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WEEKEND LADDER

A summary of the week’s results

21.09.2018

Week Ending 21.09.2018

Eco Blog

Brexit is heading into its final stages, yet the uncertainty is arguably higher than ever. If it comes off without too much damage for the UK, there is considerable upside to the GBP and the FTSE.

- The tariff battleground is centred on China and no less complex. Once again, any resolution would change the investment market dynamic.

The challenge the UK faces to get a respectable ‘deal’ on Brexit, now only six months away, should not be underestimated. The spotlight is on Ireland where a borderless frontier is proving a classic contradiction in terms. It is naturally intertwined with the political reality where the current UK government relies on the support of Northern Ireland’s Democratic Unionist Party. As one paper on the topic headlined, ‘Labour to the left of me, Johnson to the right…stuck in the middle with EU’, the political threats for PM May make the negotiations even harder.  The Conservative Party Conference on 30 September takes on a much greater than normal degree of importance, though most agree that the harder line Brexiteers have no feasible plan.

The other components are on trade deals with the EU at large, a major piece of work on the flow of goods and particularly services. This latter component is often ignored. This week progress appears to have stalled, as the Chequers plan formulated in June proved unacceptable to the EU. Chequers proposed a so called ‘combined custom territory’ where the UK would apply its own tariffs and trade policy for goods consumed in the UK, while applying EU rule to goods intended for the EU. While complicated, a variation of such a regime applies to Sweden and Norway. Goods are classified by their Combined Nomenclature (CN) and tariffs applied accordingly.

Multiple secondary effects are apparent. The Road Haulage Association, for example is encouraging its members to start on the new paper trail required by the CN as well as calling on EU truck drivers to apply for British citizenship. That is but a microcosm of the myriad of industries that will have to redesign their business models.

Even assuming there no further political hurdles, the path towards a deal has a complex set of possible outcomes as suggested below. 

Four potential scenarios for Brexit talks in early 2019

Source: ING
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  • For the optimists that believe a respectable outcome can be negotiated, the GBP and UK equity market present as a relatively unique investment opportunity at this time. As is often the case, the region has been sold off regardless of whether companies will be affected by an event or issue. The UK market is now the cheapest in Europe based on forward earnings (12.3X), price to book (1.7X), dividend yield (4.1%) and historic relative P/E. Some 65% of the FTSE index’s revenues are from foreign markets and the fall in the GBP will produce a profit dividend on translation. The stock mix for the UK is well rounded, with a balance of defensive and cyclical weights.

Sector market cap weights %

Source: Deutsche Bank
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Understanding the US tariff spat(s) has, to date, been more about politics than real economic impact. Given that the US administration first stated it would walk away from NAFTA only to come to a relatively benign agreement with Mexico and likely deal with Canada, plus that the noise about imposts on European cars has all but abated, many believed the China-US situation would also find some middle ground. This is no longer the case.

The public is supportive of some action on China, whereas their view (based on polls) on the other countries leaned towards finding a resolution. If the intent is to get an appropriate level of protection to intellectual property rights and foreign access to markets, the use of tariffs on household goods is therefore judged as a negotiating tool rather than the end game.

The economic consequences have been light due to the pull forward of imports from China and the fall in the value of the RMB. As the new round of tariffs will start at only 10% (presumably to avoid much in the way of a consumer price impact before the mid term elections) the bigger 25% level will only have meaningful impact into 2019.

The view is that China is likely to take its time to respond. The first measures have been a degree of retaliatory tariffs along with a sharper devaluation of the RMB and fiscal easing. The State Council meeting this week noted as much, reinforcing its proposed tax cuts, suggesting that investment spending would get support, yet not such that the economy became over-reliant on the government and easing certain regulations on trade.

The focus is likely to remain on the currency. There is a good case to be made that the RMB would have devalued given trade tension and moderating growth. On a trade weighted basis, the currency took a dive in July but is far from below a reasonable range.

Trade weighted RMB

Source: Bloomberg LP, Deutsche Bank Research
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Recent comments suggest that there is no desire to use the exchange rate, though it would be the easiest way to reduce the impact of tariffs. Other options such as loosening credit would work against the efforts to reign in excess private sector debt, though the intention to build local champions may get fiscal support through investment incentives and tax breaks.

The challenge to China is not limited to the price of export goods. The US is also intending to take action on mechanisms for universal postal pricing set by a UN body. This entity categorises countries based on their economic development and then how much national post offices pay for handling internationally mailed goods. Currently China has a deal that is clearly to its advantage. Not only does the US want a more reasonable deal, but it also is aiming to get evidence of what is in the parcels to reduce the trade in counterfeit product and illicit drugs.

  • It would be unreasonable to assume these issues will be resolved in the near term and the repercussions are likely to become imbedded in decisions from here on. The consequences are multi-fold, including inflationary impacts in the US, a step change in China’s economic development and exchange rates caught in the middle. After initially responding to each sally, investment markets have chosen to largely ignore the ongoing battle. In our view, it is optimistic to assume that there will be no damage, but it is even harder to point to the winners and losers  without noting the counterparty effects.

Focus on ETFs

- It has been long recognized that equity indices can be subdivided into distinctive characteristic based on size (large or small cap), stock momentum (usually a 3- or 6-month moving average), quality (on balance sheet metrics). Active managers have a factor bias and ETFs now provide an alternative option.

In last week’s publication, we alluded to Smart Beta and Multi-Factor ETFs as increasingly popular options to combine the some of the benefits of passive and active investing. These funds offer alternative weighting methodologies to traditional market-capitalisation whilst aiming to achieve better risk-return ratios. Essentially the main difference between these two categories is that Smart Beta focuses on a single factor, whereas, as the name suggests, Multi-Factor funds will use a combination to determine the weights in a fund. These factors include value, momentum, size, quality, and volatility. Each of these factors has its own specific risks and return characteristics.

Through the use of specific ETFs, investors can take an active view to capture the factor risk premiums compared to traditional market capitalisation indexes. However, each factor moves in and out of favour as investment dynamics are always shifting. Based on recent data, during times of stronger market performance, factors such as size deliver the most consistent excess returns, while minimum volatility lagged. On the other hand, momentum underperformed, and high-quality stocks were favoured by market participants when they were bearish.  So far this year, value and minimum volatility have underperformed.

Relative calendar year performance versus the MSCI ACWI and MSCI ACWI performance

Source: Morningstar, Escala Partners
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When taking a specific view of a factor an investor will be taking on sectoral tilts. Both the minimum volatility and value indexes have a bias towards the health care, utilities and consumer-staple stocks and are underweight technology, causing a lag in performance in the recent tech driven rally. In contrast, the momentum index’s outperformance is due to its higher weight in technology and consumer discretionary.

Sector Allocations of MSCI factor indexes

Source: Morningstar, Escala Partners
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Combining multiple factors can help to reduce the effects of different factor cycles and to lower volatility associated with individual return sources. Equally weighting each of the five factors is an option, however, given that factors outperform during different periods it would require constant readjustment. The rise in popularity of Multi-Factor ETFs allow for investors to gain the managed allocation between factors. This is achieved by index providers using logarithm-based trading to dynamically rotate between factors.

For Australian investors, there are 12 ETFs (excluding income-focused ETFs), based on a single factor or multiple factors with Vanguard recently introducing two additional products. The majority are structured on the minimum volatility factor.  iShares offers both a domestically and international focused multifactor equity ETF, iShares Edge MSCI Australia Mltfctr ETF (AUMF) and iShares Edge MSCI World Multifactor ETF (WDMF). AUMF has underperform iShares S&P/ASX 200 (IOZ) since launching in October 2016.

  • Single-factor funds may be a short-term solution yet relies on the investor to select the right factor at the right time. A multi factor product is the best option for those that wish to participate in these strategies.

Fixed Income Update

- US 10-year treasury bond prices decline as yields (again!) push above 3%.

- An ongoing UK legal battle over a defaulted bond may have ramifications for other sovereign debt.

Of note in fixed income markets has been the upward movement in bond yields over the last week, with the yield on 10-year treasuries touching 3.06%, the highest level since May. Recent rate hikes by the Fed have been based on strong economic data and, notwithstanding a slightly weaker inflation read, the futures market is fully pricing in a rate rise at next week’s Fed meeting. The futures market is also assigning a 75% probability of an additional rise in December, up from 34% at the beginning of this month, with more priced in for 2019.

US 10-Year Government Bond Yield

Source: IRESS, Escala Partners
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Prior to September 15, there were large capital flows into pension funds as corporations had until this date to make employee pension contributions and deduct the expense at the old 35% tax rate rather than the new 21% rate. Some of this influx was subsequently invested into long-dated treasuries, as the funds match off long term liabilities. In addition, corporate pensions that foresaw a need to buy long-dated bonds before the end of the year would have brought forward the purchase if possible. According to reports, these funds could “overpay” for long bonds by about 0.80% and still come out ahead given the tax change. Now that we are passed this date, demand should weaken, pushing yields higher on the long end.

Australian yields have also risen, with the 10-year bond yield up 10bp in the last week. However, the rise in US yields has outstripped that of most other countries. The interest rate differential between US treasuries and German bunds has widened to its greatest level of the past year. This is one factor putting upward pressure on the USD.

Spread differential between German and US 10-year bond yields

Source: IRESS, Escala Partners
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Unsurprisingly, the short end of the yield curve has also risen. Earlier in the week, the US Treasury sold $40bn of one-month debt to investors at more than 2%, the first time since 2008. The auction was met with strong demand, with many additional investors coming into buy beyond the usual primary dealers.

  • Within fixed income, higher bond yields have a direct negative impact on the pricing of long duration bond funds. Indirectly, emerging market bond funds are likely to be affected if higher yields lead to further strength in the USD against EM currencies.

An event that may have ramifications for sovereign debt markets is an ongoing legal battle in UK courts between Russia and Ukraine over a defaulted bond. What we know:

  • The government of Ukraine issued a $3bn 2-year bond in 2013.
  • It was structured as a Eurobond and issued under UK law.
  • Russia bought the bond as part of a financial agreement with Ukraine’s government at the time, which was led by President Viktor Yaukovich, who was pro Russia.
  • After Ukraine’s president was overthrown, Ukraine defaulted on the bond.
  • The current Ukraine government claims that the bond was issued under duress to Russia. Further, Russia went onto invade the Ukraine, worsening economic conditions.
  • Russia claims that the political disputes are not relevant in repaying of the bond.
  • This case is due to go to trial, although Russia is appealing to the Supreme Court for it not to get a hearing.

The implications for the sovereign debt market is that a ruling in favour of Ukraine could see other governments willing to renege on debt incurred by a previous regime. However, some believe that Russia will not want to go to trial and provide evidence on the invasion of Ukraine, and will therefore walk away from the loan.

Corporate Comments

- The telecommunications sector has recently received a reprieve from intense competition, with the proposed merger of TPG Telecom and Vodafone. A better positioned challenger to Telstra and Optus is likely to emerge.

- Regulatory risk has continued to impair domestic equity returns in 2018. This week, the aged care sector was in the spotlight with the announcement of a royal commission.

After an extended period of underperformance, the telecommunications sector was the surprise standout sector through August’s reporting season. While Telstra’s result was not as bad as feared by analysts, the key catalyst for listed companies was TPG Telecom’s announcement of its proposed merger with Vodafone, leading to a share price bounce across the board. TPG’s FY18 result, announced this week, thus received less attention, although was relatively commendable given the structural headwinds faced by the company.

The share price re-rating that has occurred over the last few weeks across the sector is primarily on the assumption of an easing in competition in the mobile market. TPG previously had plans to construct its own mobile network, adding to the high level of pricing tension that exists between the key operators in Telstra, Optus and Vodafone. With Vodafone already owning an extensive mobile network across Australia, the proposed merger effectively removes the construction and rollout risk (it has been noted that a satisfactory return on investment would have been difficult), while additionally removing a layer of competition from the market.

Strategically, the merger makes quite a bit of sense given the current structure and the expected synergies that would result. The complementary nature of the companies’ revenue exposures creates a combined entity with around 20% market share in consumer broadband and the mobile market.

TPG Telecom and Vodafone Merged Operations

Source: TPG Telecom
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The broad expectation was that TPG would have had to price aggressively in order to quickly gain scale and justify a vast capital outlay. It would appear unlikely, however, that the merger will have a material impact on the existing pricing outlook for the industry, particularly given the maturity and limited forecast growth of the market. Additionally, with TPG’s long-standing price leading strategy, the pressure could be on Telstra and Optus to maintain their market share and the merged group will be in a stronger position to challenge the market leaders.

Focusing on TPG’s result, a 3% decline in underlying earnings per share was slightly better than forecast. The decline in broadband margins as the nbn rolls out around the country remains the primary near-term challenge; as at the end of July, 45% of its subscriber base had transitioned to the nbn, indicating that the earnings impact is less than halfway complete. The capex spend on its mobile network was lower than anticipated, supporting its free cash flow, and could be expected to remain contained until the merger clears further hurdles. A special dividend is also in the offing upon a merger completion, giving an incentive for investors to hold onto their shares in the interim. The key risk over the next few months has now switched to merger approval (including the ACCC). With a highly regarded CEO and a long-term investment horizon taken by the company, we view TPG as the best pick in what remains a difficult sector of the market.

Over the last few years, regulatory risk has emerged as one of the key drivers of equity returns across several sectors. Financial services companies have been among the most high-profile casualties this year amid the ongoing royal commission, while the energy sector has also come under attack as politicians seek a way to keep a lid on electricity prices.

This week the attention turned the aged care sector, which is heavily reliant on government funding (accounting for around two thirds of revenue) and had already been subject to funding cuts and a higher level of scrutiny over the last few years. It has been compounded by the announcement of a royal commission, following a sequence of negative media reports on the industry. These issues have more than overshadowed what is a positive thematic of growing demand from an aging population.

While a better historical compliance record may mean that the three listed operators (Regis Healthcare (REG), Japara Healthcare (JHC) and Estia Health (EHE)) may be less affected than the rest of the industry, the potential downside is still significant. Royal commission costs may be quite material, staffing levels may have to increase as a result and occupancy levels could be put at risk by the negative sentiment.

The latter could also severely impact cashflows, with funding of expansion highly dependent upon the net inflow or outflow of cash from accommodation deposits. In the industry’s favour is the fact that a third or more of operators are operating at a loss and therfore the cost of higher staffing levels may have to ultimately be borne by the government itself.

On the evidence of the impact of the royal commission into the financial services sector, it is fair to conclude that the sector is best avoided until this takes place. All three stocks have de-rated this week, although on balance, the P/E discount to each stocks’ recent range does not appear to compensate for the emerging risks.

Aged Care Operators: Forward P/E

Source: Thomson Reuters, Escala Partners
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