A summary of the week’s results


Week Ending 25.01.2018

Eco Blog

- Exchange rate markets have got a political flavour. A weak USD received a friendly nudge from the administration.

- European attention is on the ECB meeting. Indications that inflation may muddy the picture are rising rapidly. Global attention to the structure of inflation and labour markets is part of the puzzle.

For a politician to talk about the exchange rate is unusual enough. At a high-profile forum such as at Davos, foreign exchange traders were taken aback to see the US Treasury Secretary, Steven Mnuchin, stating that the weak dollar was good for trade, while straddling with an opinion that ‘longer term, the strength of the US$ is a reflection of the strength of the US economy… and its primary currency in terms of reserve currency”. Naturally, a weaker USD may be good for trade, though it neglects the impact on inflation and investment capital flows and is in the midst of a re-examination of trade pacts such as NAFTA. Washing machines and solar panels have already become part of the tension after the US imposed tariffs on these products.

The talk on the USD is in contrast with previous statements by the US administration on a strong dollar as a positive expression of confidence and implies that there is little recognition of the potential negative judgment of the rising budget deficit and Treasury yields.

The sentiment will be imposed on the ECB meeting overnight. Whether the weak USD has any impact on European monetary policy remains to be seen. Given the strength in the economic trend, a change in language, if not action, will test the presumption that the central bank will remain immobile for 2018. Putting pressure on prices has been high PMI readings and job creation at its highest level since the early recovery in 2011. Certainly, the producer price index indicates that the CPI will follow and possibly get closer to 2%.

Source: Markit

The push from the oil price adds further pressure, especially in the US with the weaker USD exacerbating the impact.

With the tax reform and tariffs aimed at US employment conditions, the lack of skills is often nominated as a hurdle to push unemployment below the current level of 4.1%. It is also a function of regional differences, as households are less willing to move towards jobs. Ironically, holiday state Hawaii has the lowest unemployment rate in the country at 2%, whereas weather challenged Alaska registered the highest at 7.3%.  

UK unemployment is at a 42 year low of 4.3%, notwithstanding a rise in the workforce. Yet similar to elsewhere, wage growth has barely budged.  

UK real and nominal core wage growth

Source: Barlcays

In addition to low inflation and a structural mix shift towards younger, lower paid employees, surveys indicate that the Brexit uncertainty has triggered risk aversion, with households favouring holding their jobs over pay claims. By now it is probable that suggests robots and other technical advances will impact on labour markets, adding a degree of restraint to wage expectations in many parts of the world.

The Australian CPI for Q4 will be released on 31 January. Analysis of the CPI by both the ABS and the RBA highlights their bepuzzlement on the lack of movement in pricing.

Their data shows that the dispersion of pricing has been falling for some time. The number of price increases and decreases is being balanced out (shown as proportion in the chart) and the degree of price change is narrowing.

Source: ABS,RBA

Given the fairly sizeable movement in the exchange rate, impact of services and utility prices, this subdued trend implies that globalisation of products and even services contain the potential for price disparity to hold. Low and stable inflation equals low wage growth equals low interest rates and, in time, low investment returns.

  •  Inflation is the watch point of 2018 (again). The attention, however, is turning from the headline to the structure of the metric and impact of underlying forces. Companies will inevitably be vulnerable in product and service pricing, creating a winners and losers circle.

Fixed Income Update

- It bears repeating that flat yield curves are becoming common. This not only impact on potential fixed income returns but reflects the macro view of the world.

- Achieving returns in fixed interest markets is not necessarily related to headline yields. Europe can be more attractive than the rates suggest.

We have noted the US yield curve on a number of occasions, reflecting the discussion in fixed income markets that is concentrated on this topic. Following on from the discussion above, the flat curve is nuanced by the expected inflation rate. Inured by years of a low CPI, the financial markets have coalesced to the view that the 1-3% range is a high certainty. The possibility of deflation, put at circa 30% only two years ago, is now considered to be near zero, while the risk of higher inflation from monetary expansion has been put to bed.

Interest rates reflect official rates at the short end, structural factors such as deficits and capital flows in the 5-10 year range and inflation expectations in the 30 year part of the market. Unless there is a change in the outlook for the CPI, the flat shape of the US curve will persist and limit returns from roll down (bond prices reverting to par as they near maturity) and relative value trades.

Option-implied probability distribution of US inflation

Source: Goldman Sachs and AXA IM Research

For most fixed income investors, the intent is to get clean exposure to the underlying security or relative trade. Hedging costs are therefore part and parcel of the equation. Australian investors benefited from the higher cash rate in Australia compared to most other regions for many years, with this adding up to 2.5% to returns. This pattern is now quite different. The benefit is still there in European bonds as the cash rate is zero (though functionally the overnight repurchase rate is negative). The total return on European bonds is therefore more attractive to a key Japanese buyer than US treasuries.

Equivalent yield to Japanese Investor after currency hedging (%)

Source: Bloomberg, Deutsche Bank

The lesson is that fixed income is in the eye of the beholder and a simple judgement based on headline yields does not necessarily indicate the return to the investor.

Corporate Comments

- QBE’s shares rose despite an earnings downgrade this week. A new CEO now has the opportunity to reset the business amid an improving operating environment.

- Resmed (RMD) produced a solid result and its performance over the last year reflects the premium that has returned to growth stocks.

Investors took a glass half-full approach to QBE’s earnings and FY18 guidance to the market, which contained a further downgrade to the company’s profit expectations. The insurer now expects to report a FY17 combined operating ratio of around 104%, with only Australia/New Zealand and Europe below 100%. The combined operating ratio of an insurer is simply a measure of its underwriting performance, or its profit before any income earned on invested premiums; thus QBE is expecting a loss from its core insurance operations for the year.

The last 12 months have been a difficult period for the global insurance industry, with significant claims incurred from catastrophe activity. The hurricane season in the US was particularly bad, although was also well flagged to the market. In the last few months of the year, catastrophe costs escalated further, with storms in Australia and wildfires in California adding to losses for the year. Additional claims provisions in the group’s North American and Asia Pacific businesses were a further drag on performance, while its challenged emerging markets business deteriorated further in the second half. Finally, two one-off writedowns (to its deferred tax assets following the tax reform in the US and a goodwill impairment charge) rounded off the downgrade.

While there is expected to be a degree of normalisation in its insurance margin through 2018 (for example, catastrophe charges are unlikely to be repeated), QBE’s forecast guidance for the year was still below consensus forecasts. Despite the string of bad news, the stock gained over the course of the week, indicating several issues:

- the company has a new CEO (commencing from this year) and hence a rebasing of expectations was anticipated by the market; the underperformance of the stock in the past month despite an uptick in bond yield provides evidence to this point (see chart below);

- moreover, the guidance for this year appears, at face value to be reasonably conservative (given an improving market environment), which is in contrast to its recent guidance history;

- there is evidence of an improving environment for global insurers for a better premium environment.

QBE and US 10 Year Bond Yield

Source: Iress, Escala Partners

Despite the company’s poor track record of execution, it is possible that this downgrade may represent the turning point in its fortunes. The new CEO has alluded to a review of its current businesses and a restructuring plan that sees underperforming divisions divested would be well received by investors.

While it did not materialise in 2017, rising interest rates (particularly in the US) provides a strong tailwind to QBE’s investment returns. Finally, QBE’s capital position is relatively sound and it has recently been conducting an on-market share buyback (although this may be paused in light of this week’s news).

We have been attracted to the stock as a turnaround story (holding it in our guided model portfolio) and as one of the few companies with positive interest rate leverage, particularly given the absence of this characteristic in our domestic banks.

Resmed’s (RMD) quarterly earnings beat expectations on the back of 11% constant currency revenue growth, lower overhead costs and a reduced tax rate. The company, which produces devices and accessories (principally masks) to treat sleep apnea, has been reporting solid top line growth following the roll-out of new products. Despite a better contribution from the sale of masks (which are a higher margin product compared to its device sales), gross margins declined slightly in the quarter. A fall in average selling prices on the back of competition in the sector appears to be a key driver of this issue, which has been a headwind for RMD for several quarters.

Like most US-orientated companies that have reported quarterly results in the last few weeks, RMD also outlined the expected benefit from the US tax reform, although the company incurred one-off charges in this result. The reduced tax rate has been a key source of earnings upgrades for the stock this week as analysts update their numbers.

While RMD has a fairly solid growth outlook in the medium term, as with many of the ‘quality’ stocks in the healthcare sector, it has experienced a high degree of P/E expansion over the last 12 months and a de-rate is a potential risk should interest rate rise through the year. Notably, however, it is at a discount to its closest listed peer Fisher and Paykel Healthcare.

CSL remains our preferred healthcare pick (and is a core position in the IML SMA portfolios) given its superior competitive position and strong track record of performance, although we acknowledge that valuations are becoming stretched.

Healthcare Forward P/Es

Source: Bloomberg, Escala Partners