Weekly Impressions: Investor appetite for infrastructure assets to remain strong

In December, Evidente published a post which cited a speech from Governor Lael Brainard, in which she discussed the likely path for monetary policy normalisation, based on the framework of the neutral rate of interest.  This is the federal funds rate that is consistent with output growing close to its potential rate with full employment and stable inflation.  Tepid growth in the US economy and quiescent inflation suggests that the neutral rate is not far above the federal funds rate.  Ms Brainard indicated that the neutral rate would remain low (possibly close to zero) for some time to come and concluded that the normalization of the federal funds rate is likely to follow a more gradual and shallower path than in previous tightening cycles; what Evidente depicts as the new normal of low and slow.

A recent speech from Vice Chairman Stanley Fischer suggests that the secular decline in the neutral rate of interest is guiding the Fed’s view and internal debate around policy normalization.  Vice Chairman Fischer speculates that the world is moving toward a permanently lower long-run equilibrium real interest rate, consistent with the fall in the level of longer-term real rates observed in the United States and other countries (see chart).

A world with a permanently lower neutral interest rate thanks to structural shifts

The balance between desired saving and investment intentions governs the neutral rate; a lift in intended saving over investment has led to a lower neutral rate in equilibrium.  Vice Chairman Fischer cites a number of developments that have contributed to the shortfall in investment relative to saving: deficient aggregate demand since the financial crisis, the low capital intensity of the IT sector, a slowdown in productivity growth, the demographics of ageing, and high savings rates in emerging markets combined with a shortage of profitable investment opportunities in those countries.

In a supply-demand framework, the supply curve for saving is upward sloping because a higher interest rate is associated with greater supply of saving, while the downward sloping demand curve corresponds to investment demand.  The developments cited by Fischer correspond to an outward shift of the supply curve and left shift in the demand curve, which produce a lower neutral rate in equilibrium (see chart).

To the extent that these structural shifts are long lasting, Fischer suggests this supports the case for the neutral rate remaining low for the policy relevant future.  Consequently, it is likely that the zero lower bound will continue to constrain monetary policy at times.  In other words, lift-off in December does not imply that the federal funds rate won’t return to zero in the foreseeable future.  This represents a subtle hint from Fischer that growth in the US economy might remain tepid for some time and that inflation will remain low thanks to the long lasting powerful impact of excess desired saving over investment intentions.

Fischer offers an innovative means of lifting the neutral rate and thus easing the constraints imposed by the zero lower bound; an expansionary fiscal policy designed to improve the stock of public infrastructure.  Presumably he is implying that the social rates of return of such public investments would exceed the required rates of return.

Environment conducive to continued strong returns from listed infrastructure assets

Infrastructure assets have been amongst the best performing sectors on the ASX over the past decade.  Sydney Airport has yielded an accumulated return of 19% over this period, while gas line operator APA has produced a return of 17.5%, and toll-road operator has delivered a return of 11.5%, well above the ASX200 return of 5.5% (see chart). 

Large depreciation charges for these stocks depress reported earnings, thus rendering standard earnings multiples meaningless as valuation yardsticks.  But the strong performance of the sector has lifted free cash flow multiples to record highs. Nonetheless, if Fischer is right that the saving-investment imbalance is expected to persist and hold down the neutral rate of interest for the policy relevant future, then the new policy normal of low and slow should provide an environment conducive to continued strong returns from listed infrastructure stocks. 

Concluding remarks

In summary, I expect that investors will continue to pay a premium for the earnings certainty and long duration that infrastructure assets offer, a desirable attribute for sovereign wealth funds and pension funds with a long investment horizon seeking assets that match the long duration profile of their liabilities. 

Of course, the strong appetite from this clientele for low risk assets offering some growth comes with a sting in the tail.  The higher prices for these assets point to lower expected future returns.  Based on Fischer and Brainard's assessment of the slow process of policy normalisation, this dynamic has some way to play out.  Against the backdrop of the new policy normal of low and slow, investors should treat any price pull-back in the sector as a buying opportunity. 

Weekly Impressions: Behavioural traps to avoid - Overconfidence

It has been a good year of performance for many Australian fund managers, with the average active stock fund delivering returns well above the benchmark thanks in part to underweight bets in resources and the major banks.  Despite the out-performance, various structural headwinds continue to retard growth of inflows into active funds, including: the shifting locus of power towards asset owners, limited diversification benefits offered by a highly concentrated benchmark, and strong appetite for lower cost ‘smart beta’ products.

With the day to day portfolio responsibilities less pressing at this time of year, it represents a good time to reflect on some of the pitfalls associated with active management.  Drawing on the burgeoning field of behavioural finance, this post investigates the behavioural trap of over-confidence and addresses how portfolio managers can reduce the prevalence and costs associated with over-confidence. 

Skill or Good Luck?

Behavioural finance is the intersection of applied psychology and the behaviour of financial market participants.  Researchers have done a tremendous job in elucidating the heuristics or mental rules of thumb that investors (and broking analysts) rely on, which contribute to systematic errors in judgement and decision-making.  One of these heuristics is self attribution or over-confidence, where people attribute their good performance to skill or judgement, and poor performance to bad luck or factors beyond their control.

Although these errors are not unique to financial market participants, such errors can be costly, particularly when portfolio managers are managing billions of dollars.  If enough investors suffer from such biases they also lead to significant limits to arbitrage, which imposes costs and risks on other investors.

A number of widely cited studies in the field of applied psychology document the above average driver effect, in which the overwhelming majority of respondents believe that their driving abilities are above average.  Over-confidence or illusory superiority is not confined to self-perceptions of driving ability.  Many people over-estimate their abilities, knowledge and future prospects compared to other people.

Over-confidence and excessive trading hurts your portfolio performance 

Terrance Odean and Brad Barber have explored the effects of over-confidence in financial market settings. Over-confident investors over-estimate the precision and accuracy of their information, which lifts the likelihood that such investors trade too frequently based on their perceived superior information. The empirical evidence is not kind to over-confident investors; the more individual investors trade, the more they lose.

Odean and Barber use over-confidence to link gender with trading performance. Female portfolio managers have superior track records than their male counterparts thanks to lower churning of their portfolios because they are less prone to suffering from over-confidence. Individual investors are found to trade more after they experience high stock returns, which might explain why aggregate turnover increases after periods of high market returns. 

Shhh...Listen First, Speak Last

Portfolio managers that work in a group setting might draw some comfort from the fact that group decision making helps to address or neutralise the behavioural biases that individuals exhibit, including over-confidence. But group decision making can also be beset by psychological biases, notably groupthink. A head of equities with a strong personality who expresses his view forcefully can effectively discourage junior members of the team from freely expressing their own views that challenge his. In his auto-biography, Courage to Act, Ben Bernanke explains that he sought to reduce the prevalence of groupthink by speaking last at the FOMC meetings. 

Ironically, the evolution in the structure of the funds management industry might actually reward over-confidence. Fund of funds and asset consultants are increasingly shifting towards a core –satellite approach to portfolio construction, where index and smart beta products are combined with high conviction/high tracking error funds. These funds typically require PMs to have a high degree of confidence in their stock calls, and be willing and able to take large active bets.

In a recent paper, David Hirshleifer and Kent Daniel suggest that overconfidence contributes to the profitability of the betting against beta trade, which represents the poor returns from high beta stocks.  Overconfident PMs – particularly those working in high conviction funds whose clients expect high returns - are more likely to buy high beta or cyclical stocks to generate outperformance.  The strong appetite for such stocks lifts their price and drives down their expected future returns.

In praise of humbleness

The literature on over-confidence in financial markets suggests that PMs ought to be more humble and trade less. Even when investors believe that they have access to superior information, they should be cognisant of the limits and costs to arbitrage, which can cause mispricing to persist for an extended time. To reduce the likelihood of becoming over-confident in their own sectors, PMs should be encouraged and incentivised to seek out opportunities and challenge the views of PMs responsible for other sectors.

Heads of equities should encourage a collaborative and collegiate team environment, where members are not afraid to debate and express views that challenge the consensus view internally.  And PMs should document their views rigorously in real time, to ensure that over-confidence does not also morph into hindsight bias.

Weekly Impressions - The new normal: Low and slow

Mr Draghi undershoots on expectations and inflation

Financial markets were clearly disappointed at the outcome of the meeting of the ECB’s Governing Council overnight, with the euro strengthening and global stock markets falling sharply despite the announcement that the ECB would extend its asset purchase program by six months, which is now intended to run to March 2017 or beyond if necessary.

At the September meeting, ECB President, Mr Mario Draghi, had clearly raised expectations of more monetary stimulus at the December meeting than was announced.  The market’s disappointment stems from the poor run of monthly inflation data since then; readings for the months of October (+0.2%) and November (-0.2%) were particularly disappointing.  As a result, the core Harmonised Index of Consumer Prices (which strips out food, energy & tobacco) is only 0.9% higher than a year earlier, a long way from the ECB’s inflation target. 

The ECB’s own staff projections indicated slightly weaker inflation dynamics than previously expected.  If the run of poor inflation data continue and if core inflation continues to undershoot its target by such a long way, Evidente expects more aggressive monetary stimulus – specifically a lift in the run rate of monthly asset purchases of 60 billion euro - at the next meeting of the Governing Council.

The global stock market response to the ECB’s announcement represents another nail in the coffin for the military analogy of currency wars.  The euro rose by 2½% against the US dollar.  But contrary to a key prediction of the currency wars thesis – that the lower US dollar would boost the competitiveness of exporters - US stock markets fell by over 1% following the announcement.

Lift-off this month would be premature...

At her testimony to Congress, Federal Reserve Chair, Ms Janet Yellen, laid the intellectual framework for lift off at the FOMC meeting later this month, citing three key factors.

• Ongoing gains in the labour market suggest that inflation will return to its 2% target as the transitory effects of lower commodity prices and a stronger US dollar will wane.

• Were the Fed to delay the normalisation of monetary policy for too long, it would risk having to hike interest rates quickly due to the lags in the operation of policy, thus lifting the likelihood of turmoil in financial markets.

• Holding the federal funds rate at its current level for too long could encourage excessive risk-taking and thus undermine financial stability.

Evidente’s econometric modelling of US inflation suggests that if commodity prices and the US dollar remain unchanged from current levels, core inflation will rise over the course of next year but remain well below 2% by the end of 2016.

The proximity of the financial crisis suggests that the Fed is justified in being concerned about financial stability.  But more targeted macro-prudential policies designed to reduce the size and influence of the shadow banking sector, and lift the loss absorbing capital on the balance sheets of financial institutions would do far more to reduce systemic risk of the financial system.

Evidente remains of the view that the Federal Reserve will be committing a policy error by undertaking lift-off at a time when core inflation is undershooting its 2% target by over 50 basis points.  But of some comfort is an evolution of communication from Fed officials that the new normal of monetary policy normalisation will be low and slow.

...But the new normal will be low and slow

Governor Lael Brainard has invoked the Wicksellian concept that the appropriate pace and target for normalizing monetary policy depends centrally on understanding the neutral rate of interest; the level of the federal funds rate that is consistent with output growing close to its potential rate with full employment and stable inflation.  When the federal funds rate is below the nominal neutral rate, monetary policy is accommodative, and, when it is above the neutral rate, policy is contractionary.

Ms Brainard argues persuasively that the fact that the U.S. economy is growing at a pace only modestly above potential while core inflation remains restrained suggests that the nominal neutral rate may not be far above the nominal federal funds rate, even now.  Drawing on market measures of forward rates and surveys of economists, Ms Brainard suggests that the neutral rate will remain low (possibly close to zero) for some time to come.

Ms Brainard speculates that a higher expected equity risk premium (associated with risky investments) has contributed to the reduction in the neutral rate of interest.  A higher risk premium necessitates a lower risk-free rate to encourage the same amount of riskier investments as previously.  A higher risk premium is consistent with the earnings yield on stocks remaining broadly unchanged at a time when the risk free rate has trended down for years and can explain the sluggishness in growth of global capital investment during this recovery (see chart).

Ms Brainard concludes that the lower neutral rate means the normalization of the federal funds rate is likely to follow a more gradual and shallower path than in previous cycles.  Evidente expects the new normal of low and slow to be reflected in the language of the statement accompanying the decision to engage in lift-off, which should reduce the likelihood of a broad based sell-off in risk assets.

Dissecting Australian Retailers' CSR Credentials | Unlocking Embedded Value in Myer's Iconic Brand

The Rise of the Asset Owner

The fulcrum of power and influence in Australia’s sophisticated retirement income system has been gradually shifting towards asset owners – particularly industry super funds – from asset management firms that utilise active strategies.  The shifting sands reflects four developments.

• The poor performance of active equity funds in Australia during the financial crisis has led to scepticism about the ability of these funds to deliver sustainably strong returns to outperform the ASX200, net of fees. 

• The growing scepticism about the value add offered by high cost active equity funds has come at a time when there has been renewed focus on costs and management expense ratios, which has led to strong investor flows into low cost index, enhanced index and exchange traded funds. 

• The introduction of My Super has put pressure on pension funds to shift their allocation to these lower cost funds and asset classes, and also bring investment capabilities in-house.

• The Superannuation Guarantee – the 9.5% compulsory superannuation contributions made by employers on behalf of employees – has underpinned strong growth of inflows into industry super funds at a time when many firms operating in financial markets have downsized due to lower growth in revenues and profitability.

Against this backdrop, a cottage industry has emerged around Environmental, Social and Governance (ESG) considerations, which has been given an assist by the fact that many institutional investors in Australia have signed up to the United Nations Principles of Responsible Investing.  Not-for-profit campaign communities such as Getup! have been successful in raising awareness public and investor awareness around issues relating to economic fairness and environmental sustainability, social justice, including the plight of refugees being held in Australia’s detention centres.

A key implication of the shifting locus of influence towards the asset owners has been renewed interest in ‘activist’ investing.  Industry super fund led Divest campaigns have attracted tremendous media attention in Australia over the past year, including decisions of various pension funds to divest fossil fuel companies, coal miners, tobacco manufactures and the old Transfield Services (the new Broadspectrum).  Asset owners and institutional investors are more proactive during AGMs and use the proxy process to affect corporate governance policies.

Sharper focus on corporate social responsibility

Australia’s changing investment landscape is having an impact on corporate policies around factors as disclosure, climate footprint, remuneration, board independence, treatment of employees and other key stakeholders, and license to operate.  As asset owners and institutional investors continue to flex their muscle, listed companies will increasingly need to balance the goals of maximising profits and shareholder value with reputational risks around managing ESG considerations.

Retailers are particularly exposed to these developments because of the frequent contact that the community have with their stores and the high level of investor recognition they have.  This clearly has benefits in terms of promoting their respective brands but it can also be costly for retailers to manage reputational concerns if something goes wrong.

Earlier this year, Evidente noted the Four Corners program (Slaving Away) which went to air on May 5th, which showed damning evidence of exploitation of migrant workers in Australia's fresh food supply chain.  The allegations were levelled at stores that sell fresh produce to the public, including Woolworths, Coles, Aldi, IGA and others.  Four Corners posted to its website the written responses from each of these businesses, including Woolworths.

Although each of the supermarket chains deals with hundreds, possibly thousands of suppliers, the big supermarket chains need to be careful about managing their reputational risk, particularly as the community and governments have effectively conferred a license to operate to Woolworth, Coles and other supermarkets.  The sheer size of Woolworths and Coles suggest that they have more to gain from leading the charge and ensuring that their suppliers do not engage in worker exploitation.

As retailers continue to extract synergies and efficiencies from their supply chain management, they will need to carefully manage ESG considerations that might adversely impact on their suppliers.

More recently, the 730 Report has drawn attention to the practice of ‘sham contracting’ used by Myer.  A whistle blower – who was a cleaner at the flagship Myer Melbourne store - who raised his concerns to the media recently about being paid below award rates without superannuation or other benefits, has been fired.  Myer contracts out its cleaning services to Spotless which sub-contracts to another firm.  According to the 730 Report, this firm then hired cleaners as ‘contractors’ to avoid paying various entitlements under the award system.  The sub-contractor has been ordered to reimburse cleaners who were paid below the award rate and denied penalties by the Fair Work Ombudsman.

Retailers – particularly those who invest so much in their brands – will increasingly need to be careful about managing these relationships, particularly in a climate where asset owners and institutional investors are increasingly focussed on corporate social responsibility.

Myer: Unlocking the embedded value in an iconic brand

Myer’s poor market performance since re-listing around five years ago has been underpinned by negative earnings surprises, with the current 12 month forward PE of around 11x comparable to the level that prevailed in 2010 (see chart).

Growth in revenues and profitability has suffered due to structural challenges facing the department store business model including greater competition from e-tailers, a household sector keen on undertaking balance sheet repair in the wake of the financial crisis and up until recently, a strong Australian dollar, which has encouraged foreign entrants into the space.  As a result of these developments, department store sales have flat-lined in the past three years while household goods retailing and clothing & soft goods retailing have lifted substantially (see chart).

Evidente has suggested previously that some of these headwinds facing discretionary retailers are gradually transforming into tailwinds.  The household saving rate remains high by historical standards (at levels prevailing in the late 1980s) so there is scope for it to fall, particularly in an environment where the change of government leadership in September has given consumer sentiment a fillip.  Evidente believes that more monetary stimulus is necessary to support consumption and non-mining business investment.  The Australian dollar has depreciated in recent years, which is likely to discourage further foreign entrants into department stores.

Ultimately, new management at Myer will need to address the structural challenges facing the business model.  The recent equity raising of over $200 million has helped to shore up the balance sheet.

Against the industrial universe, Myer remains cheap on an ROE adjusted price to book basis, with the stock lying 30% below the trend line, suggesting the much of the pessimism is already priced in (see chart).  However, reported earnings (and therefore forecast earnings) are probably overstated to some extent because ongoing expenses associated with restructuring the business in recent years have been treated as non-recurring items.  Myer however is not the only company undergoing restructuring to have used their discretion to bring such items below the line.  Nonetheless, this practice probably overstates the stock’s valuation support.  Much also depends on the transformation of the David Jones business model under the new ownership of Woolworths Holdings. 

If the new CEO, Mr Richard Umbers is able to unlock the embedded value in the iconic brand that Myer represents, Evidente expects that patient investors will be rewarded.

Weekly Impressions: Australia's export revolution to China's Rising Middle Class

The key macro announcement in Australia in the past week was the stronger than expected employment print for the month of October.  Total employment lifted by almost 60k and the unemployment rate dropped to 5.9% from 6.2%.  Expectations of a December rate cut have consequently diminished.  Evidente has been of the view for a while that given the spare capacity in the economy and labour market, the RBA should deliver more monetary stimulus.  One strong monthly employment outcome is not sufficient to alter my view that labour market conditions are slack and that another rate cut is necessary, for three reasons.

• The labour force survey is widely understood to be plagued by sampling problems which have meant that the monthly estimates have become more volatile and a less reliable barometer of the cyclical weakness or strength of the labour market.
• As long as these sampling issues remain, the Wage Price Index becomes an increasingly important indicator to assess the state of the labour market.  On this front, there is little to concern the inflation hawks; private sector wages in the past year have grown at their lowest rate since the inception of the series in the late 1990s. 
• Employment growth and core inflation have moved in opposite directions this year.  The lift in employment growth in the past three quarters – the strongest gains since the back end of the credit boom (see chart) – has been associated with a drop in core inflation.  Evidente has written on the phenomenon of a flatter Phillips Curve more extensively for the United States; in recent years, disinflation has intensified at a time when the unemployment rate has dropped 300 basis points to 5%.  Why various measures of economic slack are becoming increasingly unreliable gauges for inflation in countries like Australia and the United States remains puzzling.

China's Rising Middle Class and the Upheaval in Australia's Exports

A number of developments in the past week confirmed that Australia's exports to China are undergoing a revolution thanks to inexorable rise of China's middle class.  At a time when BHP dropped briefly to below $20 – its lowest level since 2005 due to the Samarco dam disaster and renewed weakness in crude oil prices – the news-flow in Australia focussed on the growing shortage on supermarket shelves of Bellamy’s baby formula, while overseas arrivals from China continue to surge.    

Chinese demand for Australia's agri-food products, vitamins, wine, tourism, higher education and other non-commodity goods and services will continue to grow strongly and help diversify our export basket.  In an environment where the aggregate supply of growth in Australia is anaemic, the rise of China's middle class is a powerful and seductive investment theme that offers strong growth prospects to Australia's non-commodity exporters.  

Australia's White Gold Rush

Tasmanian based company, Bellamy’s (BAL AU Equity) – which produces organic certified baby formula - has captured the imagination of investors and the media due to the lift in the share price this year from less than $2 to close to $10.  In recent weeks, the shortage of baby formula in supermarkets has become a barbeque stopper in Australia, made more severe by Singles Day in China on November 11th.  Evidente can vouch for the shortage on supermarket shelves; recent visits to the local Coles and Woolworths supermarkets revealed that neither had Bellamy’s baby formula in stock (see photos). 

The issue has even become politicised, with politicians at the federal level voicing concerns that mothers in Australia are missing out.  However this dynamic plays out, the one sure thing is that the stellar returns from companies like Bellamy’s and New Zealand’s dairy company, A2 will attract an influx of new capital and entrants into this space.

Chinese overseas arrivals continue to surge

ata released by the ABS during the week showed that short term overseas arrivals grew by 2.5% in the September quarter to 1.87 million, outstripping growth in short term overseas departures of 1% (see chart). 

This continues a trend evident over the past four years, in which growth in arrivals has exceeded growth in departures, in large part thanks to the renewed weakness in the Australian dollar.  Stocks such as Sydney Airport (SYD AU Equity) and hotel operator, Mantra Group (MTR AU Equity) have been beneficiaries from the lift in growth of tourists visiting Australia, while stocks such as Flight Centrehave been affected adversely by the slowdown in growth of Australians holidaying overseas.

Amongst overseas arrivals, the number of Chinese tourists visiting Australia has grown rapidly and now account for over 16% of all overseas arrivals (see chart).  The growth in Chinese overseas arrivals should also benefit from a recent announcement from the Australian government of the introduction from 2016 of a new 10 year multiple entry visa available to Chinese citizens travelling to Australia.  Australia is the fourth country to offer Chinese nationals decade long visas, following Singapore, the US and Canada.

Weekly Impressions

RBA communications dominated financial markets in Australia over the past week.  Aside from its decision to leave policy unchanged at the November Board meeting, the central bank released its quarterly Statement of Monetary Policy (SoMP) and Governor Stevens and Deputy Governor Lowe delivered speeches. 

Mr Glenn Stevens gave the clearest indication that the RBA has adopted an easing bias, flagging that 'were a change to monetary policy to be required in the near term, it would almost certainly be an easing, not a tightening.'

And for good reason.  In the SoMP, the RBA re-iterated that the inflation outlook poses no obstacle to further stimulus, following the lower than expected 3Q CPI print, and that the +6% unemployment rate and record low growth in private sector wages confirms that there remains spare capacity in the labour market.  Further, the RBA lowered its outlook for GDP growth and inflation (again) and continues to acknowledge that the economy is expected to operate with a degree of spare capacity for a while. 

Against this backdrop, Evidente remains puzzled why the RBA chose not to deliver more stimulus in November to address the shortfall in aggregate demand.  Particularly at a time when the RBA has revised down its real GDP growth forecast for CY2016 to 2.5% from 3.25% in the past year.  Over the coming months, I believe that there will be a growing chorus for the central bank to cut official interest rates again, irrespective of whether the US Federal Reserve engages in lift off.

Macro-prudential policies and a steep learning curve

Mr Philip Lowe drew attention to problems associated with implementing APRA's macro-prudential measures, designed to curb growth in mortgage lending to investors below 10% pa.  The RBA has identified large upward revisions to investor loans over the past six months, and yet in recent months, a sharp fall in investor lending has been offset by a sharp rise in lending to owner-occupiers.

Mr Lowe suggested that lenders' internal systems have not been up to the task of reporting accurate data on the split between investor and owner-occupier loans.  It is reasonable to think that investors are also gaming the system and reporting to banks that they are owner-occupiers to benefit from lower mortgage rates.  The RBA and APRA clearly remain on a steep learning curve in using macro-prudential policies.

More equity does not equate to a higher cost structure

Mr Stevens echoed recent comments by head of APRA, in suggesting that the effect of recent supervisory measures (notably the lift in capital requirements) would have the effect of lowering expected future bank stock returns.  Evidente has previously suggested that a lift in the share of loss absorbing capital in banks' liability mix would have the effect of lowering their expected cost of equity, consistent with the Miller-Modigliani proposition that capital structure is irrelevant for firm value.  A lower expected cost of equity commensurate with a lower risk profile should be viewed as a welcome development, not a lift in a bank's cost structure.

Who is afraid of the robots?

A number of widely cited journal papers in recent years have predicted that the emergence of robots and ongoing automation will render obsolete a large number of occupations, leading to concerns of mass unemployment.

But these concerns are overblown.  Mr Stevens suggested that few can predict where future jobs will come from, and cited the unanticipated growth in employment in computer system design in recent decades, as well as the more recent growth in employment associated with cloud computing services, social media and environmental sustainability services.

How we spend our leisure time is also likely to give rise to occupations that are unimaginable today.  At the turn of 20th century, few could have predicted the rise of tourism related employment, vets or gardeners, simply because the little leisure time we enjoyed at the time, was not devoted to doting on our pets or travelling on holiday.  Futurists who have an eye on history, should therefore have little to be afraid of in terms of the employment consequences of the rise of the robots. 

Domino's Pizza - The risk of strong growth in a low growth environment

DMP finished up 1.3% on the week against a 0.5% decline in the broader ASX200 index.  At its AGM, the company lifted guidance for same store sales to 10% for Australia & New Zealand and 7% for Europe, while new store openings were upgraded to around 270.

The company has defied market expectations for a while now, with sell-side analysts upgrading their forecast EPS for the stock by a compound annual rate of 25% over the past seven years.  This has occurred at a time when the broader universe of ASX200 companies have experienced a growth stall (see chart).  In a forthcoming report, Evidente will provide more detailed analysis around the stock's growth prospects and draw attention to a growing risk that the few stocks offering strong growth are becoming over-priced in low growth environment. 

Weekly Impressions - Competition intensifies amongst banks and supermarket retailers

The banks and supermarket retailers dominated financial market developments in Australia over the past week.  Investors were disappointed by full year results from ANZ and NAB, with the stocks falling by 6-7% over the week, well below the 2% weekly decline in the ASX200.  Woolworths was down 13% following another profit warning, while Wesfarmers was part of the collateral damage of what appears to be a renewed supermarket price war, with owner of Coles supermarkets falling 5% for the week.

Banks – Rebasing dividend expectations

Good news from NAB that it had sold an 80% stake in its life insurance business to Nippon Life was offset by further deterioration in the business banking net interest margin, an acknowledgement that competition in business lending remains intense and a flat dividend for the full year.  ANZ’s dividend was up only 2% for the full year.

Despite marginal improvements in bad & doubtful debts for the sector as a whole, bank earnings are no longer benefiting from such a big free kick as in recent years.  Combined with dormant animal spirits in the corporate sector and anaemic growth in business lending, analysts have scaled back expectations of dividends this year after rapid growth for five years (see chart).

Lift in capital requirements leads to higher equity, not higher costs

The major banks’ desire to halt their deteriorating net interest margins does a better job of explaining the recent lift to mortgage lending rates, than APRA’s recommended lift in capital requirements (see chart).  It remains disappointing that there is a widely held view in the investment community that the lift in mortgage lending rates was a rational response to higher costs of capital.  An increase in the amount of loss absorbing capital or equity finance used to fund its assets represents a shift in capital structure, not an increase in costs.  The lift in capital requirements affects the balance sheet– specifically a change in a bank’s liability mix – not the income statement.

Mr Wayne Byers, the head of APRA, was right to testify to Parliament recently that the increased capital requirements should be associated with lower expected returns from the sector.  By making banks safer and less risky, the Miller-Modigliani Irrelevance Theorem says that more equity capital should reduce banks’ expected cost of equity.

Woolworths – Rebasing expectations

New Woolworths Chairman, Mr Gordon Cairn, swept the slate clean by delivering NPAT guidance for the first half of 2016 that was up to 35% lower than the 1H15 result.  Since Evidente suggested in early June that the risk-reward proposition had become more compelling, analysts have continued to downgrade the stock’s growth prospects, as the company’s supermarket margins come under pressure from Coles and Aldi, and BIG W and Masters continue to perform poorly.

Investors are likely to reward WOW if it divests these businesses in due course, which will leave management to focus on boosting sales and profitability of its supermarket division.  Unlike Tesco in previous years which suffered a series of severe downgrades, Woolworths is not priced for perfection, and remains cheap across earnings and book multiples.  This should help to limit the downside from current levels and probably explains why the price fall in the past week was significantly smaller than the downgrade in guidance.

Supermarket price war augers well for low inflation and lower interest rates

The profit warning was also associated with a sharp fall in Wesfarmers shares, presumably as investors lift the likelihood of a renewed price war amongst the supermarket retailers.  It is another clear signal that growth in consumer demand is struggling to keep pace with the ability for the supermarket chains to grow supply.  Evidente remains of the view that the RBA should respond to the broader shortfall in aggregate demand in the economy by delivering more monetary stimulus at the Board meeting on Melbourne Cup Day.  At present, interbank futures are assigning a probability of a rate cut in November at 50%.

So Mr Stevens...What are you waiting for?

Earlier this month, I discussed five reasons why the RBA ought to deliver more stimulus at the next Board meeting in November: Australia remains stuck in a wage recession, animal spirits in the corporate sector show little sign of revival, macro-prudential measures are curbing rapid growth in mortgage lending to investors, a low September quarter CPI print should offer the RBA the positive narrative that it seeks to cut rates, and the absence of an explicit easing bias has not stopped the central bank from easing in the past.

At the time, interbank futures were implying a 25% chance of a rate cut in November.  Following the release of a benign 3Q CPI, those expectations have ramped up to almost 70% from 30% immediately prior to the CPI print (see chart).

Prior to the CPI release, three developments this month would have influenced the RBA’s thinking. 

• The latest employment report recorded a small contraction in the month of September. 
• The major banks’ decision to lift mortgage rates (dubiously citing APRA’s lift in mortgage risk weights) would have allayed the central bank’s concerns around deteriorating lending practices. 
• The worsening global growth environment has led to expectations of more central bank stimulus globally.  Market participants have pushed back expectations of lift off in the Federal Funds rate to next year, the ECB has flagged that it will consider more monetary accommodation at its December policy meeting and the PBOC has cut the benchmark lending rate to bring the cumulative decline to 165 basis points in the past 12 months.

The 3Q CPI release showed that core inflation recorded a quarterly increase of 0.3%, the lowest outcome since 2011.  The year-on-year increase of 2.2% is remains entrenched at the bottom end of the RBA’s target range (see chart). 

My expectation that food deflation would intensify was not realised.  But the food & non-alcoholic beverage component recorded a rise of only 0.1% and has been broadly stagnant for the past 12 months.  This is unlikely to change while competitive pressures amongst supermarket retailers remain intense.  Electricity retail prices declined by 3.5%, consistent with the recent determinations by the Australian Energy Regulator for lower network charges in NSW and South Australia.

The low core CPI print surprised even Evidente's benign expectations and reinforces the view that the Australian economy continues to suffer from a shortfall in aggregate demand.  The CPI has also clearly given the RBA some comfort that importers are absorbing the effects of the A$ depreciation through lower profit margins, thus limiting the flow through of the lower currency into higher consumer prices.  Importantly, the central bank now has the smoking gun to deliver another rate cut on Melbourne Cup day; a positive narrative of benign inflation. 

So Mr Stevens, what are you waiting for?

Weekly Impressions - Deleveraging dynamic blunts China's Monetary easings

Central bank communications and actions dominated financial market developments over the past week.  The European Central Bank’s President re-iterated the bank’s willingness and ability to use all instruments within its mandate if warranted.

What specifically sparked the rally in global equity markets was Mr Draghi’s acknowledgement that the degree of monetary policy accommodation would need to be re-assessed at the December monetary policy meeting, thanks to downside risks to the outlook stemming from concerns over growth prospects in Emerging Markets and related developments in financial and commodity markets.  Although Mr Draghi cited these concerns at the September press conference, at that time, he suggested that it was too early to assess whether these developments would be transitory.

The shift in Mr Draghi’s rhetoric at last week’s press conference confirms that that the ECB assesses that the risk has increased that these developments – if left unaddressed - could have a long lasting impact on the outlook for prices.

Core inflation has undershot the ECB’s target for the past decade

On that measure, the ECB’s more aggressive rhetoric and stimulus this year reflects a belated acknowledgment that it should receive a fail for its continued inability to meet its inflation target, which is to achieve an inflation rate below but close to 2% over the medium term.  Over the past decade, the core Harmonised Index of Consumer Prices has consistently failed to get anywhere near 2%, with the exception of 2007 and 2008 (see chart).  Although inflation has picked up this year, the year-on-year rate still doesn’t have a 1 in front of it.

The strength and persistence of global disinflationary forces since the financial crisis suggests that the ECB will need to extend (and probably expand) the asset purchase programme to beyond September 2016.  Expect global equity markets to rally on this announcement.

As an aside, the ECB’s inflation target is too high.  Once the upside bias in the measurement of consumer price indices is taken into account – particularly the rapid innovation in the provision of IT and related services – a 2% inflation target translates into modest deflation.  Evidente will explore this in more detail in a forthcoming research report.

Someone forgot to tell global stock markets about ‘currency wars’

The euro depreciated against the US dollar by 3% on the announcement to its lowest level in two months (see chart).  The zero sum game embedded in ‘currency wars’ predicts that outside of Europe, stock markets should have fallen on the ECB’s announcement due to adverse effect of euro depreciation on the competitiveness of non-European exporters.  But not only did European stock markets rally strongly but so did global stocks, including stock markets in the United States.  The overwhelming weight of evidence supports the view that monetary stimulus works by boosting consumption and investment, not net exports.

Deleveraging dynamic blunts China's policy easings

China’s central bank cut its 1 year benchmark bank lending rate by another 25 basis points to 4.35%.  This represents the sixth cut in twelve months, bringing the cumulative decline to 165 bps since November 2014 (see chart).  The benchmark deposit rate was also cut by 25 bps to 1.5% and the reserve requirement ratio (the amount of reserves held be banks) was reduced by 50 bps for all banks. 

The additional policy stimulus is designed to moderate the continued slowdown in various activity indicators, including fixed asset investment and industrial production (see chart).

Growth in industrial production has been particularly weak for construction related products.  Steel industry conditions remain weak, with domestic production having moderated.  Against this backdrop, domestic iron ore production and iron ore imports (including those from Australia) have trended lower (see chart).

The policy easing thus far has done little to mitigate the ongoing deleveraging dynamic in China.  Growth of total social financing continues to moderate due primarily to a sharp slowdown in off-balance sheet financing activity, reflecting both cyclical and regulatory developments (see chart). 

A number of other key developments are weighing on activity and working to blunt the efficacy of monetary policy in China: low efficiency of investment, the decline in corporate profitability, lower interest coverage ratios for SOEs and other excess capacity sectors even as interest rates decline, and the high debt burden of the non-financial corporate sector (see chart).

Dear Mr Hartzer, Please Explain

Dear Mr Hartzer,

In the press release accompanying the announcement on October 14th, that Westpac would be undertaking a $3.5 billion rights issue, you state that “capital raised responds to changes in mortgage risk weights that will increase the amount of capital required to be held against mortgages by more than 50%...to be applied from 1 July 2016.  As a result, Westpac has also announced an increase in its variable home loan (owner occupied) and residential investment property loan rates by 20 basis points.”

Demystifying the myth that capital sits idle in bank vaults

There are two parts of this statement that I do not understand.  The first is a myth that is commonly propagated by bankers; the notion that a bank must ‘hold’ capital, the implication being that it sets capital aside that burns a hole in a bank’s balance sheet while it sits idly in a vault.

This is far from reality.  Let’s start by quantifying the incremental capital requirement.  You’re correct in stating that the capital requirement for mortgages will be 50% higher from 1 July 2016.  At present, the Internal Ratings Based (IRB) risk weights assigned to residential mortgages is around 17% on average for the major banks.  In July 2015, APRA announced that for banks accredited to use the IRB approach, the average risk weight on Australian residential mortgage exposures would increase to at least 25% by mid-2016.  This is designed to narrow the competitive advantage that the IRB accredited institutions (notably the major banks and Macquarie Bank) have over authorised deposit-taking institutions (ADIs) that must use standardised weights.

For ADIs using the standardised approach, risk weights are prescribed by APRA.  The average risk weight for residential mortgage exposures under the standardised approach is around 40 per cent (see chart).

The current IRB accredited risk weight of 17% on a $600,000 home loan equates to a risk-adjusted exposure of $102,000, so a bank would need to allocate $10,200 in additional equity finance to achieve a capital ratio of 10% of risk-weighted assets.  Under APRA’s new guidelines from mid-2016, the new capital requirement increases to $15,000 for the same size mortgage, but remains well below the $24,000 that applies to non-IRB ADIs (see chart).

The nonsense that banks need to ‘hold’ or set aside capital stems from the misconception that bank capital is an asset like reserve requirements.  Bank capital is a liability, which together with customer deposits and wholesale debt, is used to finance a bank's loans.

As you would well be aware Mr Hartzer, the key function that a bank performs is maturity transformation.  It carefully manages its liabilities which are liquid with a short duration, and its loans which are illiquid and typically have long duration.  If a bank uses more shareholders equity in its liability mix, in no way is it forced to cut back on loans or dividends.  On the contrary, it can use those additional funds to lend.  Unfortunately, the terminology is confusing; capital regulation is a regulation of a bank's liabilities, not its loans or assets.

The folly of linking lending rates to capital structure

Which brings me to the second part of your statement that puzzles me; that Westpac has lifted its variable home loan rates in response to the new capital requirements.  This might not be unprecedented but it is highly unusual for a company to link price hikes to the need to use more loss absorbing capital in its liability mix. 

In recent months, a number of ASX listed companies have undertaken rights issues to shore up their balance sheets, including Myer and Origin Energy.  Yet despite the rights issues, Myer did not announce its intention to lift profit margins to fund the incremental capital raised and Grant King has not flagged that he will lift electricity prices that Origin Energy charges customers. 

The technology giant Google uses very little debt in its funding mix and certainly cannot draw on funding from government guaranteed customer deposits.  Despite this, it doesn’t charge users for an array of incredibly useful and valuable services.  Sure, the company benefits from a network effect of attracting a critical mass of users to its services and to that end, offer such services for free or well below marginal cost.  Nonetheless, to my knowledge, outside of the banking sector, CEOs do not propagate a narrative linking their capital structure to prices they charge customers for their products and services.

So Mr Hartzer, why are you seeking to confuse politicians, policymakers and the public by linking the composition of Westpac’s liabilities with the assets or loans that the company writes?  Of course, citing the lift in mortgage risk weights for higher variable home loan rates helps to deflect blame to the prudential regulator.  It might even encourage other major banks to lift their home loan rates and adopt a similar approach in managing their own reputational risk by shifting the onus to APRA.

Nonetheless, I believe that Westpac will need to carefully manage the longer term brand damage if it continues to link further movements in lending rates to the amount of loss absorbing capital in its capital structure.

What’s capital structure got to do with it?

Finally, a number of media reports have suggested that despite APRA's additional capital requirements, Westpac has maintained its target ROE of 15%.  To the extent that these media reports are accurate, their thrust is inconsistent with Miller and Modigliani’s Irrelevance Theorem; that a firm’s capital structure doesn’t matter for firm value.  Increases in leverage leave the weighted average cost of capital unchanged because the expected cost of equity rises, commensurate with the company’s higher risk profile.  Conversely, lower leverage is associated with a lower expected cost of equity, other things being equal.

So the additional loss absorbing capital in Westpac’s capital structure should lower its expected ROE by making the bank safer and more resilient.  The chart below confirms that the largest global banks which are heavily dependent on equity finance in their capital structure tend to have lower volatility of stock returns.

Weekly Impressions: org | anz | WOW

The two key company announcements in Australia in the past week were Origin Energy’s launch of a $2.5 billion entitlement offer designed to strengthen its balance sheet and CEO succession at ANZ, with Mr Mike Smith stepping down after eight years in the role.

Origin Energy (ORG) shores up its balance sheet

In addition to the $2.5 billion entitlement offer, ORG announced that it would adopt a number of other measures to shore up its balance sheet, including cutting dividend guidance, selling non-core assets, and reducing capital expenditure and working capital requirements.

This has occurred against the backdrop of a lift in the company’s ratio of total debt to equity to over 90%, its highest level in a decade (see chart).  If the proceeds from the 4 for 7 rights issue are used to pay down debt –as the company has announced – the gearing ratio will decline to below 70%.  ORG announced on Friday that there had been 92% take up by eligible institutional investors at the $4.00 offer price.

The weight of the academic literature shows that firms undertaking seasoned equity raisings tend to under-perform because company insiders are more likely to issue equity – to finance acquisitions and investment projects - when they believe that their scrip is overpriced.  But the international evidence is more supportive of capital raisings that are designed to strengthen a company’s balance sheet.  In fact, many of the capital raisings in Australia through 2008 and 2009 in the wake of the financial crisis, were associated with subsequent out-performance as investors assigned lower default risk to many of these firms.

The balance sheet impact of lower capex and working capital requirements – up to $1 billion across FY16 and F17 should not be under-estimated.  ORG’s capex spend in FY15 was $1.7 billion, so the planned cut would amount to a 30% reduction in each of the next two years (see chart).  Much will hinge on the outlook for oil prices, but the measures to streamline the asset side of the balance sheet and lift the equity component of the company's liabilities should re-position the company in the event that oil prices remain at current levels.  But it also gives shareholders greater participation in the upside if the outlook for oil prices improves.

Sizing up Mr Smith's footprint

Mr Mike Smith announced that he would be stepping down as ANZ's CEO after eight years in the role.  Much of the media commentary has focussed on the bank's Asian footprint as his legacy.  Has the strategy to expand into banking markets more competitive than Australia to get exposure to the region's rising middle classes been a sound one? 

The company's growth prospects relative to other banks represents a good starting point.  Analysts' forecasts for ANZ's EPS are 20% higher now than when Mr Smith commenced in his role in 2007.  Although this is well above the NAB's performance, it is substantially lower than CBA and slightly lower than WBC (see chart).

 Analysts downgraded the bank's growth prospects more aggressively than WBC and CBA during the financial crisis, and never fully recovered.  In fairness to Mr Smith, ANZ's business exposure - already a feature of the bank's loan book prior to his tenure - largely contributed to the significant downgrade to the company's growth prospects during this time.  The chart below shows that the spike in the sector's non-performing assets during the financial crisis was larger for business loans than for either personal or housing loans.

The fact that the company's price to book ratio remains comparable to NAB's - as it was at the start of the Mr Smith's tenure as ANZ CEO - but worsened relative to WBC and CBA's book multiple confirms that Mr Smith's strategy has not improved the bank's growth prospects relative to its key peers (see chart). 

The difficulty with sizing up Mr Smith's footprint is not knowing the counterfactual; that is, what strategy would Mr Smith have pursued if he had not sought to expand ANZ's Asian footprint?  With the benefit of hindsight, the rapid growth of housing credit - particularly for investors - suggests that ANZ might have benefited from gaining market share from WBC and CBA  in this space and reducing its reliance on business lending, which has remained anaemic.  But this approach could have led to a price war, which would have been detrimental to sector wide profitability and attracted the attention of APRA and the RBA. 

Woolworths: The quest to combat poor value for money perception

The senior management ranks at Woolworths remain in a state of flux, while its CEO succession 'planning'  drags on; it has been over three months since Mr Grant O'Brien announced he would be stepping down.

WOW has been much criticised across a number of fronts, including its willingness to maintain and expand already fat profit margins at the expense of delivering value to the customer, at a time when Coles and Aldi have been competing aggressively on price.

WOW has started to embark on its quest to neutralise its perceived poor value for money. On a recent visit to the local Woolies supermarket, Evidente noticed that staff had put a trolley at the store entrance, with a price comparison that showed that the items in the trolley were 20% cheaper now than at the start of the year. The trolley also drew attention to the fact that prices had dropped on over a thousand products, presumably over the same period (see photo).  Evidente will shortly be releasing a research report, reviewing the investment case made for WOW earlier this year.

Weekly Impressions - Australia's policital culture at a cross-roads

The decision by the Coalition government to replace its leader, Tony Abbott, with Malcolm Turnbull dominated developments in Australia in the past week.  Much of the commentary has drawn parallels with similar machinations in the previous government, in which Julia Gillard replaced Kevin Rudd in his first term as Prime Minister.  Much has also been made of the renewed instability of Australian politics, which has seen five Prime Ministers in as many years.

Many political commentators have discussed the different style in communication that Mr Turnbull will bring to his Prime Ministership.  Indeed, Mr Turnbull himself has flagged that the Government will need to do a better job in articulating an economic vision for Australia.  Whatever that vision is – which he is yet to articulate – Evidente’s view is that four key factors will constrain the new Prime Minister’s ability to execute on that vision: the stark reality of the Senate, Australia’s terms of trade shock associated with China’s slowdown, the country’s wage recession, and the wedge between government revenue and spending.

The Senate’s stark reality

Australia’s Senate or Upper House of Parliament is composed of 76 seats; 12 from each of the six states and two from the two territories.  Most Bills are initiated in the House of Representatives or the Lower House, but need to be passed in the Senate.

The Coalition Government (composed of the Liberal and National parties) falls well short of the 39 seat majority required.  At present, the Coalition holds 33 seats, followed by the Australian Labor Party (ALP) with 25 seats and the Greens with 10 seats.  The remaining 11 seats are held by various independents and small minority parties (see exhibit).

In recent decades, it has been common for the Government of the day – which holds the majority in the House of Representatives – to rely on other parties to achieve a majority in the Senate.  But the Senate has become more hostile in recent times, with the emergence of the Greens as the third force in Australian politics, effectively displacing the Australian Democrats, which had been a centrist party.  The Greens’ left wing origins mean that it more commonly votes with the ALP, so that the Coalition must rely on the support of a disparate group of mainly populist independent and fringe parties.

The Abbott Government discovered the Senate's hostility when it failed to garner support in the Upper House for two key items in its first Budget in 2014: the Medicare co-payment of $7 for a visit to the doctor and the deregulation of higher education, both important reforms designed in part to address the growing budget deficit.  The great expectations that Canberra’s press gallery and the community have for the Turnbull Government are unlikely to be met thanks to the stark reality of the Senate.

Australia’s wage recession

Australia’s wage cost index is only 2.3% higher than a year ago, which represents its slowest annual growth since the inception of the series in the late 1990s and well below growth at the peak of the financial crisis (see chart).  The wage recession suggests that the demand for labour remains weak.  Renewed strength of employment growth in recent months might be an early sign that low wages growth is encouraging businesses to lift their hiring intentions.

Sluggish wages growth might help to explain the adverse community reaction to the travel rorts affair recently, which claimed the scalp of the Speaker of the House of Representatives, Ms Bronwyn Bishop.  From the perspective of the new Turnbull Government, the community’s appetite for economic reform will remain limited thanks to Australia’s wage recession.

Let’s not talk about the elephant in the room

The former Treasury Secretary, Mr Martin Parkinson, has been vocal for some time about the conversation that politicians have not had the courage to have with the community around the divergence between government revenues and expenditures.  After growing in line with government outlays during the credit boom, tax revenue dropped sharply during the financial crisis and although it has recovered since then, it hasn't kept up with the path of government spending (see chart).

At the coal-face, social reforms such as the National Disability Insurance Scheme (NDIS) have received bipartisan support, but there has been little public debate about how the costly scheme will be funded.

The Turnbull government faces a delicate task between not further undermining already fragile consumer and business confidence in the short-term, but putting its financial position on a sustainable footing over the medium term by addressing the growing wedge between government revenues and expenditures.  At a time when wages are growing at a record low, perhaps the community is not ready to have this conversation just yet.

The terms of trade shock

Like the Abbott and Gillard Governments, the economic fortunes of the Turnbull Government will be hostage to China’s future growth prospects and Australia’s terms of trade – the price it receives for its exports relative to the price it pays for its imports.  Growth in China’s industrial production and fixed asset investment has continued to moderate in the past year, while annual retail sales growth has remained at 10% for the past four years (see chart). 

Against this backdrop, Australia’s terms of trade has declined by 30% from its peak in 2011, which has been an important drag on growth in nominal GDP.  Despite this, the terms of trade remains well above historical norms (see chart). 

Importantly, there are renewed concerns about the authorities' ability and willingness to stimulate the economy, re-balance growth from investment to consumption, and undertake necessary reforms to State Owned Enterprises.  Further weakness in markets for Australia’s key export commodities – iron ore and coal – will undermine the Turnbull Government’s capacity to undertake budget repair.

Weekly Impressions

The key company announcement during the week in Australia came from Woodside Petroleum, that it had provided Oil Search a confidential and non-binding proposal to merge through a scheme of arrangement.  Under the proposal, Oil Search shareholders would receive all scrip consideration of 0.25 Woodside shares for every Oil Search share and become shareholders in the combined entity.  Discussions between the two companies are still at a preliminary stage.

The preliminary offer valued OSH at a 13% premium to their price immediately prior to the announcement.  OSH’s main asset is its 29% interest in the PNG LNG Project, a liquefied natural gas (LNG) development operated by ExxonMobil PNG Limited.

I recommend that investors avoid Woodside for four reasons. 

• Mergers & Acquisitions 101 says that acquirers that make all scrip bids perform poorly on average.  This might reflect the fact that insiders engage in market timing; issuing capital to fund expansion or acquisitions when they believe that their scrip is expensive.  Woodside’s share price has fallen by around 30% in the past year, so it is unlikely that its insiders believe that it is timely to use their scrip as currency.  But immediately prior to Woodside’s announcement, Oil Search had fallen by 25% over the past year, so in their wisdom, Woodside’s insiders clearly believe that their target asset now represents a bargain.
• Investors however are yet to be convinced of the rationale for the proposed deal.  The combined market value of the two companies is 2% lower than immediately prior to the announcement.  Woodside clearly needs to do more to convince investors of the synergies that it can extract from managing Oil Search’s assets.
• If the synergies between the two companies are thought to be limited, investors will be sceptical of any purported diversification benefits, particularly in an era of renewed corporate focus.  The company already ranks close to the top quartile of ASX200 companies based on Evidente’s proprietary score of agency costs (see table).  The complexity of the firm will only increase if the deal proceeds thanks to the size of Oil Search.  Moreover, management will be distracted trying to integrate the two businesses. 
• Woodside ranks in the bottom quartile of ASX200 companies based on earnings revisions (see table).

The key macro data points for Australia were the modest fall in the unemployment rate to 6.2% in August and 5% decline in consumer sentiment.  At present, this is little cause for alarm; the 3 month moving average of consumer sentiment has been at or below current levels three times in the past four years.  Each episode proved to be temporary (see chart).  The renewed volatility in financial markets has likely impacted on the short-term psychology of the household sector.

The renewed weakness of consumer sentiment in recent months and associated poor performance of listed discretionary retailers during this time has challenged my positive view on the sector.  Despite weak growth in household disposable incomes, there are a number of macro tailwinds that should benefit the sector. 

• The household savings ratio remains high, comparable to levels that prevailed in the late 1980s.  There is scope for households to become a little less prudent, and consume more out of their current income.  
• Retail spending on household goods and clothing, footwear & personal accessories continues to trend up (see chart).  Department store sales are the only discretionary retail category that has flat-lined in recent years due to structural challenges facing those business models. 
• But even sales at Myer and David Jones should benefit from a third macro tailwind; the renewed depreciation of the Australian dollar.  The lower dollar makes it more expensive for retailers to import items, particularly those that are paid for in US dollars.  But the competitive effects are likely to be powerful.  The lower dollar will lift the likelihood that a number of global department store retailers - some of which entered Australia at a time when the Australian dollar was closer to parity with the US dollar - do not further expand their presence in Australia, and even exit the country altogether.  Moreover, the lower dollar discourages the migration to online purchases.
• Consumer spending and psychology is expected to benefit from further monetary stimulus as the RBA seeks to support consumption and dwelling investment at a time when the economy is on the precipice of a capex cliff.

There were two noteworthy communications from the RBA during the week, from Mr Philip Lowe (Deputy Governor) and Ms Luci Ellis (Head of Financial Stability). 

• Mr Lowe highlighted that although the declines in the China's stock markets would have a limited impact on the country's growth prospects, the elevated volatility and authorities' attempts to restore stability had drawn attention to four key structural challenges facing China: the necessary shift from capital investment to consumption; liberalisation of markets for the key inputs of production including labour, capital and energy; demographics of ageing; and the strains and distortions of a still heavily regulated financial system.
• Ms Ellis highlighted the importance of residential and commercial property in Australian bank lending.  The two account for over two-thirds of banking lending in Australia, much lower than in the United States (see chart).  Despite the importance of residential mortgages on Australian banks' balance sheets, during the crisis, non-performing assets rose sharply for commercial property and business lending.  These are now comparable to levels that prevailed prior to the crisis (see chart).

Weekly Impressions

The 173k lift in non-farm payrolls in the month of August fell modestly short of consensus expectations but confirms that the labour market in the United States continues to strengthen. The unemployment rate edged down to 5.1%, its lowest level in over seven years.

Despite these encouraging trends, growth in the US economy has stalled. In the past five years, nominal GDP has expanded at an average annual rate of 3-4%. Disinflationary forces have intensified in the past three years; core PCE inflation has trended down to sub-1.5% yoy at a time when the unemployment rate has declined by 300 basis points.

In prior posts, I have suggested that a flattening of the slope of the Phillips curve since the financial crisis can help to explain the positive correlation between US inflation and unemployment. With inflation expectations well anchored, inflation has become far less responsive to changes in the unemployment rate (and other measures of economic slack more broadly). The unemployment rate might have also become a less reliable barometer of labour market conditions because an ageing workforce has contributed to a structurally lower participation rate.

Despite this, the Federal Reserve has clearly interpreted the decline in the unemployment rate as a signal that the labour market is approaching full employment. But the disinflation of the past three years has challenged the conventional view of what constitutes full employment (see chart).

At the annual Jackson Hole symposium, Vice Chairman Stanley Fischer attributed the disinflation to three factors: US dollar appreciation, fall in commodity prices and stable inflation expectations.  He suggested that some of these factors are temporary and would be expected to diminish over time.  Mr Fischer said that the Fed would likely need to proceed cautiously in normalising the stance of monetary policy (read: don't expect rapid fire rate hikes) but in a clear signal that lift-off is imminent, added that the Fed should not wait until inflation is back to 2% before tightening given the long and variable lags associated with the operation of monetary policy.

At a time when core inflation is undershooting the Fed's target by over 50 basis points, no wonder market participants remain unnerved and puzzled by the Fed's determination to tighten policy and its blatant disregard for its inflation target.  It is too complacent that inflation will naturally return to 2% and I suspect is being distracted by concerns that an extended period of near zero interest rates will undermine financial stability. 

The proximity of the crisis suggests that the Fed is justified in being concerned about financial stability.  But more targeted macro-prudential policies designed to reduce the size and influence of the shadow banking sector, and lift the amount of equity finance on the balance sheets of financial institutions would do far more to reduce systemic risk of the financial system.

A tale of two central banks

The difference in language and communications between the US Federal Reserve and the ECB is striking.  During the week, ECB President, Mr Mario Draghi, highlighted that the outlook had weakened and re-iterated the central bank's willingness to use all the instruments within its mandate, and that the asset purchase program provides sufficient flexibility in terms of adjusting the size, composition and duration of the program.  He added that the current schedule of monthly purchases of 60 billion euros is intended to run until the end of September 2016 or beyond if necessary until there is a sustained adjustment in the path of inflation towards 2% over the medium term. 

The open ended nature of the ECB's large scale asset purchases (LSAP) suggests that unlike the US Federal Reserve, the ECB does not take for granted that inflation will naturally return back towards 2%.  Since the current program of LSAP was announced in early 2015, it has been associated with the end of the three year long disinflation (see chart above).  The more aggressive approach by the ECB relative to the US Fed probably stems in part from the lesson learnt from a policy error in 2011, when the ECB lifted its official interest rate twice - at a time when the core Harmonised Index of Consumer Prices (HICP) was running at only 1.5% yoy - only to retreat soon after (see chart below).

A policy error in real time

 The key risk to the global economy is that the US Federal Reserve is committing a policy error by contemplating a policy tightening at a time when the economy is suffering from an extended disinflation and at a time when inflation continues to undershoot the central bank's target by a long way. 

Investment strategy: Overweight Euro Stoxx; Underweight S&P500

Against this backdrop, I recommend investors move overweight the Euro Stoxx index.  The chart below shows that analysts have been modestly lifting their growth outlook for the Euro Stoxx index this year, coinciding with the ECB's more aggressive monetary stimulus.  At around 14x, the market is not cheap but will remain expensive as investors continue to price in a recovery in earnings and gain more confidence that the ECB is determined to address the euro zone's shortfall in aggregate demand.

I recommend that investors fund the overweight position by having underweight in the S&P500 index.  The chart below shows that in the past year, around the time that the Fed started to communicate to market participants its intention to end its zero interest rate policy, analysts' expectations of growth have stagnated after a five year long period of upgrades.  US dollar appreciation - associated with expectations of rate hikes - has clearly crimped the US dollar earnings of offshore earners.

RBA's patience continues to wear thin

The June quarter National Accounts confirmed that growth in Australia remains tepid.  Real GDP expanded at rate of 2% yoy, with the key contributions coming from consumption, dwelling investment and net exports, while inventories and private business investment provided significant drags (see chart).  I noted in last week's post that despite the weakness in business investment already evident in the past year, the economy is on the precipice of a capex cliff over the 2015/16 financial year, in the order of 20% or $30 billion. 

The renewed depreciation of the Australian dollar will help to further lift the competitiveness of exporters and boost the contribution to growth from net exports.  But as long as the much anticipated transition from mining to non-mining capex remains elusive, the RBA has little choice but to ease policy further to ensure that consumption and dwelling investment continue to support the outlook.

The tepid state of growth in the Australia's economy owes much to the terms of trade shock, which have fallen by over 50% since global commodity prices peaked in 2011, and the RBA's caution in easing policy during this period.  Despite the magnitude of the terms of trade shock, the Overnight Cash Rate of 2% remains well above official interest rates in most other advanced economies. 

Against this backdrop, EPS growth prospects have stagnated for five years now and the consensus 12 month forward EPS estimate remains 25% below its pre-crisis peak (see chart).  Thus, the ASX200 has been hostage to periods of multiple contraction and expansion.  At current levels, the PE of around 14x is broadly in line with historical norms by the standards of the past decade.

A dividend discount model for the market tells a very different story.  The price to dividend ratio has remained broadly steady over the past five years, but a 25% lift in analysts' dividend forecasts have underpinned the rise in the ASX200 over this period (see chart). 

The recent market volatility has seen the P/D ratio decline to around 21x.  Rather than representing a buying opportunity, in my view the lower P/D ratio suggests that market participants are becoming more sceptical of the ability for the ASX200 companies to lift dividends at the same rate as the past five years have shown.  Indeed, the chart below shows that the rate of analysts' dividend upgrades have slowed over the past year.

Weekly Impressions

The 5½% drop in the S&P500 in August was the biggest monthly fall since mid-2012, while the ASX200 declined by 7½%, its biggest fall since mid-2010.  Annualised volatility in the S&P500 spiked to 27%, its highest level since November 2011.  Nonetheless, the 6 month moving average of volatility of 14% remains broadly in line with historical trends over the sweep of the past 45 years (see chart).

Positive surprise on 2Q GDP, but growth remains stalled

The data flow from the United States was surprisingly upbeat.  The second estimate for real GDP showed a 3.7% (annualised) lift in the June quarter, up from the advance estimate of 2.3% and well above the March quarter outcome of 0.6%.  This lifted average annual growth in nominal GDP (the current value of GDP) to 4% in 2014/15.  But nominal GDP growth has stalled for the past five years at 3-4%pa (see chart).

The growth stall might help to explain why animal spirits in the corporate sector have remained dormant because nominal GDP is a more robust guide to business and consumer sentiment than real GDP.  After all, businesses and households do not earn inflation adjusted cash flows.

The US Federal Reserve’s unwillingness to combat disinflationary forces has contributed to the growth stall.  The core personal & consumption expenditure (PCE) price index (which excludes food & energy items) is only 1.3% higher than its level a year ago.  No doubt, the Fed remains puzzled that the disinflation of the past four years has emerged at a time when the unemployment rate has declined by more than 300 basis points (see chart).  So much for a ‘tighter’ labour market contributing to higher inflation.

The apparent breakdown in the traditional inverse relationship between unemployment and inflation has been reflected in a flattening of the Phillips curve since the financial crisis, confirming that core inflation has become less responsive to changes in the unemployment rate (see chart).  The flatter slope reflects 1) the fact that the unemployment rate has become a less reliable barometer for labour market conditions due to structurally lower labour force participation; and 2) inflation expectations remain well anchored.

Evidente has previously suggested that the flatter Phillips curve means that further cyclical improvement in the labour market might not lead to inflation moving back towards the Federal Reserve's 2% objective, giving the central bank scope to remain patient in it approach to normalising monetary policy (see blog post from 6th April 2015).  But it appears that the Yellen Fed’s patience with its zero interest rate policy (ZIRP) is wearing thin, with the Fed flagging an imminent start to the normalisation of the Federal Funds rate.

 

Market volatility to remain high until the Fed clearly enunciates its goal

I and many others remain puzzled by the Yellen Fed’s approach because it is not clear what the Fed is seeking to achieve.  Investors continue to be unnerved by the Fed’s willingness to tighten monetary policy at a time when inflation continues to undershoot its 2% target. US breakeven (TIPS implied) inflation expectations have fallen to 1.6%, their lowest level since 2010, wages growth is running at 2%pa and as cited above, core PCE inflation is running at below 1.5%pa.  Financial market volatility will remain high until the Federal Reserve more clearly enunciates the goals of monetary policy and why it remains indifferent to achieving its inflation target

Australia's capex cliff to keep pressure on the RBA to ease policy again

In Australia, the poor June quarter capex survey went under the radar due to the reporting season and elevated market volatility.  The survey represents unambiguously bad news for the outlook, confirming that the economy is on the precipice of a $30 billion capex cliff, which would amount to a 20% slump (see chart).  The long and drawn out transition from mining to non-mining capex continues to weigh on growth and frustrate the RBA.  In my view, the re-balancing of growth will need an assist from further monetary stimulus

Woolworths – New hierarchy will need to re-focus on supermarkets

As far as reporting season, there were few big earnings surprises amongst the big cap stocks during the week.  The news flow focussed on the drop in after tax net profit for Woolworths and the announcement of Mr Gordon Cairns as new Chairman.  Masters continues to bleed money, and results at discount retail chain BIG W remain disappointing.  The first step for Mr Cairns will be to find a replacement for outgoing CEO Mr Grant O’Brien. And the first step for the new CEO should be to divest the Masters and BIG W businesses, and re-focus Woolworths on its core competitive advantage of supermarkets where margins remain under pressure.

Postscript: After I had completed this post, Vice Chairman Stanley Fischer spoke at the annual Jackson Hole symposium, and attributed the low inflation in the United States in recent years to: US dollar appreciation, fall in commodity prices and stable inflation expectations.  He said that the Fed would likely need to proceed cautiously in normalising the stance of monetary policy (read: don't expect rapid fire rate hikes) but in a clear signal that lift-off is imminent, added that the Fed should not wait until inflation is back to 2% before tightening.  These comments will only add to the market's confusion regarding the Fed's indifference to its inflation target. 

Weekly Impressions

In another turbulent week for global stock markets, the S&P500 moved sharply lower overnight, shedding over 3%, apparently on continued concerns about China's future growth prospects following the weaker than expected manufacturing survey mid-week and renewed volatility in the Shanghai Composite Index.

The key question for investors is whether US stocks at current levels, represent good value now.  Despite the correction in recent months, the stock market still doesn't look particularly cheap, with the 12 month forward PE on the S&P500 of 15.7x still higher than historical norms (see chart).  The headwinds facing US stock investors stem from the stagnation in expected profitability over the past 12 months.  This follows a rapid recovery in profitability from 2009 to 2011, followed by more modest upgrades from 2011 to mid-2014.  Since then, growth prospects have remained broadly unchanged, in part reflecting the appreciation of the US dollar.  An effective tightening of monetary policy - thanks to the end of QE and imminent end to the Fed's policy of forward guidance - probably has been another headwind facing corporate America. 

The ASX200 fell by around 5% during the week to its lowest level since December 2014.  The start of the year now seems a very long time ago, when synchronised monetary easings by over 20 central banks - including the RBA - over the course of a month - helped to propel stocks higher.  Analysts have marginally downgrade future growth prospects for the ASX200 companies in aggregate year to date, which means that the 12 month forward PE of 14.5x is little changed from the end of 2014 and in line with historical norms.

Future growth prospects of the ASX200 have now stagnated for almost five years, so episodes of multiple expansion and contraction have driven market volatility over this time.  Since mid-2013, the 12 month forward PE has hovered in a narrow range of 13x to 16x, so the current PE is at the mid-point of the range, making the market look neither cheap or expensive at current levels (see chart).

Beyond the cycles of multiple expansion and contraction, a pick-up in earnings growth is the necessary ingredient to drive the market sustainable higher.  But while the Australian economy remains stuck in a nominal funk, revenue headwinds will remain persistent.  Margin expansion can only drive profitability so far.  Since global commodity prices peaked in mid-2011, growth in nominal GDP has been even more anaemic than the early recession of the early 1990s.  In previous posts, I have suggested - contrary to conventional wisdom - that the RBA has been too slow to respond the negative terms of trade shock, which have declined by over 50% from the peak.  The central bank has been more concerned about the composition of growth - hoping that net exports and non-mining capital spending would drive growth - than overall growth in nominal GDP. 

Evidente has also previously highlighted that the five year long stagnation in growth prospects for the ASX200 is testimony to the resilience of corporate Australia, considering the stiff revenue headwinds that companies have faced.  Companies have trimmed costs aggressively, undertaken restructuring, sold off underperforming and non-core assets, and deferred capex where feasible.  Some analysts have taken a glass half empty view of the weakness in business investment, interpreting this as evidence of under-investment in future growth.  But most investors have rightly taken a glass half full perspective, and ascribed tremendous value to companies that have foregone investment opportunities that do not meet their cost of capital requirements, and returned capital to shareholders, predominantly in the form of higher dividends.

At a time when the terms of trade has shed 50% and future earnings growth prospects have stagnated, it is remarkable that analysts' dividend forecasts are one third higher than five years ago (see chart).

At the stock level, even small earnings misses continue to be punished by the market, notably Seek and Dick Smith Holdings.  Given the stellar rise of Seek over the past decade as the dominant online platform for job ads, the 10% fall on the result garnered plenty of news flow, namely comments from the CEO that investors remain subject to short termism, and exhibit little patience for Seek's plans for global expansion.  There might well be an element of truth, but Seek is not being singled out by investors.  After all, the equity risk premium has increased in recent years, as investors have lost trust in CEOs to undertake value accretive investments and acquisitions.  But the adverse reaction to SEK's results reflects the fact that analysts' growth expectations had become excessively optimistic.  Not only did analysts' earnings upgrades for the stock start to slow in early 2015, but have started to downgrade the company's growth prospects in recent months (see chart). 

Other high growth stocks that have been subject to growth stalls or downgrades in recent months include REA and Carsales (see chart).  Domino's Pizza has bucked the trend, with analysts continuing to upgrade the company's future growth strongly in the past year.

For high growth stocks trading on rich multiples, even small earnings misses can lead investors to re-assess the company's longer term growth prospects.  Consequently, investors have de-rated SEK, REA and CAR (see chart).  Given the top-down headwinds that have buffeted corporate Australia cited above, the aggregate supply of growth has been scarce over the past five years.  In hindsight, those few stocks that offered strong growth prospects were strongly bid up by investors.  For Domino's, the risk it that its strong growth profile has become even more scarce in an environment where the growth prospects of other market darlings have stalled.

Weekly Impressions

The 5% devaluation of China's currency dominated financial markets in this past week.  The China bears seem to garner most of the headlines these days, and so it was again: according to the pessimists, the devaluation confirms that the economy is in dire straits and that the government is desperate to boost net exports and so ameliorate the ongoing weakness in consumption and business investment.  To many commentators, China's devaluation represents the latest chapter in the ongoing saga of 'currency wars' waged amongst the world's central banks.

Devaluation yes, but after many years of appreciation

What seems to have gone under the radar in much of the press and commentary is that the Chinese Yuan (CNY) has undergone a significant appreciation in recent years.  Because it has been broadly pegged to the US dollar, the CNY effectively had appreciated by 25% against a basket of its major trading partners.  As a result, the devaluation only returns the CNY's trade weighted index back to levels that prevailed as recently as November 2014 (see chart). 

The bears are right to argue that the devaluation is a signal that the authorities remain concerned about China's future growth prospects. But they have good reason to: manufacturing and industrial production remain in a funk, disinflation is widespread (with pockets of deflation), the recent sharp fall in Chinese stocks has rattled confidence, and many residential and commercial property markets are suffering from a glut of inventory.  Against the backdrop of a weakening economy in recent years, the CNY would likely have depreciated if it had been a floating currency.  The PBOC has not put up the white flag; it is right to seek to re-align the currency with the economy's fundamentals.

In fact, the devaluation of the CNY - together with the recent relaxation of reserve requirements, cut to official interest rates, and (at times clumsy) efforts to support the stock market - has brought the PBOC in line with other central banks, that have eased monetary policies which has been designed to address the global shortfall in aggregate demand.  When the ECB and BOJ adopted more aggressive monetary stimulus at various stages in the past year, financial markets welcomed those moves. 

Yet the PBOC is derided as irresponsible when it seeks to also address the classic symptoms of a domestic cyclical downturn.  This is not to deny China's many structural challenges, including much needed reform of the financial system and re-balancing of growth towards consumption.  Such structural reforms are necessary to help China achieve sustainable growth over the medium term.  But China - along with most other economies - is currently suffering from deficient demand and the best solution is more aggressive monetary stimulus.

Record low wage growth in Australia a signal that labour demand remains weak

In Australia, the clearest sign of an economy that is also suffering from a shortfall in aggregate demand was continued absence of wage pressures.  The private sector wage rate (excluding bonuses) is 2.2% higher than a year ago, which represents the slowest annual growth since the inception of the wage price index in the late 1990s (see chart).  In a speech delivered during the week, the RBA's Christopher Kent confirmed that record low wages growth reflects weak demand for labour, and this is consistent with animal spirits remaining dormant in the corporate sector.

The much anticipated handover from mining capex to non-mining capex remains elusive and continues to be a source of frustration to the RBA.  In another speech from the central bank delivered during the week, Mr Phillip Lowe acknowledged that while this transition continues to drag on, it is appropriate that the household saving rate decline further; that is, it is reasonable to expect consumption to grow faster than disposable income to support growth at time when the corporate sector was showing little appetite for taking on investment projects. 

As long as the 'economy is expected to operate with a degree of spare capacity for some time' (in the RBA's own words), institutional investors should have an overweight in some of the richly valued defensives that have strong earnings predictability.  Based on Evidente's proprietary earnings predictability scores, stocks that have ranked highly on this measure have outperformed significantly since 2011, coinciding with the peak in global commodity prices (see chart).  Other stocks that rank strongly on Evidente's earnings predictability measure include: ASX, Ramsey Healthcare, AGL, Amcor and Coca Cola Amatil.

Investors have now digested the major banks' capital raisings, but expect EPSg to revert to low single digits

At the sector level, banks continued to dominate the reporting season, with CBA being the last major to announce a capital raise (a rights issue of $5 billion).  Certainly significant considering that they reported a full year after tax net profit of $9 billion.  Encouragingly, the lift in bad & doubtful debts announced by ANZ in the prior week (citing renewed risks in agriculture and mining) does not seem to have been shared by either NAB or CBA. 

Given that the bad & doubtful debt cycle is likely to have troughed, EPS growth for the sector is likely to revert to low single digits, consistent with growth in nominal GDP.  This was reflected in CBA's growth of 5% in NPAT for the full year.  Balance sheets across corporate Australia in aggregate, remain in excellent shape.  But pockets of stress pose risks to the majors, particularly low and declining yields for commercial property, which continue to be characterised by rising vacancy rates, particularly in Perth and Brisbane. 

Upside to EPS growth is limited and the sector is trading on multiples that are at the high end of historical norms, suggesting limited scope for valuation expansion.  Nonetheless, I continue to recommend that investors have a small overweight position in the sector due to sustainably high payout ratios and strong predictability of earnings.  Higher capital requirements will dilute their ROEs but the banks have the flexibility to eke out more efficiency gains and drive their already low cost to income ratios even lower.  Stronger capital buffers will also help the banks to better cope with adverse exogenous shocks, such as renewed weakness in property markets.

Macro-prudential measures to curb credit growth to housing investors - Avoid REA

The ongoing strength in residential property markets in Sydney and Melbourne helped Realestate.com (REA) to report a 24% lift in NPAT for the full year.  The CEO's presentation slides highlighted the penetration of premium listing products, investment in high growth markets and boasted the size and engagement of its audience.  The CEO also devoted no less than three slides to that old chestnut, innovation.

But there was no mention of the two key macro drivers of the stock: turnover of the housing stock (which governs listings) and new lending commitments (the two are strongly correlated).   House lending has been on an upward trend for the past three years, lifting from 14% to 18% of the stock of housing credit, underpinned by lending to investors, while lending to owner-occupiers has stagnated (see chart). 

The key risk going forward is that lending to investors slows as the lift in investor lending rates and more stringent LVR restrictions take effect.  The RBA and APRA are clearly determined to engineer a moderation in credit growth to this segment to sub-10%.  Lending to owner-occupiers is likely to pick up the slack only if the majors loosen their LVR restrictions to this segment (unlikely) or the RBA eases policy again (likely, but not for a while).  In the meantime, expect growth in total lending commitments to slow and turnover in the housing stock to plateau or decline.  To achieve growth in listings in these conditions, REA will need to win market share from Domain, which could spark renewed price competition.  Investors should avoid REA while this dynamic plays out. 

Ansell: The dark side of global diversification

The earnings torpedo delivered by rubber glove and condom manufacturer Ansell last week highlights the dark side of global diversification.  Investors - who marked down the stock by 16% on the day of the result - clearly didn't believe the CEO, who cited adverse currency moves, currency hedging gone wrong and disappointing economic performances in many key developed and emerging markets.  The Chanticleer column in the Australian Financial Review wrote an excellent piece this week on the poor performance of a number of complex, multi-national businesses, with assets located in multiple jurisdictions, including Ansell, Orica, QBE and NAB.  The poor returns from ASX listed global conglomerates demonstrate just how difficult these businesses are to manage for Australian based CEOs. 

Evidente has updated its model of firm complexity, based on five factors, including product diversity and geographical dispersion.   According to the model, the most complex stocks include: Seek.com, Qantas, Worley Parsons, AMP and Computershare (Ansell ranks in the top quartile of complexity).  If history is any guide, the risk is that these stocks can invariably deliver earnings torpedos, particularly for those that have poor quality management and weak governance structures in place. 

Dear Banker, Please do not mess with Mr Stevens

During the reporting season, Evidente will be providing regular updates of the key themes emerging from company announcements, as well as communications from the government and central bank.

In a busy week for macro news flow, the RBA decided to leave its policy rate unchanged, as was widely expected. In the statement accompanying the decision and the recently released quarterly Statement of Monetary Policy, the RBA confirms that headwinds facing the outlook are likely to persist and that the economy is expected to operate with a degree of spare capacity for some time yet. 

Of course, those monitoring the macro data flow would know that the economy has been operating at well below full capacity for some time already.  The fact that underlying inflation remains at the bottom end of the RBA's target range of 2-3% (and is probably undershooting the target by a long way when upside measurement bias in the CPI is taken into account) and private sector wages are growing at their most sluggish rate since the late 1990s confirms that the economy continues to suffer from a shortfall in aggregate demand.

It should therefore come as little surprise that sectors offering a high earnings certainty and sustainably high payout ratios have delivered above market returns over the past three years.  Consequently, the infrastructure, healthcare, telecommunications and bank sectors are trading on high multiples by historical standards, despite low growth prospects (except for healthcare).

If Mr Stevens is correct that aggregate demand will continue to be deficient (which I think he is), from a portfolio construction perspective, there is little reason to be underweight these sectors despite their rich valuations.  

Of these sectors, the one that continues to polarise opinion amongst portfolio managers is the banks, particularly following the past week in which the sector has shed 7%.  But I expect the renewed price weakness following ANZ's capital raising to be short lived.  The release of APRA's discussion paper a month ago - suggesting that the majors should add around 200 basis points of CET1 capital from their June 2014 levels - was timely and the majors have been astute in being proactive in getting ahead of the curve. 

The pessimists argue that being forced to use more equity in their liability mix will dilute banks' ROEs and undermine their ability to maintain high payout ratios.  However, higher capital buffers reduce the risk profile of the banks, and previous work I have done shows that conservative capital structures encourage banks to have higher payout ratios (see chart below and Evidente's blog post from November 12th 2014). 

Without the ongoing tailwind of lower bad & doubtful debt charges, the strong out-performance of recent years is unlikely to continue.  But I recommend having a small overweight bet in the majors due to the sector's strong dividend sustainability and ability for the banks to surprise the market on cost control.  For those unconvinced, any further price weakness on the back of what I consider to be misplaced concerns about higher capital requirements should be viewed as a buying opportunity.

Global investors have largely missed out on the bank sector's outperformance of recent years, based on their view that Australia's major banks are trading on rich book multiples relative to their global peers.  But those high book multiples persist thanks to high risk adjusted ROEs.  Moreover, based on proprietary work, I estimate that the majors have managed to hold onto the market share gained from the shadow banking sector during the financial crisis.  In contrast, shadow banks in other countries have regained the market share they ceded in the crisis.

Don't mess with Mr Stevens

Indeed, two developments in the past week ought to provide a cautionary tale for investors in shadow banks listed on the ASX.  First, Westpac announced that they would no longer provide funding to payday lenders, including Cash Converters (CCV) and Money3 (MNY).  Second, the outgoing Suncorp CEO acknowledged that when he commenced his role in 2009, Mr Glenn Stevens told him in no uncertain terms how he expected Suncorp to behave (presumably in terms of lending practices and risk taking activities more broadly).

A key lesson stemming from the financial crisis was that prudential regulators need to more carefully monitor the size and activities of shadow banks.  In order to check growth in non-regulated financial institutions, the RBA and APRA are likely to put pressure on the major banks to limit their funding of shadow banks.  Those shadow banks will have little choice but to tap investors for additional equity capital.  This process could potentially end in tears for shareholders, particularly as the regulators are determined to ensure that the aggregate market share of shadow banks in Australia does not recover to pre-crisis levels.  Evidente will shortly be releasing a detailed report on the outlook for ASX listed shadow banks.

The less cautious consumer: Good news for discretionary retailers

The only domestic cyclical sector that I continue to recommend an overweight position in is discretionary retailers, due to their exposure to a less cautious consumer (see Evidente's blog post from May 29th 2015). 

The June retail trade release confirmed that low interest rates and the wealth effect from rising house values are encouraging households to lift spending, particularly in light of the 2.2% lift in spending on household goods.  The modest decline in department store sales suggests that this sector remains structurally challenged, with David Jones and Myers responding with the announcement of strategic and workplace changes designed to adapt their offering to evolving consumer tastes.  The renewed depreciation in the Australian dollar could be a godsend to Myers, as it might encourage some of the global department store chains which opened stores in Australia at a time when the Australian dollar was significantly higher - including Zara and H&M - to exit the country in due course. 

RIO - Don't throw the baby out with the bathwater

Finally, RIO's interim result was well received by the market.  I remain comfortable maintaining an overweight in the stock, despite the prospect of renewed weakness in iron ore prices (Evidente's research report on 10th July contains more detail: Iron ore - Don't throw the baby out with the bath water).  Previous episodes of stagnant commodity prices have been associated with strong market returns from RIO, suggesting that at present, the market continues to under-estimate the company's ability to control operating costs, reduce capex and lift dividends (see chart). 

Monetary policy no villain

There is a widespread view among financial market participants that attributes much of the world economy's ills to irresponsibly loose monetary policy.  Many central banks have reached their zero lower bound and been there for a while, and pursued unconventional policies such as quantitative easing and forward guidance, designed to kick-start the psychology of risk taking.  But the headwinds facing the global economy have been far stronger and persistent than many had anticipated.

The RBA has not had to resort to such measures and although the cash rate of 2% is anchored at multi-decade lows, it remains among the highest official interest rates across advanced economies.  The interbank futures market assigns a probability of less than 10% that the RBA will cut the cash rate at the August board meeting.  In recent communications, RBA Governor, Mr Glenn Stevens, has highlighted his view that financial conditions remain accommodative and that the central bank will continue to monitor the effects of interest rate cuts in February and May.

Mr Stevens has speculated recently that Australia's growth speed limit might have declined due to slower population growth and that this might have also contributed to the stability in the unemployment rate.  Estimating potential growth or the structural unemployment rate is a notoriously difficult exercise.  But with private sector wages growing at their slowest rate since the late 1990s and underlying inflation anchored in the bottom half of the RBA's target range of 2-3%, it is hard to mount a case that the economy is hitting up against its speed limit.  Indeed, Mr Stevens himself has previously observed that the economy could do with more demand growth.  It is therefore reasonable to expect that there ought to be an easing bias, even if the RBA has not formally adopted one since cutting interest rates in May. 

For institutional investors, the outlook for monetary policy in Australia is likely to remain a sideshow to other macro themes, notably what the spill-over effects will be of the turmoil in China's stock markets, and the prospect of a lift in the US Federal Funds rate.  Nonetheless, investors will continue to field questions from those concerned that low interest rates in Australia run the risk of stoking speculative bubble in residential property markets, in high yielding stocks and encourage firms to lift payout ratios, thus under-investing for future growth.

Some of these concerns remain largely misplaced.  First, low interest rates have led to a lift in dwelling investment, which has been desirable given the mining and energy sector CAPEX cliffs.  But supply side constraints in the major cities - thanks to onerous regulatory restrictions on new high-rise developments - have also contributed to higher prices.

Second, high yielding stocks haven't actually out-performed.  Low beta stocks - many of which have strong earnings predictability - have delivered strong returns and are trading on higher multiples than historical norms.  But this has less to do with low interest rates and more to do with the fact that the risk premium has increased, as investors remain reluctant to take on too much risk.

Third, the sweep of the past 25 years shows that there the aggregate payout ratio is well within historical norms, despite the RBA official cash rate being at its lowest level over this period.  In fact, the chart below highlights five periods in the past 25 years where the aggregate payout ratio has peaked at levels above the current rate of 75% (see chart).  In previous blog posts, I attribute the rise in the payout ratio since the financial crisis to a loss of trust in CEOs' abilities to undertake value accretive growth projects and acquisitions.  Moreover, in a world awash with excess capacity and suffering from deficient demand, what incentive do CEOs have to undertake large growth projects?

Interbank futures are right to not expect the RBA to cut interest rates at the August board meeting.  But if the economy is still suffering from a shortfall in aggregate demand by year end (my expectation) there will be a growing chorus for further monetary stimulus.  APRA seems to be doing a good job of jawboning the banks to continue to lift the amount of equity capital in their liability mix, thus giving the RBA more scope to ease policy without stoking a property bubble.  The jawboning and other macro-prudential measures adopted by APRA have already led to a lift in lending rates for housing investors across the major banks in the past month.

A salute to corporate Australia

Many global investors have eschewed Australian stocks from their portfolios for a while now.  The high Australian dollar, sensitivity to the slowdown in China's growth and the attendant decline in commodity prices, the fact that the major banks continue to trade on higher multiples than their global peers and growing concerns of a bubble in Australia's residential property markets (particularly Sydney and Melbourne) have conspired to keep cautious global investors on the sidelines.

But the resilience of Australia's corporate sector has confounded most global investors.  Aggregate profitability has not declined over the past five years, despite the significant macro headwinds that have curtailed top-line growth.  Let's not gloss over just how severe the terms of trade shock has been; not only is the RBA's Commodity Price Index one third lower than five years ago, but the value of the Australian dollar relative to the US dollar has declined by only 10% over this time (see chart). 

Corporate Australia has responded admirably by  trimming costs aggressively, restructuring, divesting under-performing assets that have been peripheral to their core focus, and deferring capital spending where feasible.  No sector has remained untouched, including banks, mining, energy, telcos and retailing. Of course, the macroeconomic consequences of this belt tightening has led to a shortfall in aggregate demand, but that's a problem for the RBA to address, not corporate Australia.

Various measures of Australia wide corporate profitability show that there has been little change over the past five years, including the National Accounts measure of Gross Operating Surplus or forecast EPS for the ASX200 companies.  Consequently, forecast EPS remains one-quarter lower than the pre-crisis peak and has significantly lagged forecast EPS for the S&P500 companies, which is 20% higher than its pre-crisis peak.  But US companies have not had to deal with a large terms of trade shock and the Federal Reserve has been more determined to stimulate growth than the RBA. 

Given that forecast EPS for the ASX200 has remained stagnant for the past five years, multiple expansion has driven the market higher, with the 12 month prospective PE lifting to 15x from 11.5x (see chart). 

A decomposition of forecast EPS shows that balance sheet growth has slowed, and that the profitability or ROE achieved on the net asset base has deteriorated to 12% (see chart).

On face value, the important role that multiple expansion has played in the past five years does not point to an optimistic outlook for stocks.  The PE ratio of 15x suggests that there is limited upside from further multiple expansion.  In other words, it appears that earnings expansion will need to drive the market higher going forward.

But when we turn our focus to dividends, the picture changes somewhat.  I am a firm believer that sector analysts over-estimate the control that a company's CEO has over a stock's performance because there are so many factors that shape a stock's returns that are beyond the CEO's control.  But there is one key variable that a CEO and CFO can control; payout policy.  Many companies have increasingly catered to investors' insatiable appetite for income in recent years by lifting payout ratios.

At a time when expected profitability has stagnated, forecast dividends have grown by over one-quarter in the past five years.  Consequently, the payout ratio for the ASX200 companies has lifted to a ten year high of 75% (see chart).  I believe that this forms an integral part of the quiet revolution in corporate governance, because companies disgorging cash to shareholders reduces the conflicts of interest that exist between shareholders and managers (see my post from last week). 

Some - including the RBA Governor - have bemoaned the absence of entrepreneurial risk taking among Australian companies and implored the corporate sector to invest for growth.  But at a time when the world economy is still awash with excess capacity and revenue conditions remain anaemic, why would companies invest in projects at or below their cost of capital?  Fortunately, the corporate sector has done the sensible thing and returned capital back to shareholders.

A focus on dividends helps to re-cast the market's rise in the past five years.  The 25% growth in expected dividends means that the aggregate DPS is now approaching the pre-crisis peak.  Compare this with forecast EPS, which remains 25% below its pre-crisis peak.  Indeed, dividend expansion has actually been the dominant driver of the higher market since the dividend multiple has remained broadly steady at around 20x (see chart).  In other words, the prospective dividend yield has hovered around 5%.

The key risk to the market in the near term therefore lies in bank sector dividends and the highly concentrated nature of dividends paid.  Dividend concentration has increased since 2007, with the top 10 dividend payers generating 60% of total dividends paid by ASX listed companies, up from 43% in 2007 (see chart).  As APRA continues to lift capital requirements, bankers will no doubt cry wolf that these measures will dilute their ROEs and reduce their ability to sustain current high payout ratios.  But in previous work I have published, I show that banks with more equity capital actually pay higher dividends because they are safer.  More generally, I believe that the aggregate payout ratio will continue to increase despite already being at a 10 year high of 75%, particularly as companies continue to find innovative ways to free up cash.

To more recent events - Good news for value stocks

Finally, in the past week, two stocks have bounced: Pacific Brands which revised its profit guidance higher, and Kathmandu, on that announcement that Briscoe, a NZ based retailer would be lodging a takeover offer.  In mid-June, I spoke to a number of portfolio managers about discretionary retailers and drew their attention to a chart for the stocks in their sector which plots their P/B ratios against their consensus ROE expectations.  At the time, there were three value traps that lay well below the regression line: KMD, PBG and MYR (see chart).

I have updated the chart (see below) and it is noteworthy that despite the fact that both KMD and PBG have re-rated since mid-June, they remain well below the line, suggesting that there could be more upside.  It also remains to be seen whether investors will now start to re-assess whether the risk-reward trade-off has improved for other stocks long considered to be value traps, notably MYR.