05 August 2014
Themes for August

The Middle East and Ukraine remained the global flashpoints of conflict in August. In Gaza the war concluded with a ceasefire that so far has been holding, though the path to forging a lasting peace seems as elusive as ever. Elsewhere in the Middle East the emergence of Islamic State (IS) as a regional power continued as it consolidated its grip on a stretch of land straddling Iraq and Syria that is around the same size, and with roughly the same population, as Jordan. The US did however begin an aerial bombing campaign in Iraq that has halted its progress for the time being. The West will have to decide if it can stomach joining forces with Assad to bomb IS in Syria, as seems necessary if they are to be fully defeated.

In Ukraine Putin appeared to bolster rebel ranks with Russian troops and hardware, perhaps unnerved by the diminishing territory of the rebel forces. It seems likely that Putin is attempting to keep the region unstable so he can maintain influence, whilst also damaging the Ukrainian economy, thereby slowing or preventing any moves Ukraine might make towards the EU and NATO. Meanwhile Russia responded to more sanctions by cutting off imports of food produced by a few dozen countries, including Australia. Russia imports 43% of its food. Sanctions and counter-sanctions are starting to have a real economic impact outside Russia – Germany’s GDP unexpectedly contracted by an annualised 0.6% in the second quarter.

Macroeconomic news
In Australia we saw retail sales defy expectations of a post-budget slump – rising 0.4% in July, following a 0.6% increase in June. In addition business conditions and confidence are at the highest levels since early 2011. This increase seems at odds with the surprise jump in unemployment from 6.0% to 6.4%, and the decline in national income of 0.4% in 2013-14 after falling 1.6% in 2012-13. Presumably the increase in retail sales and business confidence can be explained by low rates and the property market, which is up over 10% over the last year. This has had the effect of stimulating more construction and home improvement, and also making households feel wealthier and therefore more willing to spend. However Australian wages failed to keep up with inflation for the first six months of the year, rising 2.6% compared to a 3% gain in the cost of living. In addition the terms of trade declined 4.1% in the June quarter, and were down 7.9% over the year. With household debt at a 25-year high and low competitiveness – it does seem that we are spending and borrowing beyond our means whilst the fundamentals of our economy continue to deteriorate.

The property market in China continues to decline with 76% of surveyed cities in July showing price declines, and all 10 of the biggest dropping. This appears to be spurring the Chinese to invest more in overseas property, with investment up 17% on a year earlier for the first six months of the year. Sydney and Melbourne are some of the most popular destinations for investment. Meanwhile imports from Australia were down 5.7% and the iron ore price continues to decline.

1408 Macroeconomic

In the U.S. the recovery continues its momentum with GDP posting a 4.2% annualised gain in the second quarter, after a 2.1% contraction in the first quarter. The ISM services index, which represents 80% of the US economy, rose to 58.7 – its highest point since 2005. Job openings increased to a seasonally adjusted 4.67 million in June, the highest level since February 2001. Payrolls added 209,000 jobs in July, the sixth month in a row that employment grew by 200,000 or more. That’s the first time that’s happened since 1997. Exports of consumer goods were the highest on record. Jobless claims is at the lowest level since 2006. The main area of concern in the U.S. remains the softening housing market, the Case-Schiller composite price index declined 0.3% in May, its first fall since Jan 2012. However overall the data remains very positive, I believe this will prompt the Fed to begin talking more seriously about raising rates within the next three months.

1408 Markets

Australian Equities
Reporting season concluded in Australia with 35% of companies beating expectations, compared to 24% of companies missing (and 41% in-line). Such a ratio is probably to be expected given the increasing prominence of the pre-reporting season confession sessions. Healthcare provided the biggest outperformance with a 6.8% beat, materials the biggest underperformance with a 3.9% miss. EPS growth came in just over 12% for 2014. However if you take out miners, which looks like a short-term bounce, you get to EPS growth of 9%. Take out financials and you get to earnings growth of 3% for industrials, which looks uninspiring. A significant portion of the EPS growth came from cost-out programs which may not be repeatable. EPS growth expectations for FY2015 are coming in around 5%.

Capital management was the major theme of the reporting season. There were $3.7bn of buybacks announced, and $1.5bn of expected equity raisings that did not happen. The biggest buybacks came from WES and TLS at $1bn, with CSL alluding to a similar-sized buyback to be announced at their AGM. SUN also pleased with a special div, and TLS raised its final div for the first time in seven years. Supporting this activity are strong cash-flows – analysts have revised up June 2014 and June 2015 free cash-flow estimates by an average of 2%. Driving the improved cash-flows are lower capex and cost-out. Large-caps such as WES, TLS, SUN, and WPL are paying out in excess of 90% of earnings. Whilst this is pleasing for shareholders who are desperate for income, you have to question the growth prospects for these companies when they are paying out so much. Glenn Stevens has been commenting on the lack of “animal spirits” in corporate Australia.

CBA reported a strong but largely in-line result. Impairment expense was +9% on the prior half, which is coming off record lows. This is an important number to watch. IAG and SUN delivered strong operating margins though revenue growth was lower than previous periods. QBE delivered negative revenue growth for the second consecutive period, though it is priced attractively and should benefit from eventual Fed rate rises and a buoyant US market. The capital-raising was well received. In the healthcare sector we saw strong results from Ramsay Healthcare, CSL and Cochlear. WES and WOW both reported good Food & Liquor results. WES managed a good result from its home improvements division whilst WOW did not – Masters produced a $169m loss in FY14. WES also benefitted from the sale of its insurance operations to IAG – allowing it to undertake capital management. BHP and RIO both demonstrated their capacity for cost-out in their results, with RIO ahead of expectations. Gold companies reported subdued earnings results as the gold price declined by 19% over FY14. TLS reported a solid FY2014 result with substantial cash generation, an increase in div, and a $1bn share off-market buyback. TLS has extra capital as a result of solid operating performance and recent divestments.

International Equities
In the U.S. 84% of companies beat consensus in the earnings season. In Europe 59% of earnings were a beat. Both numbers are in-line with the trend of the last decade. Notable U.S. beats this earnings season include Chevron, Sprint and Pfizer, while in Europe, Peugeot, Airbus and Merck were among the companies that surprised to the upside. The banking sector reported solid results, though litigation issues meant earnings estimates for 2014 were revised lower. There seems to be no cap on the fines that can be levied on banks as the regulators get to name their price, and no bank could risk an even temporary withdrawal from the U.S. financial system. Unfortunately none of these cases go to trial, which would give the public a chance to better understand what is occurring behind closed doors. Meanwhile it’s been a record year for health care mergers and acquisitions, with deals including Roche’s $8.3 billion acquisition of InterMune, and AbbVie’s $54 billion bid for Shire.

In media news 21st Century Fox (FOX) withdrew its proposal to acquire Time Warner (TWX), saying the owner of HBO has “refused to engage with us.” Murdoch indicated he would have paid up to $95 for TWX (vs the initial bid at $85), but that the reaction in FOX’s share price and TWX’s board has persuaded him to abandon the bid. I believe that Murdoch will likely come back at some point after the market has seen that there are no other bidders for TWX (now that it has been put in play). Meanwhile both FOX and TWX reported good numbers with FOX reporting revenues of $8.4bn +17% YoY, and income of $0.43 per share up from $0.42. They also announced a $6bn buyback. TWX unveiled a 10% rise in second quarter earnings to $850m.

Rates / FX / Commodities
More than half junk bonds are covenant-light for the first time in history, yet both speculators and bond managers have bought record amounts. There is no better example of how cheaply risk is being priced at present than the junk bond market which until recently was trading at record-low yields with massive issuance. This is, of course, the outcome of financial repression unleashed by the central banks. It does make the system increasingly sensitive to an exogenous shock, or indeed to the inevitable period when the central banks start reversing course. Meanwhile Eurozone inflation fell to a rate of 0.4% in July (vs expectations for no change at 0.5%). This was the weakest showing in nearly five years and the impetus for the ECB to take drastic action only increases with time.

Oil markets have been largely unmoved by recent geopolitical tensions due largely to the U.S. shale gas revolution. The U.S. has added more than 3 million barrels of oil a day since 2008, to its highest level of production in 27 years. This means that the linkage between geopolitical ructions and equity markets, via the energy markets, has been diminished. Meanwhile after a slight rebound in July iron ore prices resumed their decline in late August to finish over 10% lower. This comes as the expected contraction in Chinese ore production has yet to materialise at the levels that were forecast. The market remains in oversupply with the Australian majors planning further substantial increases.