncertainty provided by container deposit schemes introduced in NSW/ACT and Queensland.

CCL has been one of the better value-orientated P/E re-rate stories among large cap ASX stocks through this year (the stock was also one of the few industrials that had risen in the recent market correction) among what was perceived to be a benign, but gradually improving earnings profile, however these expectations can expect to be recast after today. Despite today’s selloff, recent market movements lead to the conclusion that there are better options available for investors looking for quality defensive stocks that have a solid dividend yield.


 

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