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WEEKEND LADDER

A summary of the week’s results

02.12.2016

Weekend Ladder 02.12.2016

Eco Blog

- Both China and India enact structural changes to their financial systems. While the repercussions are largely local, the reshaping of these economics has global impact.

- Australian Q3 GDP is expected to be the bottom of the cycle, though retail sales remain weak into Q4.

- European voting is on watch this weekend. The future of the EU will be a predominant topic in 2017.

China is enacting a range of measures to stem capital outflows as FX reserves come under pressure. As is common with China there are a multitude of plots, vested interests and policies that come into play. The fall in the renminbi, while welcomed as a way to buffer the export sector, is occurring at a faster pace than the government is comfortable with and driving a feedback loop through capital outflow as the private sector seeks to protect itself from the currency move. It is also suggested the restrictions are related to the efforts to clamp down on corruption, given the view that some corporate transactions lack any rationale and instead appear to be a way to shift funds out of the country.

China capital movements

Source: Deutsche Bank, WIND
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The State Council is slated to require any outbound investment to be cleared if over $10bn, and over $1bn if they are outside the company’s core business. It is also suggested that state owned enterprises (SOE’s) will not be allowed to invest more than $1bn in any individual real estate transaction. 

This move comes after a protracted period of measures to manage capital flows including limitations on cross border financing, a crackdown on fake transactions where goods are bought and then returned leaving the capital abroad and disallowing dual currency credit cards from many banks, which in its own right pushes the credit card market to the Chinese local provider, UnionPay.  

The renminbi will, in all likelihood, remain under pressure given the path of the USD. In the meantime the delayed Shenzhen – Hong Kong Connect will start up on 5 December adding around US$2.3tr in total equity assets available to global investors, though the free float component is only about half that figure. The Shenzhen market has a high weight to tech and media compared to the Shanghai exchange, which is dominated by financials and ‘old industries’.  It is only a matter of time before China’s representation in global equity indexes will rise as the combined China exchanges are second only to the NYSE in terms of market cap.

The official November China PMI was better than expected at 51.7, maintaining the sharp rate of improvement in activity in the past six months. The Caixin index which tracks smaller enterprises, also has staged a big recovery from the slump in 2015. While there is a persistent cynicism on the quality of data from China, the stimulus over the past year appears to have had some traction. However, it has been funded by private sector debt in China which remains of concern.

Recently the household sector joined the affray, with a big jump in mortgage debt, some of which comes from the informal or shadow banking sector. There are clearly some imbalances reoccurring in the Chinese housing market, though this time the central authorities have pre-emptively sought to clamp down on speculative behaviour. November shows a -29% year on year decline in top 30 city property sales. On the other hand, second tier cities have seen an upward spike in land auctions with such realisations critical to local authority revenues. Much as the government therefore would prefer a stable housing market, the constraints of tax sources for the regions inevitably has them revert to land transactions when short of cash.

The combination of high debt in an economy as dynamic as China and a financial system that has yet to find its feet is persistently called out as one of the risks to the global outlook.

India’s 8 November surprise move to ban large denomination currency is proving to have far reaching repercussions. In summary, this involved replacing the currency notes to encourage a move into the banking system away from the cash economy. While the GDP to end September has come in at a more than respectable 7.3% (slightly below expectations), this next year is muddied by the impact of the major disruption to trade due to a cash shortage. Many believe GDP could be 1% lower for a few quarters before things stabilise.  Along with the introduction of a GST, the consensus is that these moves are required to build the appropriate structures in the Indian economy notwithstanding short term disruption.

The outcome of the currency change has seen a big move in users of Paytm, an electronic payment system, and a large shift in sales to those able to take non cash payments from the cash traders. Unsurprisingly this has been substantially in favour of corporates compared to small traders. Until all ATM’s are recalibrated with new cash (roughly 60% to date) households will experience a cash shortage. The other side of the coin has been an astonishing jump in bank deposits such that there is a massive surplus within the system.

India banking liquidity

Source: Barclays
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To cope, the central bank has changed its cash reserve ratio as a temporary measure and allowed banks to widen their securities that qualify as repos. All this may seem like a storm in a teacup, but is symptomatic of the stress that an economy will experience when undertaking change.

India is seen as incrementally taking up the next growth baton from China for the coming decade.  If the Modi government can truly reform parts of the structural handicaps that have plagued India for decades, the path to its position in the global economy starts to look more promising.

Overall, the outlook for emerging economies is uncertain. The impact of any trade restraints are far from clear, the persistence of commodity price strength is another swing factor, current account deficits may be challenging, but on the other hand the potential growth from generally younger populations and with a keen desire to improve their lifestyle remains an overarching feature. Further, ‘self help’ is always possible. Expectations for South America revived through 2016 due to change in governments. Korea may be another candidate and while not an emerging economy by most people’s thinking, does fall into the Asia Pac regional allocations that otherwise are used to express interest in this theme.

As previously noted, Australian GDP is likely to be very soft for Q3, with some expecting flat growth taking the annualised rate to 2.3% from 3.3% as at end Q2. It places attention on new data to give a sense of the likely growth into 2017. Retail sales for October were uninspiring. Food retailing took a step back again after signs in September that growth may be improving. Household good sales were soft and department store sales fell by 4.4% compared to same month last year. This soft patch, however, may be a temporary hiatus as the 3 month rolling data is quite respectable.

The all-important housing market sent out mixed messages.  Apartment approvals in October slumped by 23%, now a cumulative 37% over two months.  Non-residential construction approvals is typically a very volatile series and most were not overly perturbed by the 47% fall in October given the 100% jump in September. The trend line is in fact encouraging pointing to continued activity in this sector.

Non-residential building approvals

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Notwithstanding the fall in housing approvals, housing credit demand remains solid, up 6.4% year on year and tentative signs business lending has bottomed, now running at 4.4% year on year. If a pattern unfolds of slow but stable household credit growth and improving business demand, the potential for the economy is unquestionably better placed.

Fixed Income Update

- November performance figures favoured floating rate credits as fixed rate bonds post negative results.

- Actively managed funds outperform passive funds as bonds sell off in the wake of the Trump election.

- Yields on Italian government bonds finally take a breather leading into the Italian referendum.

Global bond investors wil be glad to see the back of November, as holders of long dated fixed rate bonds suffered losses for the second month in a row. Yields rallied (bond prices fell) across markets, with the Australian 10 year government bond yield returning to levels not seen since January this year, and the yield on 10 year US Treasuries hit 18 month highs.

While fixed rate bonds with long duration underperformed for the month, in contrast, domestic floating rate short duration credit bonds held up as credit spreads on hybrids contracted and pricing on investment grade was little changed. As a reminder, ‘duration’ is a measure of the interest rate sensitivity of the bond price to a change in interest rates /yields - the longer the duration in years the greater the impact on the bond price. Short duration bonds can have little interest rate risk, as many have floating rate coupons that reset at regular intervals to a benchmark (Australian FRN’s set against the Bank Bill Swap Rate (BBSW)).

Global high yield also had a turbulent month in November given they are mostly fixed rate securities, as did emerging market (EM) sovereign debt. The depreciation of many emerging market currencies and the spread widening on their bonds weighed heavily on this sector as the EM local currency index fell to its lowest level since March this year, with currencies in that index such as the Mexican peso hitting their lowest ever level against the USD.

Performance of fixed income sectors for the month of November (as per their benchmark or model)

Source: Escala Partners, Bloomberg
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Over the last year index tracker funds have been taking market share from actively managed bond funds with $15bn USD said to have flowed into actively managed US bond funds vs $135bn into passive funds. However, since the US election, nine of the top 10 largest “core” bond funds in the US have outperformed the benchmark (index). During periods of stress in bond markets we would expect that this would be the case as active managers can help stem losses by reducing their duration in the derivatives market, whereas passive funds are beholden to the duration exposure within the index.

This weekend brings the Italian referendum. Concern over support for populist groups which may undermine Italy’s membership within the Eurozone, has led to a significant rise in bond yields on Italian government bonds. A sell off in the country’s debt securities has seen the yield on the 10 year government bond move to above 2%, the highest level since 2015. However, in the last couple of days the yields have retraced as the the ECB is reported to be on point to stabilise markets through the use of their Quantitive Easing (QE) program. There is flexibility within the QE framework to increase or lower its purchases of different government debt, including Italy.

The rise of yields on Italian government bonds in the lead up to this weekend’s referendum

Source: Bloomberg
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Corporate comments

- Vocus Communcations (VOC) issued guidance for FY17 which was below the market’s expectations. Having experienced a sharp sell off in recent months, the stock now screens as the highest risk/reward option in the telcos sector.

- Conditions for the cyclical divisions of ALS (ALQ) are improving.

- Medibank Private (MPL) faces a period of higher investment in its business in order to stem the ongoing loss of customers as health insurance premiums continue to rise.

Vocus Communications (VOC) issued its first guidance for FY17 at its AGM this week, which was approximately 6% below consensus expectations. For a company that has experienced a poor sequence of events over the last few months (resignation of CFO, boardroom infighting and soft guidance from competitor TPG Telecom), it could ill afford a miss on its forecast earnings for the year and thus was sold off much more heavily than the downgrade would imply. This trend has been evident across the market this year. High growth stocks that have disappointed are punished and also fits with the general rotation into sectors that screen as value style.

Having completed three significant acquisitions over the last 18 months (Amcom, M2 and NextGen), which has increased the number of moving parts, the dispersion of analyst forecasts for earnings across the market was in any event wide. Management clarified the earnings outlook by giving a detailed account of the influencing factors. These included additional costs of transitioning customers from the legacy copper network to the NBN (a one-off cost as opposed to a permanent margin impairment), the loss of a wholesale fibre build contract and additional investment in support roles for its corporate and wholesale division.

The primary issue that caused the reduced guidance, however, was a weaker contribution from the company’s most recent acquisition of Nextgen. Nextgen’s core asset is a backhaul fibre network that connects Australia’s capital cities to regional and remote areas. The deal was expected to result in a higher level of vertical integration for VOC and was premised on significant synergies being realised. This business has underperformed since being acquired by VOC, with customer cancellations, lower margin contract renewals and a weaker sales trend.

On a more positive note, VOC’s update also contained news that projects a better long-term picture. While the total consumer broadband environment may be relatively low growth (and reasonably competitive), VOC’s ability to increase its market share through this transition is critical. To this end, its 10% share of new NBN connections in the September quarter compares favourably with its 6.4% share as at 30 June. Further, as we have noted, given VOC has historically been primarily a reseller of Telstra’s network in the past, its margins in an NBN environment are expected to be relatively similar, a point which was confirmed by VOC.

VOC also confirmed its previous targets for the realisation of synergies over time (illustrated in the following chart), which are unchanged from its previous guidance. While there may now be a higher level of scepticism in this forecast given the range of issues highlighted this week, it nonetheless should still underpin the medium term earnings outlook for the company.

Vocus: Forecast Run Rate of Cumulative Acquisition Synergies

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There is no doubt that the considerable expansion that VOC has made over the last two years has placed a high degree of pressure on the company’s ability to manage the integration of these businesses, particularly after the multiple issues disclosed this week. While the stock still screens as quite attractive on the basis of its projected earnings growth and current forward P/E (on 11X), we acknowledge that the risks have also increased following this downgrade. We have retained the stock in our model equity portfolio and recommend holding through this period, however will provide an alternative for investors in our next portfolio update for investors who are not comfortable with the riskier outlook for VOC.

ALS’s (ALQ) first half result was inline with the group’s guidance, with a 17% drop in profitability driven by the ongoing weakness in its oil and gas services business.

After making a significant investment in expanding its exposure to the oil and gas services industry over the last few years (just prior to the collapse in the oil price), ALQ has surprisingly made the decision to divest the majority of these businesses at what could be regarded the bottom of the cycle. These businesses were loss making in the recent half, with ALQ focusing on cutting its cost base to match the conditions of the current environment. As a result, the sale price that ALQ may achieve is expected to be a fraction of what the company paid.

The decision to diversify into the oil and gas industry is a mark against management which has historically applied a disciplined approach to bolt on acquisitions, particularly in its now-core life sciences division, which typically has a greater proportion of recurring revenue streams driven by increasing global regulatory standards. ALQ undertook a capital raising 12 months ago to provide funding for further acquisitions in this division and has been deploying this capital in recent months, which should have the effect of improving the overall earnings quality of the company.

Meanwhile, the primary cyclical division of ALQ, commodities businesses, is now beginning to show early signs of a recovery, with activity levels in the industry typically following the direction of commodity prices. While this is yet to flow through the bottom line for the company, the leverage to an improving market is quite significant.

This is where the medium term upside resides with ALQ and has helped lift the stock well above a proposed takeover price of $5.30 by a private equity group back in June. While it is thus hard to recommend an investment in the company given a level of takeover premium in the stock, it now has several favourable tailwinds in its favour that should provide a good platform for earnings growth over the next few years.

ALQ: Geochemical Markets Activity

Source: ALS
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Medibank Private’s (MPL) investor day highlighted the challenges facing the health insurance industry which have contributed to a difficult environment for the company since listing two years ago. While management have done an admirable job in taking costs out of this business in this time, the primary issue facing it and the broader industry has been that health insurance premium and claims growth has been well in excess of wages growth in the economy, forcing their policy holders to either trade down to cheaper products (typically with lower coverage) or drop their coverage entirely. With MPL’s core brand at a premium price point in the market, this has led to a loss of market share over the last few years.

MPL’s response to these developments is to increase its investment in customer service, which it claims will deliver approximately $40m in benefits by 2020. The risk in the interim is that the group’s margins come under pressure as a result of these increased costs without any noticeable recovery in market share. While a more stable claims experience should warrant a higher earnings multiple than the two large domestic insurers, a lack of top line or earnings growth should see the stock marked down from the high growth health care sector. With MPL currently trading on a P/E of nearly 18X, this would appear to more than price in the potential upside for the stock.

environment. As a result, the sale price that ALQ may achieve is expected to be a fraction of what the company paid.

 

The decision to diversify into the oil and gas industry is a mark against management which has historically applied a disciplined approach to bolt on acquisitions, particularly in its now-core life sciences division, which typically has a greater proportion of recurring revenue streams driven by increasing global regulatory standards. ALQ undertook a capital raising 12 months ago to provide funding for further acquisitions in this division and has been deploying this capital in recent months, which should have the effect of improving the overall earnings quality of the company.

 

Meanwhile, the primary cyclical division of ALQ, commodities businesses, is now beginning to show early signs of a recovery, with activity levels in the industry typically following the direction of commodity prices. While this is yet to flow through the bottom line for the company, the leverage to an improving market is quite significant.

 

This is where the medium term upside resides with ALQ and has helped lift the stock well above a proposed takeover price of $5.30 by a private equity group back in June. While it is thus hard to recommend an investment in the company given a level of takeover premium in the stock, it now has several favourable tailwinds in its favour that should provide a good platform for earnings growth over the next few years.

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