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WEEKEND LADDER

A summary of the week’s results

31.08.2018

Week Ending 31.08.2018

Eco Blog

- Changing household spending will have significant ramifications for the corporate sector. Having to choose between servicing the pattern of Millennials and younger generations versus those of the baby boomers entering retirement is becoming more obvious.

- Settling trade disputes has clear upside, creating more certainty for business and allowing currency levels to trade at fair value.

- US growth could well extend higher and further than many currently believe.

Household spending habits are becoming harder to track as consumers fragment into different payment systems, creating an incomplete picture from any one source. Nonetheless, the NAB customer spending pattern (in all forms of transactions barring cash) is likely to be reflective to the broader aggregate. State-based data is from the address of the spender.

The growth in accommodation and food services is significantly higher than other categories as consumers shift their emphasis to services and experiences from goods. The uniformity across states is high, implying this is indeed a meaningful phenomenon. Transport in this quarter is likely the impact of fuel prices, while the rise in financial services is observable in many developed countries.

Of note is that the change in household services are, on aggregate, not particularly high, somewhat surprising given the emphasis on energy costs. The falls in arts and recreation (bar the pattern from Tasmanians) is the juxtaposition to the informational media and food services trend as habits change.

Overall growth in NAB customer spending ($) by Industry and State (% change Q2 2018 on Q2 2017)

Source: NAB
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Age distinction has the caveat that the 18-29 demographic is almost exclusively using electronic payments (though this has already been the case for some time) and therefore the growth may be somewhat overstated. Even so, it would appear that this cohort is overspending and also likely to be utilising the buy now/pay later non-banking services that are increasingly prevalent.

Overall growth in NAB customer spending ($) by Industry and Age (% change Q2 2018 on Q2 2017)

Source: NAB
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  • These patterns will be expressed in many listed companies, determining their potential growth. Some, such as travel and food services, are hard to access in the Australian equity market, though there are global players in these sectors. Financial services, notwithstanding the current spotlight, appear to be on an inevitable rise.

The out of cycle mortgage rate rise by Westpac will cost the average mortgagee of $300k an additional $35 per month. Naturally, those that have borrowed more recently will have a greater outflow. There has been some commentary on the extent to which banks are also only refinancing loans at lower LVRs. If apartment prices fall, it may be that highly leveraged borrowers will have to top up equity. High cash flow borrowers are now the gold standard, with competition for these mortgages on the rise, as evidenced by Bankwest’s cut in principal plus interest payment rates.

The approval data for housing continues to weaken, particularly for apartments. Capex in Q2 was also disappointingly weak, particularly in plant and machinery. More importantly, the expectations for capital spending are soft, implying barely positive outlays during 2018/19. The optimistic interpretation is that companies are upgrading IT systems rather than fixed assets, but that remains to be seen. Some listed companies have noted that if they are able, new investment is in the US, given the immediate write-off of spending that is currently on the table.

  • Indications of lower business investment puts paid to a strengthening economic cycle, though the infrastructure and export sectors will continue to pick up the pace.

The headlines of the proposed trade settlement between the USA and Mexico was on the auto sector. In short, this requires 75% regional (North America in total) content and $16 per hour wages for 40% of the content. About 70% of vehicles already meet these requirements, while the others are given five years to comply. It will likely require some auto companies to rearrange their production. Part of this may be to accelerate the use of robotics, already part of a big push as electric cars require less components.

Many commentators believe Canada is essential in the final deal to go to Congress. The sticking point for this one may be dairy and timber, along with dispute resolution.

One of the imponderables is the ability to manage currencies so that a tariff does not disappear into an exchange rate movement. Mexico and Canada both have free floating currencies and rarely interfere in their forex markets, yet these have depreciated against the USD (along with many others) in the past year, ironically as the trade caused uncertainty.

This issue is likely to be a key in any negotiation with China. China does manage its currency movements and the US might call for the government there to avoid declines to compensate for tariffs.

Meanwhile, the US household sector’s comfortable position is being consistently reinforced. A strong rise in confidence is supported in the real data, with private incomes up 5.3% from a 4.7% rise in aggregate wages (wage rate plus employment levels) and the remainder from business and dividend income. Spending matches the income, leaving savings stable. Similar to here, the emphasis is on recreational goods and services as well as household items, a typical pattern that follows a housing cycle. In turn, pending home sales and mortgage applications continue to retreat.

The medium-term outlook for the US economy creates much debate. Recent comments by the Fed Chairman, Powell, suggest that a practical and measured approach to rates will supersede an adherence to formulaic rate rises (e.g. based on specific inflation or unemployment levels) that could tighten policy too much. Sustained high confidence is at odds with any downturn. Households are relatively rational in spending rates. The one possible pointer is the strength of the USD. While the economy is mostly inward focused, there is a correlation between a rising USD and slowing momentum. Into 2019, a slower pace of rate rises and the possibility that trade issues will take a back seat post the mid-term elections could shift the expected growth up a gear and prolong the upturn.

  • US economic strength remains encouraging and could extend further if rebalanced with a lift in the trend outside the US.  We view this probability as supportive of maintaining equity weights.

Focus on ETFs

- The financial sector remains the largest in the ASX200, it has a high weight to the four big banks but offers a high dividend yield. Companies in the small financial index include those that are aiming to erode the market share of the large companies, with growth being the main focus. Both segments, therefore, serve a different purpose.

The financial sector makes up over 30% of the market capitalisation in the ASX200, which is a considerable concentration within the index. Segmenting out the REITs from the financial sector helped reduce weight of financials in the ASX200, however, it has led to increase in the structural concentration within the sector. Regulation changes and tightening of lending standards for the traditional participates is opening up new opportunities. This can be shown by the composition of small cap financial sector compared to that of large caps.

Composition of large (LHS) and small (RHS) cap financial sectors

Source: Morningstar, Escala Partners
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Unsurprisingly, the ASX200 financial sector consists of mainly of lending banks, investment funds and insurance companies. The small cap financial sector is much more diversified. As traditional banks have moved away from certain types of lending, this has resulted in the emergence of the consumer finance sector in small caps, which now makes up 21%. In addition, there are new entrants in the category that are currently classified as micro cap and not included in the above with a combined market cap of $1.2 billion.

These changes to the industry along with the continuous embrace of a cashless society has led to the arrival of FinTechs. These are companies that offer new ways to manage money through technology enhancement and are now beginning to challenge traditional financial services. Companies such as Zip Co (Z1P) and Afterpay Touch Group (APT) offer consumers a new purchase experience at the cost of traditional payment methods. To confuse matters, Zip Co falls within the consumer finance sector, whereas Afterpay comes under IT Services.

BetaShares S&P/ASX200 Financial Sector ETF (QFN) and SPDR S&P/ASX 200 Financials EX A-REIT ETF (OZF) both are passive funds that are designed to track the ASX200 Financial ex-REITS index. As noted above, the big four make up over 70% of the index. Both of these ETF have a 0.39% management fee. Another option is VanEck Vectors Australian Banks ETF (MVB), which tracks the performance of the largest and most liquid companies of the Australian banking segment. It will typically hold 6-8 stocks, the big four, Macquarie Group Ltd, Bendigo And Adelaide Bank and Bank of Queensland Ltd, again reinforcing the weight to the majors. The management fee is 0.28% and it provides a yield of nearly 5%.  These ETFs currently offer limited to no exposure to non-banks and alt-lenders.

  • As we have referenced in previous publications, the reshuffle of the telecommunications, consumer discretionary and information technology stocks will occur in September to reflect the development and convergence of the companies within these three sectors. With the emergence of alt-lender, non-banks and FinTech changing the way we manage money, we may eventually have another GICS recasting of the financial sector to include alternative services.

Fixed Income Update

- We analyse the changing ratings composition for investment grade credit over the last 10 years.

- Bond markets have a turbulent week, with concerns emanating from Argentina.

- Suncorp Group prices a new subordinated bond in the wholesale market, meeting strong demand.

The recent resilience of high quality credit markets has been notable. In the face of falling emerging market debt and currencies and, to a lesser extent, high yield debt (companies rated below investment grade), bonds from investment grade (IG) rated companies have held up well.  IG bonds are rated between AAA to BBB- by the rating agency Standard and Poor (S&P). While we recognise the relative safety of investing in IG credit, it is worth highlighting the composition change of this sector of fixed income in the last few years.

The investment grade bond market has grown from US$4.8 trillion in 2008 to $9.3 trillion by June 2018.  One of the driving forces behind this has been the increased access that corporates have to capital markets. Prior to 2008, most corporates rated below A relied on bank lending. When global central banks implemented quantitative easing programs, demand for corporate and financial bonds increased as traditional buyers of this debt competed with buying from the ECB, Bank of England, Bank of Japan and the US Fed. This has enabled corporates to issue corporate bonds as a cheaper source of funding.

As BBB rated issuers have emerged so too has the weighting of BBB as a percentage of the whole investment grade bond market. In the last decade this ratings bucket has grown from 25% of the IG market to almost 50% today. The potential implications are:

  • Increased volatility in IG credit. With a higher weighting to BBB companies in the index, risk off moves will have a greater impact on the market.
  • Higher credit spreads on the lower rated issues may increase IG credit returns.
  • The higher proportion of BBB rated issuers increases the potential for downgrades to BB ratings. (referred to as fallen angels). Based on 90 years of data Moody’s shows that on average 4.5% of BBB rated issuers will be downgraded. If this pattern holds, $200billion in debt may be downgraded in a year. As a company is downgraded to below investment grade, some funds are forced sellers, widening spreads and lowering returns.

Growth of BBB rated bonds as % of the investment grade bond market

Source: Bloomberg, Escala Partners
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  • To mitigate the risk of this changing composition, investors should ensure that diligent analysis of a company credit has been done rather than just relying on the ratings status (to avoid the falling angels). The large number of BBB rated companies translates to a greater suite of bonds available at higher spreads. Portfolio diversification across IG names also remains key.

Noting recent market activity, trading sentiment reverted to more of a ‘risk on’ feel at the beginning of this week. The US-Mexico trade deal, together with some strong US inventory data and a rise in consumer sentiment levels supported risk assets. Defensive bonds such as US treasuries therefore sold off, as yields in the US drifted up 7-8bp. However, this was short lived as renewed troubles in Argentina emerged on the back of comments made by the President asking the IMF to speed up its disbursement of a $50 billion loan.  The currency subsequently sold off with the Peso depreciating 15% within minutes and the local central bank raising interest rates to 60% in a bid to support the currency. The shape of the Argentinian yield curve is heavily inverted with rates falling from 70% on 3-month borrowings to under 30% from 3 years and beyond.

Argentinian sovereign bond yield curve (ARS)

Source: Bloomberg, Escala Partners
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Concerns about Turkey and US trade talk regarding China also had negative implications for Emerging Market debt and favoured government bonds from developed markets. The Australian market has been less reactive with yields staying within a 3bp trading range and finishing the week unchanged. The local 10 year is at 2.56% which the same as December last year.

  • Emerging market debt as a whole remain under pressure. Portfolios containing this sector of the fixed income market will need to be patient, as returns are likely to be volatile, at least in the short to medium term.

Domestically, Suncorp Group priced a benchmark sized subordinated bond (tier2) in the wholesale (OTC) market. The non-call 5.25-year security priced at 3m BBSW + 2.15%. This was another example of major Australian issuers preferencing an OTC bond as opposed to issuing in the the ASX listed market.  The size was $600m with demand in the order book said to have been more than $2 billion.  

Corporate Comments

- Boral (BLD) delivered on its full year result. Domestic infrastructure, US housing and synergies from its Headwaters acquisition provide a solid backdrop for good earnings growth into FY19.

- The cost of transitioning its network from franchises to company-owned has impacted Caltex (CTX), although it was a lack of capital management which led the stock lower.

- The underperformance of ‘value’ investing and FUM outflows has led to a challenging period for Perpetual (PPT). The incoming CEO may consider a refreshed strategy.

- Westpac’s (WBC) mortgage rate hike, if followed by its peers, will provide further dividend support for the sector.

Boral (BLD) delivered a solid full year result, pleasing investors after operational and weather-related issues triggered a profit warning back in April. Full year earnings growth of 38% was broadly in line with expectations and driven by the company’s acquisition of Headwaters in the US. A 20% lift in EPS was perhaps a better indication of the underlying performance, taking into account the equity raising associated with the acquisition, while full year dividend growth was a more modest 10%.

The recent focus on BLD has been on its North American expansion, yet it was the group’s core Australian business which was the highlight for FY18. The result dispelled some of the concerns on the peak in the residential property cycle. While housing starts were relatively unchanged year on year, the growth in non-residential construction and infrastructure work underpinned EBIT growth of 24%, ahead of the company’s guidance. Despite cost pressures emerging through the year, strong demand conditions have allowed BLD to recover these through price increases and maintain its margins, with further increases expected in upcoming months.

Within its expanded North American operations, the result was somewhat below par, in recognition of operational issues (such as integrating new capacity) and weather disruptions, although the impact of these was less obvious in the second half. Underlying demand conditions were reasonably supportive, with key indicators such as detached housing starts, renovations and infrastructure tracking at a mid-single-digit pace. As was expected, synergies from its Headwaters acquisition were key behind the increase in earnings. Giving rise to increasing confidence around the integration of the business was the announcement of increased synergy targets. With US$115m in savings now targeted over four years, this should provide a mutli-year tailwind for earnings growth.

Boral: North America Synergies

Source: Boral
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BLD’s outlook commentary was similarly positive; its Australian business is forecast to deliver high single-digit EBITDA growth (excluding volatile property sales), North America is expecting around 20% EBITDA growth, while guiding towards 10% profit growth in its USG Boral plasterboard joint venture. Other factors are also in its favour; for instance its forecast tax rate on its US earnings will fall from ~32% to ~26% following recent changes, and the weakness in the AUD is a positive for domestic investors. While the outlook remains quite good with several drivers of earnings over the next few years, its valuation remains quite attractive. Despite the share price move this week, on 15X forward earnings, it trades at a discount to its more recent history as well as the broader industrials sector. We have the stock in our model equity portfolio.

Caltex’s (CTX) half year result was at the low end of its guided range, however, it was likely a strategy update that led to a pullback in its share price this week. The company had been undertaking a review of its asset base in order to determine its best ownership structure, which could have involved a spin-off into a separately listed entity. Reviews of CTX’s infrastructure (refineries and terminals) and retail service stations were conducted on an individual basis. A subsequent capital release was anticipated, potentially freeing up valuable franking credits for certain shareholders.

The conclusion of the review, however, was to retain ownership of its infrastructure assets, while only a partial monetisation of its retail sites is now under consideration. A key factor in CTX’s thought process was upcoming changes to accounting standards, which will now require rent and lease charges to be capitalised, reducing the borrowing capacity of the company.

The result itself contained rather mixed outcomes. On its preferred replacement cost of sales measure, EBIT declined 2% for the half. Its fuels and infrastructure division recorded growth of 6%, a good outcome considering lower refining margins (typically quite volatile), which on average were 10% lower in the half.

Meanwhile, EBIT in its retail stores dropped 14%, with the key impact being weaker volumes following the rise in fuel prices and the transition in the network from franchises to company-owned operations. The change in the retail model was accelerated after the underpayment of workers was revealed within its franchise network. While this is occurring, CTX is also targeting an uplift in earnings ($120-150m in EBIT over 5-6 years) through its expanded partnership with Woolworths, announced last month. Though early days, there remains some skepticism on achieving these targets.

Caltex: Refiner Margin (US$/bbl)

Source: Caltex
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In short, the disappointment in capital management probably overshadowed a softer profit figure, with the outlook relatively unchanged. Following the stock’s underperformance over the last 12 months, it is again appearing on more value screens, although there is perhaps additional risks to its shorter term earnings profile. The stock’s characteristics see it placed as a holding in the Investors Mutual portfolio.

Perpetual’s (PPT) FY18 result showed a 2% increase in earnings and 4% rise in dividends (representing a payout ratio of 91%), which was broadly in line with expectations. PPT reported mixed trends across its three business units. Perpetual Private (wealth management) recorded strong earnings growth of 14% and its Corporate Trust division a similarly impressive 16% increase. This, however, masked the weaker performance of its core funds management business, which still accounts for more than half of overall group profit.

Within funds management, the key drivers are underlying asset returns, FUM flows and margins. The performance of the Australian equity market is most important, given that this asset class represents approximately two thirds of total FUM. With the Australian market around 6% higher over FY18 than the previous year (on average), this was a clear positive for fund managers.

However, it has been FUM flow, and to a lesser degree, margin pressure that has hurt PPT for several years, which has not been helped by a historic high level of turnover within its portfolio manager ranks. Net flows were negative for a third consecutive financial year and more than offset the benefit from market movements. To the extent that flows follow performance, the short term rankings of PPT’s key funds does not bode well for any turnaround into FY19. PPT’s ‘value’ style of investing has not been in favour and this has remained evident through this reporting season.

Perpetual Investments: Fund Quartile Rankings

Source: Mercer, Perpetual
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The other cloud currently hanging over PPT is the transition to the new CEO, who starts in the role next month and hence a strategy update will likely follow. While the stock has a reasonably attractive dividend yield of 6.2%, it appears to have little value in the current market. At 15X FY19 earnings, this represents only a slight discount to its recent history, despite the challenges noted above.

This week Westpac (WBC) became the first of the major banks to blink in the face of higher funding costs, hiking its variable mortgage rates by 14bp. As we have noted, over the last six months a spike in short term funding costs have reduced net interest margins across the sector and had to date been absorbed by the banks. There had been some thought that in the wake of the Royal Commission and subsequent political pressure that the banks may have been more circumspect with out-of-cycle hikes. In the high likelihood that WBC’s peers follow in coming weeks, a similar 14bp hike would, all things being equal, increase underlying earnings across the sector by 3-4% over a full year.

While incrementally positive (particularly considering the current low-growth environment of the banks), the potential earnings uplift only restores margins back towards what would have been anticipated at the beginning of the year. Nonetheless, the development should be supportive for maintaining dividend levels and hence investor interest across the sector.

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