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WEEKEND LADDER

A summary of the week’s results

06.04.2018

Week Ending 06.04.2018

Eco Blog

- Tariffs, tariffs and tariffs was the front page economic news for the week. How to restructure between surplus and deficit countries is a tough assignment, but barriers are not seen as an answer.

- Locally, the trade surplus is helping the AUD in its battle versus the interest rate outlook and sentiment.

Trade has dominated most of the reports from global commentators. Hope, rather than confirmed belief, has most of these stating that the chance of a full-blown trade war was ‘not the base case’. Nonetheless, investment markets are wary that it is becoming harder for both sides to step away without loss of face. The benign outcome would now be that in the period before any implementation, around 60 days, will see a raft of exemptions and changes that mute the impact.

The debate centres on what it will take to reduce the US trade deficit, without a big impact on overall growth. Related to that is the integrated nature of global activity that complicates the picture.

On the former, the view is that a tax on trade will increase the price of goods in most cases and also result in the trade being redirected to a source that is not captured by the tariff. Exports can be to another country that completes the process. Upstream designates the value of goods that go elsewhere for a final value add, whereas downstream is the final stage. China’s exports are almost equally divided between the two.

Participation in global value chains

Source: United Nations database
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With the first round of the US tariff proposal (1,333 products notionally worth $50bn), the US imports only 12% of these products from China. However, Friday’s suggestions that this will be lifted to $150bn will sharply increase the stakes.

The US administration seems intent on protecting its manufacturing sector at a grass roots level. History is replete with examples of why this rarely achieves the goal of reinvigorating these sectors. In the 1980s, the US imposed a range of stiff barriers to Japanese car imports. Their growing superior quality and fuel efficiency had seen imports double in the ten years to 1982.  Prices of cars in the US subsequently rose, US car companies failed to invest and the industry was ironically saved when Japan relocated manufacturing into the US in response to the rising Yen and Japanese wage costs.

The final impact of the current imbroglio will not be known for some time. Yet, it will inevitably influence business sentiment outside the US, with both European and Japanese economic momentum indicating a softening tone in recent months.

Addressing the global imbalance in current accounts (as a broader measure compared to just trade) is, however, a challenging issue and undeniably one for the US. Germany is constantly mentioned on the other side given its huge surplus generated from its export sector and low domestic consumption. Solutions are rarely given. The Euro keeps the currency at bay in Germany (though the recent strength may well be part of the slow down in the region) and low population growth limits the level of local demand. For the US, a weaker USD and slower domestic demand would then be the answer.

Pulling activity back into the US is coming at a time the labour market is edging towards full capacity.   A deceleration in employment growth is hinting at the structural limitations to the labour market rather than a slowing economy. This coming week sees the US CPI release, which drops out some of the very low readings of last year. Core inflation may therefore pop up to 2.1% from 1.8% and may lead to an interpretation that inflation is to climb from here.

Locally, a decent trade surplus in February maintained the pattern of the past 12 months. The resource sector has been resilient, with rural exports adding in the month. The services sector bears watching given the flow on effects into employment in education and tourism-related industries.

A downturn in spending by holiday markers coming into Australia (travel exports) may be attributed to the rise in the AUD in late 2017, though the currency was less relevant to the growing sources of tourism from Asia. It cannot be assumed that we remain a favourable destination for travellers given the multitude of options on offer.

Travel Exports and Imports

Source: CBA
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The direction of the AUD is finely balanced. The weakness in the USD appears to have, at least for the moment, run its course. Risk-off sentiment and a reaffirmation of rate rises in the US may hold the USD to its recent levels. By most assessments, the AUD/USD is at fair value, based on interest rates, commodity prices and the fear factor; in the case below, the VIX or volatility index.

Short term fair value model for the AUD/USD

Source: Natioanal Australia Bank, Macrobond
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In the coming week the NAB business survey and housing loan data will be released, while for China, the CPI and trade data may be affected by the Lunar New Year seasonal impact.  

Investment Market Comment

- Increasingly investors are looking for companies and funds that have a higher standard in governance and environmental issues. This is far from simple as there is a significant level of judgement in the decision. The banner headline of ‘sustainable’ or ‘ethical’ should be treated with care; in some cases the foundation is questionable.

Facebook’s Cambridge Analytica scandal, which is believed to have affected up to 87 million accounts, has seen the company’s share price retreat in recent weeks. Not only has the share price come under pressure but so too has scrutiny of the governance standards within the company. 

Some Environmental, Social and Governance (ESG) funds have reconsidered their respective holdings in Facebook. There are three ‘ethical’ ETFs offered in Australia from BetaShares, UBS and VanEck. Betashares has removed Facebook from its Global Sustainability Leaders ETF, citing “the combination of the recent serious data breach with other previously identified issues has caused the Responsible Investment Committee (RIC) to determine that Facebook is no longer eligible for continued inclusion in the index (and, as a consequence, in the ETF)”.  VanEck, which replicates the MSCI International Sustainable Equity index, did not hold Facebook as it was not considered an ESG leader compared to its peers. UBS has made no changes to its Facebook holdings given it screens only for a narrow subset.

Each of these funds replicates a customised index that has its own screening process and will therefore have different holdings as illustrated in the top 10 weightings:

Source: BetaShares, VanEck & UBS
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The UBS offering only screens against companies with significant business activities involving tobacco and those engaged in the production of certain weapons. Because of this, only 11 companies out of the 2,426 in the MSCI ACWI ex Australia are excluded.

BetaShare has an exposure to 100 large-cap global (ex-Australia) companies by using negative screens to eliminate companies engaged in activities deemed inconsistent with responsible investment consideration. It then owns companies that are identified to be ‘climate change leaders’. This is defined as a company that is 60% more carbon efficient than the average for the company’s industry, itself a value judgement that is potentially debatable. 

Similar to BetaShares, VanEck’s newly listed International Sustainable Equity ETF has both negative and positive screens. It screens out all companies that own fossil fuel reserves for energy generation purposes, as well as business activities that are not considered socially responsible investments. These screens are quantitative, while the positive screening is more subjective. MSCI’s (the index provider) analysts use a rating model consisting of 37 issues to determine ESG leaders in each sector. Of these securities, any that are high carbon emitters are excluded. This leaves an investor with a portfolio of 207 stocks and significantly underweight IT and energy as well as the US. 

Performance of ESG ETFs

Source: BetaShares, VanEck & UBS
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As shown above, BetaShares has provided the strongest performance over the past 12 months with its largest weighting in IT and Consumer Discretionary sectors, with companies such as Apple, Facebook and Netflix being in the top 10 holdings. 

Sector Weights (LHS) and 1-Year Performance (RHS) at at 31 March 2018

Source: Bloomberg, Escala Partners, BetaShares, VanEck & UBS
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Ethical products are continuously trying to find a balance between the extent of their screening and performance. When considering ethical investments, the methodology should be scrutinized and also whether the performance is simply a function of sector weight rather than the ethical framework.

Fixed Income Update

- Movements in credit spreads drive price weakness across senior, subordinated and hybrid bond markets.

- The RBA keeps rates on hold at 1.5%, while the market pairs back the probability of a rise in 2018.

Higher yields dominated the fixed income markets in January and February, but more recently, it has been movements in credit spreads influencing asset prices. Credit spread widening has occurred in all debt within the capital structure, with price weakness in senior, subordinated and hybrid securities. Senior investment grade credit spreads are best measured by the iTraxx index which is currently sitting at 0.70%, a retracement off its lows of 0.52% in December 2017.  

Australian iTraxx

Source: IRESS, Escala Partners
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Reasons cited for the price weakness include:

- Recent increased volatility in the stock market reflecting the often positive correlation between equity and credit,

- Profit taking in bonds as spreads hit their lowest levels in 10 years (pre-financial crisis levels),

- Uncertainty on growth and implications of the US tariffs,

- A possible re-allocation out of credit and into bonds (US Treasuries) as rates become more attractive,

- The increased supply (and reduced demand) of short term debt into the US markets driving up short term Libor and BBSW benchmarks.

As one would expect, the bottom of the capital structure (increased risk levels) is where the spread movement has been the most pronounced. Bank hybrid margins have moved by some 80bp across the curve since the beginning of the year, equating to an average price decline across the market of 1.1% in March. In addition to spreads following the lead of senior debt, supply into this market with the Westpac rollover and new issue by CBA has weighed on prices. The hybrid market is often very responsive to changes in the supply-demand dynamic.

Talk of Labour’s new proposal (if elected) to remove a refund for excess franking credits is likely to have impacted recent demand by SMSFs that are in pension phase. It is estimated that around 20% of the hybrid market is currently held by these funds. Given the time lag in this eventuating, if at all, it is only the hybrids longer than 1.5 years that should be impacted.   

The recent CBA deal is yet to commence trading, but the Westpac WBCPH was issued prior to this spread widening, with the secondary market now pushing the spread out on this bond taking the trading margin to BBSW+3.90% after issuing at BBSW+3.20%.

Westpac Capital Notes 5 (WBCPH) price movemen

 

Source: IRESS, Escala Partners
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  • Direct holders of credit bonds and those invested in liquid short duration style credit funds are likely to have recorded a negative performance in the month of March from this credit spread widening. This includes some of the funds we recommend such as Kapstream, Macquarie Income Opportunities, JP Morgan Strategic Bond Fund and direct holdings of listed hybrids.

As expected the RBA kept rates on hold this week at 1.5%. Of note in its accompanying statement was the mention of the “tightening of conditions in US dollar short-term money markets (over and above that due to Fed tightening) which has flowed through to higher short-term interest rates in a few other countries, including Australia”. This narrative refers to the recent rise in Libor-OIS spread in the US which we discussed last week, and the flow on effect it has had on the domestic BBSW rate (short term rates).

The likelihood of interest rate rises by the RBA this year has been pushed back over the last month. At the beginning of March the Australian futures market was pricing in a 50% chance that rates would rise by 0.25% by November. This probability has now been reduced to 30%.

  • In contrast to credit funds, government bonds and funds that heavily invest in these securities (eg JCB fund, Henderson Australian FI, Franklin Templeton Aggregate Bond Fund and Pimco Global Bond Fund) posted positive performance in March as rates eased and rate rises in Australia were paired back. A month such as this emphasises the benefits of a blended approach to investing as a way to smooth overall returns. 

Corporate Comments

- Santos (STO) justified last year’s opportunistic takeover proposal from suitor Harbour Energy with a follow up bid this week. A Foreign Investment Review Board decision is the key hurdle to a completed transaction from here.

- Star Entertainment (SGR) has released a positive trading update, however EPS will be restrained in the near term by the issue of shares to two strategic partners. The stock looks better value now with an improved dividend yield on offer to investors.

In a relatively quiet shortened week of corporate news, it was a conditional takeover proposal for Santos (STO) that grabbed most of the headlines. US company Harbour Energy has put forward an offer of $6.50 per share (the Australian dollar equivalent, with the bid priced in US dollars), part of which would be a special fully franked dividend. The proposal is the fourth such approach from Habour since an initial bid of $4.55 was rejected last August. The latest bid has been deemed sufficient for the Santos board to engage with Harbour and allow due diligence, although a recommendation is still yet to be determined.

At face value, the latest offer price from Harbour appears to be a significant jump from its initial gambit. The oil market, however, has improved materially since mid-last year and this has helped to alleviate any lingering balance sheet concerns that were hanging over the company. It is worth noting that Santos remains a relatively high cost energy company (despite the cost out progress that it has made in recent times). The company’s leverage to different oil price assumptions is evident in the chart on free cash flow over the last three calendar years. For 2018, Santos has estimated a free cash flow breakeven of US$36/bl, while a US$10 change in the oil price would impact free cash flow by up to US$300m – an approximate 50% deviation from its 2017 level.

Santos Free Cash Flow

Source: Santos
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While Santos has made significant gains in reducing its debt burden over the last few years (with the company suspending its dividend in the meantime), the Harbour deal has incorporated a high degree of leverage, with close to US$8bn in debt to help fund the transaction. Evidently, Harbour has a fairly positive view of the fundamentals of the oil market given this riskier structure, although the upside leverage is highlighted above and could possibly justify the price.

With Santos yet to agree to the transaction, the one big question mark over the completion will be Foreign Investment Review Board approval, which goes a long way to explaining STO’s ~10% discount to the offer price. Predicting the outcome here is somewhat more difficult, particularly given STO’s core position in the Australian east coast gas market and the politically sensitive nature of this industry following the recent sharp rise in energy prices. With this uncertainty likely to remain unresolved for some time, STO shareholders may be wise to take some risk off the table by reducing their position.

Star Entertainment (SGR) provided a trading update late last week, which showed an improved revenue growth trend on its positive first half result. Normalised revenue growth for the first three months of 2018 is tracking at a tick under 20%, driven by a rebound in high roller turnover and a lift in the Star Gold Coast performance. Actual revenue growth, however, was reported as flat as a result of a lower than expected win rate in its high roller business, which is typically quite volatile from period to period.

SGR also announced a new strategic alliance agreement with Chow Tai Fook and Far Eastern Consortium, its Hong Kong-based joint venture partners (with a 25% stake each) in the development of the Queen’s Wharf Brisbane casino project. Under the agreement, SGR has issued new equity (a 5% stake to each) to the groups, which have agreed to participate in future hotel developments at SGR’s Gold Coast and Sydney casinos as well as committing to a new marketing alliance to drive high roller growth at these properties.

Consequently, while there is a near-term earnings per share drag expected as a result of the capital raise, SGR’s newly strengthened balance sheet and development model that is now more capital-light has allowed the company to increase its target dividend payout ratio from 50% to a minimum of 70% of normalised net profit after tax. SGR will now have some appeal to investors focused on income, with an FY19 yield of 4.5-5% and an expected growing earnings profile. The earnings outlook for the company remains solid and the stock has de-rated (as with much of the market) through the first quarter of 2018. We have the stock in our model portfolio.

Star Entertainment: Forward P/E

Source: Bloomberg, Escala Partners
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