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Rising USD: The Dragon With Many Heads

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Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Nov 19 2014

This story features AUSTRALIA AND NEW ZEALAND BANKING GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: ANZ

In this week's Weekly Insights:

– Rising USD: The Dragon With Many Heads
– Yield Stocks: Dangers And Opportunities
– Trouble On The Horizon For USD, Equities
– Stakeholder Yield Remains Superior
– Rudi On TV: The Week Ahead

The Rising USD: A Dragon With Many Heads

By Rudi Filapek-Vandyck, Editor FNArena

Michael Knox, chief economist and strategist at stockbroker Morgans is a non-believer.

While the rest of the world, including most media and market commentators, simply points to the US shale revolution when asked to explain why crude oil is now trading below US$80/bbl, Knox puts together global data and market input and he keeps returning to the same outcome: somehow the story doesn't seem to add up.

Either the demand story is over-estimated or global supply, somehow, is larger than we are led to believe.

Oil should not be trading below US$80/bbl but at noticeably higher price levels. Maybe there's another explanation?

The Paris-based International Energy Agency, or IEA, estimates there are around 323,000 tonnes of refinery-based oil and 202,000 tonnes of refined petroleum products held as inventory across the world (data as at Q2 this year). The total combined value of these inventories adds up to almost US$50bn.

Large chunks of these inventories are leveraged and thus vulnerable to movements in the price of oil and/or the US dollar as owners, which include financial investors and speculators, don't like to incur losses.

Knox has been doing some historical data research which has laid bare correlations that suggest a weaker USD pushes up the price of crude oil faster than the actual fall in the currency. Hence, the same built-in leverage should thus cause the price of oil to weaken by more than is seemingly justified on the basis of a weaker USD.

Concludes Knox: "Generally speaking, a rise in the $US will result in a fall in the $US oil price at as much as four times the rate of the increase in the $US. Similarly, a fall in the $US will result in a rise in the $US oil price as much as four times the increase in the $US".

Welcome to a world that is poised for more unexpected developments now that the US Federal Reserve is preparing to "normalise" interest rates again.

It is probably a fair assumption to make that terms such as "steady", "controlled" and "gradual" will be front and foremost in the minds of all Fed Open Market Committee members, for obvious reasons. While most market commentary goes out to the changing outlook for US and global bond yields, not too much thought seems to be given to the consequences of the Fed initiating a reversal in trend for the world's reserve currency.

Yet, if history can be our guide, potential consequences from a stronger greenback can make or break trends for financial assets, and investment strategies, in the years ahead.

Let's start with the general premise the US dollar is now poised for a multi-year comeback. In typical finance lingo this translates into something like: we are now in a secular bull market for the USD.

Most investment experts seem to agree. The US economy is shaping up as the best performer when benchmark economies in Europe, Japan, Russia and China are definitely not. The Fed looks ahead of the game in comparison with central banks in these countries. Cheap energy and repatriation of manufacturers onto US soil further add to the bullish case for a stronger greenback.

There's even a cycle-based argument to further support the USD-recovery thesis. Trade weighted bear and bull markets for the greenback tend to last between 6-10 years and analysts at Credit Suisse, to name but one source, believe we are presently three years into a new USD bull market. Underlying conclusion: if history can be our guide, we're not even half-way and there should be a lot more strength coming.

Here's the chart that reveals all:

History suggests a number of potential consequences that may once again reveal themselves as the present cycle unfolds:

1). US equities perform better during USD bull markets

This may seem counter-intuitive since a stronger greenback should weigh on foreign profits at US corporates, but the US economy still represents nearly 70% of all sales generated by listed companies in the US. Thus a stronger greenback is only impacting on 30% of total sales for corporate America. In contrast, 50% of all sales at EU companies come from outside the eurozone. Which explains why a stronger USD/weaker euro should give European profits a boost too.

Further adding to the bullish picture is that a stronger greenback improves dollar-value spending for US consumers. With a global market share of some 16%, those US consumers -having been absent in recent years- should further improve companies' growth potential, both inside and outside the USA. Note recent research suggests US consumers' discretionary spending has now fallen to a 30-year low, suggesting the only way is up.

The fact that a stronger USD also weighs on energy prices (see Michael Knox above), and on commodities in general, further adds to the bullish picture. A stronger USD also has the potential to keep inflation contained, which might keep the Fed more relaxed and push out the timing of actual rate hikes.

To put a statistic behind the thesis: equity markets have gone up 72% of times during a USD bull market.

There is one quirky side-effect as to how a stronger USD can possibly trigger a re-rating for equities in Japan and in Europe. History shows stocks markets are de-rated whenever consumer price inflation dips below 1% (as investors worry about deflation). A weaker euro and yen, because of a resurgent USD, might help push inflation in these economies above 1%, thus triggering a re-rating.

2). Commodities tend to underperform

A bull market for the world's reserve currency is not good news for commodities and it probably is not purely a coincidence that this year's upside surprise from the greenback has come at a time when commodity prices have underperformed expectations. The usual explanation given is global growth has disappointed, which is correct, but similar to the investigation by Michael Knox at the beginning of this story: do we really believe that's all there is to this story?

In this context I refer to Morgan Stanley analysts issuing a stern warning on aluminium inventories (see "Aluminium: At Risk" in last week's Weekly Insights).

Here's the statistic behind the historical observation: on average, commodity prices fall by 12% when the USD goes through a period of strength, while when the opposite happens, commodity prices, on average, rally by 92% in price!

3). Emerging Markets tend to underperform

The historical performance statistic for Emerging Markets Equities is quite a shocker: only in 33% of the times during USD strength have EM equities managed to outperform. The reasons for this seem many and relatively straightforward: many EM countries, and their private sectors, are more exposed to USD debt. Weaker local currencies push up inflation. There's also the large impact from carry trades, and their reversal, and from USD repatriation back to the homeland. Plus EM countries are more often leveraged to commodities (see above).

I don't think it'd be too difficult for investors to draw conclusions for the Australian share market. As a matter of fact, if history repeats and the USD-recovery story has many more years to run, the trends that have dominated local equities thus far in 2014 may well simply last a lot longer (on a longer term horizon, not necessarily for the short term).

For the gold bugs, here's a chart that leaves little to the imagination:

And as is always the case when significant changes take place after many years of artificially depressed US bond yields, there always is plenty of room for the totally unexpected.

Who has been a major beneficiary of cheap money and a weak USD but won't be ready for the reversal when it arrives?

Not the US shale sector, it appears. As reported earlier, shale gas and oil producers in the US have grown into the largest sector for high yield corporate debt in the US in only a few years. This, for obvious reasons, has made a number of market watchers uncomfortable now that we are in a lower oil price environment.

However, if we can rely on a recent assessment by Deutsche Bank's US Credit Strategy team, there should be no pending disasters around the corner. Deutsche Bank's findings suggest WTI crude oil prices would need to fall to US$60/bbl before debt/enterprise valuations among US energy B/CCC names rise to a level that would imply a 30% default rate for the whole segment.

Conversely, this assessment proves actually more worrying for OPEC in that it implies oil prices have to fall an additional 20% from current levels for tipping points from a High Yield credit perspective to appear.

I think we can safely put that potential problem in the too hard/rather unlikely basket.

Yield Stocks: Dangers And Opportunities

The yield theme is going to stick with us for a whole lot longer, methinks.

The fact that strategists at Credit Suisse built a case in support of more RBA cuts in 2015 only reaffirms the case. Surely their peers at Morgan Stanley, authors of some very bearish predictions for the Australian economy in the years ahead, wholeheartedly agree?

Alas, the yield theme is not new and it is an easy observation to make that good yield stocks -whatever the qualification behind the label "good"- are no longer cheap. They might thus be in danger of a de-rating, at some point, and that can hurt short term portfolio performance.

So which yield stocks are still worth buying?

Analysts at Goldman Sachs have been asking that very same question and they've published two reports about it. Firstly, the stockbroker's favourite Top Three among defensive high yielders in the Australian share market consists of … (wait for it)… ANZ Bank ((ANZ)), Mirvac ((MGR)) and Spark Infrastructure ((SKI)). So much for the notion that Australian banks should be avoided like the pest given regulatory overhang.

One key observation made by the analysts deserves to be highlighted:

"Record low interest rates have also seen the spread in dividend yields across defensive stocks compress to an unprecedented low, suggesting that the market is not differentiating enough on the sustainability and growth profile of many ‘defensive’ names. Against this backdrop we believe it is increasingly important to own yield names with a sustainable and growing dividend".

On this observation, the analysts have also lined up a Top Three of dividend stocks that should be avoided (because the risk is very much in favour that dividends will need to be cut at least once, but potentially multiple times in the years ahead). The negative Top Three, according to Goldman Sachs, consists of Woodside Petroleum ((WPL)), AusNet ((AST)) and ALS Ltd ((ALQ)). In particular the first name on that list will draw some attention as many funds managers, stockbrokers, financial planners and investors have by now accustomed themselves with the fact that Woodside shares are trading like a yield stock.

My personal view is that Woodside's implied 7.6% (fully franked) dividend yield for the present year is a strong signal the board will cut the dividend, otherwise the shares would be priced at a yield of 5%-something, just as is the case for banks and for Telstra ((TLS)). But Goldman Sachs' projections suggest I am way too kind for Australia's pre-eminent oil and gas stock. Citing a structurally lower oil price, and a declining production profile, Goldman Sachs' research suggests Woodside's current dividend appears poised to decline by no less than 45% over 2014-17, and that's even assuming the payout ratio stays above 70%.

In the case of AusNet, Goldman Sachs is worried about weakness in regulated returns and the fact the stock already pays out 100% of free cash flow. The analyst point out AusNet has two open disputes with the ATO and is the subject of two separate class actions relating to bush fires. Could become nasty, easily.

What is haunting ALS Ltd are core operations in structural decline and competitive peer pressures that translate into lower margins. Goldman Sachs reminds us all the firm has been forced to issue two profit downgrades in the past four months. On current projections, the dividend will decline by 28% over 2014-17.

Always be mindful that combining dividends with operational weakness is opening up the possibility of severe disappointment through dividend cuts and a correcting share price (the so-called "Double Whammy").

Back to the positive side of Goldmans' research, ANZ Bank was chosen because the analysts continue to believe in the bank's Asia strategy and thus in "above peer growth" for the years ahead. On top of this, the shares trade some 8% below fair value (because the market is not as confident) and ANZ is offering investors 5.7% FY15 yield, fully franked, with projected growth of 5.5% for FY14-17.

Mirvac, Goldman Sachs notes, is the only REIT under coverage that still trades at a discount to its Sum-of-the-Parts valuation. Plus the stock offers a 5.2% FY15 yield with projected FY14-17 DPS growth of 7% per annum driven by above trend property sales.

Spark, say the analysts, offers a secure 6.2% FY15 yield, with dividends forecast to grow at 7% per annum from 2014-17 as it meets its de-gearing target.

Back to the negative side: other yield stocks under threat of a cut in excess of 5% by FY16 include Macquarie Atlas ((MQA)), Tabcorp ((TAH)) and AGL Energy ((AGK)).

To end this story on a positive note, Goldman Sachs offers the following prediction for banking stocks in general: "Specifically with respect to the potential for higher capital requirements from APRA post the G20 and Financial System Inquiry, we expect the sector to underwrite its DRPs to meet any potentially higher capital requirements".

Quant analyst Mathan Somasundaram over at BaillieuHolst has also just updated his Top Twenty Sustainable High Yield Dividend Stocks:

– Among large caps: CommBank ((CBA)), Westpac ((WBC)), BHP Billiton ((BHP)), ANZ Bank and National Australia Bank ((NAB))
– Among mid caps: Perpetual ((PPT))
– Among small caps: Bentham IMF ((IMF)), Northern Star Resources ((NST)), Mermaid Marine ((MRM)), Platinum Investment Management ((PTM)), Webjet ((WEB)), Hills Industries ((HIL)), Skilled Group ((SKE)), Treasury Group ((TRG)), Mortgage Choice ((MOC)) and Bradken ((BKN))
– Among micro caps: Finbar Group ((FRI)), HFA Holdings ((HFA)), Nick Scali ((NCK)) and Dicker Data ((DDR)).

Trouble On The Horizon For USD, Equities

The share market seems to have run out of puff and a case can be made that it's not just an Australian phenomenon.

No surprise thus, bearish assessments are once again raising their head, in particular from technical analysts. On Monday morning I received one question from a noticeably worried investor: is the ASX200 really heading for 4900 by year end?

The team of global tech analysts at UBS often sees their reports accumulating many internet miles after publication and their latest market update has been no exception.

So what does the global team think of all this?

Confirmation of deteriorating market strength. The analysts at UBS suspect we'll see a meek attempt by US equities to rally into December, but internals and breadth look weak and the team sticks by its view that the first half of 2015, and the first quarter in particular, will probably bring losses and increased volatility.

In the short term, the USD looks to have reached a short term peak and thus weakness should become the path of least resistance. No surprise thus, the above mentioned equities rally will be supported by a short term revival for mining and energy stocks.

The good news is that beaten down gold should be ready to rally on the back of the above. The team at UBS is projecting a sharp come-back for gold with price targets of circa US$1280 by year-end and up to US$1400 during H1 next year. It'll be a rally to rent and not one to own, in their view.

As far as the equities correction goes, UBS Tech reports 1950 for the S&P500 looks like a possible target, implying the term "pull back" is probably appropriate given the downside -if correct- remains below 5%.

If you hadn't spotted it by now, the key message in UBS's tech assessment spells "commodities due for a rebound".

A story on the outlook for equities wouldn't be complete without the mention that one of the better known local funds managers, Geoff Wilson from Wilson Asset Management, has now officially turned bearish with his prediction the ASX200 is likely to end 2015 at a lower level than at the start of the year. For more about Wilson's view, follow the following link:

http://www.asx.com.au/education/investor-update-newsletter/201411-where-next-for-shares.htm

Stakeholder Yield Remains Superior

Research conducted both locally as well as overseas suggests stocks from companies buying in their own shares more often than not outperform peers who don't. However, a recent quant research report from Macquarie suggests investors shouldn't narrow their focus to buy-backs only.

Macquarie analysts developed the concept of "Stakeholder Yield" which covers companies ability to reward stakeholders outside the business from the cash generated inside the business. This concept covers share buy-backs, of course, but also higher dividends and paying down debt. Macquarie's research builds a strong case that companies that combine all three strategies to reward shareholders, simply deliver superior returns for their shareholders.

Investors, wherever you are, take note.

For Australian shares, the quant analysts have developed a score system and combined this with stock ratings from the fundamental analysis division. As such the Top 11 consists of the following names:

– Seven West Media ((SWM))
– Dexus Property ((DXS))
– Village Roadshow ((VRL))
– GPT ((GPT))
– Bradken ((BKN))
– JB Hi-Fi ((JBH))
– Amcor ((AMC))
– Downer EDI ((EDI))
– IOOF ((IFL))
– Singapore Telecom ((SGT))
– CommBank ((CBA))

FNArena's regular update on share buy-backs:

Ansell ((ANN))
Aurizon ((AZJ))
Aveo Group ((AOG))
Cape Lambert Resources ((CFE))
China Magnesium Corp ((CMC))
CSL ((CSL))
Dexus Property ((DXS))
Donaco International ((DNA))
Fiducian Portfolio Services ((FPS))
Helloworld ((HLO))
Hills ((HIL))
Karoon Gas ((KAR))
Logicamms ((LCM))
Telstra ((TLS))

Companies believed to potentially announce buy backs in the not too distant future:

BHP Billiton ((BHP))
Rio Tinto ((RIO))

(Note how Aurizon has now moved from "potential" into the "actual buyback" basket).

We continue to welcome your participation/contributions. Send them to info@fnarena.com

Rudi On TV: The Week Ahead

On request from readers and subscribers, here are my scheduled TV appearances for the seven days ahead:

– Wednesday – Sky Business, Market Moves – 5.30-6pm
– Thursday – Sky Business, Lunch Money – noon-12.45pm

(Due to my on-stage presentation to the ATAA in Sydney on Monday evening, this story was written on Tuesday, 18 November 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

For paying subscribers only: we have an excel sheet overview with share price as at the end of October available. Just send an email to the address above if you are interested.

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CHARTS

ALQ AMC ANN ANZ AST AZJ BHP CBA CSL DDR DNA DXS FRI GPT HIL HLO IFL JBH KAR LCM MGR MOC MRM NAB NCK NST PPT PTM RIO SKI SWM TAH TLS VRL WBC WEB WPL

For more info SHARE ANALYSIS: ALQ - ALS LIMITED

For more info SHARE ANALYSIS: AMC - AMCOR PLC

For more info SHARE ANALYSIS: ANN - ANSELL LIMITED

For more info SHARE ANALYSIS: AST - AUSNET SERVICES LIMITED

For more info SHARE ANALYSIS: AZJ - AURIZON HOLDINGS LIMITED

For more info SHARE ANALYSIS: BHP - BHP GROUP LIMITED

For more info SHARE ANALYSIS: CBA - COMMONWEALTH BANK OF AUSTRALIA

For more info SHARE ANALYSIS: CSL - CSL LIMITED

For more info SHARE ANALYSIS: DDR - DICKER DATA LIMITED

For more info SHARE ANALYSIS: DNA - DONACO INTERNATIONAL LIMITED

For more info SHARE ANALYSIS: DXS - DEXUS

For more info SHARE ANALYSIS: FRI - FINBAR GROUP LIMITED

For more info SHARE ANALYSIS: GPT - GPT GROUP

For more info SHARE ANALYSIS: HIL - HILLS LIMITED

For more info SHARE ANALYSIS: HLO - HELLOWORLD TRAVEL LIMITED

For more info SHARE ANALYSIS: IFL - IOOF HOLDINGS LIMITED

For more info SHARE ANALYSIS: JBH - JB HI-FI LIMITED

For more info SHARE ANALYSIS: KAR - KAROON ENERGY LIMITED

For more info SHARE ANALYSIS: LCM - LOGICAMMS LIMITED

For more info SHARE ANALYSIS: MGR - MIRVAC GROUP

For more info SHARE ANALYSIS: MOC - MORTGAGE CHOICE LIMITED

For more info SHARE ANALYSIS: MRM - MMA OFFSHORE LIMITED

For more info SHARE ANALYSIS: NAB - NATIONAL AUSTRALIA BANK LIMITED

For more info SHARE ANALYSIS: NCK - NICK SCALI LIMITED

For more info SHARE ANALYSIS: NST - NORTHERN STAR RESOURCES LIMITED

For more info SHARE ANALYSIS: PPT - PERPETUAL LIMITED

For more info SHARE ANALYSIS: PTM - PLATINUM ASSET MANAGEMENT LIMITED

For more info SHARE ANALYSIS: RIO - RIO TINTO LIMITED

For more info SHARE ANALYSIS: SKI - SPARK INFRASTRUCTURE GROUP

For more info SHARE ANALYSIS: SWM - SEVEN WEST MEDIA LIMITED

For more info SHARE ANALYSIS: TAH - TABCORP HOLDINGS LIMITED

For more info SHARE ANALYSIS: TLS - TELSTRA CORPORATION LIMITED

For more info SHARE ANALYSIS: VRL - VILLAGE ROADSHOW LIMITED

For more info SHARE ANALYSIS: WBC - WESTPAC BANKING CORPORATION

For more info SHARE ANALYSIS: WEB - WEBJET LIMITED

For more info SHARE ANALYSIS: WPL - WOODSIDE PETROLEUM LIMITED