The Wrap: Equities, The Budget, Electricity & Slots

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Weekly Broker Wrap: US equities versus Oz equities; budget preview; electricity prices; US slot markets; Bell Potter initiates on Freedom Insurance.

-Morgan Stanley expects US equities to outperform Australian equities
-UBS expects Medicare indexation to be re-applied to GPs and diagnostic imaging
-Speculation regarding increase in Medicare Levy surcharge for non-insured
-Electricity price volatility expected to increase, gas prices higher for longer
-Ainsworth Game Technology trending higher in US slot machine business
 

By Eva Brocklehurst

US Equities Versus Oz Equities

Morgan Stanley lifts its outlook for US equities and suspects Australia will not follow a late-cycle push in the US, given the fact domestic growth headwinds are offsetting global reflation and earnings.

The broker's US analysts suggest the global cyclical upswing of 2016 and synchronised growth into 2017 mean the market is entering a classic late-cycle phase. Underpinning this optimism is S&P500 earnings, that are expected to grow by around 10% in the first quarter with revenue growth accelerating to 8%.

Morgan Stanley observes this is the healthiest top-line seen in the US since 2012. The broker notes a clear correlation between the US performance and the Australian benchmark as the ASX200 has traded an average discount of 10% to the S&P500 since 1992.

A deeper discount is now expected to emerge, linked to housing and unemployment. With the current economic outlook a 25% discount to the US multiples would not be out of the question, in the broker's opinion.

While the US market may receive a boost as the headwinds of regulation and de-leveraging turn into tailwinds, Morgan Stanley believes Australia is lagging the global reflation cycle. Record low wages growth and record high gearing are leaving the Reserve Bank of Australia in a very difficult position.

The themes driving positive earnings momentum mean Morgan Stanley believes materials and energy still offer upside, recommending revisiting quality and growth.

Budget Preview

The federal budget is due to be handed down on May 9. UBS economists suggest this should be the first budget in a number of years that shows a modest improvement from the Mid Year Economic Fiscal Outlook (MYEFO).

This is predicated on a stronger underlying economy, higher corporate tax receipts and higher-than-expected commodity prices. The economists believe underlying improvement in the budget will be used to fund a modestly higher 2020/21 surplus and pay away long-standing, but unpassed in parliament, savings measures that have attracted criticism, as well as provide a higher contingency reserve for future policy.

UBS expects Medicare Benefit Scheme indexation will be re-applied to GPs and diagnostic imaging after the government agreed diagnostic imaging would also attract indexation. UBS expects proposed bulk bill incentive cuts will be abandoned, along with a fix for pathology collection centre rents.

The broker also expects the government will examine cuts to after-hours GP home visits. The budget is unlikely to propose a major change to pharmacy but the broker notes speculation of an increase in mandatory price reductions on first generic entry to 25% from 16%.

The broker expects a benign budget for the aged care sector, which is complaining of reform fatigue, and it would be unusual for the government to act ahead of the legislated review that is due in August.

Private health insurance reform is also considered unlikely, given the ongoing reviews. UBS notes some speculation around the Medicare Levy surcharge increasing for the non-insured.

Electricity Prices

Wholesale electricity prices have increased dramatically in 2017. UBS concludes that a combination of power generation withdrawals and higher gas prices are the main culprits. Recent government announcements regarding new generation will not impact prices in the medium term. The broker believes the market is over-estimating the risk of regulatory intervention and ignoring the evidence, and believes $80/megawatt-hour prices are sustainable, a 50% increase versus FY16.

The broker concludes the closure of the Hazelwood power station will increase the National Electricity Market's reliance on an ageing coal fleet and gas-fired generation in order to meet demand. With gas prices likely to be higher for longer and increased gas generation, the broker expects increased volatility in electricity prices going forward. UBS forecasts a 39% increase in retail prices over four years and 50% for business customers.

The downside risk for prices stems primarily from the potential for regulatory intervention, although this may be more likely at the retail rather than the wholesale level. UBS also notes that higher prices may lead to industrial closures and increased use of residential solar PV/batteries, which could lead to demand destruction.

The broker believes large thermal generators with low-cost fuel are the biggest winners and these include AGL Energy ((AGL)), recently upgraded to a Buy recommendation, the Queensland government, Energy Australia and Origin Energy ((ORG)) (Buy).

Citi finds electricity prices are disconnected from the fundamentals, with little incentive for the incumbent generators to break the high price cycle. The broker forecasts a $65/megawatt-hour long-term electricity price but arriving there will take time.

This price is considered to be what is needed to incentivise more renewables and is also an average cost of base load coal and gas/hydro in peak periods. The broker finds it hard to envisage where new energy will come from to replace Hazelwood and ease electricity prices without higher coal power station utilisation, something incumbents appear unwilling to provide.

The broker, therefore, forecasts any decline in prices will be gradual and emanate from increased gas availability and increasing supply of renewables as well as demand falling in response to higher prices. The implication from the analysis means the broker downgrades AGL to Sell and upgrades Origin to Neutral. The broker expects Origin to benefit from monetising its gas portfolio in a tight energy market.

Slot Markets

Ord Minnett believes Australian poker machine manufacturers are well positioned for growth and Aristocratic Leisure ((ALL)) should enjoy a significant period of strong performance into 2018. The US market is expected to sustain another year of growth, with 24% of participants in the broker's annual slot market survey intending to increase spending on replacements.

Aristocratic Leisure will be a main beneficiary, as 95% of participants believe this company is the current top performing manufacturer. As a result of the trends in the survey Ord Minnett raises FY17 net profit forecasts for Aristocrat Leisure by 5%.

Ainsworth Game Technology ((AGI)) is also expected to grow sales, as its profile builds and purchasers are expected to devote 9.0% of a new floor to Ainsworth, up from 6.2% in 2016.

Freedom Insurance

Freedom Insurance Group ((FIG)) designs distributes and administers insurance products that target the no advice and general advice markets. The company does not take any underwriting risk, with all underwriting risk passed onto Suisse Re.

The company currently offers accidental death, accidental injury and term life insurance products in addition to a range of other third-party products. Bell Potter initiates coverage on the stock with a Buy rating and $0.94 target. The company has guided for sales to be between $59-64m in FY17.

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