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WEEKEND LADDER

A summary of the week’s results

10.08.2018

Week Ending 10.08.2018

Eco Blog

- The growth rate for the US (beyond tax cuts) sits between a moderating trend for the household sector and the potential acceleration in investment spending.

- Food inflation will invariably be affected by global weather conditions. It is a small component of developed economy CPI but has a larger psychological impact on the household sector.

- So far, the Chinese economy has shown little signs of a change in pattern due to trade or the movement in the currency. The escalation in tariffs points to a more serious implication and, more importantly, a probable long-term rearrangement of economies.

The US household sector is showing remarkable restraint. Mortgage applications have softened as affordability has retraced in line with higher prices and interest rates. Principal and interest payments are now 18.5% of median income compared to the low of 11.6% in 2013. Median income has been rising at half the rate of housing costs, while the average mortgage rate has increased from 4.20% in 2017 to 4.74% by June 2018.

Similarly, consumer credit outstanding is growing at a much slower pace this year while spending has largely been steady. Some has come from a slowdown in new vehicle purchases after a number of strong years, attributed to a surplus in second hand cars.

Consumer Loans Demand

Source: US Federal Reserve, Amundi Research
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Offsetting the consumer is a pickup in demand for commercial and industrial (C&I) loans from businesses, and banks are also willing to ease their loan standards, possibly reflecting a view on cash flow post the tax cuts. Banks are already reporting weaker demand for residential real estate construction loans implying that housing activity could slow in coming months.

C&I loans, small firms, demand and standards

Source: US Federal Reserve, Amundi Research
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  • Both trends are positive for the duration of US growth, all else being equal. Excess consumer debt habitually causes problems, while the growth in loans should support capital spending.

The impact of global weather conditions will inevitably flow through into food prices. Agricultural commodity prices average around 40% of final wholesale product prices, with naturally a large range (cocoa in a chocolate bar is 5%).

It is unlikely to have a specific impact on interest rates given most central banks look through food and fuel price cycles. Food is a relatively modest proportion of the CPI in developed countries (usually in the order of 15%), yet consumers tend to be sensitive to food prices and believe inflation is higher than the official measure when faced with rising prices. For developing economies the CPI weight of food is naturally higher, though persistent subsidies can distort the impact.

Food commodity prices have been quite benign for some time, compared to 10 years ago and have been a contributor to the slow pace of inflation. 

Global food prices

Source: FOA
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Futures suggest that wheat prices will rise about 25%. The overall impact will be muted by a large inventory pile, at around a third of annual production.

Within all these caveats, there is an increasingly diminishing set of goods and services where prices can be flat or falling to offset the long term rise in categories such as education, health and housing related costs.  The weather may well signal the start of higher than expected inflation and lead to wage pressure.

  • Inflation is clearly on the rise. It is the risk of a higher than expected outcome that has investment markets on alert.

China produced an acceptable PMI reading of 53 (implying stable expansion), though new orders were particularly weak and companies unsurprisingly expressed concern on trade. In tune, a small current account deficit was also reported for the first half. Imports (driven in a large part by rising commodity prices) have been steady, but export value has fallen over this year, though is holding at 10% growth yoy. The still positive trade balance is offset by an outflow on services and income.

With respect to inflation in China, the reported 2.1% annual rate appears benign, but there has been a reversion in food prices (high weight to pork) from deflation to inflation and some service components specifically travel have risen sharply. The ramifications of the escalating tariff battle have yet to be seen in data. Soybean pricing will add to food inflation in coming quarters and the impact of the fall in the renminbi is also yet to come through.

China is easing its monetary policy presumably in anticipation of a tougher period ahead. If the full scale of tariffs is implemented, the economic landscape is likely to feel the impact, not only in China but across the world.

Focus on ETFs

- The FAANG (Facebook, Apple, Amazon, Netflix and Alphabet, parent of Google) stocks make up nearly 15% of the S&P 500, which is a considerable concentration in a small number of high performing names. 

Along with most indices the S&P 500 is a market capitalisation index (the Dow and Nikkei are not, for example), and as the FAANG stocks outperform, they can disproportionately drive index returns higher due to their weight. As a result, market capitalisation indexes are inherently momentum-based. However, during the last few weeks (acknowledging a small sample period) we have seen an increase in volatility as these stocks have produced mixed second-quarter results. Facebook and Netflix were hit the hardest, having their weakest month in over 2 years. Conversely, Apple reached $1 trillion in market capitalisation.

Two-year cumulative performance

Source: IRESS, Escala Partners
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ETF investors may be looking at ways to ‘de-FAANG’ their portfolios in an attempt to reduce this concentration risk. One solution would be investing in an equally-weighted S&P500 index. This methodology requires all constituents to be equal. Therefore, when the price of a stock goes up, the index has to sell shares in that company and buy those that have fallen in value. Consequently, this makes the index somewhat value-orientated as it buys stocks that have underperformed and sells stocks that have outperformed. Additionally, sector weights for equally weighted indexes are a product of how many stocks are in a sector, largely an irrelevant reflection of the industry merits.

Outside of ETFs that follow the market cap weighted S&P500 there are eight ASX-listed US equity ETFs. ETFS S&P 500 High Yield Low Volatility ETF (ZYUS), BetaShares FTSE RAFI US 1000 ETF (QUS) and VanEck Vectors Morningstar Wide Moat ETF (MOAT) are all rules-based ETFs that have shown underwhelming performance over the past couple of years, mainly as a result of being underweight technology.

Betashares NASDAQ 100 ETF (NDQ) gives investors exposure to the largest 100 companies within Nasdaq, a tech-heavy index. This ETF has nearly a 50% weighting to the FAANG stocks, therefore the concentration risk is even higher than that of the S&P500.

Performance as at 31 July 2018 of ASX-listed US Equity ETFs

Source: Morningstar, Escala Partners
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Another option for investors to manage their ETF US equity exposure is in mid-cap companies, through iShares S&P Mid-Cap ETF (IJH). This replicates the performance of the S&P400, which comprises companies that have a market capitalisation between US$2 billion and $10 billion. This offers investors potentially higher growth prospects than large cap companies but typically with less volatility than small cap companies. Mid-cap stocks may also increase the prospect of becoming a takeover target.

The S&P400 has less concentration risk both at a stock level and sector level. The chart shows the percentage of top 10 stocks within the S&P400 is 6%, compared to 21% of that of the S&P500.

Sector and 10-Top Holding Weights

Source: Morningstar, Escala Partners
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  • Those investors that use passive, index-tracking ETFs are effectively allocating through using different types of methodologies or different indices within a region. We see a role for this through tactical allocations, however, for long term investing we prefer the use of active management to generate excess return in more concentrated portfolios.

Fixed Income Update

- We examine the differences between subordinated bonds and bank hybrids with respect to the pricing differential that exists between these debt instruments.

Over the last few years Australian banks have been increasing their issuance of additional tier 1 and tier 2 capital to satisfy APRA’s requirements of raising their capital ratios by 2%. The Australian listed debt market has been the beneficiary with increased supply of bank hybrids and a small number of subordinated bonds. Investors have soaked up the supply given the relatively attractive yields of these instruments. Further, the listed market allows for purchases in small denominations, unlike OTC(Over-The-Counter) bonds which have a $500k (Austraclear) or $100k (Euroclear) minimum parcel size.

Bank hybrids offer a higher return to subordinated bonds as they have an elevated level of risk. Hybrids have a reasonably complex structure. The coupon payments are at the discretion of the issuer, the instruments are strictly speaking perpetual with no fixed maturity, they rank lower down the capital structure than subordinated bonds and they may convert to equity. The differences between subordinated bonds and bank hybrids and the variance in risk is highlighted in more detail below, which helps explain the dispersion in pricing. 

Source: Escala Partners
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At current pricing the extra yield of a bank hybrid over a subordinated bond is roughly the yield on the franking credit (ie a ~30% higher yield). The cash component (unfranked) yield-to-maturity (YTM) is about the same for a given credit rating and term. By way of example, NABPE subordinated notes have a cash YTM of 4.2% for a 5.1-year term. By comparison NABPD capital notes 2 (hybrid) have a cash YTM of 3.98% plus a franked amount of 1.71% for a 3.9 year expected maturity.  An investor therefore is compensated for the extra risk of a hybrid versus a subordinated bond by approximately the franking credit. As is the case for all valuation assessments, the determination is whether this offers a sufficient risk/reward.  We do however acknowledge the limited supply of subordinated bonds in the listed market, and investors may be prohibited from buying in the wholesale market due to the minimum parcel size requirements.  

One of the Labor party’s election promises is to limit franking credit refunds from those investors who do not pay tax (eg. pension phase super funds). In the event this proposal comes to fruition, the bank hybrid market may need to readjust its pricing (possibly to the tune of ~30%) to still maintain an appropriate compensation an investor receives for investing in hybrids over subordinated bonds.

  • We maintain a recommendation to only invest in bank hybrids that mature within 2.5 years. There is little pick up by extending out further, and the risk of a change to franking credits, in our view, is not being sufficiently valued in the market.

Corporate Comments

- Amcor (AMC) has paid top dollar to expand its presence in North America. While the deal metrics are not as attractive as past transactions and FY18 may mark a challenging year, the stock may be returning to value screens.

- Transurban’s (TCL) high growth levels are expected to slow into FY19. There is much riding on the ACCC’s decision that could block its expansion in Sydney.

- Commonwealth Bank’s (CBA) result was messy with significant one-off charges, although the underlying trends are unlikely to shift the view of benign returns in the medium term.

- Suncorp (SUN) beat expectations despite weakness in its banking division, with insurance and cost-out picking up the slack.

- Tabcorp (TAH) is overcoming a tough competitive environment and now assisted by synergies, regulatory change, a defensive lotteries business and the exit of its loss-making Sunbets venture.

- Expectations for AGL Energy (AGL) have been reduced as wholesale electricity prices peak and the retail margins contract.

Packaging group Amcor (AMC) was marked down after announcing an agreement to acquire North American company, Bemis, in an all-script transaction. The deal size is significant for AMC (Bemis’ annual sales are just under half that of Amcor’s). It has been a target for AMC’s for some time given the company’s prevailing low exposure to the key North American flexibles packaging market.

While AMC has a solid track record over several years of valuation creation through a disciplined acquisition strategy, the primary concern raised this week was the price paid for Bemis (the 25% premium at a 10.6X EBITDA multiple is well in excess of recent acquisitions) and what appears to be a relaxation of the company’s strict hurdle rates (15-20% return on funds employed after three years). Despite a high level of expected synergies from the deal (estimated at US$180m, or 4-5% of Bemis sales) and potentially double-digit earnings per share accretion, the cost of the deal has led to AMC instead guiding towards returns “in excess of AMC’s weighted average cost of capital”. Further to this, Bemis has gone through a challenging period in recent years, which has led to a declining top line.

While the criticisms of the deal are valid, these are somewhat offset by its strategic nature and the success that AMC has had in other transactions. The news should be expected to overshadow AMC’s full year result later this month, with the company’s earnings coming under pressure given a rise in raw material costs and the lag in recovering these. This has been reflected in a derating of the stock through this year, with its forward P/E now a more palatable 16X.

Transurban (TCL) reported a typically solid result, with a 9% increase in toll revenue backing a 10% increase in EBITDA and a (pre-announced) 9% increase in its full year distributions. Traffic and toll revenue growth were recorded across its portfolio of tollways, with Melbourne’s CityLink the standout (13% growth) following an increase in the toll multiplier for large vehicles.

The short-term catalyst for TCL is the ACCC’s decision on its bid (as part of a consortium) for Sydney’s WestConnex, which is not expected until the first week of September. Given TCL’s existing toll road network in Sydney it is viewed as the natural owner of the asset, although the decision could be a competition litmus test for future transactions for the company.

What may have disappointed the market was TCL’s distribution guidance for FY19, which fell below consensus expectations from sell side analysts. A 59c distribution in the next financial year would represent a modest 5% increase on FY18 and a step down from the double-digit growth rate over the last several years. Nonetheless, while capital appreciation may be expected to be capped by a potential lift in domestic interest rates, the stock is still likely to have appeal for its defensive yield characteristics. In particular, we note that many other high-income listed stocks are struggling to grow their dividends in the current environment, something which is likely to be apparent as reporting season progresses.

Transurban Distribution Growth

Source: Transurban
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Commonwealth Bank (CBA) stands alone among the major banks in reporting in August, although the spotlight was going to be even brighter given the myriad of issues it has faced in the last 12 months. The result was messy with in excess of $1bn in pre-tax one-off charges (including the $700m settlement with AUSTRAC), yet it was less worse than was feared, leading to a positive share price reaction. Reported earnings declined by 5% for the year, with underlying earnings (ex one-offs) still relatively soft at 4%, allowing a token 2c increase in full year dividends.

As with the broader banking sector, CBA continues to face a challenging environment for earnings growth. Credit growth (particularly mortgages) has been weak and impacted by several measures introduced by APRA that have targeted investor and interest-only housing lending. An industry-wide tightening of mortgage serviceability standards should be an additional headwind into FY19. In FY18, CBA’s volume growth in home loans (+3.7%) was also below system growth (+5.6%).

Costs, margins and asset quality are the other key areas of interest. Risk and compliance costs continue to rise for the banks and has been hampering efforts to improve cost-to-income ratios. Funding costs have spiked in the first half of 2018, and will reduce net interest margins if not passed on to borrowers. Finally, asset quality has been strong for several years, with a group bad debt charge of 15bp another positive outcome. However, an increase in home loan arrears was notable, which is typically a leading indicator of future bad debt trends.

Commonwealth Bank: Retail Lending Arrears (90+ Days)

Source: CBA
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Within the banking sector, CBA has often been among the least preferred by analysts given the premium it has historically traded on compared to the other majors. The argument currently has additional merit, given the converging return on equity profile following the increase in regulatory capital requirements and asset divestments across the sector.

CBA’s capital position is sound and it provides a level of defense against the potential for dividend cuts post sale of its wealth management division. We have an underweight position in the banks in our model portfolio, although acknowledge the attraction of the sector at present for its income characteristics.

These weak trends in the banking sector were also visible in Suncorp’s (SUN) annual result, although the focus was on the improving environment in insurance and the benefits from an extensive cost out program, which are tracking ahead of schedule. Operating earnings were up 5% for the year despite a decline in its banking division. The dividends was flat, however, a special dividend was declared (supported by SUN’s strong balance sheet) and further capital returns ($600m forecast) are expected following the announced sale of its life insurance business. While shareholders will be pleased with the additional returns, the downside the perception of a bargain price for the asset sales and a large balance sheet writedown recorded by SUN.

Within SUN’s core general insurance business, the highlight was a rebound in margins, notwithstanding some lower quality factors of reserve releases and reduced cost of extreme weather events. The prospect of SUN achieving its FY19 target margin of 12% looks promising, with premium growth (particularly in motor and home insurance) expected to flow through and benefits from cost out adding to the mix.

Suncorp Motor Insurance Growth

Source: Suncorp
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The outlook for SUN is balanced between soft returns in banking, a return to more normal mid-cycle insurance returns and efforts to reduce cost.

Arguably much is the upside is now captured in the recent expansion in the stock’s valuation, although it has good momentum and a solid yield. These better insurance returns have been captured in both the Investors Mutual and Martin Currie SMAs this year.

Tabcorp’s (TAH) result was of interest as it was the first to include the acquired Tatts Group business. While TAH’s earnings slightly missed expectations, the stock bounce was a reflection on increasing market confidence on the medium term earnings outlook that is driven by material cost synergies out to FY21. The market has been somewhat skeptical of the revenue synergy targets that helped to get the deal across the line, but the cost improvements alone provide a substantial uplift to earnings over this time frame.

Tabcorp Synergy Forecasts

Source: Tabcorp
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Aside from these synergies, the investment thesis for Tabcorp has several other levers. TAH is exiting its loss-making UK Sunbets joint venture, the lotteries business has been tracking well with margin improvement as sales transition towards online and the company has an increasingly favourable regulatory environment, with bans on synthetic lotteries, the introduction of point of consumption taxes and a crackdown on credit betting (which both adversely affect online-only bookmakers). Combined, these factors have helped to overcome the structural issues, particularly the decline in wagering turnover in its retail outlets.

Those with a negative view on TAH typically focus on this latter point. Despite this, consensus forecasts currently sit at 13% CAGR in earnings per share over the next three years, well above the average industrials stock. With a forward yield of 4.4%, the company is relatively unique in terms of its potential growth and yield metrics and we note that the stock has found interest among our SMA managers.

A near-30% rise in underlying profit and similar increase in dividends was not enough for AGL Energy, which lost ground after issuing underwhelming guidance for FY19. As illustrated in the chart, wholesale electricity and gas margins were responsible for the uplift (this was well flagged and has followed a reduction in supply following the retirement of a number of power plants in recent years), which was partially offset by tougher conditions on the retail (customer markets) side of its business.

AGL Energy: Year-on-Year Profit Change

Source: AGL Energy
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The outlook for AGL has been tapped down this year. Firstly, the retail market is unlikely to experience any relief in the short term. Costs have gone up across the industry as consumers have shopped around for a better deal following the spike in energy prices, with higher levels of discounting and churn resulting. Additionally, the industry is likely to undertake a degree of self-regulation to help to appease political and ACCC concerns and limit any intervention. AGL announced several measures this week, including a relief program for customers facing financial difficulty and extending discounted offers for customers in instances where these may have expired.

Secondly, is a peak in wholesale electricity prices. The tailwind from rising wholesale electricity prices has now passed, with new generation capacity (predominantly renewables) coming online helping to balance the market. Ongoing coal power station retirements, however, will cap the downside as well as prices that will be required to fund new supply. AGL is looking to counter this affect with a new cost out programme, targeting a figure of $120m in operating cost savings over the next three years.

Overall, while the more optimistic profit forecasts for AGL have been pared, the downside is also expected to be limited. The stock now has a reasonable level of valuation support, on a forward P/E of 13X (not unreasonable for a utility company) and a healthy forward yield of 5.8%.

Next week is among the two busiest of reporting season with a packed schedule.

Monday: Bluescope Steel, JB Hi-fi, Aurizon, GPT, Bendigo and Adelaide Bank

Tuesday: Cochlear, Domino’s, Challenger, National Bank

Wednesday: Woodside Petroleum, IAG, Fairfax, Computershare, Dexus, Seek, Mineral Resources, Vicinity Centres, Wesfarmers, CSL

Thursday: Origin Energy, QBE, Telstra, ASX, Charter Hall Retail, InvoCare, Treasury Wine, Iluka Resources, Downer, Sonic Healthcare, OZ Minerals

Friday: Goodman Group, Evolution Mining, Link Administration

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