Australia | Sep 14 2022
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S&P conducted a webinar this week on inflation and the outlook for Australian sectors and companies, and we provide a round-up of the agency’s observations.
By Sarah Mills
One would suspect with such a title that S&P sees tough times ahead, but on examination, it appears to pertain more to a lack of clarity. And if there are tough times ahead, it does not appear to apply to Australia’s heavyweights.
Global and regional observations
No surprises here. All APAC countries are experiencing above-target inflation, including Australia.
In capital markets, the agency observes rising US yields are hitting sub-investment grade markets, as capital flees to safe-havens.
Inflation and interest rates in Oz
S&P examines the impact of rising interest rates and inflation on the energy and infrastructure sectors, retail and A-REITS and all up, this appears benign.
Most of the large companies in S&P’s universe are fairly resilient to rate rises, enjoying strong hedges.
While companies with non-discretionary demand such as utilities and supermarkets are best positioned to ride out rising inflation, to date demand for non-discretionary services is holding, thanks to low unemployment and elevated savings post covid.
This also partly reflects on the fact that most inflation has been recorded in food, household goods and energy.
Retail sales have recovered to pre-covid levels as have most travel metrics with discretionary annual spending growth growing at 5.5%.
S&P expects this will continue for the rest of 2022 and into early 2023 but expects rising rates and high prices should dampen consumer spending some time in the next 12 months.
The agency notes rising interest rates are also affecting short-term corporate debt profiles, with many seeking debt from banks, rather than accessing capital markets.
The reopening of European capital markets after the summer holidays is anticipated to be a key factor in determining whether this new trend is likely to hold.
S&P says its weighted portfolio is heavily weighted to non-discretionary retailers and niche consumer-facing or business service providers that are less impacted by waning consumer confidence.
Overall, the regulated utilities sector is the best placed of all the asset classes to weather inflation, says S&P, and most large companies across most sectors have decent protection against rate rises given they are reasonably well hedged, hence fairly well-protected in the near-term.
Supply Chains And Wages The Main Culprit
Supply-chain challenges, staff shortages and rising wages remain the major sore point for Australian companies and S&P expects this will continue.
While some pressure from staff shortages is likely to abate in 2023 as international travel returns (and to date minimum-wage rises are not outpacing broader inflation), S&P expects supply-chain issues will continue to dog the corporate sector.
The analyst expects the shift from “just-in-time” to “just in case” inventory management will continue to feature and will take some time to pan out.
S&P considers supermarkets will prove resilient to waning consumer confidence, albeit margins are likely to be crimped.
Most have adapted their sales mix to lower less-price sensitive items; strong bargaining power on the procurement side should serve them well over the next few years.
But rising rates and high prices are expected to weight on non-discretionary spending over the next 12 months, challenging apparel and consumer durables companies.
The agency has been taking rating action on apparel retailers with unsold inventory but notes dollar discounters are doing well.
S&P expects gas and thermal coal prices will remain strong for the next year or so, with thermal coal demand outpacing that for metallurgical coal, which is unusual.
The agency notes oil prices have retreated on inflation and growth concerns – particularly over China’s GDP and its fragile property sector.
So, even though prices have first risen, then fallen sharply this year, the agency continues to forecast a weaker price outlook, targeting a price of US$55/bbl in two years time.
It is noted the sector has taken advantage of the flush conditions to deleverage or fund capital expenditure, or both.
S&P has some kind words for Woodside Energy ((WDS)), having revised the company back to stable, expecting strong cash flows over the next couple of years should easily fund the company's capital expenditure demands.
One attendee asked if S&P would revisit Santos’ ((STO)) rating if it were to reduce its exposure to Papua New Guinea. The agency says PNG alone would not swing the pendulum and says Santos’ execution on the management and funding of its large capital expenditure pipeline, along with improving its credit profile, would be the main catalyst.
Mining and Metals
Like oil companies, mining and metals companies have used strong cash flows in the first quarter to deleverage balance sheets, and the agency considers they are well positioned to weather a downturn.
Prices are retreating, but S&P had already adjusted forecasts down, so no changes were forthcoming.
The analyst reiterates its expectations for strong copper prices given ongoing pressures of the green transition.
S&P describes the energy infrastructure sector, which is starting to recover from the pandemic, as “volatile and fragile” but notes it is fairly well protected from inflation, with most utilities enjoying some protection in contracts to pass through inflation, either through indexing, regulatory protection or rate increases.
While the sector is likely to experience some earnings imposts from rising interest rate and insurance costs, the agency considers it to be a long-term growth investment.
The outlook for coal and gas prices will be a key factor affecting the sector going forward and most have stretched balance sheets. Coal earnings are particularly at risk.
S&P notes government policy should continue to support large investment over the next five years. Governments remain keen to progress their green transitions despite plans to scale back other infrastructure project. Any delays to spending will prove a setback to the industry.
Airports, Tolls, Ports And Rail
S&P says airports face greater uncertainty than toll companies from the affects of inflation and rising interest rates on consumer demand.
Domestic travel is forecasts to remain strong.
The agency retains a stable outlook for airports and believes they should be able to fund “measured” capital expenditure.
Ports and rails are expected to continue to benefit from strong commodities prices and that rail in particular should continue to find support.
When it came to the AREITs, S&P says rising rates remain a risk to valuations, cash flow and credit quality but says its universe of AREIT issuers are well hedged with good debt profiles.
The agency notes 68% of debt is hedged and fixed for five years and this should mitigate risk. Well-spread debt profiles between fixed and floating debt should protect against the risk of near-term financing.
The analyst also notes tenants with leases in excess of five years constitute the bulk of leases.
S&P reports the office sector is starting to recover, with positive absorption levels being recorded in CBD properties.
Vacancies are forecast to remain elevated at 12% as new stock comes on board, but that this should moderate and improve as the supply dynamic improves thereafter.
S&P reports rising inquiries and demand for high-end and environmentally friendly buildings, particularly CBD stock, as corporates fly to quality ahead of the green transition.
It expects demand for flexible, sustainable “upstanding” workplaces in hybrid working environment will continue to drive the narrative.
Prime industrial assets remain well supported. Warehousing, transport and postal sectors constituted 60% of industrial leasing in the June quarter, and the analyst reports strong pent-up demand.
Nonetheless, the agency remains cautious, reporting that e-commerce tenants in North America are seeking to sublet space or negotiate lease terminations.
Retailing proved a mixed story, S&P noting an uptick in discretionary footfall and a slight rental “drop-off” in super prime city properties, with city indicators lagging.
Savings and disposable income are being directed to be discretionary and non-discretionary, but S&P expects higher interest rates are likely to come to bear in 2023.
All up, the analysts believes the non-discretionary retailers in its universe are well placed from a credit perspective to absorb the double whammy of inflation and higher interest rates.
But consumers are less likely to uphold strong spending patterns and this should hit non-rated players.
When it comes to the civil construction sector, commercial, big infrastructure and industrial construction companies have full pipelines and are performing well.
S&P says their ability to pass through costs of materials and stay within timelines (thereby avoiding costly delays) will be the differentiating factors.
The analyst notes most have enterprise bargaining agreements so not much wage inflation.
Their fixed-price contracting compares favourably to the residential construction sector, where several high-profile defaults were triggered by rising costs and supply-chain impacts.
S&P says the outlook for building materials suppliers remains bullish for 2023, pending the economic outlook and construction activity.
The NSW government is delaying major civil infrastructure projects given rising costs (green investments being the exception) but this is likely to provide a floor.
Mergers And Acquisitions
S&P expects mergers and acquisitions should continue in infrastructure and utilities over the next five years as the green transition continues apace.
Commodities deleveraging is also expected to support M&A. While the big players are likely to be digesting recent massive acquisitions, the analysts considers the junior miners to be ripe for takeover given the economic challenges.
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