The Wrap: BoJ’s Dilemma; Insurers; Travel Stocks & Bonds

This story features WEB TRAVEL GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: WEB

The company is included in ASX200, ASX300 and ALL-ORDS

Weekly Broker Wrap: BoJ's ETF dilemma; travels stock resurgence, young people shun PHI, bond yield tantrum on the cards, positive outlook for insurers' premiums, and green steel

-Are we facing a bond market tantrum? What are the potential consequences?
-Optimism growing for travel stocks, with Webjet favoured over Flight Centre
-Public debate: what should be the BoJ's strategy in the Japanese stock market?
-UBS sees margins bottoming for local insurers
-Green steel: great in concept, a lot trickier in practice

By Mark Story

Bond yields: Is there a full-blown tantrum brewing?

With global bond yields having risen sharply over recent weeks to become more in line with fair value, Oxford Economics speculates whether what started as a benign correction could evolve into a tantrum with wider consequences. Based on in-house modelling of a severe market scenario, US GDP would be -1% lower by 2022, and world GDP would be down by -0.5%.

US yields have risen by around 60bps in recent weeks, due to a surge in the term premium, indicating heightened uncertainty about growth and inflation prospects. The rise in the term premium has been similar to that which drove the “taper tantrum” sell-off in 2013.

Various factors, including the 2013 “taper tantrum” yield surge, coupled with the realisation that yields appear to have been well below equilibrium levels when the surge started, suggest to Oxford Economics the rise in yields could have further to run.

While a further increase in US yields of 50bps-70bps is seen as not out of the question, Oxford Economics suspects yields would also be likely to rise in other economies, and especially large increases are possible in some emerging markets.

For example, the experience of recent bond sell-offs suggests Europe and Asia tend to see a rise in yields of about 50bps for every 100bps increase in US yields. However, rises in emerging market yields tend to be as large, or somewhat larger, than that of US yields.

Oxford Economics forecasts in January saw US 10-year yields reaching 1.56% by the end of the year (lower than where we are now), from 0.9% at the end of 2020. But the rise in yields has come much faster than the forecaster anticipated. This is important because sudden yield surges are more likely to have disruptive effects on financial markets, such as inducing leveraged investors to sell.

The net effect of rising yields through increases to borrowing costs can directly impact growth. Then there’s the indirect impact caused by a potential sell-off in stocks globally, by diverting capital away from emerging economies, and by inducing fiscal tightening in some economies.

As well as stock market weakness, Oxford Economics believes rising US yields could cause capital flows to EM to dry up. This would magnify the impact on borrowing costs, weaken currencies (a potential problem for dollar debtors) and by driving up the US dollar, weaken commodity prices – again hitting emerging markets in particular.

The Oxford Global Model simulates a scenario in which the current sell-off evolves into a full-blown bond market tantrum. Term premia would rise back to 2013 “taper tantrum” levels, causing equity prices to fall and financial conditions to tighten.

The economic impact would be far worse if rising yields led to a tightening of fiscal policy. But the forecaster thinks this is unlikely due to rising yields having limited near-term impacts on debt servicing costs for most governments. Oxford Economics also notes while a limited economic impact is generally good news, bond holders would need to recognise that central bankers may have more tolerance for rising yields in this environment of expansionary fiscal policy.

Overall, while the forecaster still thinks the implications of a sustained rise in yields are limited for the economy, there are clear implications for bond investors. Total returns on US 10-year yields have already plunged to – 9% year on year in recent weeks.

The more worrying point, adds the forecaster, is the absence of any guarantee that central bankers will come to fixed income investors’ rescue any time soon, if they remain resolutely focused on the economy and the apparent lack of an inflationary threat.

Travel: Reopening’s drive recovery for Webjet and Flight Centre

With green shoots of recovery now emerging in the travel industry, Goldman Sachs assumes international travel recovery starts from mid-2021, with economies like the UK/US taking the lead, with a further strengthening over 2022.

On a pre-crisis basis (2019), direct travel spend represented around 3% of global GDP and in excess of 10.3% on an indirect basis (including job creation through related services, economic impacts in the regions). However, in 2020 direct spending reduced to around 1.7% of global GDP. According to Euromonitor, global travel spending in 2020 declined by circa -44%.

While vaccinations will help with recovery, the International Air Transport Assocation expects airline sales to return to only around 54% of 2019 levels in 2021. However, in a relative sense, IATA expects North America to see a faster recovery, with 2021 airline industry revenue forecast to be around 61% of that in 2019.

The key hurdle for the travel sector at this stage is the government-imposed restrictions. While many countries have lifted these restrictions, Goldman Sachs notes the quarantine requirements make both leisure and business travel difficult both from cost and time perspectives.

The chief medical officer in Australia commented these restrictions are likely to remain in place till the end of 2021. However, more recent comments from the federal government suggest July reopening, initially through travel hubs, such as New Zealand and Singapore.

Meantime, the broker believes that while progress on vaccinations, and possible variant outbreaks, will be the key risk to reopening programs, concerns of further flare-ups could ease significantly faster if herd immunity is achieved ahead of expectations.

While Goldman expects the covid-19 impact on the leisure market to be largely temporary, the broker sees greater uncertainty on the corporate travel market as some prior demand is likely to be adequately substituted by remote working trends.

Given the highly uncertain environment, the broker believes balance sheet strength and buffer capital to sustain through a downturn are the most important factors to watch for in a travel-exposed stock. The relative valuation pre and post-covid for individual companies, and versus the market in general, is the next key factor in Goldman's valuation framework for the travel-related stocks.

As the number two bed bank globally and Australia’s leading domestic Online Travel Agent (OTA), Goldman Sachs believes Webjet ((WEB)) looks well-placed to be a structural beneficiary of the travel recovery. Given that Webjet’s OTA profitability was already one of the strongest among competitors prior to covid, the broker expect this to improve as activity levels return to normal.

Goldman forecasts Webjet to post an earnings (EBITDA) compound annual growth (CAGR) of 9.5% over FY19-24, and believes the company’s OTA business offers a balanced exposure to the domestic-led recovery and anticipates it will maintain a strong balance sheet.

Earnings per share (EPS) are however forecast by the broker to see a CAGR decline of -6.3% over the same period, largely as a result of the capital raise incurred in FY20. But underlying net profit CAGR forecast by Goldman is 13.7% over FY19-24. As a result, the broker initiates coverage with a Buy and a 12-month target price of $7.36 but does not expect dividends to resume till FY23.

In the meantime, while Fight Centre ((FLT)) has higher risks from exposure to international recovery in the short term, Goldman Sachs believes the company is likely to emerge post-covid with improved profitability. The broker sees major balance sheet risks for Fight Centre and initiates coverage with a Neutral rating and a price target of $20 (dividends resuming from FY24).

While Fight Centre had already started implementing strategic changes to curb cost growth, and improve focus on other business models like digital commerce, home based (independent) agents and corporate travel, the pandemic led-reset accelerated this transformation. For example, consistent with the transition to online sales, Flight Centre has already announced the closure of a significant proportion of shop fronts, guided at over 40% in A&NZ and over 50% of stores globally.

In the short term, the broker expects the corporate sector to outweigh the leisure sector for Flight Centre due to exposure to essential clients, plus the heavy exposure to domestic travel, unlike leisure where 75% of total transaction value (TTV) exposure comes from international bookings.

Since the onset of the covid crisis, Flight Centre has raised around -$900m in capital, -$200m of debt facilities, -$400m via a convertible note issue and -GBP115m via a UK-based loan.

Flight Centre had cash on hand of $1.3bn at the end of December 2020, and assuming a simple monthly cash burn of -$76m (-$71m of operating expenses, -$2m of capital expenditure and -$3m of variable costs) in line with management guidance, implies a runway of over 17 months.

However, Goldman Sachs expects cash burn to be at a slower pace as domestic activity picks up in each region. The broker also remains comfortable with Flight Centre's balance sheet position to sustain through the period of the downturn and into full recovery.

BoJ: Confront huge stockholding headache

The Bank of Japan has come under mounting criticism for the distorting effects on market pricing and corporate governance resulting from the continued expansion of its exchange traded funds (ETF) purchase program, which since 2010 has seen the central bank become the largest holder of Japanese stocks. While unrealised profits on the bank’s ETF holdings fell to JPY0.3trn in March 2020, the market rebound since then has seen profits soar to an estimated at JPY15.8tn last month.

Since the BoJ started to invest in ETFs ten years ago the market value of its ETF holdings reached JPY40.5tn or 6.6% of the market capitalisation of the first section of the Tokyo stock exchange in September 2020. Since then, purchases have continued and the BoJ is now the largest holder of Japanese stocks exceeding the Government Pension Investment Fund.

Critics have argued the BoJ’s ETF purchases are damaging price discovery by propping up stock market. This criticism has only intensified in the wake of the robust stock market recovery in recent months. Critics have also taken aim at the distortive effects on the pricing of individual stocks, which the BoJ has addressed by revising its operational procedures

For example, in 2016 the bank raised purchases of ETFs tracking the TOPIX as a share of total purchase by reducing the share of purchases of ETFs tracking the Nikkei 225, to make its operations more market neutral. Then in 2018, to address criticism that its operations could add squeeze market liquidity, the BoJ modified its stock selection benchmarks to account for the actual market availability of individual stocks rather than simply focusing on the listing’s share of market capitalisation.

The rising share of the BoJ as an owner of individual stocks has also invited criticism about the possible distortive effect on corporate governance. One market analyst estimated the number of companies the BoJ indirectly owns is over 5% of total stocks, or close to 400 at the end of October 2020.

Another rising concern is that ever-increasing ETF holdings have made the BoJ’s balance sheet more vulnerable to stock price volatility. To address this issue, Oxford Economics expects the central bank to reduce the pace of purchases by dropping the target amount and limiting buying to market downturns.

Unless the stock market falls into a serious downturn, these changes would effectively reduce the pace of ETF purchases. Compared to bond holdings, Oxford Economics suspects shifting ETFs off the bank’s balance sheet, without risking market disruption will be challenging.

Given the already significant size of ETF holdings and the associated risks, market participants and economists are now discussing a possible exit strategy, especially how to shed ETFs from the BoJ’s balance sheet without having a negative impact on the stock market.

Despite speculation about the exit strategy, including sales to individual investors or government investment funds, Oxford Economics expects the BoJ to remain silent. Meantime, BoJ Governor Kuroda is firmly sticking to his position that discussion on exit policy is premature.

The exit policy for ETF holdings is particularly tricky because, unlike bonds, stocks have no inherent expectation of redemption at maturity. Oxford Economics also notes redistributing unrealised gains or losses and risks in its ETF holdings will be contingent on unpredictable markets and require politically sensitive decisions.

But even if the pace of the BoJ’s ETF purchases is effectively reduced at its next policy meeting, Oxford Economics notes the size of its ETF holdings will continue to expand, making the bank more vulnerable to market risks and the future exit policy more difficult.

[Late news: the BoJ is expected to announce it will cease purchasing more ETFs other than in times of market turmoil when it concludes its March policy meeting today.]

Australian Healthcare: Deteriorating value to see more younger lives exit PHI

The portion of private hospital insurance (PHI) claims contributing to the risk equalisation (RE) pool, now at 30-year highs (47.1%), reinforces the value gap for younger/healthier customers, as the average health of the pool deteriorates. As a result, Macquarie forecasts Medibank Private ((MPL)) to remain a payer to the risk equalisation pool, and nib Holdings ((NHF)) to continue selecting better risks faster than their customers’ age.

The broker suspects the deteriorating value may accelerate younger lives leaving the system. While young people claim less, their premium rate growth reflects the increase in market claims due to fund's inability to risk rate lower premium rate volatility. Hence as risk equalisation (acting like reinsurance) increases, claims volatility and premium rate rises reduce across the market, and as of 1 April 2021 premium rate increases will be the lowest in 20 years.

Macquarie notes a strong correlation between Medibank’s average policyholder age versus peers and the RE benefits it has been receiving. Continuing this trend, the broker estimates Medibank could contribute around -$11m to the RE pool in FY22 given the ongoing mix shift towards the younger AHM brand.

Meantime on the flipside, nib Holdings normalisation of policyholder age to industry averages is being outpaced by the insurer's ability to attract better risks. As a result, Macquarie forecasts nib's contributions to stay at a consistent percentage of total claims.

Macquarie’s analysis shows that while nib's average policyholder age is converging with industry averages, the insurer's ability to attract better risks is more than offsetting the aging of the book. The broker is forecasting nib's ratio of RE contributions as a portion of total claims to revert back to pre-covid-19 trends.

The broker maintains Neutral recommendations on both Medibank Private and nib Holdings, with price targets of $2.80 and $5.45, respectively.

General Insurers: the road to recovery

A period of elevated catastrophe claims, plus a decrease in bond yields, and a drying up of reserve releases have all taken their toll on domestic insurers, which have witnessed their underlying insurance margins fall to historically low levels. Adding the sector’s woes was the unique industry capital event in the name of covid-19 which also left insurers directly impacted by the need to provision for Business Interruption (BI) exposure.

However, while industry data suggest a slowing of premium rate increases in Australia, UBS expect premium rates to accelerate again in 2021 especially in property lines (home and commercial). While the road to recovery remains gradual for the insurers currently trading at price to earnings ratios well below recent years, UBS expects the sector’s share prices to recover once the market gains confidence in the margin recovery.

Having analysed the key drivers of the margin outlook for Insurance Australia Group ((IAG)) and Suncorp Group ((SUN)), UBS concludes that margins – which suffered due to the unique covid-19 and lockdown environment – have likely bottomed in 1H21.

IAG and Suncorp’s underlying insurance margins are at their lowest levels in over ten years, with industry losses from recent weather events and BI claims pushing reported margins down even further. However, the broker expects recovery from these levels over coming periods with upside risk, should company initiatives be delivered.

Excluding any further significant covid-19 disruption, UBS expects premium rate increases in Australian commercial lines and Australian home to be maintained or increased further over 2021. The broker also expects the large step-up in margins to come through in 2H22 and FY23, with upside risk if each of the insurers deliver on cost initiatives; achieve higher than expected premium rates; and if bond yields recover from current low levels.

IAG’s margin headwind in recent years has only been around 50bps. UBS’s base assumptions have IAG delivering on its 15-17% underlying margin target by FY23.

The broker’s forecasts result in Suncorp falling almost -100bps below the bottom of management's 10-12% target. In the last two years the increase in Suncorp's natural hazard allowance has been a -230bps headwind in the underlying insurance margin. The company also incurred higher reinsurance costs through the purchase of additional cover, bringing the insurance margin headwind to closer to -300bps.

Having concluded that IAG’s target doesn’t appear overly ambitious, UBS suspects the company may not go as hard as Suncorp on premium rates in outer years in order to attract volume. But if Suncorp is to achieve the middle or upper end of its target range, the broker also suspects the operating environment would likely see IAG deliver above the top of their target.

IAG has provisioned $1.24bn (pre-tax) for potential business interruption claims, which is equivalent to a large natural peril event, without any reinsurance recovery. While there is a view that IAG has been impacted by more than its market share due to wording issues above its peers, UBS suspects this could still be an industry event of $2bn to $4bn, similar to the most costly natural peril events experience in Australia.

UBS maintains a Buy rating on both stocks, with a preference for IAG, due to the share price underperforming the ASX200 by over -30% over the last 12 months. Suncorp is currently trading around a -25% price to earnings discount to the ASX200, the low end of its -10-25% discount in the last ten years.

The broker’s earnings forecasts sit -5-7% below consensus for IAG and -5-10% below for Suncorp. For Insurance Australia Group, UBS’s revenue and insurance margin is only slightly below consensus.

Green Steel: Technically possible, economically challenging

With steel accounting for around 7% of global greenhouse gas emissions, there’s been a heightened search for alternative production methods like "green steel" to reduce the global carbon footprint. While there is no standard definition for "green steel" it’s generally described as steel that has been produced with a -90%-plus reduction in emissions intensity, versus the business as usual case today.

While green steel is technically possible, it relies on low-cost renewable power and cheap hydrogen. But given that replacing coke (coal) in the blast furnace with hydrogen (to act as an iron ore reducing agent) isn’t technically possible, the only technology approaching commercial scale to produce steel from iron ore, at very low emissions, is H2-DRI/EF (which comprises fully electrolytic hydrogen-based direct reduced iron).

DRI uses either natural gas or coal to reduce iron ore. The initial step for steel makers is to convert DRI facilities to a hydrogen-based processes. The benefit of H2-DRI is it replaces all or part of the natural gas consumption with hydrogen, cutting up to -90% of the emissions.

However, the trouble with H2-DRI/EF is cost and supply. DRI plants typically use an electric furnace to produce steel and are run on high-grade iron ore pellets. But only about a quarter of global iron ore supply is in pellet form.

As a result, JP Morgan notes a significant investment in the iron ore mining industry would be required for the H2-DRI/EF route to become the solution long term.

While Greenfield capex for H2-DRI/EF is comparable to a blast furnace at $1,000-1,500/t, operating costs are around 25% ($90/t) higher at $2/kg hydrogen. JP Morgan suggests this could be (partly) overcome with green steel price premiums and carbon prices. But this assumes consumers are willing to pay a little more for products with a low carbon footprint.

It’s understood the current momentum in the EU, where announced projects target circa 15Mt of green steel by 2030, could displace around -3% of seaborne met coal consumption. While this isn’t yet material, JP Morgan notes that when combined with rising scrap steel availability and ESG pressure, it could start to shape portfolio decisions for miners.

JP Morgan estimates the cost to replace current (1.35bt) blast furnace production is -US$2.4trn, which is the key deployment hurdle. Overall, in the absence of high carbon prices/green premiums, the broker expects hydrogen-based steel to likely help feed new demand, rather than replace current supply of around 1.9bt.

It’s worth noting that new developments are constantly being brought to market. For example, in 2019 Primetals Technology announced it had developed the world’s first direct reduction process that could use iron ore concentrates from beneficiated ore.

A pilot plant is due for commissioning in the first half 2021 and should run its first campaign this year. If successful, and proven at a commercial scale, JP Morgan believes it has potential to remove the requirement for a pellet plant, which would materially reduce the capital intensity for green steel.

Earlier this year, Fortescue Metals ((FMG)) announced plans to build a "green steel" pilot plant in the Pilbara. Currently, there is test work underway to trial two green steel technologies: replacing coal in a blast furnace with green hydrogen; and molten electrolysis of iron ore using renewable electricity.

It’s understood Fortescue plans to invest in green electricity, green hydrogen, and green ammonia projects through its wholly owned subsidiary, Fortescue Future Industries (FFI). While there are no time lines, Fortescue has a vision for 300GW of renewable power projects under the FFI vehicle, and has committed to contribute around 10% of net profit (NPAT) toward FFI projects.

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.

FNArena is proud about its track record and past achievements: Ten Years On

Click to view our Glossary of Financial Terms