Week Ending 12.01.2018
- Where an economy is in its cycle will start to matter more rather than just monetary management. US leads Europe, while for Asia it is somewhat more complicated.
- China’s debt structure is a work in progress and a risk for growth. On the other hand, it is leapfrogging imbedded structures prevalent in the western world in financial services.
Reference to ‘late cycle’ is a catchword for 2018. Few doubt that the US is in that phase, given a protracted period of respectable growth, but more importantly, a dramatic shift in employment conditions and asset pricing. The recent softer trend in the labour market is possibly a sign of close to full employment, rather than a portend of an emerging slowdown, as skill shortages restrict the potential employment of those still on the sidelines. Small business, the predominant source of labour demand, suggests that over half of these organisations cannot find suitable candidates even though they judge it a good time to expand their businesses. A growing number state that they will raise employee compensation and a proportion of the tax cuts, when it appears in cash flow, could be channelled to wage rates. This would reinforce the notion that the US is now at optimal economic speed.
While, on aggregate, Europe is only possibly in the middle of its renaissance, Germany, Scandinavia and the Netherlands are also extended in terms of the pressure that growth is putting on their respective economies. The high export dependency, with domestic demand restrained by demographic factors, puts Europe more at risk of a pullback were global trade to ease. On the positive is the growing confidence France and southern Europe are living up to the expectation that some reforms are creating enough confidence to lift their economic growth. The unemployment rates in these countries, while still high, has fallen significantly in the past year.
- While economic growth is not necessarily correlated to investment markets, the potential earnings upside in Europe is greater than that of the US given these underlying trends. A resilient Euro helps too, if unhedged.
Under these developed world circumstances, the assumption would be that developing economies can travel alongside, given the demand for goods that they produce. However, increasingly it is domestic circumstances that determine the outcome, at least for the larger economies. China is naturally the focus, but the broader south eastern Asian region (the so called Asian 8) is part of that global growth powerhouse.
The contrast in the source of growth for the Asian 8 versus China is evident in the chart. Chinas export dependency is easing in favour of internal trends.
Asian 8 growth trends China growth trends
Having stimulated its economy in 2015/16, the government in China has been tightening policy for most of 2017. The underlying reason remains the problem of very high non-government debt levels, which is frequently cited as the source of potential global dislocation. Corporate debt has doubled in the past ten years and so-called shadow banking (lending outside the banking or formal sector) adds another sense of unease given the low transparency in what underpins this leverage
For the past year the government has introduced a range of measures to limit lending in China. This week, the regulator took another step to curtail uncontrolled forms of lending by curbing entrusted loans. These are intercompany lending where the banks act as an intermediary and offer a guarantee. Companies with access to low cost loans were therefore borrowing and lending on at higher rates to companies that could not raise debt through the normal channels. The banks acted as intermediaries, but did not have to disclose the debt on their books or provide capital against the loans as they technically were not the lender. The sums involved were not insignificant at US$2.1tr.
Property has no escaped their attention. Restrictions on buyers and leverage is expected to see property activity slow and prices even turn negative this year.
The optimists see the intervention of the authorities as a sign that sufficient oversight will be exercised to contain the debt issues. China can fund this debt as local savings rates are still high and capital flows are under their control. The risk is that too much tightening results in an overreaction and subsequent reversion to stimulus with further debt. Corporates, and to some extent the community at large, are lulled into the belief that, given central government control, it is also the government’s responsibility to rescue them from any risks. The fortuitous cycle of monetary easing coinciding with a global growth phase will at some point snap. China, too, may find that policy measures have been expensed in the past with little in the kitty to break a downward tilt.
Most forecasts for 2018 GDP growth for China are in the order of 6.5%. A softer patch early in the year is expected to lift in the second half as tightening measures run their course. The big issue for China is domestic demand. At present this is in a good spot, with consumer confidence at a ten-year high. The pattern of consumption is changing. Spending is expected to be up 7.5% this year with sectors such as education, cosmetics, beauty services and households services exceeding the average, while consumption growth in food and clothing is below average. It is accompanied by a shift from basic products to trading up into those that have a premium flavour. Examples are specialty drinks rather than standard juice or instant coffee, plant extract shampoos and facial cleansers. In this context, Chinese consumption resembles that of countries such as South Korea or even Japan, rather than the western trends.
The most pronounced difference to Western consumer patterns is in the payments systems. Alipay and WeChat Pay have become ubiquitous as they form an ecosystem where consumer integrate much of their lives. The extent of data capture and consequent marketing of products and services through these platforms is more powerful than any Western-oriented internet or social media concern.
China lags in many areas. It is still far behind on measures of R&D spending, competitive pricing and product quality in industries such as health products and services, aerospace and even motor vehicles and robotics. But in IT and, in particular, payments and consumer interaction, it is easier to make the case that it leads the rest of the world.
Another development that bears watching is the use of the renminbi in global trade. China will now settle its oil purchases in its own currency. Assuming a middle eastern buyer, this country can convert the currency or alternatively buy Chinese goods and services, but more importantly, hold the currency through China bonds. The Chinese bond market is now the third largest in the world. This move parallels that of the US, where oil and other commodities are prices in USD, resulting in a natural source of demand for its Treasuries. Chinese bonds offer a 4% nominal or 2% real return, perhaps not a bad diversifier for an oil country.
- Long term patient investors should favour a meaningful weight towards Asia in both equity and credit markets. It may not be an easy path, but the opportunities, improving financial participation and level of interest in the region can only grow.
Fixed Income Update
- Domestic term deposits assets climb to their highest level in 27 years.
- Investors worried about inflationary pressures shift into funds that buy inflation-protected securities.
- The start of 2018 sees global bond yields push higher (prices lower).
Most investment portfolios in Australia will have an allocation to term deposits (TD’s). The typical reasons for holding these securities include:
- Protecting capital due to their high ranking on the capital structure and the $250,000 government guarantee
- The short-term nature of the instrument when capital is needed for future cashflow requirements (eg tax payments)
- A holding place for when asset valuations appear expensive and one is waiting for a pull back before further deployment into investment markets.
In 2017, TD assets rose to their highest level since 1990, with $608 billion as at the end of November (December figures not yet available). The reason for the rise is uncertain, but with the savings ratio falling in 2017 and wage growth not evident, it does suggest that concerns on high asset valuations and the desire to protect capital are the main drivers. While this may prove to be prudent positioning if investment markets correct, it has come at an opportunity cost so far given the 2017 returns in equities, and even fixed income which has outperformed the TD market.
The banks (except CBA) increased their rates 9-12 months TD’s leading into yearend while easing the rate on shorter term money. Fixed income research house ‘Bondadviser’ suggests that the reason the banks wanting to attract longer term deposits was to manage asset/liability risks.
Funding Composition of Banks in Australia
In global markets, concerns of an uplift in inflation, which has remained stubbornly low in the last few years, has investors pouring money into funds that invest in inflation protected bonds. Last week US funds attracted $743m which marked the 11th straight week of positive flows. This is the longest streak of inflows since early 2017.
Inflation concerns were also documented in the minutes from the Fed’s December meeting which discussed the low levels of unemployment sparking wage growth and the new tax reforms fuelling price increases. A rapid lift in inflation data could result in the rates moving more quickly than what is anticipated.
- Many of the fixed income funds that we recommend have also been adding inflation-linked bonds to their portfolios (known as TIPS in the US). This will help protect the portfolio should there be an unexpected lift in inflation. In contrast, regular long dated bonds that aren’t inflation linked will likely fall in price should inflation emerge higher than expectations.
Investors pour money into inflation protected bond funds
The start of 2018 has been met with a selloff in government bonds. The biggest moves have been in the US and Japan, with their 10-year government bond yields rising 0.13% and 0.39% respectively year to date. European and domestic bond yields are also higher, albeit to a lesser extent. Germany’s 10-year Bund yield is up 0.09% and Australia’s 10-year ACGB 0.07% higher over the same period. A number of different reasons have contributed to the price moves including:
- An interpretation of a more ‘hawkish’ stance coming out of the ECB minutes.
- Reports from Bloomberg that the Chinese government has done a review of China’s FX reserve holdings and recommended a slowing or halting of purchases on US Treasuries (although there has also been reports that this has been denied by Chinese officials).
- Bank of Japan reducing in its monthly bond purchases (QE) on 10-25-year bonds.
- Well known bond trader Bill Gross (Janus Henderson, formerly Pimco) suggesting that the bond bull market is over.
- Energy was among the top sector performers in the second half of 2017, although the performance across the sector was quite variable. If current higher price levels are sustained, this will accelerate balance sheet repair and/or distributions to shareholders this year.
While the rally across a range of commodity prices has been the primary driver of aggregate earnings for the Australian equity market over the last two years (albeit off a low base), the standout among key commodities in the second half of 2017 was the rise across the energy sector, which produced a 25% return for the six months. Underpinning this performance was strength in the oil price (we refer to Brent crude, which is most applicable to Australian producers), which advanced from a mid US$40/barrel to a high US$60/barrel range.
OPEC’s production cuts finally achieved the desired effect. With a high level of compliance to these reduced supply targets, this justified the cartel’s decision at its recent meeting in November to extend this arrangement for a further 12 months.
Coupled with steady global demand growth and a modest increase in US supply (compared to more recent years), the ongoing normalisation of the market’s balance led to falling levels of inventory and significant price growth.
Unsurprisingly, in the last few months the energy sector has been the subject of significant upgrades to earnings estimates as analysts have revised oil price assumptions for 2018. With varying degrees of leverage to the oil price, the upgrades have not been uniform and have helped to lift the ASX 200’s earnings base. A slight offsetting factor has been a stronger AUD and thus lower revenues for producers when converted into local currency. Reflecting little change to longer term price forecasts (of around US$60/barrel), however, underlying valuations have not changed nearly as much.
Energy Sector: 12 Month Forward EPS Revisions
Forecasts for 2018 suggest little upside for oil from here, however the current price level has provided a more comfortable operating environment compared to the market’s lows of early 2016. Outside of less predictable geopolitical influences, the factors described above are expected to provide support for the oil price at around US$60/barrel through the year, with additional US supply absorbed by ongoing growth in demand.
The emergence of US shale production has effectively put a ceiling on the price, as any sustained period of higher pricing will provide additional free cash flow for these operators to increase their production levels. Additionally, this response can come at a much quicker rate than what was previously typical for the oil industry, which should result in shorter market cycles going forward. A somewhat unknown factor in the medium term is the gains from improved productivity in US shale which has driven costs lower. This was a feature in the first half of this decade, although has notably slowed in the last 18 months.
US Oil Production per Rig by Region (bl/d)
Of the Australian listed energy market, the large companies typically export much more LNG than oil and so LNG pricing is more relevant. While long term LNG contracts have linkage to the oil price, in a weaker environment, contract rollovers can often be negotiated at a lower rate. Additionally, residual excess production is usually sold on the spot market which has proven to be volatile in its pricing and more reflective of the global supply and demand of LNG. Seasonal strength has resulted in a significant rally in LNG spot prices in the last few months, although off a low base.
Presently, the global LNG market is in an oversupplied state (the growth in Australian production in the last decade has been a large contributor to overall growth) and could remain so into the next decade as projects currently under construction continue to be completed. While this is expected to curtail any new project sanctions in the medium term, demand growth, particularly in Asia, has been outpacing expectations, which could lead to a balanced market sooner than anticipated. Part of this demand growth is attributed to the Chinese Government’s policies to curb pollution and shift away from coal, and while LNG growth is expected to be part of this solution going forward, natural gas (potentially piped from Russia) could also be part of the mix.
The evolution of the LNG market has the largest implications for Oil Search (OSH), given its exposure to high-quality growth options in LNG, the timing of which may depend on the appetite for new supply. The stock has been our preferred exposure to the energy market for this reason, along with the strength of its existing operating asset base. In a market where share prices imply fairly high oil prices to justify valuations, incremental value-adding growth opportunities can be an important point of difference of relative performance.
Santos (STO) and Origin Energy (ORG) have been the two standout performers among large caps in recent months. This has likely been driven by investors becoming more comfortable with the high debt levels the two companies have carried (a legacy of their investment in large LNG projects in Queensland). Consequently, their ability to repay this debt in a more timely manner has improved in the better oil price environment, which has reduced the equity raising risk for both. Operating cost reductions have been a feature for both companies over the last two years (following the collapse in oil), ensuring a better position going forward in a recovering market.
Santos has the most leverage to the oil price among these two and hence is the best exposure for an investor who is positive on the short term price outlook. Currently, this is tempered by a takeover premium in its share price following an approach from a US competitor last August.
Origin has a lower level of leverage given its position as a leading domestic integrated electricity and gas company. The spike in wholesale electricity prices is an additional bonus for ORG (although less so compared with AGL) and there are potential benefits from asset restructuring (likely a separation of these two core divisions) in the future. ORG is held in the Investors Mutual core portfolio.
Woodside is the benign option in the sector, with the highest margins but with a flat production profile. This has provided it with better protection in weaker markets, although less upside when conditions improve and a relatively more stable dividend profile than its peers. It thus has been the favoured energy exposure for the Martin Currie SMA.