The Weekly - Divorce and Marriage

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30/04/2018
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Last week markets were slightly spooked with the rise of bond yields in the US. The 10 year US Treasury bond breached the 3% threshold – a key psychological benchmark. This has consequently sparked fears that the Fed will act more aggressively with future rate rises to combat rising inflation. However, we do not see this as any indication that investors (including ourselves) should be fleeing from equity markets into the fixed income arena - bonds on the whole remain relatively unattractive, for now.

However, this is not to say that consideration shouldn’t be given to increasing exposure to fixed interest in due course. Last Thursday the US reported a fall in jobless claims, from an expected 230,000 to 209,000 – this is the lowest level since 1969. The US labour market is now very close to reaching full employment, and so the good news continues to roll in for Donald Trump’s economic policies. Love him or loath him, he certainly seems to be on a roll at the moment. However, all this positive data only increases concerns that the US has been overstimulated and consequently leaves little headroom for further improvements. Further interest rate rises combined with frothy stock markets may well make fixed interest an alluring asset class by the end of 2018.

Philip Hammond also had some cheer last week when it was announced by the Office of National Statistics (ONS) that the deficit had fallen further. There are some calls that due to these better than expected statistics the government should increase spending in other areas, such as the NHS. However, despite the deficit narrowing, our national debt is still increasing.  We borrowed £42.6 billion over the last financial year. Our national debt stands at almost £1.8 trillion (86% of GDP), or to put it another way; apportioned against the 65.5 million UK population, this equates to a debt of £27,480 per person. Furthermore, when just factoring in UK taxpayers the aforementioned figure is even higher. The UK government currently spends around £47 billion servicing this debt; this is more than we spend on education (£40 billion) and defence (£35.3 billion).  

While there are certainly valid arguments for increasing spending, the most prudent approach would be to wait until there has been some clarity over Brexit, unless of course additional taxes are raised - something the Conservatives will be reluctant to do. While nobody enjoys austerity, it would be foolhardy to discharge any ammunition (fiscal stimulus) when it might be needed further down the road, especially as UK growth collapsed to just 0.1% in the first quarter of 2018. Of course, being British, this was put down to the poor weather having a negative impact on sectors such as construction and infrastructure. However, this will dampen fears of an immediate UK rate rise by the Bank of England which have stimulated the UK stock market and dampened Sterling’s recent rise.

Thanks to an activist investor, Elliot Advisors, Whitbread has woken up to smell the coffee.  Alongside its set of preliminary annual results it announced the demerger and divorce of Costa coffee and Premier Inn hotels. This in our opinion has been long overdue; the synergies between both brands are limited – apart from maybe a few Costa Express vending machines gracing the lobby of a Premier Inn. This demerger is expected to create additional shareholder value, with Costa expected to have a market cap of between £2 billion and £3 billion, and Premier Inns expected to have a value of around £8 billion. Even after the recent uplift in the shares the current market cap (value) of Whitbread is £8 billion. However, this demerger is not expected to go ahead for at least 2 years, so investors need to be patient.

Unsurprisingly, Sainsbury’s was the largest riser in the FTSE this Monday, as news broke over the weekend that it is planning on getting hitched with Asda. This would create a supermarket behemoth, the largest on the UK high-street, which would leave Tesco with the second largest market share. In our view a shakeup of the UK supermarket sector has been long overdue since Aldi and Lidl entered the fray, however, is this right for both parties involved? The parent company of Asda is Walmart, the US retail corporation (the largest in the world on revenue terms). The merger will see Walmart holding 42% of the issued share capital of the combined business, as well as receiving £2.9 billion in cash. The latter will be funded by third party finance and, in time, replaced with longer term funding - the issuance of debt (bonds) presumably.

On the face of it, this looks like a good deal; both operate within the same sector so there will be some obvious beneficial synergies such as cost cutting, but we believe this deal is better for Walmart than Sainsbury’s. As well as maintaining a stake in the new business and receiving a sizable cash pay-out, Walmart will be able to exit a business that has no convenience stores and, through the merger, enter a business that does. Sainsbury’s has its local stores that currently compete with the likes of Tesco Express. In our opinion, this is where the battlefield for market share currently sits. The weekly supermarket shop and brand loyalty is a thing of the past; convenience and price are now what dominate this sector. This is why Lidl and Aldi have done so well, they have opened stores in convenient locations which stock little or few brands, at low cost and reasonable quality. Asda do not compete on any of the aforementioned fundamentals, apart from maybe price. In recent years Asda’s struggles have been well documented, and it could be argued that eventually it would succumb to the law of diminishing returns. However, this merger valued Asda at £7.3 billion, which should leave Walmart tapping their back pocket with Asda value. The benefit of this deal for Sainsbury’s is more difficult to see. 

UK GDP Disappoints. Rate Rise Unlikely

Last week saw the release of the latest economic growth figures from both the UK and the US. Domestic growth was particularly benign with weaker manufacturing growth, subdued consumer facing sectors and construction, which has fallen off a cliff in recent months, all contributing to a mediocre +0.1% growth figure. The response from the market was swift with Sterling pulling back sharply and the probability of the Bank of England hiking interest rates in May falling from 90.0% at the start of the week, to 25.0% at the end.

Despite slowing by 60 basis points (bps), US Q1’18 economic growth was far superior to our own. It rose by +2.3% which was ahead of expectations with the slowdown being attributed to seasonal issues and a moderation in business spending. Growth is expected to accelerate over the next few quarters as lower corporate and income taxes take effect. An increase in government spending should also help lift growth back towards an annualised rate of 3.0%.

With GDP data dominating the macro, last week also saw a significant number of corporate earnings figures released. 168 companies in the S&P500 reported although the US market had a largely uneventful week, closing out Friday just -0.1% lower. European equities were a mixed bag with the French CAC40 outperforming and the German DAX30 underperforming. Despite the weakness in headline economic growth, the FTSE100 posted solid gains for the week (+1.5%). With circa 80.0% of company earnings coming from overseas, the FTSE isn’t overly correlated with the happenings of the domestic economy.

One area of the market that was impacted by the weakness in UK GDP was gilts which experienced falling yields across the curve. With a rate hike next month now looking increasingly unlikely, two-year gilt yields dropped by 7 basis points on Friday alone to 0.805% which was the lowest level for 6 weeks. The 10-year gilt yield was down nearly 6 basis points to 1.454% with the Bank of England now unlikely to move on rates until later in the summer.

The Week Ahead

As ever, the first Friday of the month brings the latest non-farm payrolls data within the US Labour Report.  Forecasts suggest that payrolls will pick-up following a minor setback last month whilst the record-low unemployment rate of 4.1% could tick a further 10 basis points lower. All eyes though will be centred on wage growth as investors assess the outlook for inflation and the Federal Reserve’s rate rise intentions.  The Fed is scheduled to release a statement on Wednesday following its latest open market committee meeting where further monetary tightening is unlikely on this occasion but could signal a move in June.

On home soil, this week brings a fresh set of Purchasing Managers Index (PMI) readings to gauge business activity levels across the Services, Manufacturing and Construction sectors. Manufacturing continues to run at high levels but both Services and Construction suffered sharp drops in activity during a snow-hit March so this month’s data is expected to bounce back.