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WEEKEND LADDER

A summary of the week’s results

02.03.2018

Week Ending 02.03.2018

Eco Blog

- If confident investment markets are part of the US administrations ethos, trade restrictions are not helpful.

- With the potential of further sanctions against China, the country may make an even bigger break from the pattern of the past decade.

- A few signs emerged indicating that the period of falling good prices from low labour cost countries is coming to an end.

- Australian Q4 2017 GDP set for release next week should edge up but confirm that 2.5-3% GDP growth is the likely best-case range in forthcoming years.

Trade may be the topic for March. Following the US restrictions on solar panels and washing machines earlier this year, steel and aluminium are set to follow. It sets an awkward and uncertain tone for export sectors, even though the values involved are at this stage small in the overall context of trade. The steel and aluminium restrictions are not based on an economic argument such as dumping, but rather on the rarely used ‘national security’ grounds, which weakens the framework for global trade conventions particularly the WTO.

Two bigger threats loom. The first is NAFTA (US/Canada/Mexico). Change seems inevitable, but the risk lies with a complete withdrawal. Whilst this agreement superficially has little bearing outside these countries, it is likely that the degree of disruption to corporate supply chains, risk of a sharp rise in costs in the US adding another level of internal stimulus will have consequences far outside the region.

The other, arguably bigger risk is further broadly reaching restrictions on China. The deadline for the recommendations is August and hints on the potential nature of these may play out in the coming months. Technology transfer and intellectual property are at the focus.

It is unclear how this could unfold. China may prefer to take a restrained view in order to limit a major challenge, or alternatively look to impose some restrictions on American imports with soybean often noted as a potential target. It may simply make it harder for US companies to operate in China.

China could pull out another round of stimulus as it did in 2016. Already there are signs that some elements of the economy are softening, unsurprising given tightening financial conditions through 2017. The recent official February PMI survey was weak, partly due to the timing of the New Year, but did indicate that fixed asset investment is no longer necessarily the powerhouse of yesteryear.

Growth in fixed asset investment

Source: Deutsche Bank, NBS, WIND
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The good news is that the consumer is in full swing, an important long-term trend towards a better balance for China.  Tension with the US is likely to push China to put even more energy into its intent to develop higher value add in areas such as semi-conductors, electric vehicles and alternative energy.  While the US may claim victory in the short term, its hard to conclude that it will not damage longer term relationships to its disadvantage.

Almost certainly it will encourage China even further toward its focus on regions to its west and within Asia. Chinese trade is inevitably changing in product and destination. Some of the detail below gives a sense of the context. The US is a naturally the largest destination of exports with electronic components a significant part as US companies such as Apple outsourcing its manufacturing to Asia.

While still small, the growth is mostly into the emerging world and it is safe to assume that any threat to its current export markets will see this take a step up. The product mix, in terms of growth is surprisingly basic arguably aligning with this growth in less developed countries.

Source: IHS Markit
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In products such as lithium batteries China is also dominant, having exported $8bn in 2017 over double its nearest competitor, South Korea.  It was only 2015 when the US was the largest manufacturer of batteries.

This coming weeks sees the first meeting of the National Peoples Congress since the key Party Congress of last year. The trade issue is not expected to surface yet, with most of the attention on reforming the financial structure. Hints on the increasing global role China is developing may be a subtle way to imply that the US is not necessarily the critical part of the country’s future development.

  • This tension in global trade is one of the risk factors we have highlighted for this year. It adds to uncertainty given the repercussions are unclear. Locally, the iron ore sector may see some pressure if China does reduce its steel production.

The perception is that Asia is awash with low cost labour that will persistently suppress goods prices. Increasingly there are signs that this will not be the case. The recent pop in US apparel prices in the CPI was also evident in Europe.  Malaysia and Thailand have restricted migrants from other countries in the region resulting in a sharp spike in labour costs. Malaysian private sector wage growth is not 7.3% and Bangkok’s minimum wage is up 5%. This may spur companies to move manufacturing into lower cost regions, but the trickle through effect suggests the cycle of ever cheaper manufacturing based on labour costs may be over. It will then require investment into productivity enhancements to maintain prices. That itself could become a pattern of investment spending focused on systems rather than capacity.

  • With services inflation steady in most regions, it is the tradeable goods sector that may surprise this year. Commodity prices are up, transport costs are up and wages are no longer a tailwind.

Local economic news took a break prior to the Q4 2017 GDP release next week. While relevant to peg down, in reality it represents a look back rather than forward.  Some of the parameters are broader than the subsets that pepper the ongoing data. For example, consumption spending is captured in total rather than the increasingly narrow retail sales. The saving rate, imperfect as it is (a residual rather than an accurate measure) will also indicate the extent to which households are prepared to fund consumption now possibly in anticipation of wage growth in the future.

Global data of relevance indicating trends in February will trickle through in the coming week. The key releases are mid-month with the US CPI out on the 13th and European CPI on the 16th. The FOMC meeting on the 21st is likely to confirm the expected rate rise and should not disturb markets.

Investment Market Comment

- The global energy sector has been a serial underperformer for much of the past decade. Stabilising oil prices and capital restraint by many in the industry augurs for a cautiously better outcome, at least in the short term.

Aside from a brief period in 2016, the energy sector has underperformed all other sectors for the past five years. The bounce in performance in 2016 was partly due to the lag in dividend adjustment, which essentially made some stocks in the sector a yield play for a brief moment. In the past 12 months the energy sector has largely missed out on the equities rally with the global energy index up only 3% despite Brent Crude oil prices climbing over 14% in the same period.

Oil Price, MSCI Energy Sector and MSCI ACWI Performance

Source: Bloomberg, Escala Partners
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How does a sector that has historically had a high correlation with the movement in the oil prices, approximately 0.70 over the past 3 years, have such a price disconnect in recent times? The top 10 biggest companies within the energy sector make up over 50% of the market capitalization. These have had an average 12-month price movement of 0.85%, and out of the majors only ConocoPhillips has outperformed the price of Brent Crude oil. Exxon Mobile as the largest in the sector is down nearly 7% over the past 12 months. Investors were unimpressed by Exxon’s recent report of their fourth-quarter earnings that missed analyst’s expectations. Things could have been worse for the oil giant as this included a $2 billion tax benefit.

Source: Bloomberg, Escala Partners
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The energy sector is not only made up of exploration and producing companies, it also includes equipment and service companies who supply the rigs and required to the industry. These companies have fared much worse than that of the producers as oil rig counts have remained relatively flat depressing the demand for their services.

Energy Sector Performance (since 2/11/2016 oil low)

Source: NDR Multi-Cap Institutional, S&P Capital IQ & MSCI
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Investors may be only now coming to grips with an environment of lower oil prices and where consumption falls over time, hence their reservations over the sector notwithstanding present oil prices.  It also reflects on sectors with large weights in companies where the imbedded asset base restricts their long-term growth potential. Nonetheless the recent results around the world have highlighted the focus on capital management and disciplined capital spending. There is the potential for the sector to sustain is relatively recent outperformance and with stock specific decisions we have noted an incremental increase in the weighting to the sector by global fund managers.

Fixed Income Update

- Comments from the new Fed Chair push yields higher in the US, while yields in Australia trade lower.

- Hybrid pricing indicates that investors poured into the maturing Westpac deal (WBCPC’s) to secure allocations in the rollover security (WBCPH’s).

- CBA look set to announce a new hybrid deal next week and ASX listed Metrics Credit is undertaking a new rights issue.

Following on from a reasonably benign few days of trading, US government bond yields moved up again in the latter few days of February following a hawkish speech by Chair Jerome Powell. Investors responded by pricing in a higher probability of even further rate hikes, with some participants now forecasting four rate rises in 2018. The market is now implying a 30% chance of this eventuality, up from 10% prior to the speech.

Given the divergence in monetary policy in the US vs Australia, February has marked a directional change in yield movements between the two regions. The forward trajectory of US rates has gained momentum, while the prospect of the RBA raising rates has been eased. At the beginning of the month the futures market was pricing in a 70% chance of a rate rise in Australia by November. This has now fallen to 40%. 

US versus Australia 5-year government bonds

Source: IRESS, Escala Partners
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Turning to the local debt market, assuming that there is little risk of default and/or a call being exercised, credit security prices will track back towards $100 as they approach maturity. This is known as a pull to par. On a floating rate credit such as a bank hybrid, the coupon is set with reference to the Bank Bill Swap Rate (BBSW) plus a margin. The security’s price will reflect the current trading margin, which in turn determines the yield to maturity. For a hybrid, one would expect that this trading margin would always remain at a premium to BBSW, as compensation for the credit risk. 

In the lead up to the call date on the WBCPC’s, and prior to any announcement by Westpac, the trading margin on this security turned negative, with the yield to maturity falling below that of the prevailing BBSW rate. We do note that the hybrid market has been known to have price dislocations, with bonds getting executed at levels which are not in line with market pricing. However, in this case we view the likelihood that many participants were aware of the entitlement in a new issue and bought the WBCPC’s for this purpose, ie, by holding the WBCPC’s they have had the option to roll into the next deal.

  • Investors undertaking this trade should evaluate the economics of this trade, specifically whether the opportunity cost of investing in an asset paying below the BBSW rate is worth the prospect of a better allocation in the next trade in total return.

WBCPC and Median Trading Margins

Source: Yield Report
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The new Westpac deal that superseded the WBCPC’s is due to begin trading on the 14th of March under the ticker WBCPH. It was priced at BBSW +3.20% which was the tightest margin offered for a in 2 years. Perhaps viewing this attractive cost of funding, CBA is rumoured to be coming to market with a new bank hybrid. It is unclear if it will be a new deal looking for fresh money or whether it will be an early replacement of the CBAPC’s, which have a call date in December.

The ASX listed Metrics Credit Listed Investment Trust (MXT) this week announced a capital raising through a rights issue to existing holders. The underlying fund has direct exposure to the Australian corporate loan market. The rights issue is offered at $2 which is in line with the fund’s Net Asset Value (NAV) and is priced at a discount to the recent trading price of the security.

Corporate Comments

- Costa (CGC) has upgraded its guidance. The valuation now reflects this positive momentum in its growth profile.

- Caltex’s (CTX) earnings were in line with expectations, with the company providing a strategy update as it looks to offset some headwinds to its business.

- Adelaide Brighton’s (ABC) profit was marginally below consensus, although a positive outlook was noted for 2018.

- Harvey Norman (HVN) completed a poor reporting season for retailers. The company will be challenged by a maturing housing cycle.

- QBE is unlikely to make wholesale changes to its geographic footprint, although will go down a path of simplification to improve its profitability.

The long-held view that companies to report disappointing results do wait until the final week of earnings season proved to be broadly correct, with many stocks falling on their release to the market.

Fruit and vegetable producer Costa Group (CGC), however, bucked this trend reporting profit growth of 15% for the six months. Its result beat expectations, helping the company to also lift its full year guidance and adding to its short, but impressive, track record of over-delivering on its own expectations since its life as a listed company began less than three years ago.

The result was a testament to its diversified asset base, with its mix of five core categories (avocados are a relatively new segment for the company). Citrus was CGC’s standout division amid a record production year and supportive export pricing. Tomatoes (particularly the snacking variety) and mushrooms also performed well, while a later blueberry harvest held back its berry division (which has previously been one of the core growth drivers of the business).

Costa Group Revenue Mix

Source: Costa Group
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CGC has retained an attractive growth outlook, with its acquired entry into avocados adding to a profile that includes berry, mushroom and citrus expansion projects. Management have, to date, executed well and underpinned its medium-term earnings profile. Small international investments in China and Morocco are in their infancy and yet to bear fruit. While it has less production risk than other listed companies within the agriculture sector, it nonetheless is still exposed to fluctuations in the pricing of its products. Presently, the stock is justifying its premium market valuation (its forward P/E has expanded from around 16X two years ago to 26X today), although this perhaps understates some of the risks in its business.

Caltex’s (CTX) full year result marginally beat its own guidance, although it was an update on the group’s strategy that captured the attention of investors. On its preferred ‘replacement cost operating profit’ measure, the company registered an 18% lift in profit, with a 17% increase in its final dividend. While CTX has shifted its focus away from the relatively volatile refining market, this continues to be the key variable in profit change from year to year. This was again the case in FY17, as margins rebounded from the fall of 2016.

Caltex Refiner Margins

Source: Caltex
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CTX made several announcements on its strategy, with the most significant of these relating to its retail model. In response to the widely-reported underpayment of employees within its franchise network, CTX has decided that greater control can be achieved by acquiring the 496 sites which are operated by franchisees or third parties. This is expected to come at a cost of up to $120m over the next three years.

Additionally, CTX is updating its in-store retail offering across some of its stores with a focus on fresh food and partnering with upcoming food retailers. The performance of its initial rollout of the concept is promising, although investors will need to be more patient in terms of the flow through to earnings. The initial costs are expected to outweigh its optimistic goal of a $150m uplift to EBIT within five years.

Finally, CTX is exploring if it can realise value through further asset restructuring, with a possible separation of its core asset base. However, an additional unknown in the short term which is likely to be more significant is any news on Woolworths’s proposed sale of its fuel business to BP, where CTX currently has a large supply contract. Announced in late 2016, it was blocked by the ACCC in December, with BP yet to respond to the regulator. If BP is able to successfully appeal the decision it would represent a significant earnings gap for CTX to cover, with the company stating that it would mitigate the impact through M&A activity. Current investors in the stock are backing a proactive management team to deliver against this potential headwind, along with a benign growth outlook for fuel demand, with this balance reflected in the stock’s reasonable valuation.

Construction materials company Adelaide Brighton (ABC) reported full year profit slightly below expectations, although issued fairly positive guidance for 2018. The group recorded solid top line growth of 12% (which was supported by acquisitions), although rising costs such as energy and a large doubtful debt provision (likely a one-off) held back margins, with underlying profit growth of 5%. In keeping with its history of a reliable dividend-producing stock, the company lifted its dividend by 4% while issuing an additional special dividend over and above its targeted payout ratio (the frequency of these special dividends means they are typically expected by analysts and investors).

ABC’s outlook statement was quite positive, noting that conditions are either ‘strong’ or ‘strengthening’ in the larger eastern states of Australia. The view is underpinned by a solid pipeline of infrastructure related work, which is expected to more than offset any weakness in the residential property construction cycle. ABC has less operational leverage to infrastructure than other companies, but it should still benefit from higher demand and pricing outcomes. In addition, this year it should benefit from the absence of the one-offs which were a drag in 2017. Along with Boral (BLD), ABC is one of our preferred ways to gain exposure to the in the current infrastructure theme in Australia.

Adelaide Brighton: Demand Outlook

Source: Adelaide Brighton
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Also linked to the residential housing cycle is Harvey Norman (HVN) which rounded out a disappointing set of results (on aggregate) for the retail sector, with a below-par half yearly report. In its core retail operations, earnings were flat year-on-year, despite a 5% increase in sales. Corporate governance concerns were again brought to the fore, with an increased loss and writedown (to nil value) of its joint venture investment in dairy farms, while the gains from positive property revaluations were also softer. Additionally, a further issue raised was the diverging performance of its company-owned stores (profit +11%) compared with its franchises (profit -3%), resulting in higher ‘tactical support’ payments in the half and a 44bp margin decline across these stores.

In the medium term, the challenge for HVN is how it counters the expected decline in demand from a softening housing sector and margin pressure following Amazon’s entry to the market. Giving support to its valuation is a significant property portfolio, while its (reduced) dividend still leaves it at a healthy yield of around 6%. Capital management has been highlighted as a possibility given a robust balance sheet with excess franking credits to distribute.

QBE’s full year was pre-released to the market last month and the primary news of its profit announcement was on its remediation efforts following a difficult year that was compounded by large catastrophe costs in North America. The sale of the group’s troublesome Latin American division was announced, although at this stage it appears that this will be the only wholesale change to its geographic footprint.

While this may have disappointed some, the benefits from simplifying the business and focusing on higher generating profit units is a strategy that has been successfully implemented by several other larger cap ASX companies over the last few years. There is likely to be some doubt over QBE’s ability to execute on this given its recent track record and hence investors should not expect to be rewarded until it has demonstrated that it is on the right path. We note, however, that the new CEO has previously made improvements in the Australian business.

QBE reiterated its share buyback commitment of $1bn over three years, although this may be slowed this year given the near-term requirement to repair its balance sheet. We have the stock in our model portfolio, with positive macroeconomic trends of rising interest rates and an improving premium rates providing a supportive environment for the company to implement its strategy.

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