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WEEKEND LADDER

A summary of the week’s results

26.05.2017

Week Ending 26.05.2017

Eco Blog

- China’s rating downgrade has little impact on bond pricing but is a signal that the growing concern on debt will not be easily resolved.

- The Japanese economy maintains its decent, though muted growth trend. Beneficiaries are increasingly distinguished from those left behind.

- The Fed has signalled its rate intention for June with the discussion now focused on its balance sheet.

- Australian Q1 GDP is likely to be weak. Construction activity is proving to be the most important swing factor.

Moody’s cut to China’s sovereign rating from A1 to AA3 followed by a downgrade of 26 state owned enterprises (SOE’s), mostly banks, insurance and resource companies . China’s sovereign debt is not that high, but Moody’s is taking the view that the integrated risk of government and enterprise is one and the same. China’s debt issue is far from new, yet there is no smoking gun that one can point to. Rather Moody’s is referencing the inevitable slowdown in GDP growth at a time debt levels are also rising. A positive outcome from this downgrade would be a renewed emphasis on State Owned Enterprice (SOE) reform and accountable local government financing.

In practice, the downgrade will have a minor impact as only 4% of this debt is in foreign hands. Locals pay little attention to these global rating agencies with China’s own organisations, such as Dagong Global Credit Rating, dominant in that region. But it may slow the opening of the bond market to foreign participation, which reduces the chances of early inclusion in global indexes.

It also underlines that China is taking its own path rather than following the global (or largely US) leads. From using its own rating system rather than those familiar to global investors, it shapes its own format as has been the case with stocks like Alibaba, Tencent and Baidu over the dominant US equivalents.  If China is included in the MSCI equity index on 20 June, these stocks will matter all the more.

There is another element to these verdicts on country risk. Export contribution adds a higher level of uncertainty compared to domestic conditions. Both China and Australia are export dependent, more so than is obvious from the data, as the secondary impact is much greater. For that reason, countries such as Germany, with a large current account surplus, are tempered by restrained debt and a fiscal balance. A high leverage to global growth and high debt don’t go well together. The other is the dependence on external holders to finance domestic debt. Japan, Italy and now China, have largely internalised their debt and are therefore less beholden to global attitudes, albeit at the likely expense of growth.

The interaction of global trade remains at the heart of this economic cycle. Japan has been a beneficiary, but due to China rather than its traditional markets of the US and Europe. Exports to that country are skewed to automobiles, integrated circuits and engines, all of which are up by over 20% year on year.

Export Volume By Region

Source: MOF
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There is no shirking the reality that Japan faces a low growth future, yet GDP growth for 2017 is forecast at1.2-1.7% with much the same in 2018. As the CPI is resolutely at near zero, this is real growth and on a declining and aging workforce. Productivity growth in some industrial sectors is particularly pronounced relative to the services sector, though the dispersion between firms is large and widening according to the OECD.

This points to the investment thesis for Japan in this cycle; there are sectors and companies that have merit outside of the challenges for the overall economy. This offers positive return given at least stable domestic conditions, as one acknowledges that even the best companies may struggle to perform if there is a negative economic outlook. 

The minutes from the US Fed May meeting made it clear a June rate rise is a near certainty. The more interesting development is that the change to the balance sheet is well on the cards. Many Fed watchers therefore believe a September rate rise may be delayed to December to give markets some time to digest the end of quantitative easing as we know it. The impact of a decrease in the Fed balance sheet is now the hot topic. If buying of mortgage backed securities and long term Treasuries is wound back, how much is the equivalent of a rate rise? 

The second and correlated debate is on the reflation trade. It is increasingly acknowledged that the traditional CPI is not the best measure nor is it likely to rise by much. However, the so-called shelter component (housing and related cost) is possibly on the verge of a bigger than expected increase. Another reflation aspect is investment spending. If both the corporate sector and government infrastructure spending gets underway, the multiplier effects are likely to mean money supply (through the velocity of money) will accelerate.

Key to this outcome is getting some tax deal to pass into legislation. Once back from the pursuit of foreign policy, the US administration can be expected to bunker down to achieve something for the domestic agenda.

Local economic news was light though forward indicators suggest Q1 2017 GDP is going to be line ball positive. The construction component is particularly weak and there is as yet no concrete evidence it will turn. The best hope is that State spending does get underway and that there is some flow through from higher mining sector profit.

Source: CBA Economics
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Fixed Income Update

- Australian banks get downgraded by Standard and Poors. What does this mean for the listed debt and hybrid market?

- Short term volatility in rates opens up trading opportunities.

The ratings agency Standard and Poors (S&P) downgraded 23 Australian banks by one notch this week citing concerns on the growth of private sector debt and residential property prices over the last 4 years. While the four major banks were not downgraded at their senior issuer level, they did have their subordinated bonds downgraded one notch to BBB and their hybrids to BB+.

In Australia, bank hybrids are, for the most part (there are a couple of exceptions), traded on the ASX. As these securities are mostly owned by retail investors (estimated at 85%), buyers are not so concerned about the ratings and for regulatory reasons these bonds are not allowed to be rated. However, this change does highlight the exposure that the banks have to the property market. In turn, investors should be mindful of their own exposures to this sector whether it be through direct property investment, funds that invest in residential mortgage backed securities, or indirectly through exposure to equity and debt securities in the banks.

While retail investors are the biggest participants in the ASX listed hybrid market, it is estimated that around 15% of these securities are held by the institutional market. In contrast to retail, institutional investors often rely on credit ratings and have mandates that reflect the amount of exposure that they can have within the fund for a given ratings bucket. With bank hybrids being downgraded to BB+, they are now considered to be below investment grade. While there are some institutional mandates that require an investment grade rating, our understanding is that the main buyers of Australian bank hybrids by institutions are offshore; these investors who will still be able to purchase these securities in their high yield (below investment grade) allocation.

As yet, the price action across the Australian bank bond market has been fairly muted, with any spread movement being focused on the regional and smaller banks. We may see some further weakness in the coming weeks, however, given the focus on yield by retail investors, the impact shouldn’t be too great. The table below summarises the changes and the impact on credit spreads immediately following the announcements.

Source: Macquarie Bank
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The downgrade of our banks follows in the footsteps a similar move by Moody’s to all the Canadian banks, also over concerns on relating to Canadian household debt levels and elevated property prices. In general, credit ratings have been broadly deteriorating over the last 20 years. In 1996, roughly 70% of groups rated by S&P Global held an investment-grade rating. This has fallen to less than 45% today. 

Looking back on the month thus far, government bond yields are only slightly lower. However, there has been some decent movements across the curve in the US and Australia with 10bp swings on a given day. This volatility creates opportunities for active managers and should benefit active management over passive bond investments for those that take advantage of the moves.

Yield movement on the 5 year US Treasury in May

Source: Escala Partners, IRESS
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Corporate Comments

- Service companies like ALS (industries) and the Worley Parsons (mining sector) have recovered strongly in the past year as revenue growth improves and business restructuring of recent years pays off.

- Iluka gets a boost from higher zircon prices. History shows that the sustainability has been low. Is this time different due to industry concentration?

- Banks stay in the news. The outcome from the levy is far from clear, but its hard to paint a positive scenario. Meantime WBC sells a portion of its stake in BT Investment Management (BTT). Funds management businesses are high cash flow yet industry change may now pose a risk.

- Bets are on for Aristocrat as its hits the jackpot. Ethical investors will not accrue these returns.

From its peak share price of $12.98 in 2012 to its recent low of $3.35, ALS (ALQ) has not only ridden a leveraged commodity cycle in line with other resource sector service providers, but has also sought to reduce its reliance on commodities though acquisitions and global expansion.  The company’s operations are summarised as ‘TIC’ – testing, inspecting, certification. For its full year to end of April, ALQ acquired 10 business mostly in its life sciences division.

ALS Business Streams

Source: ALS Limited
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The FY17 result was appreciated by investors sending the stock price sharply upward, notwithstanding a below par contribution from life sciences due to a number of ‘own goals’. A better than expected mineral division was key, coming from higher margins and a 22% uplift in sample flow, with indications this sector has a decent fundamental tailwind.

The other participants in this industry sector are dominated by large global companies, which allows for a level of comparison and supports the contention that growth is achievable. These equities trade at high valuations, in excess of 20X P/E, notwithstanding the cyclicality in their earnings as they tend to be cash generative.  ALQ now sits on the upper end of this spectrum and holders would need to gain confidence that the long term growth ambition of the incumbent CEO (ex the life sciences division) can be achieved. We view ALQ as a potential high quality stock, though the entry point may need to be carefully judged.

Worley Parson (WOR) followed suit, using its investor day to deliver an upbeat assessment of its potential. Cash flow is improving as legacy payments are recovered from major debtors, the headcount has reduced, capacity utilisation is therefore up and competition is more concentrated and rationale. WOR predominantly focus on small contracts is working in its favour as clients are picking and choosing where to undertake spending, rather than commit to large scale programmes. Once again, the P/E sits in the mid 20X, but the expected operational leverage (often underestimated) has investors behind the story.

Resource based good news did not stop with the services companies. Iluka (ILU) announced that it was increasing its zircon reference price by 13% to US$1100/ton. Zircon is used in ceramics, refractory product and a range of other specialised applications. It tends to be associated with housing and industrial production and the demand from China’s housing market is often considered a key factor.

Global Tile Consumption, 2015

Source: Iluka, Ceramic World Review
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The reference price is akin to a recommended retail price with the eventual outcome dependent on grade, order size discounts and market channels. The leverage to any price rise is close on perfect as there is no additional cost per ton. ILU has therefore moved from a loss in 2015, to a small profit in 2016, an expected $120m in 2017 with a further doubling in 2018. The risk to investors is to ‘click and drag’ the trend, with history showing it can unwind as unexpectedly as it comes about. For this reason, we do not recommend stocks of this nature as a direct holding as they require vigilance to be ahead of the game.

The banking sector remains in the news. For investors, the question is by how much will net profit be affected by the levy and the flow into dividends and valuation. Unsurprisingly, the banks will claim that the levy cannot be absorbed and have sought support from their investor base. The key issues are the tax deductibility of the levy, the exact definition of the liabilities against which it is applied and the ability of the banks to adjust their liabilities. Separately, the levy is widely expected to finds its way into product pricing and fees, the latter of which is proving a good little earner for the banks.

The outcome is likely to play out in politics. Would one or more of the banks cut their dividend and blame it on the levy? Or would they prefer to go into hiding and gently tweak lending costs to avoid scrutiny? Do they risk the levy being increased if they report, as Westpac has, that the payment will fall short of the government estimates? In practise, with public opinion out of favour and likely support from other political parties for a levy, the banks will need to tread a fine line in their approach. ANZ has taken a softer tone with the Chairman conceding to the inevitable, but looking for a sunset clause, an agreement the tax will not increase and that it also applies to large foreign banks.

The sector is in no-man’s-land with valuations slightly higher than historic ranges (P/B compared to ROE and P/E), little prospect of credit growth to accelerate revenue and a grinding approach to cost cutting. At this stage dividend cuts are not yet driving the mainstream view, yet dividend increases are very unlikely. The banks therefore resemble volatile bonds, with yields between 5-6% (plus franking) and stock price volatility in line with the market. Aside from equity market conditions, the greatest risk is a sharp rise in the loss provisions, still sitting at or near all-time lows.

In another development, Westpac has chosen to realise 19% of its stake in BT Investment Management (BTT), falling in line with other banks that are selling non-core assets to bolster their capital ratios. The corollary is the accounting treatment of these sales. If capital gains are achieved and included in operating net profit, the management may get bonuses that otherwise would be forgone, depending on the criteria set for such incentives. This is a regrettable issue which bank boards have allowed to slip through in recent years and another way to raise the cynicism towards general bank behaviour. 

The BTT share price has done well compared to other listed fund managers as its grasp on funds has been relatively stable. These are high cash flow businesses but ongoing issues such as fee structures, variability in performance increments and most importantly, key man risk in many of the fund strategies add some caution.

Slot machine maker Aristocrat (ALL) hit the jackpot for its investors this year with the stock price up 71% over the past year. Net profit for the six months to March rose by 60% due to across the board performance in the US. Smaller segments such as the international operations achieved a 215% profit jump and the digital division segment profit rose by 53%. Only Australia lagged.

The one and only strategy slide in the investor pack below illustrates this business, its solely about gaming machines and technology.

Source: Aristocrat
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These returns pose a challenge for investors with ethical screens invariably excluding the stock. ALL is comfortably in the top 50 stocks of the ASX by market cap and an overweight position would have had a significant contributor. If judging performance of any fund or portfolio, it can be as important to appreciate what has been left out as what is included.

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