Invast's 2013 Update On Carry Trading And Initial Impressions On Westpac

Invast Insights

Week Commencing November 11, 2013

www.invast.com.au | 1800 468 278

This week we look at the following topics:

1.0 Preview: Is the carry-trade alive and kicking?

2.0 Our takeout from the RBA decision

3.0 Our initial impressions on the Westpac result

4.0 Is Europe about to dive again?

5.0 Book review – Who moved my Cheese?

6.0 Weekly economic calendar


1.0 Preview: Is the carry-trade alive and kicking?

We are currently in the process of putting together a special report on the

whole concept of carry trading. The decision to write this section came from

client feedback, mainly those who attend our weekly seminars and webinars.

It is a very interesting topic and often overlooked. So we decided to

summarise the whole strategy from scratch, introduce how it can be

implemented and why it is so popular among global traders. We go through

some examples and also outline what type of market events can take place

which disrupt carry trades and can cause the tide to turn.

In anticipation of this report, click on the video image to the right which is

Vito Henjoto’s preview of the report.


2.0 Our takeout from the RBA decision

The decision to maintain interest rates at the November Reserve Bank of

Australia (RBA) meeting was no real surprise but the tone of the statement

did raise an eyebrow or two around the Invast office. The lead up to the

meeting carried ample positive economic data and an inflation reading of

1.2% for the quarter, something which we thought would have caused alarm

at the RBA. But the statement that accompanied the November meeting

sounded dovish and if anything brushed aside the single high inflation

number as perhaps a non recurring event. Very different to the way the RBA

overreacted to inflation in early 2009 going into the Global Financial Crisis.

Instead the RBA said “Recent data on prices show inflation consistent with the

medium-term target. The Bank's assessment is that this is likely to remain the

case over the next one to two years.” To us this suggests that the RBA is

prepared to see the inflation rate rise towards the top end of its band next


year before really worrying about it. The fact that the statement included one

to two years also implies that the current policy setting is here to stick around

for most of 2014, unless of course, things drastically improve. On the demand

front, RBA is still cautious on the pace of mining investment curtailing and the

full impact on GDP yet to flow through the numbers.

On growth the RBA said “In Australia, the economy has been growing a bit

below trend over the past year and the unemployment rate has edged higher.

This is likely to persist in the near term, as the economy adjusts to lower levels

of mining investment. Further ahead, private demand outside the mining

sector is expected to increase at a faster pace, though considerable

uncertainty surrounds this outlook.” We interpret this as saying that the RBA

still sees a fragile consumer, fragile building and housing numbers and a

mining and investment pipeline which doesn’t look like improving drastically

anytime soon, hence a possible GDP growth gap emerging over the next six

months or so.


With this in mind, the RBA doesn’t want to be caught asleep on the wheel particularly as the United States, Japan and Europe continue to pump cash into their economies. A reversal of interest rate policy by the RBA at this point in time will do nothing but artificially prop up the value of the Australia dollar and further weaken the fragile state of the broader services economy. To that point, the RBA continues to talk down the prospects of the A$ but it knows very well that talk is all that it can do, fighting a currency war is not something it intends to pursue beyond rhetoric. The statement notes “The Australian dollar, while below its level earlier in the year, is still uncomfortably high. A lower level of the exchange rate is likely to be needed to achieve balanced growth in the economy” – clearly obvious and lacking any threat of intervention.

The bottom line for us is that the RBA is unlikely to be shaken by inflation readings which print above expectations and is solely focused on the composition of economic growth within the economy. In terms of the unemployment rate, no real surprise with the rate of unemployment in Australia rising to 5.7% from what was an artificially unsustainable 5.6% level booked last month. The market was waiting for this number to better


reflect the jobs market and the 5.7% print was in line with market

expectations. We are a little surprised that it wasn't in fact higher, the

participation again steady at 64.8% which masks some of the truth behind

the state of the employment market. Composition was again not that positive

with full time employment down 27,900 and part time employment offsetting

that by gaining 28,900.

In terms of geographical composition, New South Wales fared poorly with the

rate of unemployment rising to 5.9%. This is in contrast with the 5.1% print

booked in January this year. Things may have really deteriorated in the

premier state. Things are still tough in South Australia where the rate has

risen to 6.6% - perhaps why the government is so sensitive around

compensation towards the car industry while there seems to be some early

signs of encouragement in Western Australia which saw its unemployment

rate dip to 4.3% from 4.6% - a beneficiary from the improvement in iron ore

prices over recent months.


3.0 Our initial impressions on the Westpac result

Westpac's cash earnings per share of 228.9 cents per share is one of the most important number and in line with consensus estimates. No surprise here. While earnings grew by 8% share dilution caused the per share estimate to rise by only 6% - again no big surprise but worth pointing out. The dividend is also solid but in line with expectations when considering the special component. We don't really dwell on the earnings number too much when banks report - the market usually gets a good idea of the bottom line throughout the year. What we do look for is the quality of composition - the difference between a good and bad number.

It’s good to see Westpac finally growing its top line - net interest income - the difference between incomes generated on loans and interest paid on deposits throughout the whole book. But the rate of growth is not excellent or worth popping champagne bottles about - a lacklustre 3% growth on the prior corresponding period of 4% growth in the second half compared to the first half.


The trend is improving but this leads to our core concern for the Australian

banks - where will net interest margins go in 2014? We have made the point in

the past that loan quality is solid among the Australian banks and even

through Westpac's 90 day arrears have risen slightly to 0.57% of risk weighted

loans over the half, this is still at a very low level.

Bottom line: We're more focused on loan pricing and the impact on Westpac

which will be the biggest loser in an all out price war on Australian residential

mortgages. As a completely domestic lending, residential home-loans

represent a greater proportion of Westpac's earnings when compared to its

peers. Net interest margins fell 2 basis points to 2.14% when compared to last

year but this is still a very good number.

There is scope for downside in Australia - perhaps sub 2% - and we think 2013

has so far been a low competition environment, regardless of what bank

bosses say. The market will like this result because it is clean and doesn't


contain any nasties but with Westpac trading on a price to earnings ratio of

around 15x this number - we're a little cautious on where margins are going

next year. Earnings have only grown by 6% on what has been a very good

year - 15x earnings on that measure is too high for us. We maintain

intentionally cautious and prefer ANZ.

4.0 Is Europe about to dive again? We ask Mike

The decision to cut interest rates by the ECB last week to 0.25% - a record low

– shows how desperate the situation has become. While many in the market

saw this as a surprise, we were warned in our daily morning meetings by one

of our most experienced staff members – Director of Institutional Sales, Mike

Moran – that the ECB cannot just sit on its hands. Mike has been trading

currencies since your author – Peter Esho – was in his diapers. He knows a

thing or two about market movements and the way key traders position

themselves into important announcements. Mike holds the view that many

large and experienced traders were positioning for Euro weakness going into


the meeting but not necessarily through the EURUSD cross itself which did

fall from above 1.35 to slightly below 1.33 in response to the announcement.

For the record, Mike’s top trade over the next few weeks is short EURAUD.

From a more fundamental point of view, Europe is still the one single issue

that keeps us up at night. While most of the problems were swept under the

carpet in 2012, the unemployment rate continues to spiral out of control. The

Germans have figured out that the ECB flooding the system with cash is the

only real solution – to inflate their way out of the mess – but the German

central bank and politicians must continue to talk down the prospects of this

operation in order to serve their own constituents and protect their capital

contribution to the ECB which is the largest from any single member.

It’s hard to see the ECB opt down and alternative route when the US Federal

Reserve, Bank of Japan, the Canadians and the rest of the developed world

maintain loose monetary policy with inflation on the backburner. The


ECB’s Mario Draghi might pump more cash into the system if the 0.25%

benchmark rate doesn’t help reduce unemployment in 2014. This comes at the

same time the Americans will be reconsidering their stimulus volume as stock

markets hit record high levels.

To put Europe’s problems in perspective, the 12.2% unemployment rate

booked this month is the highest level since the currency bloc was formed in

1999. October’s inflation read of 0.7% is miles away from the 2% ECB target

and so there is plenty of room to move on the monetary policy front. Fear of

runaway inflation is laughable at the ECB, they are only focused on one thing

and that is a competitive currency to help drive down the unemployment rate

which is not only a threat to the EU economy but also the social and political

fabric that holds the bloc together. We saw a glimpse of what can happen in

2012 when Italian and Spanish sovereign bond yields starting moving higher.

The chart below shows Italy’s unemployment rate trend which highlights the

problem in terms of trend. Keep in mind the runaway bond yield problems


and political fallout took place in 2012 – since then, the economic

environment has further deteriorated. Italy’s bond market is the third largest

in the world trailing the United States and Japan. Ten year bond yields have

remained flat at around 4- 5% for most of the year which is well below the 7%

plus seen in early 2012, but the economic trend is pointing towards more

uncertainty.


Image: Italy’s monthly unemployment rate sourced from www.tradingeconomics.com


We plan to explore the European situation in more detail over the coming

weeks. We aren’t alarmists or bearish on global markets at this stage but we

are keeping a very close eye on Europe and the desperation the ECB now

finds itself having to deal with. We remain overall very comfortable with the

pace of the global recovery and have recently pitched our view that resource

and cyclical stocks are one of the best places to be at the moment in the

Australian stock market, but the one thing that keeps us up at night is the

potential for Europe to re-enter the downward, self fulfilling spiral of fearing

in early 2014. For this reason, we wouldn’t be buying the EUR against any

major counter currency regardless of the bullish scenarios some may present.

Sometimes, it pays to be conservative.

5.0 Book review – Who moved my Cheese?

As readers of this publication would have realised by now, we like to think

differently and there is no doubt that many will chuckle at the title of this

week’s book review. It’s not a lengthy, business type book. In fact you could


probably read it within an hour but it will be one of the most important

books you read as an investor in trader because it is a book that deals with

change – change in fortune, change in circumstances and change in

conviction which in financial markets can make the difference between large

gains or losses.

The book is written as a parable and is fictional in nature, a clever setting by

its author Spencer Johnson who is well regarded for other similar titles. The

book has featured on the New York Times business bestseller many since its

release and remained on the list for almost five years. The key takeouts from

the book without giving the plot away are the following points:

• Change happens

• Anticipate change

• Monitor change

• Adapt to change quickly


• Change

• Enjoy change!

• Be ready to change quickly and enjoy it again!

The book has a three and a half star rating from 2,050 Amazon customer

reviews, but we would probably rate it at least a four star when taken in the

context of investment markets. For around A$15, it’s money well spent and

could even make a great Christmas present for friends or family.


6.0 Weekly economic calendar


Drop by our blog for more trading information.

http://blog.invast.com.au/




7.0 Disclaimer

Please note that you are receiving this report complimentary from Invast Financial Services Pty Ltd (AFSL 438 283). Invast staff members may from time to time purchase securities which are included in this or future reports. The authors of this report may or may not be holding a position in the securities mentioned. Please note that the information contained in this report and Invast's website is of a general nature only, and does not take into account your personal circumstances, financial situation or needs. You are strongly recommended to seek professional advice before opening an account with us.

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Invast's 2013 Update On Carry Trading And Initial Impressions On Westpac

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Transcript of Invast's 2013 Update On Carry Trading And Initial Impressions On Westpac