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WEEKEND LADDER

A summary of the week’s results

09.03.2018

Week Ending 09.03.2018

Eco Blog

- Australian GDP was weaker than expected in the fourth quarter of 2017. While this was due to investment spending, the household sector is likely to be the swing factor this year, facing low disposable income growth. Wages are on watch.

- China’s economic destination is painted by the People’s Congress. The emphasis of shifting towards developing a value-added sector is evident in addition to control of financial stability.

- Trade has been the talk of the week, yet it remains unclear what the impact will be.

The Australian Q4 GDP growth was a scratch below expectations at an annualised 2.4%.  Business investment was weak in the quarter, yet strong over the year and public spending was up 4.1% through 2017. The household sector remains in the doldrums through the year; unsurprising given the low rate of wages growth, though did edge up into the final quarter. Another pointer to weak spending is the fall in the savings rate from a high of 10% in 2009 to below 3%.  Consumers have been supporting their spending via a run down in saving and growing debts, clearly a trend that cannot be sustained.

Household consumption and disposable income

Source: ABS, Deutsche Bank
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Residential construction has clearly turned negative, though the approvals data released earlier this week suggests that the slowdown will be gradual as the bias shifts to single family units from apartments.

Employment and wages growth are proving to be the swing factor into 2018. The labour market has been resilient in recent months, but as we have pointed out it has been mostly due to the healthcare, tourism and education sectors. As the introduction of the NDIS (disability scheme) cycles in the coming months, the impact will ease. Further, higher restrictions on students may see education also stabilise at these levels. Conversely, wages growth may respond to public sector rises and become more widespread.

In a speech, RBA Governor Lowe delved into investment spending, highlighting the substantial change in the emphasis to intangibles from manufacturing and buildings. While hardly surprising, it points to a shift from capacity addition to efficiency and marketing. Corporate profit growth has had a pronounced cost-out thesis in recent years, while the pay-off from intellectual property is far from obvious. The case can be made that this investment is stay-in-business rather than growth that is likely to increase earnings.

Non-mining Business Investment

Source: ABS, RBA
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  • Global investment spending is on the rise. Whether this proves to a benefit to returns on capital is a key question to sustaining the equity rally. Our view is that it is likely to see a greater differentiation between companies and be stock specific rather than an overarching support factor.

Trade tensions overrode analysis of the National People’s Congress in China. There the message is subtly reinforcing the shift in emphasis to investment in ‘the new economy’ - electric cars, internet costs, integrated circuits and new materials, and improving the quality of domestically-made product. In turn, the ‘old economy’ retains its supply side restructure with further proposed cuts in steel and coal production.

A feature of note was the constraint on the fiscal budget with a reduced deficit in line for the year. Given the relatively strong momentum already being achieved, fiscal stimulus is unnecessary and follows the line of a gentle brake in the investment bias. As opposed to barriers, the congress talked up the plans to provide better access to manufacturing and services to all comers. China has been acquiring global businesses for some time and inevitably had to bow to pressure to allow reciprocal investment.

A moderating growth rate in China is well accepted as inevitable and necessary to prevent another cycle of dependence on debt. Perhaps, surprisingly, it is infrastructure spending that has been a primary cause of risk. The long-term nature can result in overheating at the wrong time in the cycle, the funding has been hidden in local government financing vehicles and land sales have been used to support some of the spending, resulting in property speculation.

The persistent theme of the risk of excess debt within the Chinese private sector remains on the list. However, there is a sense that given it is well understood and as it can, to a large extent, be influenced by the central authorities, it may be more manageable than is appreciated by commentators imbedded with Western economy ethos. As an example, banks have been allowed some leniency in their provisions for non-performing loans on condition of greater disclosure and a programme to deal with these loans. It will reward banks that dispose of these debts and, by default, progressively shift lending to the better capitalised organisations.

  • The China equity index has been on a tear over the past year driven by its large internet companies. Domestic demand stocks have inevitably lagged that dynamic, which are predominantly represented within our managed funds across the Asian region. A long-term view on the local consumer and its differentiated behaviour compared to many trends imbedded in western countries is a focus of these funds.

Trade tensions were front page news through the week. The full scale of repercussions are not yet clear with the potential to escalate if the political dynamics take over.

Investment Market Comment

- Volatility has made a return in 2018 after being largely absent in the previous 12 months.

In 2017, synchronized growth resulted in markets steadily progressing to record highs, and volatility was missing in action. This year has had a different start with volatility spiking back into existence. To understand the market implications could be, we first should remind ourselves of what volatility in financial markets measures. 

The most commonly quoted measure of volatility is the CBOE Volatility index (VIX) also known as the ‘Fear gauge,’ which measures the implied volatility of the S&P 500. The value of the VIX is derived from the price of options on the S&P 500 and is considered to be a forward-looking measure of volatility. Therefore, when the index experiences sharp swings, as it did earlier this year, record spikes in the VIX ensued.

S&P 500 (LHS) and The VIX (RHS)

Source: IRESS, Escala Partners
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By industry convention, volatility is the standard deviation of returns. The below chart shows that equity markets did experience unusually low average volatility in 2017, while the fixed interest indexes were in line with history.

Average monthly, 1-year rolling volatility

Source: Bloomberg, Escala Partners
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Since 2000 the MSCI ACWI Index has had a rolling 1-year volatility of nearly 14% per year and annual returns of 6.7%. Usually in times of rising volatility we have seen a fall in the index. Yet, there is no predictive factor here; low volatility does not forecast higher returns or the inverse.

MSCI ACWI Index – rolling 1-year returns and volatility

Source: Bloomberg, Escala Partners
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In a past weekend report we covered the events of late January this year.  The S&P has now had its first negative month since March 2017, with all other major indices also experiencing a correction.

The pattern change in monetary policy as well as other developments such as the trade talk suggests that a return to a higher level of volatility is likely. We do note that this should be seen in context of the exceptionally low volatility of the past year rather than implying that a fall in markets is inevitable.

  • Alternative investment strategies such as market natural funds are a viable option for investors to have some protection in a rising volatility environment and produce positive returns outside of market conditions.

Fixed Income Update

- The RBA keeps the official interest rate at 1.5%.

- CBA comes to market with a new bank hybrid.

- Demand for US treasuries and corporate bonds wain, driven by concerns over the USD weakening, the cost of hedging for European and Japanese investors and the prospect of higher yields in the future.

As expected the RBA kept rates on hold this week at 1.5%. The central bank said in the accompanying statement that it expects the Australian economy to grow at a faster rate in 2018 than it did in 2017, though inflation is expected to rise to just above 2%. Bonds were broadly unchanged following the announcement.

As speculated last week, CBA brought to market a new ASX listed hybrid deal (CBAPG). The term is set at 7 years, with a conversion to equity after 9 years if they don’t exercise the right to call the bond. The hybrid is paying BBSW + 3.40%. This deal, together with the recently issued Westpac hybrid (WBCPH), was issued at levels in line with the market but failed to offer a new issue premium (ie a higher rate than the secondary market). This opens the possibility of a fall in price soon after launch if the market moves unfavourably and there is no ‘buffer’ to absorb the price shock.

Major Bank Preference share credit curves

Source: IRESS, Escala Partners
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The recent move upward in yields on US treasuries has dominated financial publications (including our own!) of late. While the trade tariff policies in the US and the ECB’s hint of the end on QE have moved yields slightly over the week, there are other interesting themes playing out in offshore markets that are potentially very bearish for US treasuries and US corporate paper. One concern is recent data on Treasury futures positioning. This showed that investors are making big bets that yields on 10-year Treasuries will rise further by accumulating short positions on treasury futures. The number of shorts has now hit record highs.

Net speculative bets on bond futures

Source: JPMorgan Chase & Co, Commodity Futures Trading Commission
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In addition, Japanese investors are said to be selling down their holdings of US Treasuries following concerns over the USD weakening in the wake of Trump’s tax reforms and fiscal spending polices. Japanese holders, including the government own, nearly $1.1 trillion in Treasury bonds, second behind China. In the three weeks up to mid-February, Japanese investors are said to have sold ~$20billion worth of international debt securities including US Treasuries. This trend has spread to other global investors, with net selling of US corporate paper taking place in December, which is only the second time this has occurred in the past three years.

The reasons cited for the selling are a combination of concerns over a further rise in yields together with USD weakening for the unhedged holdings and, for those are that are hedging, the rising cost of those hedges. This is particularly true for European and Japanese investors. European investors only earn 0.12% more for shifting into US corporate credit over European sovereign bonds after hedging costs. That is down more than 80% from a year earlier. Japanese investors are only picking up an extra 1.05% after hedging by buying a 5-year investment grade corporate bond over a Japanese government note. This has nearly halved in 2 years.

US credit returns eroded by rising hedging costs

Source: Wells Fargo, Bloomberg, Financial Times
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  • For Australian investors, asset pricing and the rates market in US market is of interest given the strong correlation that exists between the US and Australia. Further, most fixed income portfolios generally hold global assets (including US bonds) that are directly impacted by the performance of this market.

Australian Reporting Season Wrap

- Reporting season got a pass mark from the market, which outperformed its international peers in February.

- While results were solid, rising costs may hold back some of the benefits from better revenue trends.

- After its recent recovery, the Australian market looks to be fairly fully valued. The upside case will likely come from an extension of the recovery in resources, while the valuation risk is primarily from the prospect of higher interest rates.

Relative to expectations, February’s half yearly reporting season for the Australian market was quite good, backing the gains that the ASX 200 has made over the last six months. Global equity markets endured a heightened bout of volatility early in the month, which provided some noise and thus distorted some investor reaction to individual company results reporting in the first half of February. Nonetheless, providing some proof of the positive tone to reporting season was the fact that the ASX 200 was able to outperform most developed equity markets over the course of the month. Below we discuss some of the key themes and takeaways to come out of reporting season.

Healthy Number of Companies Beating Expectations

A typical measure of the success of a reporting season is the relative number of companies that beat expectations compared with consensus estimates and, subsequently, the ratio of companies that are the subject of earnings upgrades to downgrades. On this front, reporting season was quite solid. The number of companies beating expectations was relatively balanced with the number that missed (this is typically viewed as a ‘win’).

Additionally, downgrades from sell side analysts post the results were also quite limited. On a positive note, the earnings revision ratio of the market has now been improving for several months, which was reflected in few profit warnings in the lead up to reporting season. However, it should also be noted that earnings expectations are still relatively low (profit growth was ~5% for the December half) and the broader market’s growth has been narrow in its range and dominated by the resources sector.

Evidence of Cost Pressures

Despite a better revenue growth outcome, the key disappointment from reporting season was weakness in margins, driven by some emergence of cost pressures. This was most visible in the mining sector, where strong earnings growth was tempered by a rising cost base. Other select industrial companies also reported rising costs, particularly manufacturers exposed to raw materials (less so on the services side). In several cases, these costs were not immediately passed on to their customers, resulting in softer margins.

EBIT margins across the industrials sector had previously recovered over the last few years to a cyclical high level as companies focused on reducing costs. Higher input costs may now mean that that operating leverage on the upside in a slightly better revenue environment may perhaps be lower than originally anticipated. Wage pressures are still yet to show up in many businesses, although this is a risk in the medium term given the recent strong run of employment growth.

Capital Management and Dividends

Improving shareholder returns continues to be a focus of Australian companies, which was reinforced this reporting season. Dividends are expected to again grow in FY18, although likely at a lower rate than the underlying earnings growth of the market. This reflects two key points: the investor preference for higher dividends has been in place for some time in the lower interest rate environment and thus payout ratios have been quite elevated, about 70% for the market as a whole. Secondly, excluding the recovering resources sector, earnings growth for many companies is still quite benign, leaving little capacity for significant dividend growth across the market.

Nonetheless, share buybacks were again a feature of reporting season from resources (Rio Tinto) to more cyclical companies (BlueScope Steel, Lendlease and Qantas). Few companies are in an acquisitive mode, with restructuring companies more often than not preferring to divest underperforming assets and return the proceeds to shareholders.

ASX 200 Forward EPS, DPS and Payout Ratio

Source: Bloomberg, Escala Partners
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Balance Sheets

Across the market, balance sheets are in relatively good shape. Gearing has steadily reduced over the last few years, with this again led by the resources sector. Combined with lower interest rates, interest cover ratios have improved materially over this time, leaving many companies well placed to deal with a higher interest rate environment if this were to materialise.

High Price to Earnings Companies Rewarded

After a hiccup in late 2016 and outside of a few cyclical sectors such as resources, 2017 was a year that higher earnings growth companies again returned to market leadership. While the earnings trends among this somewhat limited group of stocks has, in aggregate, been quite positive, in the majority of cases this has been reflected in a further re-rating of their respective P/E multiples.

In this earnings season, many of these companies reported quite well and were again rewarded by investors. In this group would include healthcare stocks CSL and Cochlear, online media companies REA Group and Seek, and consumer companies Treasury Wine and a2 Milk. The margin for disappointment, however, is narrowing for these companies, with the fortunes of Domino’s Pizza a reminder of how growth companies can unravel. Through 2018, an additional headwind will be one of valuation, given the fact that discounted cash flow models are quite sensitive to changes in interest rates.

Sectors/Themes

As has been the case for the last 18 months, resources and related industries were undoubtedly the key driver of the broader market’s earnings in the first half, with this also likely to be the case for the full year. The resources industry has been in an upgrade mode for some time now on the back of the recovery in commodity prices and continues to cycle higher prices on a rolling year basis. However, while earnings were much better in the half, they missed expectations on the back of higher than forecast costs.

Other sectors that exhibited a fairly supportive environment included those exposed to tourism (e.g. airlines/airports and casinos) and rising east coast infrastructure investment. As we highlighted in a note last year, this latter theme is complicated by an expected tapering in residential property construction.

Two sectors stood out as displaying weaker conditions. Specialty retailers reported softer top line growth and tighter margins in the December half, reflecting some of the broader household consumption issues that the economy faces (with high debt levels and low wage growth), while the telecommunications sector continues to be hampered by high levels of competition and the contraction in margins through the ongoing transition to the NBN.

Current market valuation

We again refer to our top down analysis tool in assessing the current valuation of the market, which categorises stocks into the three broad sectors of financials, resources and industrials. As we have noted, the recent earnings recovery for the market has been primarily driven by a lift in resources earnings. This has meant that the increase in the index has been less due to a further expansion in the P/E multiple, as was the case for several years. The forward expected earnings growth of the market is in the mid single-digit range, although this is held back by the weaker outlook for some of the larger stocks in the index; thus the ‘average’ stock is doing somewhat better than the market-cap weighted figure. The broad consensus view in the market is that resources remain the key source of potential earnings upside for the index, particularly if spot commodity prices hold.

Financials

The major banks have now cleared most of the key outlier risks that the sector faced from a regulatory point of view, having now built their capital to levels that provide some comfort to APRA. The banks have recently lagged the market, however, this is perhaps justified by a weak earnings growth outlook, a slowing top line and hence little prospect for meaningful growth in dividends. Outside of the banks, investment markets have generally been quite favourable for diversified financials. While there were some notable earnings misses in the insurance sector, there were signs that the cycle is improving both domestically and abroad.

Resources

After a sharp lift in FY17, resources earnings are again expected to be stronger in FY18 and in the next 12 months, although many are of the view that the cycle is maturing. Some de-rating may occur if demand were to moderate, whether from China or as a result of other factors, such as an escalating trade war. In the sector’s favour is positive global economic momentum and forward indicators, reasonable valuations, shareholder-friendly strategies and significant upgrades to earnings if spot prices are sustained.

Industrials

The industrials sector has been one of the more consistent sources of earnings for the market over the last several years, albeit at a lower level than what longer-term investors may have been used to. The outlook is typically quite mixed; as highlighted above, retailers and telcos have faced a tougher environment, while health care has again been a reliable source of growth. Full valuations are likely the key risk across many companies, particularly the pool of quality stocks that are now trading on even higher P/Es, which may retrace if interest rates were to rise.

S&P/ASX 200: P/E, EPS Growth and Scenario Analysis

Source: Bloomberg, Escala Partners
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