The Wrap: Rates, Bonds, AREITs, Power Price Misery

This story features VICINITY CENTRES, and other companies. For more info SHARE ANALYSIS: VCX

Weekly Broker Wrap: markets not reading central bankers well; global growth is flattening; AREITs and rising interest rates; the effect of high power prices on supermarkets and miners; merged AfterPay Touch in focus.

-Normalising is not tightening
-Global Growth – Flattening
-Back To Normal, And AREITs
-High Electricity Prices: From Supermarkets To Miners
-AfterPay Touch: In Focus

By Rudi Filapek-Vandyck

Normalising is not tightening

Central bankers are moving away from emergency settings, but investors are not understanding the message correctly, argue economists at Standard Life. The end of emergency does not equal the start of tightening and neither does it signal the end of the cycle is near.

Having said so, the post GFC-crisis has been more complex than the era before it and Standard Life admits even central bankers themselves are still trying to grapple with what exactly is happening under the bonnet of their economies and why, and what the impact is on interest rates and policy measures.

The underlying message remains the same, however, and that is that things are improving around the world, which is a positive. Meanwhile, markets and the Federal Reserve continue to see things a little differently when looking ahead and that, explains Standard Life, is due to the gap between "hope" and "experience".

"For much of the post-crisis period, expectations about policy normalisation have been confounded by events that have forced delays and even policy reversals. Once bitten twice shy, many market participants remain wary of the Fed's ability to deliver on its current guidance despite the three rate hikes since December and effective pre-announcement of balance sheet run-off, neither of which were anticipated this time last year."

Standard Life's prognostication remains for the Fed to start shrinking the balance sheet, most likely in September, and then maybe with a follow-up rate hike in December. For the whole of 2018 only two more hikes are anticipated, below the infamous dot plots communicated by the Fed and certainly below predictions of four hikes as put forward by more hawkish forecasters elsewhere.

****

Over in the UK, Standard Life's forecasts remain more cautious than those communicated by the Bank of England and the economists agree it appears the BoE may well be prepared to tighten policy before the UK exits the single market, even if its forecasts have not been met.

But Draghi's speech at the ECB forum on Central Banking in Sintra, Portugal, should not be interpreted as a more hawkish stance by the central bank that warrants significant market repricing. Standard Life observes financial markets are missing the point in that here is an evolving policy stance towards normalisation on display, not the advent of a new tightening phase.

Standard Life's view remains that the ECB asset purchase program will be wound down in stages from the beginning of 2018 with purchases ending by the end of the year. Extension is possible if conditions deteriorate significantly, say the economists.

Meanwhile in Japan, the Bank of Japan is expected to stick to its ultra-accommodative yield curve control (YCC) with Standard Life anticipating no change, probably for as far as the eye can see, but definitely throughout the remainder of calendar 2017. The only major market circuit breakes, speculate the economists, would be a significant rise in the US dollar-yen rate in the event of a gapping of real yield differentials.

All around Emerging Economies, Standard Life sees the same dynamic now in play. Policy rates, in real terms (adjusted for inflation), are still negative and given the recovery in economies, and tightness in labour markets, such extreme policy settings no longer seem appropriate. Here too a "normalisation process" is taking shape.

Standard Life's view was backed up by economists at National Australia Bank who concluded that, while advanced economy central bankers are looking to remove the proverbial 'punch bowl', "For the moment, near term rate hikes by these central bank are not in prospect, and in the case of the ECB and Riksbank QE programs are continuing for now, but the change in direction has had an effect on markets, reflected in a marked rise in 10 year government bond yields – across many countries – starting around late June."

***

There were no specific forecasts for the RBA cash rate in Australia in Standard Life's market update, but Pimco Managing Director Portfolio Manager, Robert Mead offered to fill the void during the week. Pimco's base case is for GDP growth to keep shugging along between 2-3% for the next 3-5 years, with inflation well contained in the 1.5%-2.5% range.

But complacency is not appropriate with Australian households' debt surging to well over 100% of GDP. This means, offers Mead, any changes to the supportive environment (read: China) could have major ramifications for the Australian economy. Pimco suggests any rate hike aspirations by the RBA will have to wait at least until "well into 2018".

Since the Federal Reserve is expected to continue hiking rates in the meantime, it is likely next year the RBA cash rate will end up below the US Fed funds rate, points out Mead.

Global Growth – Flattening

Economists at both National Australia Bank and ANZ Bank report that on forward looking indicators it appears the global economic upturn that started in 2016 and hit a bit of a speed bump in the past six months, is likely to decelerate in the second half of the year.

Says National Australia Bank: "Our leading indicator of global economic activity shows growth trending down rather than up through the latter half of the year, driven by two especially volatile components of the measure – the drop in industrial metals prices and a subsiding in air freight volume growth to more normal levels. Their volatility means it is too early to move away from our forecast that the global economic upturn continues, with growth lifting from 2016’s 3.1% to a predicted 3.3% this year and another rise to a trend-pace of 3.5% in 2018."

Says ANZ Bank: "The ANZ Global Economic Advance Reading (GEAR) Index, which is a composite index of financial conditions and liquidity, is foreshadowing an easing in our [Global Lead Index] GLI over 2H 2017. The GEAR is becoming less positive for global growth as the Fed is about to embark on balance sheet normalisation alongside further rate normalisation. In addition, other major central banks, with the exception of the BoJ, appear to be shifting away from explicit easing biases. In some cases the shift in policy bias is towards tightening."

Back To Normal, And A-REITs

What if? The question has been asked a few times by A-REIT sector specialists at Citi. What if everything were to revert back to normal? Meaning interest rates would have a lot higher to climb.

The impact on share prices for the REIT sector on the ASX would be quite devastating, on the analysts' calculations. In late May, Citi's analysis suggested potential share price downside of -25% on average. Since then, note the analysts, share prices have fallen by circa -9%.

The latter signals a whole lot more adjustment would need to happen in case of full normalisation to pre-GFC settings (which Citi is not forecasting).

Of more importance, however, is that Citi's research runs contrary to popular perception that under a scenario of interest rates normalisation, actively managed REITs should perform better than their passive peers. As the prior period of exceptionally low global interest rates and bond yields has primarily led to a bull market in asset values, it is Citi analysts' conclusion that this time the wheels will turn into the opposite directon, with passive funds to outperform the active ones.

As such, for investors who require exposure to the sector, and under the assumption the global normalisation has further to go, Citi's sector preferences are Vicinity Centres ((VCX)), Stockland ((SGP)) and Scentre Group ((SCG)); all are currently trading below normalised multiples, note the analysts, while the sector overall continues to trade at a premium.

Least liked are Mirvac ((MGR)) and Goodman Group (GMG)) and Dexus Property ((DXS)) respectively on perceived earnings downside risk and cyclically elevated multiples.

High Electricity Prices: From Supermarkets To Miners

A recent study by analysts at Morgan Stanley suggests Australia's experience with persistent food deflation might be coming to an end, despite both Coles ((WES)) and Woolworths ((WOW)), as well as key competitors Aldi and IGA ((MTS)), continuing to reduce prices.

The reason, states the report, is "significant cost inflation driven by electricity". Morgan Stanley reports electricity costs are expected to rise by some 40% in FY18 for one unnamed retailer. Suppliers to supermarkets have already begun lifting prices since July 1st for that same reason, states the report.

A different angle on the theme was provided by mining analysts at Goldman Sachs who believe power bills for the mining sector are set to increase significantly in coming years. While electricity remains a small component of costs -Goldman Sachs estimates it represent no more than.6.3% for the industry on average- rising power cost will nevertheless have an impact on profitability, predict the analysts.

Most at risk will be grid fed operations in Queensland and NSW, while self-generation companies, such as the WA iron ore miners, will have a bigger buffer, according to the report. The analysis indicates circa US$500m of annual power contracts are up for renegotiation between now and 2020 with futures markets pointing towards the potential of a 20-40% lift in contract rates.

Amongst the operations that are due for a power shock are gold mines such as Cowal ((EVN)) and Cadia ((NCM)) and coal assets such as Illawarra Coal ((S32)) & Narrabri ((WHC)). Companies that might have to temper earnings expectations for FY18 include Newcrest Mining, Evolution Mining, South32 and Whitehaven Coal.

AfterPay Touch: In Focus

Recently merged AfterPay Touch ((APT)) is attracting quite the bullish broker updates. Last week The Wrap included Bell Potter's positive assessment post merger (July 7). This week we picked up an update by Wilsons, with the report stating: "APT is not an easy business to value given the growth profile."

A quick look at the revised numbers instantly reveals the problem Wilsons had to struggle with: projected growth in earnings per share this year (FY17): 184.9%. For FY18: 455.1%. For FY19: 36.5%.

For those as yet unfamiliar with this company, Afterpay provides consumers with a short-term, deferred payments option, allowing them to 'buy now and pay later', usually in four increments. No interest is being charged. The Touch System Platform is cloud-based and enables the secure electronic delivery of non-physical products, services and entitlements, including vouchers, tickets and other tokens.

Wilsons has slapped a $3.95 price target on top of its Buy rating. The shares are trading near $3.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms