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WEEKEND LADDER

A summary of the week’s results

01.09.2017

Week Ending 01.09.2017

Eco Blog

The financial sector risk is increasingly localised with cross border flows now predominantly in investment assets.

In the US modest consumption trends, coupled with the likely impact of Hurricane Harvey, will take the edge off spending. This is in contrast to relatively robust consumer confidence.

- Housing lending in Australia is softening, yet without a sufficient equity buffer, the RBA will find it hard to enact a rate rise. 

Reflections on financial markets 10 years after the commencement of the global crisis illustrate the significant change in capital structures that have been brought about by regulation and general risk reduction. If there was a takeout from the Jackson Hole central bank forum, it was the defence of how the constraints imposed post 2007 were necessary to prevent banks from returning to a public bailout.

In a large report, McKinsey examines the changes to the financial sector while also noting that new risks have inevitably arisen. The most marked impact has been the decrease in cross border finance as banks returned to a home bias. European banks have retrenched the most, after being caught out in dubious high-risk lending around the world, such as their participation in US subprime lending.

Global Cross-Border Capital Flows

Source: IMF Balance of Payments, McKinsey Global Institute Analysis
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While regulation can appear, in some circumstances, overly odious, there is little doubt that the level of oversight is a much better outcome than that of pre-2007.

The chances of a global crisis akin to 2008/9 is therefore less likely. Globalisation of finance continues, with 27% of global equities held by foreign investors, up from 17% in 2000 and similarly for bonds, where global ownership has doubled to 31% over the same time frame.  Another striking data point is that 69% of cross border capital flows are now in direct fixed investment and equity versus 36% before 2007. But these flows may be volatile and require higher rates of return. 

In looking at the potential risk factors therefore the sources may be through behavioural trends such as the massive flows into ETF’s. We often wonder if many investors in the myriad of options know why or what they have bought. The risk is a misstep by a central bank, inevitably based on the view that rates go up too quickly, though the reduction of their balance sheets is also an issue given its uniqueness.

The most prominent risk concerns China’s substantial growth in credit in the past few years. We have recently noted that there appear to be some steps being taken to change the structure of the Chinese financial system, such as the opening of its credit and bond markets to foreigners and the inclusion of stocks in the MSCI. These steps place greater scrutiny on capital management within these companies and also introduce external shareholders into the state-owned enterprises.

Hurricane Harvey looks likely to become a top 10 domestic property damage event since World War 2. Historically, these events result in a notable dip in consumer spending and construction, with refinery activity also hard hit in this case. In all, the early estimates suggest Q3 GDP may be approximately 0.2% lower than previous forecasts, though Q4 may reverse the effect once the recovery spending comes through. 

Consumption spending is already more muted than hoped for, though there are large categories, such as auto sales, which are influencing the outcome. Nonetheless, it stands in contrast to confidence surveys which have displayed a consistent upbeat tone. Instead, it may be the barbell between the robust recovery in household wealth against the persistently weak wages growth that is containing spending. The alternative is that spending data is under-estimating outlays as households move further away from traditional products and formats.

US Consumer Confidence – Conference Board vs Univ. Michigan 

Source: Bloomberg
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Locally, the relatively moderate slowdown in residential housing activity raises the question of how the RBA now views this key segment. Banks are required to meet the 30% limit on interest only loans by September. House prices themselves are not an explicit target, but the RBA needs to be sure borrowers are capable of withstanding a rate rise by increasing their equity stake in properties.

Value of Finance Approvals by Segment 

Source: Escala Partners, Morningstar
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Data released by APRA this week shows that interest only loans are still a hefty 38% of total mortgages though easing back a little in Q2, and that 20% have a loan to value ratio greater than 80%.

Further, the focus is also on the savings rate which is showing a worrying downward trend at a time when personal credit growth is increasing. For the RBA, a poor outcome would be increased spending from the wealth effect while wages remain weak.

Fixed Income Update 

Many investors increase their allocation to cash during times of uncertainty. However, a diversified fixed income portfolio has shown to outperform cash and term deposits through market cycles.

The likelihood of a December rate rise by the Federal Reserve bank is scaled back.

- Fitch, Standard and Poors and Moody’s confirm likely ratings outcomes for the US as a decision on the debt ceiling looms.

Like most market participants we have our concerns on how central bank policies will impact on the bond market. With the winding back of Europe’s quantitive easing program, the tapering of the Federal Reserve’s balance sheet and rate rises in the US, we are in unchartered waters. One view is that these changes to policy should lead to a rise in bond yields and underperformance for fixed income. Others point to the high debt levels, ageing demographics, low inflation and wall of money searching for yielding assets which should keep interest rates at low levels regardless of the central bank’s actions.

Through market cycles, history has shown that investing in a diversified portfolio of fixed income assets has outperformed staying in cash. The low correlations between interest rates and credit spreads often means that when rates increase credit spreads tighten, with the opposite holding true. The net effect on a portfolio of bonds with an allocation to both duration and spread product is a smooth return profile, as price movements on the two sectors offset each other. While cash and term deposits benefit from not having price volatility, they do pay a lower income stream than a diversified bond portfolio. A large allocation to these safe assets can weigh on overall returns over time. Tactically allocating to cash and redepolying when value in other assets is evident is great when you get the timing correct. It should be noted that in reality, timing the market is a challenge and the cost of that cash allocation may erode the benefit.

By way of example, the chart below shows the growth of 3 Escala designed portfolios of fixed income assets over the last 3 years in contrast to remaining in term deposits or cash. Even for conservative investors that seek capital preservation, the returns from the a risk averse portfolio has exceeded the cash alternative.

Fixed Interest Model Portfolios vs Benchmarks, Based at 100

Source: Lend Lease
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Rising geopolitical risk stemming from the missile launch from North Korea, together with Hurricane Harvey in the US, lifted bond prices as investors put money into safe haven assets. Geopolitical tensions usually cause yields to fall, only to bounce back within a short timeframe. The impact of Harvey is likely to have more lasting consequences as suggestions that the knock-on effects will dampen US growth. This may be the catalyst for the Federal reserve bank to refrain from raising interest rates again this year. The markets have re-priced this probability, with the chance of a rate rise in December at 30%, down from 41% a month ago.

Expectations of rate rises into 2018 have also been slightly dialled back, with the probability of a rise by August next year down to 39% from 44% the month prior.

Next week US lawmakers will seek to come to an agreement on whether to raise the government debt ceiling, currently at $US19.9 trillion. The ratings agency Fitch, which assigns a AAA rating to the sovereign, has said that if the debt ceiling is not raised then the US may lose its AAA status. In contrast, S&P’s AA+ rating and Moody’s AAA- ratings are expected to remain unchanged regardless of the outcome. Both agencies have stated that as long as the government avoids default on their treasuries then there will be no immediate change.

Corporate Comments

Lend Lease delivers a robust result, but many call this to be the top of its return cycle with risks increasingly moving to managing the large external contracts.

Those concerned about the cost of smashed avocado and berry smoothies may wish to consider an investment in Costa Group, which beat guidance though P/E expansion has been the major driver of the share price.

Spark Infrastructure has been a productive investment in the electricity sector.  Distribution growth may slow a little as investment spending picks up but the stock remains well supported in the sector.

Secondary effects from the weakness in retail and specifically, discount department stores, is likely to prey on the outlook for retail REITs.

- Post result sector performance for the past year has exposed the structural weakness in telco versus the underestimation of profit recovery in materials. The debate turns to what 2018 will hold. 

With a partial premature release of its profit result a few weeks ago, Lend Lease (LLC) confirmed its 9% net profit growth for FY17 to $758m. The group represents a mix of distinct businesses, with the property and construction sector, each of which has its own outlook, return requirement and valuation. While the group has diversified its regional overlay, Australia still dominates the EBITDA.

Source: Costa Group
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To allay concerns on the domestic apartment sector, management was at pains to emphasise that the doubling of activity in the number of apartments was balanced with a 90% settlement profile into H12018.

The development pipeline in commercial and residential property remains strong at $49bn, as well as $20bn in construction projects.  The group has an appealing position in urban renewal, encompassing a mix of developments in the UK, Chicago and Boston. Commercial asset sales are centred in Australia with contributions from projects such as Victoria Harbour, Circular Quay and the perennial Barangaroo.

Investment income is a mix of commercial lease income, often prior to an asset sale, multi-family units in the US and a large retirement home portfolio. LLC is exploring a potential part or full realisation of this asset base. 

If there was an area of concern, it was the fall in operating cash flow from $853m in 2016 to $146m in 2017. Cash flow in property development and construction is inevitably lumpy, yet there is also a significant reinvestment. While management allayed some concern by pointing to settlements after the year end, the differential between sales and cash flow bears monitoring.

Ironically the result was struck on a return on capital over LLC’s own stated objective, pointing to the inevitable risk in sustaining such results. The construction margin was the exception and evidence of the risk, with a slightly below par outcome attributed to adding staff and processes to ensure delivery. 

Along with others in this sector, the multiple has expanded given the prolonged strength in residential building along with LLC’s diversity in regional and operational businesses. The pipeline is well known and any upside is judged to come from better construction margins. Yet the workload is increasingly contracted by government and third parties where LLC will wear the repercussions of any slip up in execution.

Costa Group (CGC) has been one of the small cap food sector success stories since floating two years ago, with its share price more than doubling in that time. FY17 was a successful one for the company, with the company beating its earnings guidance, which itself was upgraded twice through the year. Organic growth from its previous investment to expand its blueberry production has underpinned its earnings, with a 55% increase in production. To date, the threat of an oversupplied market and therefore overly negative implications for blueberry pricing have not come to fruition; Costa noted that industry demand growth as at June was 28% in blueberries and 17% in raspberries. Strong tomato pricing provided a further leg of margin expansion for the group.

Costa Group: Revenue Growth by Division

Source: Spark Infrastructure
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Avocados are the more recent addition to the Costa produce range, giving it a fifth integrated division line and a greater level of diversification, with two acquisitions since late last year. The contribution was not overly significant in FY17, however investors will be anticipating further acquisitive growth in what is a fragmented market. Other growth options are key to the positive investment thesis, including further berry plantations, mushrooms and a few smaller international joint ventures.

Costa also provided guidance for FY18 of 10% profit growth, which at face value, appears relatively soft given the expected further benefit from recent acquisitions. While it is possible that it is initially providing a conservative figure (as with FY17), it inherently implies a much slower organic growth profile. The company has reduced its agricultural risk exposure through protected cropping environment, however, it still has some exposure to price risk in its key segments. With the predominant driver of share price growth in the last six months driven by P/E expansion as opposed to earnings, its current pricing level is perhaps not reflecting this potential downside.

The electricity sector is likely to find itself in the limelight this year and it tussles consumers’ understanding of the participants in the chain and political expediency to attribute blame.

Spark Infrastructure (SKI) found it necessary to devote multiple pages of its half year result release to supporting its contention that customers are better off in privatised assets, that the distribution network had reduced costs and the problem lay with generation costs and lack of a comprehensive energy policy.

Composition (%) of the Annual Residential Electricity Bill in Victoria

Source: Factset (as of 30 June 2017)
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In the shorter term, the Transgrid acquisition is expected to improve on its operational costs and benefit from renewables, while in the longer turn the integration of power networks would benefit SKI with its Victorian, South Australian and NSW asset base.

The stock has had a solid run up following its consistent growth in distributions.  A pickup in investment may follow higher depreciation and cap the increase in the payout into the next few years and the stock is more likely to trade in a range at the circa 6% distribution yield level.

In the wind-up of the result season, we have noted some issues outside of the usual commentary on individual companies.  

The problems of Big W and Target were a stark reminder that this store format is losing its relevance and that Australia likely has a significantly excess amount of space in shopping centres leased to the big three. In turn, this will have repercussions for the REIT sector. Investors should have some caution on suggestions it will be different here. Over the past quarter stocks such as National Storage and Iron Mountain have outperformed the traditional REITS and retail REITS, in particular. This may not be the end of that cycle.

US REIT Performance by Sector for 2017

Source: Escala Partners, IRESS
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It also reinforces our view that a dedicated allocation to REITs is unnecessary and in the case of an Australia specific allocation, unproductive. The local sector is heavily weighted to retail and, to a lesser extent, office assets. As we have come to learn in recent weeks, yield alone can be a problematic thesis for a stock if the industry structure is challenged.

In a similar vein, any hint of weakness in discretionary retailing immediately got tainted by an Amazon effect, notwithstanding that this has yet to emerge and that the impact is likely to be nuanced to products rather than store groups. However, the vulnerability may lie elsewhere. Amazon and other participants in social media are eating into the advertising pie as well as providing access to sport and entertainment that will undermine those reliant on this space. All free to air networks in Australia have been unrewarding investments in the past few years, though Nine Entertainment has gained some favour as the ‘least bad’. Telstra too is battling the cost of sports rights and subscriber churn in Foxtel as viewers turn to other sources. 

On a post result basis, the ASX200 Accumulation Index is up a more than acceptable 8.9% over 12 months. For any portfolio, sector mix mattered. The telco sector was uniformly poor registering a 28% loss even after dividends. REITs was the other sector in negative territory. Stalwarts such as healthcare and consumer staple underperformed but the margin was small. Healthcare has been handicapped by the fall in the USD on top of already high valuations, while consumer staples have seen margin pressure, be it in supermarkets or soft drinks.

Underperforming Accumulaiton Sectors Relative to Index, Based at 100

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The other side of the ledger was the material sector with a 22% accumulation return driven by stellar returns from the big miners. The financial sector was another good contributor over the year with NAB narrowly edging out ANZ as the best of the big four over the year but also easily beaten by the likes of Challenger, IOOF and Bank of Queensland.

The question turns to what could be the outcome for 2018, given we are now reasonably well informed as to where companies are positioned at the beginning of their financial year. Our initial sense is that utility stocks may struggle after posting a good performance in recent years. Distribution yields are matched against capital investment requirements, potential regulation in some segments and likely higher bond yields. Productive investment could come from stocks sold off on big themes yet with reasonable balance sheets and ability to manage costs. These may include the aged care sector, select retailers and some newer listings that have disappointed, yet retain their original investment premise.

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