A summary of the week’s results


Week Ending 31.03.2017

Eco Blog

What will take US growth higher? A bout of consumer spending or business investment, or both? This path will determine interest rates and equity performance in the coming year.

Europe is holding pace, with private sector investment leading the way. Imbalances, and of course, politics, could knock it down.

Locally, all data points to a soft CPI. If the heat goes out of housing, the RBA is gaining ammunition to take another shot at lower rates.

If US sentiment indicators was the economy, the rate of momentum would be striking and sit in contrast with expectations of a moderate GDP for the first quarter of the year.  Underlying consumer confidence shows that older Americans have very high expectations of improved conditions, while younger households are less ambitious. All respondents correctly assess that the job market is robust and that interest rates will rise. Where they differ from financial market predictions is that households believe inflation will ease, though the estimated CPI is higher than actual realised CPI.

US Consumer Confidence and Personal Consumption


If the pattern represented in the chart above is to hold, real spending should pick up over coming months and the supportive strong labour markets and benign inflation add to that theme.

Given much talk about reviving the US business sector, stronger economic growth is still coming from consumer spending rather than investment. Indeed, in the past year, US investment spending has been weak, mostly due to the energy sector, but it is still unusually soft given the nature of this economic cycle. It further illustrates that businesses react to changes in the fundamental conditions in their industry rather than policy.

The long-term chart below shows that weak private sector investment is commonly associated with recessions.

US Private Non-Residential Fixed Investment

Source: FRED (Federal Reserve of St Louis, US Bureau of Economic Analysis)

On the assumption the new administration will engender investment, the US may see both consumer and business sector growth accelerate. In turn, interest rates may go up faster than expected and both these factors lend themselves to a different mix of equities to those that served investors well over the past few years. We are mindful of this potential change when considering global equity portfolios.

By contrast, Europe has been the opposite, with private investment spending driving the Eurozone through 2016. Manufacturing indicators suggest this pattern will extend into 2017.


Europe has been the beneficiary of the fall in the Euro, resulting in business investment. Further, its industries have higher capital intensity than the US. As an example, in the S&P 500, the technology sector makes up 21% of the weight, whereas in Europe it is only 4.3%.

German federal debt to GDP continues to edge lower, registering just under 35%. For Europe as a whole, the level is stable at around 77% (well below the US) and, therefore, the government spending growth in the above chart is being funded from fiscal inflow.

There are many of the view that Germany is holding back growth in Europe by absorbing a large current account surplus through trade and an austerity-like grip on its government sector. The question is what it can do to reduce this imbalance. Stimulating the local economy would likely spark higher inflation, given the already low rate of unemployment. Encouraging domestic demand for goods from other countries is easier said than done and reflects consumer preferences. In another world, the likely path to adjustment would have been a higher currency. In the Euro, Germany is tied to the weak outlook and policy settings for its cohort. Further, its high household saving rate is not out of kilter with its aging population.

Another fix could be higher fiscal spending. Some can be driven by defence as Germany moves to 2% of GDP; part of its NATO obligations. Other government spending may do little to reduce a trade surplus if it reinforces Germany’s competitive advantage. In practice, the most effective way for Germany to re-balance its surplus is by investment into other European countries. Many would understand why corporates are reluctant to do so.

There is a growing consensus that Germany, and therefore Europe’s, trade growth has, in any event, peaked. Subtle or direct pressure on trade balances from the US may start to play a role. China is also buying less industrial goods from Europe as it moves to higher value-add local manufacturing. If Europe does turn to government, investment and consumer spending, the mix of stocks within European portfolios is likely to also change. Of course, the real solution for Europe would be less regulation and lower tax rates; a universal call.

Locally, the CPI release due at the end of April is the next guideline for the RBA. In the meantime, ARPA is leaning on the banks to curtail housing lending. The RBA may therefore be able to focus on the weak labour market and its mandated inflation of 2-3%. Indications are that core the CPI will be weak. There is the usual seasonal impact from health and education (where price rises are introduced once a year) and the likely bump up in fresh food prices due to the cyclone in Queensland. But low wage growth will certainly hold back many sectors along with sloppy consumer spending. Will the RBA be tempted to drop rates one more time?

Add into the mix the change in the outlook for our current account with higher export values and low import growth. China’s high PMI for March released this Friday did not move any part of the financial markets. Given the clamp down on their property sector, it appears the assessment is that restraint in China is unlikely to see iron ore prices take a further leg up. Will this be another helpful signal for the RBA to drop rates?

Fixed Income Update

Heightened levels of bond issuance in the US and emerging market countries has resumed following a brief pause for the week of the FOMC rates meeting.

- Many global bond fund managers have added exposure to Mexican bonds as these assets appear undervalued.

- Suncorp has issued a new domestic hybrid in the ASX-listed market.

Following a short breather, the new issuance market is now back up and running. As many emerging market countries issue debt in USD, they have increased their borrowings ahead of further moves in US rates. It also reflects better conditions for emerging market economies given their frequent reliance on commodity prices and global trade. Governments in Asia (excluding Japan) have borrowed $8.2bn in the year so far, up from $6.5bn over the same period last year. Indonesian is one of note, with a $3billion bond launched last week.

Investment grade corporates in the US also resumed their record levels of new issuance in 2017 with technology, healthcare, auto and financial companies all issuing new bonds over the last week. While these deals are still said to be oversubscribed, the demand appears to be waning. In the last week, credit spreads in the US have widened slightly, following a six month run of spread contraction. The chart below shows the trajectory of credit spreads since October last year.

US Investment Grade Credit Spreads

Source: Bloomberg, Escala Partners

Emerging market debt typically performs poorly in a US rate rising environment, although this hasn’t been as widely felt as some predicted. However, the US election result has had negative repercussions for Mexican debt. Uncertainty on trade policy caused the peso to fall to its lowest level ever against the USD, given more than 80% of the country’s exports go to the United States. While there has been some correction in the last two months, the Mexican peso is still trading well below its long term average. This currency weakening has forced the central bank to repeatedly raise rates in order to shore up the currency.

Mexican Central Bank Cash Policy Rate


Rising inflation has also added to the need for tighter monetary policy, resulting in the official interest rate doubling within a year. For bonds in local currency, the impact of the lower currency and higher rates has led to a notable fall in asset prices. As some fund managers are of the view that the President’s trade policy election promises are unlikely to completely come to fruition, these bonds look undervalued.

Domestically, Suncorp brought to market a new five year capital note which converts to equity after seven years, if not called two years prior. The issue margin came at BBSW +4.10%, which appears tight for this credit, but is reflective of the contraction in spreads that has ensued over the last few weeks. The expected issue size at $300m is on the smaller side, which could make liquidity a challenge.

Corporate Comments

APRA have announced additional supervisory measures that are designed to slow investor housing lending. The banks may see a pick up in margin as a result offset by some loss of volume growth. 

- Bank of Queensland (BOQ) missed expectations with its first half result, favouring credit quality over volumes. 

- Corporate activity remained in the news this week, although without any firm bids emerging. 

APRA’s macro-prudential policy intervention in the Australian banking sector continued this week, with the announcement that banks will now limit the flow of interest only residential mortgage lending to 30% of a bank’s total new lending, along with a tightening of loan-to-value ratios (LVRs) for such lending. In better news for the industry, APRA made no change to the 10% growth cap in investor lending (for each individual bank) that it had previously enforced. This had proven effective in cutting investor lending growth, thought to be at risk following a rebound in the second half of 2016.

Of the major banks, interest only lending had represented approximately 40% of residential loans, with the majority of investor loans in this form. APRA’s modified rules are thus targeting this higher risk segment of the market and will likely act as a further headwind for broader credit growth in the system (absent investors switching to principal and interest loans). From an earnings perspective, the news is not all bad for our banks. Lending restrictions such as these are likely to lead to further out-of-cycle mortgage hikes (as seen in recent weeks) as competition for new business eases, which should be incrementally positive for net interest margins of the sector

Residential Mortgage Lending: Rolling Growth

Source: APRA, RBA, Escala Partners

Bank of Queensland’s (BOQ) first half earnings were below expectations, although the key drivers were relatively consistent with the updates from the major banks. For the six months, earnings declined by 2%, which was limited by a fall in the bank’s bad debts expense. The dividend was held constant for a fourth consecutive half, reflecting the stalling of dividend growth across the banking sector. Coupled with a weak earnings trend, the bank’s payout ratio has increased to 84% in the half, leaving little margin for error in coming periods.

BOQ has adopted a strategy of credit quality over lending growth, given the pressures evident in funding costs and the high levels of competition for mortgage lending. While its asset quality is thus relatively sound, this has led to a contraction in lending volumes and thus top line revenue. Management did a good job in restricting expense growth to just 1%, however with revenue weak. The bank’s cost to income ratio thus increased, resulting in negative ‘jaws’.

Despite the mortgage repricing that the banks have undertaken since the second half of 2016, BOQ’s net interest margins still contracted for a second consecutive half, with term deposit spreads (a key source of funding) lifting again. The outlook here looks marginally better, and if BOQ were to follow the majors with repricing (as they have done in recent weeks), this remains an incremental source of margin upside.

Bank of Queensland: Term Deposit Spreads

Source: Bank of Queensland

BOQ remains relatively well capitalised, although it has taken a cautious stance ahead of any further tightening of regulatory capital guidelines. A point in its favour relative to the major banks is the average residential mortgage risk weighting across its book of 42% (the major banks are between 22% and 25%) and its healthy deposit to loan ratio, in excess of 70%.

Relative to the majors, BOQ currently trades on a lower price to book ratio and P/E, which would appear warranted given its inferior return on equity. The stock has some appeal from its high dividend yield, although the dividend may be reviewed should recent earnings trends persist. At this stage, the sector looks fully valued after a recent run on the back of a steepening yield curve and a further dip in bad debts, although the earnings outlook remains benign.

Following Downer EDI’s (DOW) bid for Spotless (SPO) last week, corporate activity remained in the news with several companies making headlines. The common thread between companies this week was that all have been fairly disappointing for investors over time and that none have, to date, materialised in an actual offer.

Myer (MYR) shares jumped after Solomon Lew’s Premier Investments (PMV) emerged with an 11% stake in the company, although a full takeover offer appears unlikely and may simply be a strategic position. Fairfax Media (FXJ) has reportedly attracted interest from private equity group TPG Capital with the intention of realising the value from separating the Domain assets. Fairfax has, however, already rallied on plans by the company to list the group into a new ASX-listed entity. Meanwhile, LIC Ariadne Australia has emerged as a substantial holder of Ardent Leisure (AAD) (which posted a disappointing result last month) and hotel manager Mantra (MTR) has rebounded on speculation that international hotel group Marriott was considering an offer.

The biggest losers from this week’s developments are likely to be short sellers that have benefited from the weakness in the supposed targets. However, shareholders buying now to participate in any further bid premium are likely taking a high level of risk given the lack of concrete offers.