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Andrew Forrest and Nev Power are determined (they tell me) to make Fortescue the world’s lowest-cost producer of iron ore. They have no choice really: Fortescue is in the extremely uncomfortable position of being caught in the crossfire of BHP Billiton and Rio Tinto’s attempt to shut down the Chinese iron ore industry.
Whether this plan by the big two miners is a good idea or not, and whether it will work, is beside the point. It’s happening. Get used to it.
So that plan from CEO Nev Power to slash costs is a little bit encouraging, at least, for those who have been riding Fortescue down with Andrew (from $6 to less than $2 in a year). He and Nev are not in denial, which is something I guess, although they continue to insist that BHP and Rio are either stupid or colluding, or both, which may be true or not, but it doesn’t matter.
Fortescue and other higher-cost iron ore miners are fighting for survival under the output onslaught from BHP and Rio. Forrest says his balance sheet is OK, and he doesn’t have any debt repayments due any time soon – the problem is the cost base, which he’s now going to deal with. Fortescue’s cost per tonne must fall to $35 and he tells me Nev can do that. Good.
As for what’s going on in the market, the chart below shows that when the iron ore price fell in 2008, BHP, Rio and Vale cut production; when it fell more steadily from June 2011, Vale held production and BHP and Rio increased it.
Here’s another view, focusing only on the Australian producers, including Fortescue and the other smaller ones:
They are mainly going after the Chinese underground (therefore high-cost) miners, but the disappearance of Fortescue from the market would presumably be perfectly OK with them as well.
Here’s the global iron ore cost curve:
That graph’s a bit old now – the current price is not $US63, of course, it’s $US48. According to that chart, FMG is already underwater, although Andrew and Nev dispute that cost figure, saying their all-in costs are $US42 per tonne. The cut to $US35 requires $US7, or 17 per cent, off the costs – no easy task.
Some of those Chinese producers are apparently still producing iron ore for $US130 a tonne, would you believe, and virtually the entire industry in China is now losing money.
The burning question is: how long can they all keep going? Andrew and Nev reckon it’s basically forever because the Chinese Government is letting them off taxes and other charges. They might even be giving them straight subsidies – you just wouldn’t know.
I think it’s a fair bet they can keep going for quite a while, in which case any thought that iron ore supply will tighten this year, and possibly next, driving up the price, is optimistic. The risk to the price is on the downside.
If BHP and Rio decide to double up their bets, and not shut production even if the price gets down to break-even for them ($US35 or so) – that is, they decide to go into cash losses for a while to press home their siege of the Chinese miners – Fortescue might find that even if it’s the lowest-cost producer it’s still just breaking even or losing money, and it has fewer balance sheet resources with which to do that.
These are not good times to be invested in iron ore producers. They are now very definitely long-term investment propositions (remember that the definition of a long-term investment is a short-term one that didn’t work out).
The turnaround will come, but picking the bottom will be hard.
We lose two ways from the iron ore price war, maybe three. Most of us are invested to some extent in the big miners at least because of their size in the ASX indexes, and according to Chris Richardson of Access Economics, every $1 off the iron ore price cuts Government tax revenue by $300 million and national income, as measured by the Australian Bureau of Statistics, by $800 million.
Government expenditure was expanded between 2004 and 2008 when the iron ore price was booming and company tax revenue was beating forecasts every year; now that the iron ore price has collapsed, that expansion in spending and reduction in taxes has to be unwound or else the budget will stay in structural deficit, debt would get out of hand and governments would get thrown out every three years.
You simply can’t have stable politics and a growing economy with an endless structural deficit – just ask Italy and Greece.
Most of the increase in expenditure and tax cuts during the Howard/Rudd eras were focused on retirees and families (ie voters). The Age Pension means test was loosened and superannuation income was made tax-free for those over 60. There was also a series of giveaways for “families”.
The pre-budget leaks and hints so far suggest that the focus of the reversal of all this will be on retirees, probably not “families”, so brace yourselves, folks. I’m not sure what’s going to happen, but I’d say the pension means test will be tightened at the very least and there may be a means test put on tax-free post-60 withdrawals.
In fact there’s likely to be a full package of changes to retirement benefits. As Assistant Treasurer Josh Frydenberg said at the weekend: “… you can’t look at any of these individual issues in isolation. You have to look at the broader system and how the superannuation system impacts upon the pension and is affected by the tax system.”
Quite so. The problem is that last year’s efforts at holistic reform would lead one to conclude that this year’s could be another stuff up, but we’ll see. This time they seem to be negotiating quietly with the Senate first, so the Budget measures could be a fait accompli for once, instead of a set of political ambit claims.
Politicians monstering people in a committee hearing is a sure sign that they can’t actually do anything.
If Parliament (all parties and independents are united on this issue) was able to do something about Google, Apple, Microsoft etc shifting otherwise taxable income offshore, they would have done it already – they wouldn’t have called their quivering representatives into Parliament House and beaten them up for the cameras.
The reason I’m mentioning this today, by the way, is that it’s relevant for next month’s Federal Budget.
I think Treasurer Joe Hockey will announce something in the budget to deal with this problem, on which he will then base higher tax revenue forecasts across the forward estimates and let himself off the hook a bit.
It will make the budget look better, and remove the need for some of the less popular measures he would otherwise have to do, but it won’t work. Google, Apple, Microsoft, Facebook etc will not pay more tax in Australia, beyond token donations to get everyone off their backs.
The fact is, although these companies are avoiding tax, it’s not tax avoidance, and is unlikely to be caught by Part 4A (the anti tax avoidance provisions), even if that’s expanded.
Companies are able to shift profits because tax is levied at the place where a contract is executed and there is a maze of bilateral tax agreements between countries to ensure firms are not taxed twice – where they operate and at home.
You don’t even need to be a digital business to take advantage of this: if, as Rio Tinto seems to be doing, you sell Australian iron ore on contracts signed in Singapore, you pay Singapore tax. That’s the deal.
If you’re digital, it’s even easier: Google’s servers actually deliver content and ads into Australia from Ireland, or Singapore, or Timbuktu. They certainly don’t have to be here: in effect it’s an import business that doesn’t need a distribution arm in Australia – the “product” can be delivered from somewhere else.
All countries’ tax laws are based on where a firm has a “permanent establishment”, which is now proving to be outdated in the new digital world.
The OECD has been working on a project called Base Erosion and Profit Shifting (BEPS) for a while, with “deliverables” due this year.
British Prime Minister David Cameron got sick of waiting and introduced the “diverted profits tax”, more commonly known as the Google Tax, from April 1.
Basically it gives government officers the power to determine that profits are being diverted and to whack a 25 per cent tax on them. That legislation is heading straight to the courts for testing.
A variation of this, I think, is what Joe Hockey will announce next month in the budget. He might call it the “Cameron Google Tax”, just to make sure everyone understands it’s not his idea if it doesn’t work.
I’m not in favour of profit shifting, but I’d simply observe that although Singapore’s company tax rate is less than ours (17 per cent) they do tax these companies and the revenue is material, to them.
Singapore needs the money, in fact, and they have an agreement with us that ensures they get to keep it, and companies that operate in both places are not taxed twice. If we tax them, we’ll be breaking that agreement and they potentially won’t get the revenue, which would be upsetting for them.
Maybe we don’t care about that, and fair enough. It’s only a small place without a navy. But we’d certainly care if China decided to start taxing Rio Tinto and BHP’s profits because they are selling iron ore in China.
After all, that’s what Google is doing: exporting digital pictures created in Singapore, or Ireland or wherever, into Australia.
So Australia’s, and the UK’s, diverted profits tax will not stand up in the High Court, in my view, which means the revenue forecasts that Hockey includes in the budget from it will be spurious.
Just my two bobs worth.
While iron ore is the most relevant commodity to us, for the rest of the world it’s oil. That makes it relevant to us as well.
Last night in New York the oil price gained nearly 2 per cent to more than $US53 and finished the week with a gain of 5 per cent, its fourth consecutive weekly rise.
But as with iron ore, I believe the risks to the oil price are mainly on the downside, although that’s not to ignore the real risk that a war could erupt in the Middle East at any time that would lead to the opposite result.
The key downward pressure on the price is obviously the rapprochement between the US and Iran and the prospect that sanctions will be lifted. That would significantly increase the global oil glut.
In the meantime, Saudi Oil Minister Ali al-Naimi revealed on Tuesday that Saudi Arabian production had increased 700,000 barrels a day between February and March, to 10.3 million barrels – the biggest increase in production since November 2011.
It’s worth remembering what happened between the Arab-Israel conflict of 1973, called the Yom Kippur War, and the election of Ronald Reagan in 1980, immediately preceded as it was by the appointment of Paul Volcker as chairman of the Federal Reserve in August 1979.
Before the Yom Kippur War, oil was $US3 a barrel. After the war, it was $US12. After the Shah of Iran was overthrown in January 1979 and replaced by anti-Western theocracy the oil price jumped to $US39.50.
These events caused a profound economic shock. Inflation reached double digits around the world and central banks everywhere responded by raising interest rates – none more so than the US Fed, now under the control of the then sprightly 52-year-old Paul Volcker.
Volcker raised US rates to their highest level in history, crunched inflation and kicked off a 20-year bull market in equities that ended in 2000 with the collapse of the dotcom bubble. The subsequent bear market lasted nine years.
What we are seeing now is the reverse of the negative shocks between 1973 and 1980.
The fracking revolution in the US and decline of Chinese growth saw the price halve between July 2014 and January 2015. Since then it has stayed at around $US50.
If the sanctions against Iran are lifted, which now seems likely, there would probably be another big leg down in the price. The lowest prediction I’ve seen is from an American analyst named A. Gary Shilling who said $US10-$US20 per barrel would be needed to cause major producers to “chicken out” and slash output.
Here’s his article in Bloomberg from February but the lowdown is that $US10-$US20 a barrel is the marginal cost of production for both the US shale producers and the Persian Gulf producers.
“It's the price at which cash flow for an additional barrel falls to zero,” he wrote. So that’s what it would need to get to for them to capitulate.
Against that, it feels like the simmering, age-old conflict between the Shi’ites and the Sunnis could explode at any moment into a full-scale war between Saudi Arabia (Sunni) and Iran (Shi’ite), in which case the oil price could shoot back up to $US100 before you could say “fracking hell!”
Germany and Greece
I’m going to Germany next week and Greece the week after (with a weekend in between in London with daughter Alice and her beloved pom, Henry).
Hopefully I can knock some sense into the Germans and Greeks and bring them together around a table – tough job, I know, but someone’s got to do it.
In between such high-level diplomacy I will write to you from Nuremberg, where I’ll be next Friday, and Athens a week later, but the emails are likely to be somewhat truncated (no readings & viewings).
Seriously, I’m attending the Hannover technology fair next week and visiting a few factories in Germany and then doing a series of interviews with business people, economists and politicians in Athens, to get a sense of where that place is heading.
I’ll report back on my findings.
I wrote a piece on the tussle for shiraz supremacy between Hill of Grace and Penfolds Grange, and the history of the wonderful Henschke family, for Business Spectator during the week and in response I got an email from Peter Jackson of Winestate Magazine offering 10 free tickets to a big tasting he’s running in Adelaide on May 29th.
I can’t get there, but he’s agreed I can offer them to you: the first 10 people to write to me at email@example.com will get a ticket.
They’re worth $50 each and there’ll be tastings of 500 wines, so it should be a great night. If you live in Adelaide or feel like a weekend there, get on it!
Bellamy’s Organic and NetComm Wireless
There are two interesting CEO interviews this week:
The first is with Laura McBain of Bellamy’s Organic -- you can watch and read the interview here. Laura joined the business as its accountant when it was still a family company back in 2006. It was bought by a group of Tasmanian investors and then floated last August at $1 and is now $2.76. The business started off doing just baby formula, and now produces a range of foods for ages six months to three years, with a solid foothold in China. It’s a well-run business, with a clear export strategy into China and a growth plan to move further up the ages for children’s food.
The second is with David Stewart of NetComm Wireless -- you can watch and read the interview here. David founded a firm called Banksia Technology in 1988 and merged that business with NetComm in 1996, after which he became MD of the merged business. He is in the process of transitioning the business from internet modems for people to supply gear for what’s called M2M – machine to machine communication. As he explains in the interview, the reason that’s a better business is that there are 7.1 billion people on the planet, but at least 50 billion machines – more customers! Simon Dumaresq likes this company and has a target price of 70c (it’s currently 62.5c, having gone up from 45c since his last note). Here’s his most recent update and his last substantial note on the company.
Steve, our cat of eight years, passed away peacefully last night, claimed by a lymphatic sarcoma. He’s been a beloved member of the family, and we’ll miss him.
Readings & Viewings
Very sad to hear of the passing of Richie Benaud yesterday. Like a lot of people, it feels like he’s been a part of my whole life. Here’s the MARVELLOUS ad he did for lamb.
And here’s the beautiful video he did for Boxing Day last year with his wife Daphne around his home in Coogee (where I used to live too!).
Why the bull market could continue for another year.
Excellent paper from the Centre for Independent Studies on Australia’s tax concessions, if you’re interested in getting stuck right into it.
Barrie Cassidy: The anger generated by Wednesday's Senate committee hearings into corporate tax avoidance makes the government's budget and political challenges that much harder.
Michelle Grattan: The wild west presents yet another taxing issue for Hockey and Abbott.
Rob Burgess on the politics of pension and super reform.
Michael Kroger and Sinclair Davidson on this subject and taxes generally on Andrew Bolt’s TV shows.
Here’s a PDF on the UK diverted profits tax if you want to get ahead of the game (Joe Hockey’s game, that is).
And if you’re really a glutton for punishment, here’s the Hansard from that day when Google etc appeared before the Senate committee and got monstered.
Robert Reich: the rich have bought America’s silence.
Nouriel Roubini: signs of life in the eurozone.
How Greece can make it through 2015.
Greece is not the only country facing severe economic challenges.
A new white paper has warned that financial advice may be disrupted by the digital revolution in the same way as music was.
I don’t know if you’ve heard about the Trowbridge report into life insurance, which recommended the abolition of commissions for life insurance agents. Well, it’s been met with shock and outrage from said life agents, as you might expect, but where are the alternatives, asks this piece.
This video clearly and simply explains what all the hoo-ha about graphene is about. It’s the new hot investment topic and it’s pretty jolly interesting!
Globalisation and technology have gutted the labour movement, and part-time work is sabotaging solidarity, but workers won’t unite. Why not?
Ben Bernanke, unchained, takes on Larry Summers over “secular stagnation”.
Summers responds: I hope you’re right but…
But who, exactly, is Ben Bernanke arguing with?
The killing of Walter Scott sheds light on the problem of police lying.
Actually it wasn’t a coincidence – America was built on racism.
The UK election: Ed Miliband could still win. Here’s what would happen next…
They’ve got mechanical drones flying and navigating themselves using an “artificial bee brain”.
Using paracetemol for lower back pain may actually be harmful.
There’s a hairy skyscraper going up in Stockholm.
Sharp piece on gay marriage by the always excellent Taki.
Funny comedy sketch about Top Gear, in the wake of Jeremy Clarkson’s sacking.
I agree with this: Game of Thrones is breathtaking television. It leaves the rest behind.
Mind you, my favourite TV show at the moment is Veep. Here’s a sample (VP stands for Viagra Prohibitor)
Joni Mitchell was admitted to hospital last week, but she seems to be OK. Here’s someone’s opinion about her 10 best songs. I agree with most of them, although I might have added Court and Spark (the song, not the album, although … the whole thing is a masterpiece).
And here’s Court and Spark. Beautiful.
By Shane Oliver, AMP
Investment markets and key developments over the past week
Shares had a good run over the last week helped by continued okay economic data, M&A activity and confirmation from the Fed that its more likely to raise rates in September than June. Chinese shares continued to push higher but shares in Hong Kong are now starting to play catch up driven by mainland Chinese investors. Bond yields were mixed – up in Australia and the US as the overreaction to the weak US payroll report was reversed, but flat to down in Europe. Commodity prices were little changed and while the $US moved up again the $A pushed back above $US0.77 partly in response to the RBA leaving interest rates on hold.
From China to Hong Kong. After Chinese mainland (or A) shares rocketed up 90 per cent since mid-last year, Chinese residents are now taking advantage of the Shanghai-Hong Kong Connect arrangement (that enables investors on either stock exchange to buy shares in the other) to buy up relatively cheap Hong Kong shares. So far this month the Hong Kong share market is up 8 per cent and H shares (ie mainland Chinese companies listed in HK) are up 11 per cent. So the boom is spreading from mainland China to Hong Kong. We think both have further to go but value is clearly better in Hong Kong with Hong Kong shares on a forward PE of 11.5 times, H shares on 8.3 times and mainland shares on 13.6 times.
Shell’s acquisition of BG coming on the back of a long list of deals in the US over the last year or so highlights that M&A mania is clearly back. This is an inevitable result of companies being cashed up after strong profit gains and able to borrow very cheaply. It’s also showing up in rapidly rising dividends. M&A mania is often a sign of the sort of euphoria we see around major market tops, but other indicators are sending the opposite signal. For example individual investors are still pulling money out of equity funds in the US and believe it or not putting it into bond funds, which is not the sort of think you see at major share market tops. Likewise, investor sentiment measures are running around the middle of their normal ranges.
The Reserve Bank didn’t exactly surprise, but did disappoint, by leaving interest rates on hold yet again. It didn’t provide an explanation for not cutting – after all why should it! – so one can only guess. Maybe it wants more data including the March quarter CPI due later this month. Maybe it’s still worried about the property market. Or maybe it just wants to stretch the process out feeling it’s not yet ready to signal sub 2 per cent interest rates but wants to retain an easing bias to keep downwards pressure on the $A and so had to keep the cash rate at 2.25 per cent for now. Whatever the reason our assessment remains that the RBA will have to act on its easing bias as the blow to national income from the falling iron ore price has intensified, this along with a poor investment outlook is pointing to continued sub-par growth and ongoing spare capacity, inflation remains benign and the $A is still too high. A loss of momentum in investor housing lending is likely also providing the RBA with more flexibility. So we expect the cash rate to fall to 2 per cent in May with a strong possibility rates will fall below that later this year.
Major global economic events and implications
US economic data was a bit light on but showed continued strength in the ISM non-manufacturing conditions index, another solid gain in job openings in February to their highest since 2001 and while jobless claims rose they are trending around very low levels. The job openings and claims data provides confidence that weak employment growth in March was more due to poor weather as opposed to a renewed fundamental deterioration in the economy. Meanwhile, the minutes from the Fed’s last meeting provided no surprises and simply confirmed the more dovish stance taken at that meeting. There is now plenty of acknowledgement from the Fed of the dampening role being played by the strong $US. While some at the Fed seem to still be leaning towards a first rate hike in June, the majority looks to be focussed on September.
eurozone retail sales fell slightly in February but at 3 per cent year on year are running at their strongest pace in around 10 years. Although Greece has yet to unlock funding from the eurozone, it made a scheduled payment to the IMF and the issue continues to have little impact on the rest of Europe.
While the Bank of Japan left monetary policy unchanged, pressure for further easing is likely to mount in the months ahead as the boost to prices from the sales tax hike in April last year drops out of annual inflation data which will see headline inflation head back to around 0.5 per cent year on year, ie well short of the 2 per cent target. Meanwhile, a stronger than expected gain in the Eco Watchers confidence survey, further gains in machine tool orders and a continuing downtrend in Tokyo office vacancies suggest that modest economic growth is continuing.
Chinese inflation in March was a bit higher than expected, but at 1.4 per cent year on year or 0.9 per cent year on year excluding food it remains very low. Producer prices are also continuing to deflate being down 4.6 per cent over the past year. This remains consistent with more monetary easing ahead.
Australian economic events and implications
Australian economic data was mixed with a stronger than expected gain in February retail sales, but a fall in ANZ job ads, a weaker services sector conditions PMI for March and a smaller than expected gain in housing finance in February coming on the back of a sharp fall in January. The latter may be a welcome sign for the RBA as investor finance fell 3 per cent and is showing signs of falling momentum. In fact, with investor housing credit at 10.1 per cent over the year to February its quiet likely that APRA has had a word with some lenders forcing them to slow down and this may explain the recent loss of momentum.
By Craig James, CommSec
Employment will be the key focus for markets & policymakers
The Reserve Bank will take a step back in the coming week after the prominence it held over the past week with its interest rate decision. But another big week of economic events is in prospect in Australia over the coming week, including key data on the labour market. In China, economic growth, trade and sales figures are in focus. And in the US, retail sales, inflation and the Fed Beige Book are due. Investors will also spend time dissecting earnings results.
In Australia, the week kicks off on Monday when the Reserve Bank releases February data on credit and debit card lending. Consumers are using credit cards more often but paying off outstanding balances by the due date.
On Tuesday the NAB business survey is released alongside broader lending finance data – covering personal, business, housing and lease loans. Investors will be looking for improvement in the NAB business survey after the February results suggested that business confidence had slipped to a 19-month low. In addition, despite the low interest rate environment around two-thirds of firms surveyed reported not requiring additional credit. It is pretty clear that the rate cut in February didn’t have the desired impact on confidence and it may just be another reason why the Reserve Bank held off in cutting interest rates on Tuesday.
On Wednesday, the Westpac/Melbourne Institute monthly measure of consumer sentiment is released – a survey that provides a useful check on the similar and timelier Roy Morgan weekly survey (released Tuesday). Also the ABS will release figures on dwelling commencements in the December quarter.
On Thursday, the ABS releases the latest job data for March. The statement following the Reserve Bank decision to keep interest rate on hold, highlighted that domestic demand remained “quite weak” – and was a key driver of the underlying lift in unemployment over the past year. Interestingly jobs growth has been mixed over the early part of 2015 although the unemployment rate has eased modestly.
After rising by 15,600 in February, we think employment rose by around 20,000 people in March. And with a steady participation rate (workers in work or looking for work – expectation 64.6 per cent) the unemployment rate was probably steady at 6.3 per cent.
If employment surpasses our forecast and unemployment falls towards 6 per cent, then questions would arise if the much anticipated May rate cut is needed. Clearly it would take more than one month’s worth of data to signify a trend but there has been a solid lift in jobs growth in recent months. The key question is if the pace of hiring is strong enough to offset those exiting jobs?
Also on Thursday the Bureau of Statistics (ABS) recasts the industry data on new car sales, converting the original data into seasonally adjusted and trend estimates. The Federal Chamber of Automotive Industries has already reported that 105,054 new cars were sold in March – a record for a March month, and up 8 per cent on a year ago. Interestingly we may be seeing a mixed picture on consumer spending but the same cannot be said for sales of sports utility vehicles (or four-wheel drive vehicles). It is clear that demand for SUVs is the main driver of vehicle sales, scaling new heights in March to be up over 15 per cent on a year ago. In fact just over one in three new vehicles sold in Australia is a SUV.
Overseas: Chinese economic data takes centre-stage
The US and China vie for economic dominance over the coming week. Investors are likely to focus more on the Chinese economic data given the release of economic growth figures for the March quarter. In the US inflation and retail sales figures will be closely watched, while the rest are largely ‘second-tier’ readings.
The week begins on Monday when March data on Chinese trade is released. A trade surplus of $40 billion is expected, largely due to the anticipated pullback in imports.
On Tuesday, the ‘top shelf’ US indicators make an appearance. February figures on retail sales are issued together with the data on producer prices (PPI). Economists expect that sales rebounded by 1 per cent in March after a 0.6 per cent decline in February – a decline driven to a greater extent by lower gasoline prices. Excluding autos, sales may have lifted by 0.7 per cent. The core PPI measure may have lifted 0.1 per cent in March after a 0.5 per cent fall in February.
On Wednesday, Chinese economic growth (GDP) figures for the March quarter will be released. The economy is probably growing at a 7 per cent annual pace. On the same day China’s National Bureau of Statistics issues the usual monthly activity readings, covering retail sales, production and investment.
In the US on Wednesday, the Federal Reserve Beige Book is released alongside the Empire State manufacturing survey and the National Association of Home Builders (NAHB) index. Probably the most influential is the Beige Book – a summary of conditions across 12 Federal Reserve districts. The report will be a key input to the decisions made by Federal Reserve policymakers at their next meeting The NAHB index is expected to show a modest gain.
On Thursday, US housing starts data is due, with annualised starts tipped to lift from 0.89 million to 1.04 million in March. New building permits are also expected to have edged higher in the month. The usual data on claims for unemployment insurance is also released.
And on Friday three indicators are expected. The indicators include existing consumer prices, the leading index and the preliminary reading on consumer confidence for April.
The core reading of consumer prices (excludes food and energy) is tipped to have lifted just 0.1 per cent in March to be up 1.7 per cent over the year – giving the Federal Reserve ample time before needing to commit to the first rate hike. And the leading index is believed to have recorded a solid 0.3 per cent lift in March.