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WEEKEND LADDER

A summary of the week’s results

02.02.2018

Week Ending 02.02.2018

Eco Blog

- The CPI is restrained by falling goods and import prices, while services costs rises are holding at around 3% per annum. The RBA can find no trigger to raise rates in this data.

- US trends are mixed. Construction activity is rising, but at a lower pace, while the household sector is eroding its savings base. The tax cuts will need to deliver much-anticipated investment spending to prolong the cycle.

- Latin American economic conditions have stabilized and select stocks are increasingly appearing in Emerging Market portfolios. 

The Australian fourth quarter CPI was a touch below estimates, with nothing to indicate that inflation is on the move again. The divide between the so-called tradeables, representing mostly imported goods, and non-tradeables, or services continues to widen. Excluding petrol and tobacco, tradeable goods prices fell by 2.7% year on year, while non-tradeable prices rose by 3%. The mix of household spending can result in a significantly different cost outcome if skewed towards either component.

Services inflation is best viewed through its component parts. Housing is the largest and includes measures of new home construction costs, rent and utilities. Administered costs are those where the increase is subject to government regulation. These have sustained a relatively high rate of inflation for some years. Various other services such as travel, professional and financial services tend to be related to the economic cycle where rising demand sees prices respond. For example, domestic travel and accommodation costs were up 6.3% this past quarter as more locals holidayed at home while global tourist numbers also rose.

Non-tradable inflation

Source: ABS, ANZ
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The CPI trend looks muted. The most recent regulated increase in private health insurance is a touch below that of 2017, utility prices rises are likely to fade through this year and housing, too, is starting to flatline. The higher AUD will keep a lid on import costs while sectors such as communications are as competitive as ever. With inflation under the low end of the 2-3% range that the RBA assesses as its notional band, it would be hard to make a case for a rate rise.

Building approvals slumped in December, partly attributed to the timing of the Christmas break. Volatility in the series, given the scale of apartment buildings, is not uncommon. Nonetheless, the annual rate of new approvals is now on the decline in all states bar Victoria. Detached housing approvals are up 5.5% year on year, a modest pickup in pace, but essentially flat over the past three to four years. Rental growth in the CPI was only 0.6%, implying that supply was meeting demand.

Residual Building Apporvals

Source: CBA
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Non-residential approvals ended the year 27.9% higher, with all sectors bar retail looking good for activity into 2018. This fortuitous slowdown in housing and rise in infrastructure and non-residential construction could well be the key to an upward trend in economic growth this year. Whether it transforms into a rise in household income is less likely, given the weakness in other sectors and low increases in enterprise bargaining agreements.

  • Flat inflation, a cautious RBA, stabilising activity levels and constrained households point to portfolio allocations to Australia somewhat below benchmarks.

US data implies the economy is in cruise mode. Certainly, there are few signs yet that it will accelerate this year, with impending investment decisions likely to take time to appear. If anything, private sector construction activity is easing. Housing remains firm, with a 5.4% rise over 2017, but non-residential construction fell by 3.4% due to a slide in office buildings and power facilities.

Public sector spending has recently shown signs of life. The bulk has been on office and educational facilities funded by state governments, while spending on highways and roads has been flat in nominal terms.

Source: Census Burea/Haver Analytics
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If the intentions from the recent State of the Union address have any real outcome, the scale of the public-sector chart will need revisiting.

A trend that is attracting attention is the run off in saving to support spending. Already, debt in sectors such as auto and student loans cause concern, and without a lift in real income the inevitable shift into credit at a time rates are rising imply that the household sector’s contribution to the economy will be capped.

US: Spending beyond their means?

Source: Oxford Economics/Haver Analytics
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  • The US index has started the year on a strong note, buoyed by tax cuts and upgrades to earnings. While this is a real basis for higher profits and therefore share prices, there needs to be greater depth in activity to support the duration of such growth.

Latin America rarely appears on the investment radar. After having spent the 2011 to 2015 years dragging down the Emerging Market equity index, the region has stabilised. In 2016, Brazil and Peru were the best performing countries in the MSCI EM index and in 2017 Argentina and Chile ran second and third with returns of 52% and 48%. The laggard has been Mexico, a function of weak economic trends and the potential impact if the NAFTA trade agreement is cancelled or substantially changed.

The MSCI Latin American index is indicative of the dominance of Brazil and Mexico in the region as well as the low level of value added industries.

MSCI EM Latin America Exposure Breakdowns

Source: MSCI
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Nonetheless, there are ways to benefit from these sector weights. Generally, the banks are in good health, with access to funding and management teams that are not, as a rule, subject to political interference. More importantly, the financial conditions in Latam are in favour of the bank,s as the worst inflation trends and volatile interest rates are behind them. Materials and energy companies are benefitting from the commodity cycle and join others with better capital management and cost restraint.

The political backdrop remains uncertain given a number of elections, especially in Mexico and Brazil. But the taint of corruption is assessed to be far lower, as high profile scandals focus the public’s attention on their ruling government.

  • If this pattern holds through 2017 and the trade risk is alleviated, Latam companies offer a differentiated set of Emerging Market opportunities away from the usual focus on China.

Fixed Income Update

- Global bond yields rise (prices fall).

- The margin between US and Australian 10-year government bonds is at its tightest in 18 years, while shorter dated yields in the US trade higher than our domestic equivalents. We review the likely buyers of the two sovereigns and how this is likely to drive performance.

- Westpac to issue another bank hybrid to replace the WBCPC’s.

Government bond yields have been on the rise this year to date. The 10-year US Treasury yield reached its highest level since April 2014, breaking through some technical trading ranges. The yield of 2.79% as at the end of the week, nearly 40bp higher than the beginning of the year. The 5-year Treasury has also lifted by a similar margin to a yield of 2.57%. Bond yields in Europe have followed suit, with the 5-year German Bund turning positive for the first time since 2015. The official negative interest rate policy was recently confirmed by the ECB.

The yield on 5-year German Bunds turn positive

Source: Bloomberg, Escala Partners
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Yields in the Australian market have also risen, albeit to a lesser extent, with the 10year trading as high as 2.84%, 20bp higher on the month. This has resulted in the spread differential between the US 10 year and equivalent Australian bond trading at its lowest level in 18 years. Shorter term rates (2-year and 5-year) are now higher in the US than Australia.

Spread differential of the US and the Australian Government 10y Bond

Source: Bloomberg, Escala Partners
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Given the narrowing of margins and the yield on the short end of the US curve rising above that of Australia the question arises how this change in pricing trend will affect demand for local and US bonds? Amongst other things, we consider:

- Higher yields in the US make these bonds relatively more attractive. However, if one is of the view that rates will rise further, investors may wish to delay purchases as buying now could result in a fall in the price of the current bond. Given the Fed is raising rates and unwinding the balance sheet, it is conceivable that rates on the long end will push higher. In addition, there are some key risks to the demand side for Treasuries, include reduced demand from global central banks such as China and Japan, alongside repatriation of offshore corporate assets held in Treasuries following the new tax laws and the intent to deploy the funds into investment or capital management.

- Despite the lower comparative yield, Australia maintains a AAA rating from the rating agencies. (outlook negative) as one of 11 countries in the world that hold the highest rating available. Sovereign wealth funds need to have a certain percentage of their excess reserves invested in AAA rated securities, and therefore will remain buyers.

- Foreign buyers of Australian bonds have fallen from 80% to 55% in the last 5 years. The additional supply has been absorbed domestically with the banks increasing their share to 20%. The margin squeeze should not materially affect demand from domestic buyers.  On addition, Japanese investors (our biggest buyers) are still purchasing, as the hedged yield remains attractive.

- Fund managers intent on longer duration are cautious about adding it via the US and Europe, as they have the view that rates will rise in these regions. In contrast, current futures pricing has the RBA on hold until November 2018, with the expectation that any rate rises will be shallow. Long duration style global funds see value in the Australian market as rates are more likely to remain contained.

- High household debt in Australia supports the argument for interest rates to be on hold and any lift in the cash rate to be gradual.  Bond yields, at least in the shorter dates, will be anchored to movements by the central bank. Given the potential for lower volatility, domestic bonds should remain relatively attractive to offshore investment funds.

- To date the movements in the domestic market have lagged that of the US market. While upward moves in yields offshore will eventually flow through to the local markets, investors may elect to trade the relative movement through the differential, so maintaining their longer dated ACGB.

  • While we lean on fund managers to make duration calls and forecast the likely direction of interest rates within their mandate, as asset allocators we make decisions on weightings towards styles/strategies which includes domestic and global long duration funds. To do this, we form views on the likely path of rates in Australia and offshore, together with the steepness of the yield curve.

In the Australian listed market, Westpac announced that they will be issuing a new ASX listed hybrid to replace the WBCPC’s, which have a call date in March. Deal details expected next week.

Corporate Comments

- CYBG (CYB) has continued to deliver against its guidance to the market and is an appealing option to the growth-constrained domestic banking sector.

- Treasury Wines (TWE) made good progress on its ‘premiumisation’ strategy, which has resulted in robust margin growth. Top line improvement is required to maintain the momentum.

- James Hardie (JHX) demonstrated that it has overcome the manufacturing capacity constraint issues that plagued the company early last year. The focus now turns to a healthy operating environment in the US.

- A lack of downgrades is a positive leading into February’s reporting season, although ASX 200 is again expected to be supported by the buoyant resources market.

CYBG (formerly Clydesdale Bank) reported a quarterly result that was broadly in line with the market’s expectations. A recent focus has been an increasingly competitive environment in the UK mortgage market, which was borne out in a 5bp contraction in net interest margins from the prior quarter. Despite this, the group has retained its margin guidance for the full year (of ~220bps) and again recorded solid top line mortgage growth of 7.4% (on an annualised basis).

On other measures, the bank remains in a good position. Asset quality was again excellent, with a 12bp (annualised) bad debt charge for the quarter, while its balance sheet and capital ratios are sound. While CYBG has been delivering reasonable top line growth in recent periods, the key investment thesis still revolves around its ability to achieve its cost out targets. With a better growth outlook than domestic-focused Australian banks (while only trading at a slight premium to these peers), exposure to a strengthening pound and the impending commencement of dividend payments, we have the stock in our model equity portfolio. The stock has also been a core holding in the IML Concentrated SMA.

Banking Valuations

Source: Bloomberg, Escala Partners
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Treasury Wines (TWE) was first out of the blocks for half yearly earnings season, reporting a 25% lift in underlying earnings and ahead of expectations, although the stock was largely unmoved following the announcement. The company has made impressive progress with its ‘premiumisation’ strategy over the last few years, where it has focused on growing the portfolio share of its higher end (and higher margin) luxury brands.

This has also involved exiting lower margin commercial wine volumes, particularly in the US and Europe, leading to relatively benign overall growth across its portfolio. The upside, however, has been a marked improvement in margins, which has been the key underlying driver of earnings growth in recent periods. The group’s Asian division has stood out as the sole geographic region that has shown any meaningful volume growth (albeit off a lower base), although this is now the largest exposure by region.

Treasury Wines EBITS Growth

Source: Treasury Wines
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The more significant piece of news from TWE’s result was that it is making changes to its distribution arrangements in several US states. The legacy structure in the US involves a distribution tier that links producers and retailers. TWE will changing its model such that it will now look to market directly to retailers, bypassing the distributor and thus capturing this additional margin.

While this is the upside from adopting a different model, it is not without its risks. Notably, it is the first major wine company to challenge the existing model. Executing this change will be critical for the company’s growth in coming periods, particularly around retaining its market share (which may require an increase in marketing spend) among retailers and managing the inevitable near-term destocking among distributors.

TWE also noted that the recent US tax reform bill will result in a 2-4% uplift to earnings in the second half, highlighting the likely benefit from the limited number of ASX stocks with US exposure. The company reiterated its FY19 25% EBITS margin target, indicating a further rise from its 1H level of 21.9%. While TWE has positive earnings momentum beyond the evolution of its current strategy it will likely require revenue growth to pick up over time for this trend to continue. In the interim, it is priced for little disappointment on 30X forward earnings, reflecting the premium rating that has returned to higher-growth, quality stocks in the market.

Following operational issues as it ramped up production in 2017, the focus of James Hardie’s (JHX) quarterly was going to be on the profit margin in its North American fibre cement division. On this measure, JHX got a tick. Delivered unit costs fell for a second successive quarter despite elevated raw material pricing (with pulp up 19% compared to the previous corresponding period), taking the North American EBIT margin to 26.9%, ahead of its own guided range and consensus forecasts. With further price rises expected to be put through this year and additional efficiencies to be delivered, this bodes well for the margin (and earnings) outlook.

James Hardie: North America Delivered Unit Costs

Source: James Hardie
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JHX’s international division (Europe, Australia and the Philippines) also reported good numbers, led by 14% volume growth. JHX also has a relatively high valuation attached to its shares, yet its earnings outlook is bright amid a supportive operating environment, particularly in the US where it has gained market share. Additionally, the US housing market is continuing to recover from its pre-financial crisis lows, with starts still approximately 20% below the long-term trend. House prices have also improved, providing impetus to the renovations market. Finally, broader economic sentiment is relatively positive and tax reform is an additional lever to earnings. We have JHX in our model equity portfolio.

With reporting season becoming slightly busier next week (before accelerating in the middle weeks of February), the expectation is for reasonably strong earnings growth. Resources will underpin the market’s earnings for a fourth consecutive half, with benign growth among industrials, perhaps in the mid-single digit range. A lack of downgrades over the last couple of months, however, has left investors somewhat more upbeat.

Next week’s reporting season schedule is as follows, with a mix across the various sectors of the market:

Tuesday: Shopping Centres Australasia (SCP), Magellan Financial (MFG), Janus Henderson (JHG)

Wednesday: Genworth (GMA), carsales.com (CAR), BWP Trust (BWP), Commonwealth Bank (CBA), Rio Tinto (RIO)

Thursday: CIMIC (CIM), Mirvac (MGR), Mineral Resources (MIN), AGL Energy (AGL), AMP, Tabcorp (TAH)

Friday: JB Hi-Fi (JBH), Cochlear (COH), Boral (BLD), GPT, Transurban (TCL)

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