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WEEKEND LADDER

A summary of the week’s results

09.02.2018

Week Ending 09.02.2017

Eco Blog

- US wage growth was the crystallising moment for the investment market, which had ignored the run up in bond yields in the past few months. The discussion turns to how far labour costs will push out and the impact on inflation.

- Feb members were unmoved by equity markets stating that hikes were forthcoming

- German wages, too, are on the rise, up 3.9% for members of the largest union.

- China’s demand for commodities appears intact and provides some support to prices

- Australian data releases had little consequence but supported the RBA’s rhetoric that rates should remain on hold.

- Inverse-volatility products came under pressure after historic movements in the VI. 

From what otherwise was a simple data point of long expected US wage growth, a more complicated picture of financial conditions has emerged. Wage rates rose by 2.9%, the highest since the 2009 downturn, and could be interpreted as adding to inflation risk, lower corporate profit margins and faster Fed rate hikes.

Economists commenting on this employment release called the data consistent with their expectations and as can be seen in the chart, the trend has been in place for some time. Yet investment markets seem to have belatedly realised that the growth cycle had reached a phase of interest rate adjustment that should affect asset prices.

US wage growth

Source: BLS, Haver Analytics, Deutsche Bank Research
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The big rally in equities from November to January had some of the hallmarks of irrational exuberance and to an extent was lining up for a pullback.  The issue is now whether the pressure on wages and prices in general is turning out to be higher than expected.

Inflation expectations remain low as economists puzzle over the structural impediments to consumer prices indices in most regions. The usual culprits are technological change, consumption patterns and low-cost goods due to global trade. Most companies are also reluctant to lift prices, given a broadening substitutability of goods and even services. Notable entrants in some sectors (for example Netflix, Amazon, Airbnb, Uber) appear to be willing to live with low or no profit margin to gain scale. The tax changes in the US are biased towards capital addition over labour given the accelerated deductibility of investment over the coming five years. A good proportion of this investment is likely to reduce demand for labour and enhance competitive pricing.

What could derail this? The usual culprit could be the oil price, though the rise to date has been well absorbed in the CPI. If the US withdraws from NAFTA, low cost jobs and goods from Mexico would transfer to higher cost regions and push up wages. Repatriation of migrants out of the US (who take up a meaningful proportion of the low paid jobs) could trigger competition for low skilled workers. Indeed, any increase in trade barriers and tariffs implies higher prices within the US. The US labour market is lightly organised such that a grassroots union-based push for wages is unlikely. Corporates, however, have indicated that they will pass some tax benefit through to employees which could raise wage expectations across the board.

  • The risks are on the upside for wages and inflation and any evidence of this can be expected to cause a direct reaction in investment markets. The transmission mechanism for interest rates into investment valuations comes via several methods. The risk-free rate is one common anchor, with other asset classes priced to compensate for levels of risk above this bond yield. Discounted cash flow models also directly incorporate the risk-free rate. The greater the weight on long term growth, the more sensitive the equity price should be to rates. Some suggest that growth equities that have been the primary beneficiaries in the rally are therefore most vulnerable. No method provides an accurate pricing mechanism for assets, yet inevitably influences the expected return in the longer run.

Within these cautionary comments, the persistence of economic growth, likely upward revisions of corporate earnings and the lack of signal from credit suggests that the volatility is not pointing to a sharp deterioration in asset values.  Further, forthcoming data is not necessarily likely to cause the same degree of angst. Other pointers out this week show that the consumer component of the US economy is, as one commentator put it, meandering. Vehicle sales are soft, mortgage applications have levelled off as rates kick up and consumer credit growth has slowed.

US rate hikes have been factored in for some time, with the futures market implying that three increases were the most likely outcome, while many in investment markets have discussed the possibility of four hikes. It is unlikely that the Fed will be too perturbed by the equity rattle this week. New York Fed member Dudley called the equity moves ‘small potatoes’, which was reiterated in similar terms by four other Fed members. If rate rises are dependent on investment asset prices, it would send a poor signal by implying the Fed had a role to manage volatility in markets.

Germany had two pieces of notable events. The confirmation of the coalition between the CDU (Merkel) and SDP took the political framework back to the centre, in contrast to a right lean that would have resulted from the ‘Jamaica’ collation (with FDP and Greens). Fiscal leniency is likely. Indirectly, it emerged in the pay settlement with the largest industrial union in Germany. Worker advisory boards set the pace for employment conditions with the tacit oversight of the government. The combined mix of payments and leave provisions imply a 3.9% pay rise for 2018 tracking to 3.5% in 2019. This will inevitably flow through to other sectors and put some stress on inflation in Germany. This week, industrial production showed 5% annualised growth over the last three months. Export growth was also strong. At this stage the higher exchange rate and cost pressures appear to be secondary to the product quality.

China’s trade data showed a big jump in imports. There is inevitably one off and seasonal factors in the trade (timing of Chinese New Year, import regulations, weather, oil prices), yet it does imply that so far, China is on a stable growth path against expectations of a slowdown.

China commodity imports, year on year change

Source: China Customs, ANZ Research
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The sustainability of commodity prices is a matter of much debate. While global growth continues, the demand appear sufficient to prevent a deterioration as many had expected.

Local data had little impact on investment markets. The trade balance tipped into negative territory as it swings around commodity volumes and import patterns, December retail sales were on the soft side reconfirming the subdued household dynamics and housing finance edged back, led by reduced investor lending.

Investment Market Comment

After US markets closed on Monday this week there was an historic movement in the CBEO Volatility Index (VIX), spiking from 17% to 37% in two hours. While some of the volatility has since steadied somewhat, we did see the demise of a highly leveraged inverse exchange traded note (ETN).

A ETN differs significantly from the more common Exchange Traded Fund (ETF). ETFs hold a basket of securities, usually stocks or commodity futures, whereas ETNs do not hold securities. ETNs are structured products that are issued as unsecured, senior unsubordinated debt with the issuer promising to pay the holder the value (minus the fee) of a given index tracked by the ETN. Therefore, the credit worthiness of the issuer is critical.

After the historically low levels in volatility in 2017, one of the year’s most crowded trades was shorting volatility, where investors bet against a rise in volatility. A popular and convenient way to access this trade was through the VelocityShares Daily Inverse VIX short-term ETN (XIV) which returned 180% in 2017. However, as volatility spiked the underlying index dropped 85% after trading hours on Monday.

Volatility ETNs performance

Source: IRESS, Escala Partners
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Subsequently, Credit Suisse, the underwriters of this ETN, called for an "accelerated valuation date" of the notes on February 15th, leaving investors unsure of what value they will receive upon the forced redemption of this note, though its safe to assume it will not be much.

  • It is crucial to understand how an exchange product works and how to use the security. Highly leveraged products don’t suit long-term views. We recommend the use of ETFs in our asset allocation, however, if an exchange traded product requires a 200-plus page prospectus it is probably a very complicated product that is best avoided.

Fixed Income Update

- As global bond yields rise, we look at the impact this has on returns for those with exposure to the underlying securities.

- We examine the relationship (correlations) between bonds and equities.

- Westpac commences the book build on the replacement of WBCPC securities.

There has been much discussion about the rally in bond yields in January, led by movements in the US market. Yields in US treasuries have reached their highest levels in four years, with an increase of near 30bp in January alone. While we generally talk in terms of the yield or rate on offer, it is the price movement on the underlying bonds that affects investment outcomes. How did this 0.30% lift in rates in January translate into portfolio performance with exposure to interest rate sensitive long duration bonds? Most global fixed income portfolios have a mix of high quality investment grade credit and government bonds within managed funds. This style of fund is benchmarked against the Barclays Global Aggregate Bond Index hedged into AUD, which fell by 0.45% in January.

As bond prices declined in January, the equity market rallied. Negative correlations between the two asset classes held true. However, this week we had a different result. Bonds yields are higher again and we have had the fall in global equities. While we recognise that this relationship should be viewed over a longer time-frame, the behaviour of the equity-bond correlation plays an important role in asset allocation. It is not always going to be negative (as illustrated below), but we expect, at a minimum, a low correlation. Markets face unprecedented times as global interest rates move off historic lows, central banks unwind balance sheets, the risk of inflation rises, and following a prolonged equity rally. These factors present a risk of a de-coupling of the bond-equity correlation.    

5-year equity bond correlation

Source: PIMCO, Bloomberg, FRED & ICE BAML
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Volatility in bonds has risen in recent weeks following a low ebb. November 2017 marked the lowest volatility in US treasuries for over 30 years (as measured by the MOVE index).

  • During discussions with a government bond fund manager this week, the comment was made that increased volatility is a potential positive. It opens up trading opportunities and the ability to add return over the index.

Volatility in US treasuries (MOVE index)

Source: Escala Partners, Bloomberg
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The RBA kept interest rates on hold this week. In a speech on Thursday, the Governor Philip Lowe said he doesn’t “see a strong case” for a near-term interest-rate re-adjustment. He noted that Australia’s circumstances were different and the RBA wasn’t obliged to follow the withdrawal of stimulus by other global central banks.

The yield curve steepened following the announcement. Rates on the short end are marginally lower on the week, while long end rates are higher following the lead from offshore. A steeper curve, with no imminent rate hikes expected, is favourable to long duration style funds that benefit from the roll down.  

  • Our base case is still to be underweight duration. However, given where Australia is in the rate cycle, capital preservation portfolios could look to add duration as the longer end nears 3%. 

As anticipated, Westpac came to market this week with a hybrid offer to replace WBCPC securities that mature in March. The new capital note has a call in 7.5 years, which, if not exercised, will convert to equity after two years. The price is a margin of BBSW +3.20-3.40%. Given the contraction in spreads across all credit products in the last year, the margin on offer is reflective of current market conditions, with Westpac opportunistically taking advantage of the continued demand for these products. Unlike previous new hybrids and given where we are in the credit cycle, we believe that capital appreciation on this new security is unlikely, and price volatility may result. However, for those seeking income (with a tolerance for volatility) the 5%+ return (after including franking) may be sufficient rationale to roll into the new security.

Corporate Comments

- Commonwealth Bank’s (CBA) half year result fell short of expectations due to one-off charges which may persist beyond this period.

- The limitations of volume growth may be realised for carsales.com (CAR) in coming years, with earnings currently supported by higher value premium advertising.

- Rio Tinto (RIO) had a marked uplift in earnings in 2017 and extended its share buyback. Resources are among the best ways to leverage to positive global economic conditions.

- Tabcorp (TAH) disappointed with its profit, although a brighter outlook is on the horizon.

- AGL Energy’s (AGL) increased profit was driven by rising wholesale electricity prices, which are expected to be the dominant driver of earnings in coming periods, despite a challenging retail market.

- Wesfarmers (WES) faces challenges in its UK expansion plans, writing down its recent acquisition.

- Myer (MYR) again disappointed with an additional earnings downgrade for the first half.

Commonwealth Bank’s (CBA) first half earnings fell short of forecasts, with a modest uptick in its dividend failing to impress investors. Earnings were weaker primarily due to several provisions that were taken above the line, which led to a 2% decline in profitability. The most signfiicant of these was a $375m charge that it believes may be incurred as a result of its alleged breach of anti-money laundering laws. An additional $200m has been set aside for expected ‘regulatory, compliance and remediation program’ costs, which includes those related to the Financial Services Royal Commission.

While these are expected to be one-off in nature (although some analysts point towards the possiblity of a higher anti-money laundering penalty), it does highlight the escalating risk and compliance burden that the local banks have been facing in the aftermath of financial crisis. CBA’s cumulative outlay in this category over the last 5 ½ years has been approximately $4bn. It is  likely to also mean that much of the new CEO’s focus will be addressing these issues as opposed to growing the business.

Commonwealth Bank: Risk and Compliance Spend

Source: Commonwealth Bank
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These provisions detracted from what was a reasonably good result amid a soft operating environment, with its market-leading retail banking division the key driver. Underlying profit growth rose on a mix of loan growth (albeit below system) and net interest margin improvement following mortgage repricing. The effect of APRA’s crackdown on investor lending was also evident, with year on year investment loan growth of just 0.5% for this category. CBA is among the most exposed of the major banks to housing lending. Given regulatory pressure on banks and several distractions for the new CEO, CBA is among our least favoured in the sector.

carsales.com (CAR) delivered a respectable 11% increase in earnings for the half, while lifting its dividend by 10%. The stock was marked down, however, with the composition troubling a number of analysts. The company’s core Australian car classifieds division remains the most important. However in recent times growth has been more driven by what the company refers to as ‘yield’ enhancement, or the up-sell of advertising into higher value products that have more prominence on the CAR app or website. While this can support earnings growth for a period of time, it has less sustainability than ongoing growth in volumes, which has been somewhat lacking.

More recently, revenue growth has been driven by acquisitions made in lower-margin adjacent products, such as vehicle financing with its Stratton division. It has had the effect of reducing the overall group margin, with this step down again illustrated in this half.

carsales.com: Change in EBITDA Margin

Source: carsales.com
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The upside for CAR is in achieving success in its various international investments. At this stage the contribution to overall earnings is not material at less than 10% and has had a reasonably high degree of variability. In this half, earnings from its Korean business SK Encar (which it has recently moved to 100% ownership) disappointed on higher investment spend.

CAR currently trades on a forward P/E of 23X with forecast growth over the next few years of around 10% p.a., which appears high at face value, although also reflects the lack of attractive growth stocks in the Australian market.

Rio Tinto (RIO) again came through on its capital management expectations, committing a further US$1bn buyback of its UK-listed stock this year and matching its buyback from 2017 (the company also completed an additional US$2.5bn buyback from the sale proceeds of its Coal and Allied assets). This complemented the 71% increase in total dividends for 2017, which was backed by a sharp lift in profitability as commodities strengthened through the year.

RIO’s result was otherwise largely as expected, with no significant capex announcements despite a large increase in cashflows. While iron ore was again the primary driver, RIO’s other three business units (aluminium, copper and diamonds, energy and minerals) all contributed to the 38% increase in EBITDA.

Through 2017, iron ore was supported through supply-side steel policy reform in China, which has increased the demand for high quality Pilbara imports. RIO have pointed towards a similar path forming in the aluminium market (one of its larger exposures) as Chinese supply is reduced on environmental policies.

A key takeaway from the presentation was that cost pressures are again starting to emerge in the industry given higher levels of activity and better profitability. The cost-out programmes that the large diversified miners have implemented over the last few years have been successful in managing margins as commodity prices weakened. With cost pressures yet to really materialise in results, RIO’s EBITDA margin for 2017 was higher than at any point in the last ten years, including the boom years early this decade. Notwithstanding a better pricing environment, it is not unreasonable to expect these margins to normalise in the short to medium term.

Rio Tinto: Revenue and EBITDA Margin

Source: Rio Tinto company reports, Escala Partners
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With balance sheets in good shape, excess cash being returned to shareholders, spot commodity prices continuing to trade above forecasts and undemanding valuations, we have a constructive view on resources sector and believe it is the best way to gain exposure to the strong momentum across the global economy.

Tabcorp’s (TAH) result was messy following its recently completed merger with Tatts Group (TTS), however it was the underlying trends in its core wagering division that disappointed. In the December quarter, TAH’s wagering revenue declined after rising nearly 5% in the September quarter. TAH pointed towards lower fixed odd racing yields in the second quarter yet remains challenged by several structural headwinds.

These include changing customer betting preferences from its in-store TAB outlets to digital channels, a subsequent fall in pari-mutuel (tote-based) betting in favour of fixed odds, and faster growth in sports betting (as opposed to racing), which favours TAH’s competitors. TAH’s foray into the UK with its Sun Bets business (a joint venture with News Corp) has, two years in, also been underwhelming. The business posted a $24m loss in the half amid a competitive market and an impairment charge was incurred. TAH still owes payments to News Corp under a contract that continues until the end of next year. There is suggestion that it may look to make an early exit from the business.

While TAH does have some issues that will need to be resolved, a better outlook can be envisaged with the company cycling a soft 2H17 and the flow through of synergies that are expected to be realised from the TTS acquisition (which should help to increase earnings materially over the next two years). Additionally, regulatory reform is slowly shifting in TAH’s favour, with proposed laws restricting credit betting, bonus bet inducements and the introduction of point of consumption taxes (already legislated in South Australia). These changes are expected to result in market consolidation and give the company a relative advantage over the low-taxed international online-only bookmakers in the Australian market. Some of these positives are arguably factored into TAH’s share price, which is trading on forward multiple of 22X, although the stock is supported by an attractive fully-franked dividend yield of almost 5%.

The investment thesis of positive leverage to rising wholesale energy prices was clear in AGL Energy’s half year profit, but so too were fears realised on the impact of increasing retail energy competition. As illustrated in the chart, the benefit from higher wholesale prices (which was well flagged to the market) more than outweighed the drag on earnings from AGL’s retail business (consumer markets). AGL reported a 30% rise in EPS for the half, allowing it to lift its dividend by 32%.

AGL: 1H18 Underlying Profit Drivers

Source: AGL Energy
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Much of the focus this week following AGL’s result has been on the deterioration in margin on the retail side of its business. While this is somewhat justified, the company remains more exposed to fluctuations in wholesale energy prices (and by a large factor). On this front, the outlook has softened in the last 12 months, with an acceleration in renewables investment and a pullback in the forward curve. Despite this change, it is still expected to remain a tailwind for earnings over the next two years.

The outlook for the retail division is more challenged, is a direct consequence of rising prices and the reaction of consumers. A heightened level of government interest on keeping prices contained, higher churn rates as customers shop around for a better deal and increased discounting by others is likely means that pressure on retail margins will remain high. Nonetheless, these dynamics are factored into AGL’s full year guidance, which has remained unchanged. While its medium-term outlook has become more clouded in recent months, this appears to be largely captured into AGL’s valuation. Trading on 13X forward earnings on a reasonable growth outlook, the stock is held within the Investors Mutual and Martin Currie SMAs along with our direct Escala share portfolio.

Wesfarmers (WES) has written down the value of its UK Bunnings business (Bunnings UK and Ireland or BUKI) that it acquired as Homebase Stores only two years ago. It also took a charge against Target. The combined setback to the asset base was $1.3bn. Introducing BUKI outside of Australia via an acquisition was always a risk, especially as Homebase had relied on a customer that shopped for soft furnishings and decorative items. Management states that it will now work towards a return on the vastly written down book value (from circa £700m to £150m) which tortures the balance sheet to superficially present an acceptable outcome. Walking away from BUKI is likely to cost in the order of $1bn given leases, employee commitments and stock, offset against a residual sale value. Staying may let losses drag and capital needlessly deployed to adjust the stores. This outcome hits at the reputation of the group and is reminiscent of the (much larger) Coles acquisition that caused a subpar ROI for years.

The charge against Target is another blow to this store group. The discount department store sector is over-stored yet both WES and Woolworths (Big W) are reluctant to close sites or reduce their scale due to the lease costs and overhead recovery. For some time, only Kmart has had a meaningful return, earning a near 12% margin. Even that is now coming under pressure as prices tighten across the board. Any notion of a recovery for Target seems improbable.

This announcement stated that, as the write-downs were non-cash in nature, the dividend rate would not be affected. Arguably, that is now the redeeming feature for a group with a low single-digit profit growth outlook.

Myer (MYR) added to shareholders’ pain post the downgrade of last December by reporting a continued deterioration in sales and sharp fall in first half profit. It will also reset its asset values. This may put the company in breach of its debt covenants and would crystallise a bigger restructure or sale of the business. We doubt a change at board level can do much to significantly alter the outlook.

Next week in reporting season is busier, with the following companies scheduled to release results:

Monday: Amcor (AMC), Bendigo and Adelaide Bank (BEN), JB Hi-Fi (JBH), Ansell (ANN), Aurizon (AZJ)

Tuesday: Cochlear (COH), Boral (BLD), Transurban (TCL), Challenger Financial (CGF), GPT Group (FPT)

Wednesday: Orora (ORA), Goodman Group (GMG), Computershare (CPU), Domino’s Pizza (DMP), Woodside Petroleum (WPL), Aveo Group (AOG), Vicinity Centres (VCX), IAG, CSL, Dexus (DXS)

Thursday: A2 Milk (A2M), Origin Energy (ORG), Healthscope (HSO), South32 (S32), Telstra (TLS), Suncorp (SUN), Newcrest Mining (NCM), ASX, Sonic Healthcare (SHL),

Friday: Star Entertainment (SGR), Medibank Private (MPL), IOOF (IFL), Primary Health Care (PRY)

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