Weekly market review
Written and accurate as at: Feb 13, 2018 Current Stats & Facts
The S&P/ASX 300 fell -4.6% last week, dragged down by a surge in volatility in US equities. Stronger-than-expected wage inflation data provided the proximate cause of this episode, prompting a short-lived increase in bond yields on speculation that the Fed might raise rates faster than had been expected. However, the sell-off in Australian equities was broad-based and key bond-sensitive areas such as REITs (S&P/ASX 200 AREITs -3.7%) and infrastructure (eg Transurban (TCL) (-3.7%)) fared no worse than the index. Small caps slightly underperformed, with the Small Ordinaries off -5.3%.
There is ample evidence that many investors had bought into the long side of the low-volatility trade, with a plethora of often leveraged products emerging in recent years that allowed them to do so. Last week’s surge in volatility seems to have caught many of these products on the hop and the scramble to adjust and exit positions most likely exacerbated bouts of market weakness. The role of new, little-understood financial products in helping drive volatility may prompt some memories of the GFC; however in this instance there is little indication of major financial institutions holding significant amounts of these products on their balance sheets, reducing the chance of the systemic threat we saw in 2008.
As we have been saying for some time, Australian equity valuations were not looking stretched, given where interest rates lie. As a result, moves in the domestic market have been more muted than across the Pacific.
While market gyrations captured headlines, reporting season continued apace. Commonwealth Bank (CBA) (-5.6%) demonstrated decent momentum in its core business, with both revenue and underlying (pre-provision) profits rising around 5%, ahead of market expectations. The first issue CBA faces from here is the sustainability of this strength in core trends. We believe that while the tailwind of mortgage repricing is likely to recede, management still have some leeway to support earnings via cost reduction. However we are less sanguine over the second issue of regulatory uncertainty. Management made a $375m provision for potential charges related to the AUSTRAC investigation and $200m for additional legislation, although it is unclear whether this relates to the Royal Commission. At this point, we believe it is too early in the process to form a view on likely outcomes and as a result we remain cautious on the near-term outlook for CBA and for the bank sector more broadly. National Australia Bank’s (NAB) (-2.2%) trading update was well received by the market, however we believe that current positive trends will be difficult to maintain in the face of the significant investments flagged by management in H2. With a payout ratio in the 80s – compared to ANZ in the 60s – we believe that if the outcome of the Royal Commission does result in meaningful charges for the sector, then NAB’s dividend is far more vulnerable than its peers.
Elsewhere in financials AMP (AMP) (-1.3%) delivered earnings trends which were broadly in line with expectations, while being largely unexciting. The core superannuation platform business remains under margin pressure, offset to some extent by good growth in other areas such as its banking services. However, market expectations are hinged upon its strategy of asset sales and its ability to unlock shareholder value via the sale of lower return businesses.
Tabcorp (TAH) (-12.7%) downgraded earnings and missed expectations as it appears some of the synergies from its recent acquisition of Tatts will take longer than first thought to realise. Some of this was technical, as management took some of the costs associated with the old Tatts segment back above the line, however weakness in its core wagering business deserves further scrutiny. We believe the regulatory and competitive environment for TAH is improving and there is certainly the potential for significant extraction of synergies, however we will be keeping a close eye on the progress that management are making here.
AGL Energy’s (AGL) (-8.0%) result showed strong growth on the back of high wholesale energy prices. Our concern is that we are probably near a peak in wholesale prices, while competitive intensity is ramping up in its retail consumer business. The company – wary of government intervention – has also been proactively engaging retail customers to shift to lower-price contracts.
Strong commodity prices – in particularly for iron ore – saw Rio Tinto (RIO) (-1.8%) post a strong set of results. A surge in free cash flow is funding extensive capital management, with a commitment to further stock buybacks and a dividend set at an effective yield of 4.7%. Most analysts continue to use an iron ore price significantly below spot, so the stock remains cum-upgrade. However, the key takeaway is that management flagged the return of cost inflation, after several years of its absence. While this can be offset for the moment by cost-out programmes and sustained commodity prices strength, this is an inflection point of sorts in the cycle and, should we see a significant fall in commodity prices, does raise a vulnerability in that consensus cost expectations for the next few years are probably too low. For the moment, this issue appears contained, but it will be one to watch in coming halves.
There was little to quibble with the results from Carsales.com (CAR) (-8.2%) and REA Group (REA) (-2.0%), two of the ASX’s ‘growthier’ names, with core business trends remaining sound in both. The key question here is P/E, given that the small cohort of high growth names in the Australian market remains at a premium to its historical average.
Finally, Mirvac (MGR) (-2.4%) found the market somewhat sceptical of its ability to meet expectations for its residential business. Management are flagging the bulk of its apartment settlements to occur in the back half of this year, however many people are cautious given weaker trends in the housing market.