A summary of the week’s results


Week Ending 26.10.2018

Eco Blog

- Financial conditions are tightening, led by the US. After a delay, this has worked its way into investment assets. Our judgment is that this a period of readjustment rather than a more ominous signal.

- China continues to tap measures that should give some heart to local business that the government will micro manage to prevent a sharp deterioration in growth while also opening up for more global investment flows.

In the flurry of responses to the equity market sell off, the smoking gun returns to monetary conditions. While the long rally in asset prices is often attributed to the fall in official interest rates and quantitative easing in the form of bond purchases by central banks, the practically of equity performance in the past few years has inevitably centred on near term economic data and the ‘disruption’ theme that underpinned prominent equities. What after all, do monetary conditions have to do with the growth of Amazon?

The answer is that interest rates have little effect on such a company’s growth but do impact on the flow of investment capital into equities. Further, long term growth requires a discount rate to anchor a valuation. Not only have interest rates been low, but the equity risk premium has been stifled by the low volatility.

There can be considerable complexity in interpreting how linked financial conditions are to assets, though intuitively it is simple. The Australian housing market is currently a classic case. Low rates, easy lending and a view that prices would continue to rise all combined to form a heady froth that is now curtailed by more limited access to debt. Similarly, the low return on term deposits flowed into many other investment assets, often marketed as ‘higher yield than TDs’, but with no reference to the risks of those assets.

In the US, there is no longer a cost in holding liquid assets. Short term Treasury bills and money markets now offer an adequate 2%+ in yields, double that of a year ago. Bank lending is also edging back. The monthly Senior Loan Officer Survey conducted by the Fed suggests that standards are incrementally being tightened in some sectors such as real estate lending, auto and credit cards.

Commercial and Industrial Loans, All Commercials Banks

Source: FRED, Board of Governors of the Federal Reserve System (US)

The ability of the monetary authorities to accurately assess access to capital is harder now given the level of private credit via non-bank lending. But the rise in the cost of capital will invariably result in a more selective approach to debt than before.

In a similar vein, the response of the US household sector to rising interest rates has been relatively pronounced and swift. As most are linked to the 15- or 30-year bond rate, the sensitivity is high. Headlines focus on the fall in mortgage applications of 15.6% yoy. But that masks the divide between refinancing, down 32%, whereas purchase mortgage growth is flat. It was inevitable that refinancing would dry up once rates moved higher and it should be home buyer mortgages that signals any concern that the household sector is coming under pressure.

Source: Mortgage Bankers Association/Haver Analytics

It is hard to identify any pointer to a slowing US economy. This week, durable goods orders picked up, albeit weighted towards defence and aircraft. That said, the order rate for non-defence capital goods has been flat, implying that the corporate sector is not bulking up on capital spending, or at least that sourced from US suppliers. This replicates the pattern of news from the US; there is little sign of emerging distress but there is also a strong likelihood growth will slow into 2019. Even though the US is a large and mostly self-supporting economy, it will not prove immune to the downward trend in global growth. This is increasingly evident as the US reporting season gets under way, with companies noting that demand was easing.

  • This will raise the inevitable question of whether the Fed will pause. We caution that this does not mean a return to the investment pattern of the past few years, but should reduce the risk that tightening will tip over into a recession. Once again, inflation and wage data could prove critical.

China is sustaining its piecemeal support to reduce the risk of a bigger step back in growth. The measures themselves are not going to move the dial, but sentiment may swing on the basis that the government is seen to be working hard on behalf of business.

Source: ANZ

The specific nature of each announcement implies that there is a process in what the authorities are aiming to achieve. On one hand the ‘removal of entry limit for foreign investment’ may lean to appease some US concerns. Others are focused on smaller businesses to ease any working capital constraints that have come from volatile conditions due to the tariff imposition.

  • There is little chance China will enact a broadly-based stimulus as it refrains from another debt driven cycle. These incremental initiatives rather appear to signal that it will direct where assistance might work best, while mixing in an opening up of the financial system.

Focus on ETFs

- Low-volatility ETFs are designed to deliver smaller losses in down markets. As a consequence, these ETFs tend to underperform in bull markets, yet can still drop in negative markets. Index providers each have their own technique on how to reduce volatility within an index and it pays to know how different low-volatility ETFs are constructed.

Currently, the largest low-volatility ETF is the ETFS S&P 500 High Yield Low Volatility ETF (ZYUS). This fund follows an index of the 50 least-volatile high dividend-yielding stocks in the S&P 500. Stocks are ranked by the highest yields with the top 75 stocks subsequently in ascending order by the volatility from which the top 50 are selected. Companies are weighted by dividend yield and are reweighted on a semi-annual basis. Therefore, it is not purely a low-volatility ETF due to its income tilt. Given this aspect, the fund has consistantly been overweight real estate and utilities. In the current rising interest rate environment and its biggest underweight tech, the fund has underperformed the the S&P500 over the past 2 years.

Monthly Performance of ZYUS v S&P500 (IVV)

Source: Morningstar, Escala Partners

As an alternative, iShares offer both a domestic and international low-volatility ETF, iShares Edge MSCI Australia Mini Vol ETF (MVOL) and iShares Edge MSCI World Minimum Vol ETF (WVOL). Both funds were launched in October 2016 offering a 0.30% management fee and are following MSCI indices constructed using the software program, Barra, to generate a portfolio with the lowest return variance. On top of this there are risk diversification constraints to limit sector concentration risk. Given the concentration within the Australian market, this have a reasonable impact on the construction of thelocal version.

In April this year, Vanguard launched their global markets low-volatility ETF, Vanguard Global Minimum Volatility Active ETF (VMIN). This is an actively managed ETF and it does not track or replicate the performance of an known index. Instead, it aims to provide lower volatility relative to the FTSE Global All Cap Index (AUD Hedged). As the fund is only approaching a 6-month track record, the ability to minimise volatility is still yet to be demonstrated.

  • Given the limited track records of these ETFs we suggest investors use our recommended alternative funds to reduce the volatility within a portfolio.

Fixed Income Update

- Bond rates and credit markets react to the equity market weakness.

- The new issuance corporate bond market remains buoyant with some interesting new securities coming to markets offshore.

Bonds have rallied this week in response to the equity sell off, with the US 10-year Treasury yield year dropping from 3.18% to 3.10% and the Aussie 10-year yield down 7bp to 2.60%. Earlier in the week, short-term Treasury bill yields were on the rise as the short end of the curve continued to absorb the Fed rate rises and issuance. Three-month T-bills hit a new post-financial crisis high of 2.3%, trading above all three of the main measures of US inflation. At this level, investors can get a real inflation-adjusted return from cash-like products for the first time in a decade. US Treasury bill yields have also climbed well above the S&P 500’s dividend yield.

Italian bonds had a turbulent couple of weeks as the populist government defied eurozone budget enforcers by refusing to curtail plans to increase public spending. Communication continues on the issue, with markets ready to react. On a more positive note, Moody’s announced that it will maintain the Italian sovereign as an investment grade rating despite giving it a single step downgrade to BBB-, outlook stable. This was considered a satisfactory outcome. S&P is yet to make its decision.

Credit has weakened over the month. Investment Grade (IG) spreads are wider, with the Australian iTraxx index notching up 6bp at the end of September and a further 4bp month to date, taking spreads to around 78bp. There was a similar story in the US as the US iTraxx reached its highest level since May 2017. Nevertheless, spreads are still relatively tight compared to many of the periods post the financial crisis. Other risk assets such as High Yield (HY) and emerging markets are also under pressure, as equity weakness and concerns regarding the impact higher bond yields will have on corporate funding costs play out on these securities.

US Credit Spreads (US IG iTraxx Index)

Source: Bloomberg, Morningstar

  • It is a challenging time for investments as correlations on many assets turn positive, with price weakness across the board, albeit to different extents. The benefit of fixed income, in the absence of a default, is that bonds will revert to $100 at maturity despite mark to market volatility over the journey.

There have been some interesting newly issued bonds in offshore markets of late. Amsterdam’s Schiphol Airport became the first airport in Europe to sell a green-labelled debt instrument. A green bond is specifically earmarked to be used for climate and environmental projects. Schiphol pledged to become the “most sustainable airport in the world” in an industry that is said to produce up to 2.5% of global CO2 emissions. The Royal Schiphol group raised €500m with a 12-year maturity and a coupon of 1.5% as order books exceeded €3bn. Funds raised are to be dedicated to financing energy-efficient buildings, electric vehicles for passenger transportation and other clean transport. Other airports outside of Europe have also issued green bonds, with Mexico the first in 2016. It is predicted that between $175bn and $200bn of green bonds will be sold this year, up from a record $155bn in 2017.

As investors search for yield there has been strong demand for high-yield bonds (below IG) from well-known, fast-growing companies that spend a lot of cash. Netflix issued over $2bn in USD and EUR-denominated bonds this week to fund its spending on original content. Elsewhere, Uber raised $2bn in its debut bond, which was scaled up from $1bn to meet high investor demand from an order book reaching $3bn. The company sold $1.5bn in an 8 year bond at a yield of 8%, and $500m in a private placement with a 5 year maturity at 7.5%.

While these new bonds have just started trading, another familiar name also with a below investment grade rating is Tesla, which sold $1.8bn in bonds last year. These bonds have traded down since inception, as a combination of higher interest rates and credit spread weakening have impacted the price.

Tesla 5.3% 15/08/25 USD corporate bond

Source: Bloomberg, Escala Partners

  • Credit selection of individual bonds is key to avoiding default or serious markdowns in price during the life of a bond. A well-known brand does not necessarily guarantee the credit quality of the issuer.

Corporate Comments

Brambles (BXB) continues to face cost pressures but is beginning to offset this with price increases.

- Rising costs were also a feature of updates from Qantas (QAN) and Flight Centre (FLT). A key cyclical tailwind has now turned against QAN which has better implications for FLT’s outlook.

- WorleyParsons (WOR) announced a company-transforming acquisition that its expected to be materially accretive to earnings per share, although may limit the group’s participation in an improving global hydrocarbons capex.

- Super Retail (SUL) and JB Hi-Fi (JBH) reported mixed trading updates this week as investor sentiment towards the sector cools with house prices.

- AMP announced the sale of its life insurance businesses. While the divestment will improve the stability of the group’s earning base, it has come at a cost to earnings per share and with little cash benefits of which to show. The outcome of the Royal Commission is the more pressing issue for the company’s future.

Brambles (BXB) was one of a number of companies through the recent reporting season that called out the impact of escalating costs on its margins and profit. The company’s first quarter trading update gave investors some confidence that it was beginning to recover some of these through higher pricing, although the drag on earnings is likely to persist through the December half.

In constant currency terms, sales growth was a respectable 6%, with all regions expanding year on year, while the strength of the USD (BXB’s reporting currency) will likely mean that its reported growth is lower.

Despite this, BXB noted that its underlying profit in the first half is expected to be in line with that of last year, indicating that the current half may be the low point for margins in the current cycle. A cost base that stabilises following this could potentially see profit growth ahead of sales growth as operating leverage is realised. BXB has held up better than most stocks through the recent market correction, reflecting the broadly defensive characteristics of the business, a factor which places it in the IML portfolios.

Costs were also a feature of trading updates from the travel sector at the AGMs of Qantas (QAN) and Flight Centre (FLT). QAN has been a favoured cyclical stock among fund managers over the last few years based on global economic growth, a cost out program, rational behavior in the domestic marker (which has increased passenger load factors) and low oil prices.

The latter factor is now turning into a large headwind (oil is up around 30% on a rolling year basis). To date, a hedging program has limited the impact, and the leverage will be significant into FY19, with an expected $860m incremental cost to be absorbed by the business. Earnings estimates have subsequently turned negative in recent months, limiting the appeal of its single digit P/E.

On the other hand, FLT has gained the attention of growth oriented investors, despite what has been a somewhat variable profit performance over the last several years. The company has performed well in an environment where many thought it would cede share to online-only operators and its expansion into overseas markets has generally been successful.

However, Australia is still the core driver of earnings and the company flagged that margins may be impacted through this year as it transitions to a new EBA for its staff. FLT should be a beneficiary as airlines raise airfares in response to higher fuel costs, to the extent that this does not harm overall demand for air travel (the company takes a proportion of the airfare and therefore benefits from higher prices). Having now retraced back to around 15X forward earnings in the current market correction, it is again screening as much better value despite the short-term challenges.

Engineering company WorleyParsons (WOR) has been viewed as a takeover target after Dubai-based Dar Group submitted an acquisition proposal in late 2016, with WOR electing not to engage with its suitor. Dar Group had subsequently gradually increased its stake in WOR to 26%. WOR instead turned the tables this week, with the announcement of a company-transforming $4.6bn acquisition of peer Jacobs’ energy, chemicals and resources division, to be largely funded by an equity raising and placement to Jacobs (a listed US services company).

The acquisition will effectively double the size of WOR. The strategic nature of the deal is illustrated in the improved geographic reach and exposure across sectors of the combined entity. Geographically, the Jacobs business is tilted towards North America and Europe, while WorleyParsons has a larger presence in Asia, the Middle East and Australia. Looking at end markets, WOR is predominantly exposed to upstream hydrocarbons, while Jacobs generates more revenue from chemicals and downstream hydrocarbons.

A critical view of the deal highlights two key factors. It will reduce WOR’s leverage to a cyclical upswing in global hydrocarbons capex, which has recently been central to the WOR investment thesis. As noted, Jacobs derives 41% of its revenue from the chemical sector, where investment has been strong for some time and where sector-wide spend has shown more consistent growth. Additionally, Jacobs’ work is closely linked to essential operating expenditure (as opposed to capex), with the split almost a mirror to that of WOR.

WorleyParsons: Sector Exposures Pre and Post Acquisition

Source: WorleyParsons

While this is the case, the deal has been pitched as highly earnings per share accretive (20% on a pre-synergy basis), helped by the premium that was in WOR’s share price, although arguably the acquired business should attract a lower multiple given what appears to be a limited growth profile.

Underpinning the investment case is the $130m of synergies that have been identified (to be delivered over two years), which are a mix of IT, property, overheads and procurement. At 1.4% of combined revenues, this appears to be reasonable based on previous industry M&A transactions. Offsetting this to a degree will be the high implementation costs and the initial EPS drag from a higher share count in the first year.

The deal will see the outlook for WOR shareholders evolve from one highly dependent on the global hydrocarbons capex cycle to include the company’s ability in successfully integrating the Jacobs business. The former, however, is still expected to be the key factor in its medium-term growth profile, as higher revenue and margins link for an uplift in profitability. We have the stock in our model equity portfolio.

The retail sector was in focus through this week, with AGMs and trading updates from Super Retail (SUL) and JB Hi-Fi (JBH). A cautious approach towards the sector has been based on a high debt level consumer, limited wages growth and more recently, weakening sentiment as house prices in Sydney and Melbourne peel off. These factors have overshadowed what has been good employment data.

SUL’s update did not fairly reflect the 20%+ share price sell off in the two sessions following the announcement. For the financial year to date, low single digit like for like sales growth was reported across the each of the group’s three divisions (auto, sports and leisure), while the acquired Macpac stores advanced at a faster pace at 8%.

Nonetheless, the outcome was a moderation from the company’s trading update that accompanied its full year result in August. The key company-specific issues circling SUL continue to be its ability to achieve a satisfactory return in the leisure segment having doubled down on the sector with Macpa. Further, there is now a search for a new CEO as Peter Birtles would be stepping down from the position early next year after 12 years in the job.

The news for JBH was somewhat better as it reaffirmed its previously announced sales guidance for FY19. A sales update for the first four months of FY19 had mixed trends. The core JB Hi-Fi brand has picked up over the last two months, although the Good Guys continues to struggle. While the numbers were relatively sound, the challenge for JBH will be the cycling of robust second quarter sales result for FY18, while the Good Guys could be impacted by the soft housing market. Additionally, there was no mention on the margin outcome behind the sales result, although reports have suggested easing of competition from Harvey Norman. On a yield of 6% and a forward P/E of 11X, we believe that JBH warrants consideration for value or income-focused investors.

The Royal Commission (RC) has taken its toll on the banks and diversified financials stocks through this year, with AMP among the high profile casualties in the sector. While this has left vertically integrated businesses such as AMP in an uncertain state regarding the RC outcome, the stock took a further leg down as it announced the outcome of a review that aimed to simply its portfolio, reduce complexity and increase earnings stability.

The review had three components. The sale of its Australian and New Zealand AMP Life businesses for $3.3bn, the sale of its New Zealand retail wealth protection reinsurance and the intention to conduct an IPO of its New Zealand wealth management business. The market’s focus was understandably on the AMP Life sale, a low-growth, capital-intensive division that had been responsible for a number of earnings downgrades over the last several years.

Investors had clearly been anticipating a better outcome (the 20+% share price decline should be viewed in the context of the 8.5% gain in the eight trading sessions prior to Thursday and the overall market), although this reflected the following:

  • the sale price was low, at a discount to the embedded value of the business;
  • the actual cash proceeds were even softer (the breakdown is detailed below, which includes high transaction costs and with around half of the net proceeds in equity stakes that will be retained);
  • the outcome is quite dilutive to earnings per share given what has amounted to a fire sale price received; and
  • it remains unknown how much capital will be freed up by the sale and what proceeds will be available to be returned to shareholders.

AMP: Net Proceeds from Asset Sales

Source: AMP

The decision to sell the life division was made so that AMP could focus on the remaining ‘growth’ businesses, being Australian wealth management, AMP Capital and AMP Bank. While net FUM outflows have been unhelpful this year and accelerated in the September quarter, until recently, these had been broadly offset by positive market movements. This will become more challenged given the direction of the market. The future of its wealth management division remains under a cloud (a worst case outcome would see the dismantling of vertical integration) and, coupled with a possible dividend cut given the group’s low earnings base, is likely to deter value investors (the stock’s forward P/E has now fallen to ~10X post these divestments and surplus capital is likely to be returned) from considering the stock until this picture is clearer.