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WEEKEND LADDER

A summary of the week’s results

03.06.2016

Week Ending 03.06.2016

Eco blog

Australia’s first quarter GDP again surpassed expectations, with 1.1% growth for the three months and 3.1% over the last year. The chief criticism, however, was the composition, which was almost entirely driven by net exports.

Growth in exports added 1.0% to the overall gain for the quarter following a step up in resources production, including from the large LNG projects at Gladstone in Queensland (which have now become operational). This production benefit has followed the peak in mining capital expenditure and has had a nice offsetting effect for the economy against this ongoing capex drag (illustrated in private capital formation below).

The contribution from dwelling investment was just 0.1%, although a further surge in new housing approvals in April indicates that this level of activity may be sustained for longer than many have anticipated. Household consumption was respectable (0.4%), although the primary source of concern remains weak income growth borne from the ongoing decline in the terms of trade (i.e. the relative price of exports in terms of imports) which dropped 11.5% over the year and by approximately a third since 2011. Household savings rates, which have steadily declined over the last few years, have funded the increase in consumption. The challenge for maintaining this level of household growth will likely depend on the labour market, which we have noted has shown some signs of weakness in recent months with respect to employment and wages growth.

Australian First Quarter GDP: Contribution to Growth

Source: ABS, Escala Partners
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While the GDP data has somewhat reduced the prospect of a rate cut by the RBA in coming months, the primary focus of the central back at present is soft inflation and so the bias remains to the downside.

Retail sales for April again showed a moderating growth rate, rising 0.2% for the month and short of expectations of 0.3% growth. While the trend has clearly weakened since the latter part of 2015, unseasonably warm weather in autumn contributed to the monthly figure in April, with clothing falling 0.9% month on month. Buoyant conditions in the housing market led to strong growth in housing-related purchases. Cafés and restaurants also posted solid growth, consistent with a comparatively stronger domestic services sector.

In the lead up to the forthcoming Federal Reserve meeting (June 14-15), US data points have generated increased interest. To recap, the Fed has recently stated that if there is continued improvement in the economy, the labour market and rising inflation, the second rate hike in the current cycle will proceed, which has been backed up by increasingly hawkish statements by some members in recent weeks.

Turning to the US, the key release this week was on consumer spending, which showed a spike in April (+1.0%) and the highest monthly gain since 2009, albeit after a weak downward trend through most of 2015. The jump in the monthly data series was ahead of expectations, which were already quite high following recent solid reports from retail and auto sales, and point towards an improvement in second quarter GDP growth as well as evidence of the flow through of a tighter labour market and rising wages. The saving rate, which fell to a low for the year, also suggest that the American consumer is showing increased confidence.

Within the consumption numbers was also the Fed’s preferred measure of inflation, the Personal Consumption Expenditure (PCE) Price Index. The core index, which excludes volatile measures such as food and energy, rose by 0.2% for the month (in line with forecasts by economists) to track at a 1.6% rate on a 12 month basis and continues to creep higher towards the Fed’s 2% inflation target.

US: Real Personal Consumption Expenditures

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Fixed Income Update

When considering asset allocation we look closely at the correlations between asset classes. Fixed income is often used to diversify returns away from equity portfolios by using the assumption that the medium term trend of a negative correlation between long duration government bonds vs equity and credit will hold true. However, in the month of May there were strong returns across long duration bonds, credit and equities. The table below shows the monthly returns in May across sectors:

Source: CBA, Bloomberg, S&P
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Australian government bonds were the best performers in fixed income, rallying in response to the low forecast for inflation and the RBA rate cut. The reduction in interest rates was the biggest kicker in terms of returns, with the longer the duration the bigger the move in terms of price.

By way of background, in the last few years we have seen the Australian government increasing the amount of debt that they have outstanding and also extending the average maturity. The low interest rate environment has encouraged the government (and corporates) to lengthen out the curve and lock in the low rates for longer. This has translated into an extension in duration for the Bloomberg government bond index which measures the performance of the sector over time.

The average maturity of bonds in the Bloomberg government bond index is 6.4 years (with a modified duration of 5.4 years) and this returned 1.34% for the month of May (as it includes Federal and State Government bonds). However, for those holding shorter maturities in governments bonds the returns diminished the shorter the bond. The chart below depicts the monthly return by maturity for the government sector. While the recent rate cut has been particularly favorable for holders of the index or longer bonds, one needs to be reminded of the impact interest rate movements have on these securities and be aware of the negative impact on their price should interest rates start to rise.

Total return performance in May for 3 year, 5 year and 10 year Australian government bonds

Source: Bloomberg, Escala Partners
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Corporate bonds (credit) also had a good run in May with credit spreads tightening in over the month. Long duration corporate bonds also received a price lift as rates have fallen (unlike short duration credit bonds which have seen very little price movement from interest rate movements). The reason why this sector did not perform as well as its sovereign peers, comes back to this matter of duration. The corporate bond market’s average maturity (in the index) is 3.77 years, which is significantly lower than the government bond index where the average life is 6.4 years.

The last few weeks has seen a wall of supply in global bond markets. In the US there was a record $176bn high grade bonds issued in May. Domestically there has been no shortage of supply either. Outside of governments, the Australian market had $9.7bn in issuance across 17 deals, up from $5.3bn in 14 deals over April.  

In the listed market, NAB brought a new tier 1 (bank hybrid) security this week with a 6 year call (converts to equity in 2024 if not redeemed) paying BBSW + 4.95%. Like the CBA and Westpac deals earlier this year, this security was very well received by retail and institutional clients. The final issue size is still to be determined, but is expected to be just under $1.5bn. The table below compares the main structural terms of these recent deals. Spread tightening in the last two months has resulted in a price rise on the CBAPE’s, and slightly lower issue margins on the WBCPG’s and NABPD’s.

Source: CBA, Westpac, NAB, Escala Partners
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ANZ have also announced that they are expected to bring to market a new USD tier 1 hybrid, out of London, as early as next week. This will be the first of its kind from ANZ since before the financial crisis. Structural impediments and higher cost of funds have previously prohibited them from issuing offshore. Structural changes and spread conversion between markets (due to recent spread widening in the domestic market), have opened up the opportunity for them to diversify their investor base. No announcement has been made, but market talk is that it is likely to be a 10 year fixed rate deal, pricing at ~7%.

Corporate comments

Global laboratory services provider ALS’s (ALQ) result was below expectations, with a decline in underlying earnings of 26% for the full year. The reported result was a net loss following previously foreshadowed writedowns in its oil and gas division, while the final dividend was also rebased lower.

The composition of ALQ’s earnings was consistent with the trends over recent years. The company has undertaken to grow its exposure to the more predictable and sustainable divisions of its portfolio (see chart below), particularly the core life sciences group, which has favourable long-term underlying demand across the environmental, food and pharmaceutical industries. This division again produced a solid result for ALQ, with top line growth of 14% (despite the absence of any significant acquisitions during the period) and EBIT growth of 12% on fairly steady margins. ALQ also noted that the momentum through April had been particularly strong in the business.

ALS Revenue Mix

Source: ALS
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However, it has been the more cyclical elements of its business which have been responsible for the deterioration in the company’s profits, and this again proved to be the case in FY16. The minerals division (which provides testing services to mining clients) showed a slight drop in revenue and a contraction in margins after more recently showing signs of stability. It was, however, the company’s oil and gas exposure which was the primary source of concern, with the sector facing pricing pressure as well as reduced work given the cash flow pressures faced by its client base. In hindsight, the group’s expansion into the oil and gas sector in mid 2013, while diversifying the company’s exposure further, was ill-timed, coming just 12 months before a significant correction in oil markets. ALQ is now looking to take costs out of its own business over the next 12 months in order to adjust in this new environment.

While a turnaround in ALQ’s resources exposures is hard to predict, it does not appear imminent. The strength of its core life sciences business though does mean that it is better placed than its peers to ultimately see through the cycle and remain well placed to benefit from a recovery through significant leverage. While the shorter term volatility and headwinds may persist, we have been positive on the longer term outlook for the company.

This view is obviously shared by private equity groups Advent International and Bain Capital, which teamed up this week following ALQ’s result to make a bid for the company of $5.30 cash per share. ALQ was quick to dismiss the bid as opportunistic in nature given it has come at a low point in the cycle for some of the group’s divisions. While we do not advocate stock recommendations based on the potential to be acquired, international interest in Australian companies is likely to continue following the depreciation in the $A, low funding costs and the lack of overall organic earnings generation that is prevalent in most developed markets.

Spotless (SPO) shares gained this week after the company reaffirmed its guidance for the full year. After a surprise downgrade late last year, SPO has since met its revised guidance when reporting its half year results and has now confirmed that it is on track to hit its full year numbers. Achieving the latter should help to restore investor confidence in the stock, which now trades on a single-digit P/E multiple despite its relatively defensive earnings base.

Separately, SPO disclosed that it was exploring options to divest its laundries businesses after receiving interest from a number of possible acquirers. While SPO’s laundries business is high margin in nature, it is more capital-intensive than its other divisions and it operates in a relatively low-growth environment. The company’s poor execution on integrating a number of acquisitions in the division was also a key reason for its earnings downgrade last year.

FlexiGroup (FXL) issued a slight earnings downgrade as it conducted a strategy day, the first for its new CEO who was appointed late last year. The company announced that it was exiting a number of its smaller business units that were either low-returning or not of adequate scale in a move that should allow it to redeploy the capital into its areas of strength.

FXL also announced a target for FY17 profit which was somewhat underwhelming and perhaps reflected some of the current organic growth challenges across its various businesses. While the company has performed quite well operationally, particularly with the growth and synergies it has generated from a series of acquisitions over the last few years, the stock has de-rated considerably during this time and would now be appearing on many deep value screens. With a lack of any near-term catalyst, we recently decided to switch the stock into other options in our model portfolios.

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