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Oz Equity Strategy And the Currency Conundrum

Feature Stories | Apr 27 2016

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

This story was first published for subscribers on April 13 and is now open for general readership.

By Greg Peel

Australia’s economic growth currently lies somewhere in the “amber zone”, Macquarie’s equity strategists suggest. Corporate earnings lack meaningful revenue catalysts and there is no strong valuation signal for the market.

No strong signal? That’s putting it mildly. The ASX200 lost altitude from the 6000 peak in April last year and hit 5000 in August. Between then and now the index has traded back to (or very nearly back to) 5000 no less than 18 times, from peaks that never exceeded 5400 and troughs that only once, briefly, breached 4800.

The index was last at 5000 in 2013, oscillating throughout the June quarter of that year, and previously had briefly found support at 5000 in 2008 before the wheels completely fell off. The index first hit 5000 on the way up in early 2006.

The Blue Chip Trap

So for a decade, the ASX200 has provided no capital return outside of dividends. Few investors hold the entire 200 stock in the index of course, unless playing ETFs, but many hold the small handful of stocks that represent the vast bulk of the capitalisation of the full index – Commonwealth Bank ((CBA)), Westpac Bank ((WBC)), ANZ Bank ((ANZ)), National Australia Bank ((NAB)), Telstra ((TLS)), BHP Billiton ((BHP)), Rio Tinto ((RIO)), Woolworths ((WOW)) and Wesfarmers ((WES)).

For holders of these companies we once called “blue chip” and thus by default portfolio “must-haves”, 2016 has been a bad year. The period 2006-16 has not been that flash either for those still holding these names, but for the dividend offset.

Morgans suggests the outlook for the Australian market is mixed, with growth unbalanced and sentiment still fragile. Morgans entreats investors to “look beyond the default blue chip stocks for leadership”.

The banks are being weighed down by increasing regulation and deteriorating asset quality, Morgans notes. Telstra is facing stiffer competition. Unfavourable supply-demand dynamics make BHP and Rio difficult propositions. The longstanding incumbency of Woolies & Coles in food & liquor is under threat from global players.

The ASX200 is also, of course, a moving feast of components. Every quarter companies are welcomed into the index to replace those shown the door, which only highlights the fact the “index” really only serves as performance benchmark, not as a preferred portfolio. Many miners and mining service companies have, for example, fallen off the bottom in recent times to be replaced by, for example, healthcare names and technology “disruptors”.

Morgans notes the divergence in growth across the ASX200 remains “quite wide”, which means that while the index itself remains nailed down to the 5000 level, there is a significant spread between the top outperformers and the bottom underperformers. Hence Morgans is emphasising to its clients “the need for investors to pay close attention to stock and sector exposures” and that they should expect to have to rebalance portfolios regularly. “Complacency is the biggest threat to returns in 2016,” the strategists warn.

Gone are the days when investors were advised to simply buy and hold BHP for assured returns over time.

For the record, Morgans likes Burson Group ((BAP)), NextDC ((NXT)) and IPH Ltd ((IPH)). Auto parts, “big data” and intellectual property protection. Not a rock in sight. But Morgans is far from the only broker highlighting the need for investors to reposition portfolios for the new world and unshackle themselves from the old.

One theme that is not quite “new world” but is definitely more 2016 than 1996 is exposure to offshore earnings. Looking at the ever more pale list of “blue chips” above we note Telstra, the supermarkets and the banks (outside of ANZ’s minor Asian exposure) are domestic earners. A common theme among the equity strategies espoused in recent times by the big houses is one of offshore exposure. Aside from offshore exposure offering a bigger market to play in, it also offers the benefit of exposure to a currency that having hit 1.10 to the US dollar in 2011 could only ever come down again.

When the Aussie hit US68c in January this year, it appeared all was on track. But now it’s back at US76c. Macquarie is quoted at the top of this article as suggesting corporate earnings lack any revenue catalysts and there is no strong valuation signal for the market. Throw in an Aussie dollar that is not doing what it was supposed to and the result is “a trifecta of averageness,” Macquarie laments, “that does not look like it is about to change”.

(Note that while BHP and Rio could be classified as “offshore earners” given they sell their commodities in US dollars, commodity prices move adversely to US dollar movements and thus there is an offset.)

The Recalcitrant Aussie

Recent Aussie dollar strength nearly perfectly matches corresponding weakness in the US dollar trade-weighted index, Morgans has found. Note that the Aussie is not actually in the US dollar index. Weakness in the US dollar index reflects the change of heart from the Fed between December last year and April this year, which translates to expectations for the number of 2016 Fed rate hikes falling from four in December to two (or maybe less) in April. That weakness has manifested despite the concerted efforts of every other major central bank to force their own currencies down via extraordinary monetary policies.

The RBA had been waiting for the Fed’s help to take the Aussie lower, Macquarie notes. It is proving to be a long wait. The fact the RBA has not acted has not yet come at much cost, Macquarie suggests, but it is “prolonging the agony”. It is going to take a lot of so-called “jawboning” from the RBA to get the currency to move lower, and Macquarie admits the market is probably now too wise to jawboning for it to have the desired effect.

In order for the ASX200 to finally escape the trading range it’s been stuck in for so long, the RBA needs to substantially weaken the Aussie and thus drive incremental earnings upside, Macquarie contends. A bit of “shock & awe” would be helpful at this point, but unfortunately that’s not going to happen. Apart from the RBA’s preference for a slow and gradual approach, current Australian economic data do not actually warrant a larger or faster move from the central bank. That said, Macquarie’s economists are forecasting an RBA cash rate of 1.5% by year end, implying two rate cuts from here.

But if all other central banks keep cutting (or moving further negative or pumping up QE), and the Fed holds off, the RBA may yet have to cut further to achieve the same result, Macquarie admits.

If the RBA can deliver, Macquarie would become bullish offshore industrials and also domestic cyclicals, particularly retail. If the Aussie does not depreciate, Macquarie sees little chance of a change to the status quo. The strategists see little chance of the RBA doing anything brash and thus they stick with their current portfolio preferences of banks, energy, offshore healthcare, online/outdoor media, paper & packaging and utilities.

Morgans is expecting the Aussie to remain elevated over the next couple of months as the US dollar remains under pressure up until June. At that point it will be the Fed who will be under renewed pressure to act on interest rates. Morgans is currently forecasting two Fed rate hikes in 2016 – in June and December. The analysts’ corresponding Aussie forecast is for US70.5c by year end.

That said, Morgans also notes that the 8% bounce in the Aussie since January has not adversely impacted all the major offshore earners on the ASX. Healthcare stocks have copped it, but a “flight to quality” is evident in US dollar-exposed names such as Amcor ((AMC)), Orora ((ORA)) and Brambles ((BXB)) holding up.

Within healthcare, Morgans notes a lot of chatter over potential US regulatory changes have impacted on stocks such as ResMed ((RMD)) and CSL ((CSL)), which offer “compelling” entry points at lower prices.

More to the Picture

While recent Aussie strength has taken the gloss off the performance of offshore earners, Morgan Stanley advises remaining Overweight this cohort. Morgans (not to be confused with Morgan Stanley) notes a “flight to quality” supporting some Australian offshore earners. Morgan Stanley suggests the currency factor is not the only driver in isolation.

Morgan Stanley identifies increasing company expansion offshore and the development of new export focus as key pillars supporting Australia’s transition away from a resources-dominated economy. Stocks the broker points out are leveraged to such drivers, and supported by a weaker Aussie, include Domino’s Pizza ((DMP)), Goodman Group ((GMG)), Virtus Health ((VRT)), Treasury Wine Estates ((TWE)) and Mantra Group ((MTR)).

Stocks that do not fit into the above category other than benefitting from a weaker Aussie, but which are showing value compared to historical levels, include Ansell ((ANN)), QBE Insurance ((QBE)), Macquarie Group ((MQG)), Sonic Healthcare ((SHL)), Lend Lease ((LLC)), ResMed and Orora.

Morgan Stanley’s forex team is currently advising rallies in the Aussie dollar should be sold into down to US70c. This would be good news for the abovementioned stocks. But the team holds a structurally bearish view that the Aussie will drop all the way to US62c by the December quarter.

While this might sound like great news for the Australian economy, it’s not necessarily. There’s more than one reason why the Aussie might depreciate, beyond whatever the Fed might do. Predicating this US62c call is a forecast iron ore price of US$30/t by the December quarter, as the reality of a structural Chinese demand deficit weighs.

The forex team also believes the RBA is under pressure to cut its cash rate not just because the Fed hasn’t hiked, but because recent Australian retail sales, building approval and private sector capex data have been weak.

UBS is not quite as bearish as Morgan Stanley, seeing iron ore falling only back into the forties. This will help the Aussie to ease, as will UBS’ own forecast of two Fed rates hikes this year.

The four factors which dominated the March quarter in the Australian market, UBS notes, were the commodity price rebound, the Aussie dollar rebound, the underperformance of the banks and outperformance of value names over growth/quality names. (“Value” names are typically those trading below historical valuation and offering high dividend yields, while “growth” names are those offering strong earnings growth but low dividend yields and “quality” names are your tried and true, reliable plodders, usually offering mid-range yields.)

UBS believes “value” will continue to have a good 2016. The iron ore price will fall back and the Aussie will ease, but oil prices should be higher by year end. Selling in the banks should abate, UBS suggests, when bad debts prove benign and unemployment remains low.

UBS expects Australian earnings growth to pick up in FY17 and subsequently push the ASX200 higher.
 

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CHARTS

AMC ANN ANZ BAP BHP BXB CBA CSL DMP GMG IPH LLC MQG MTR NAB NXT ORA QBE RIO RMD SHL TLS TWE WBC WES WOW

For more info SHARE ANALYSIS: AMC - AMCOR PLC

For more info SHARE ANALYSIS: ANN - ANSELL LIMITED

For more info SHARE ANALYSIS: ANZ - ANZ GROUP HOLDINGS LIMITED

For more info SHARE ANALYSIS: BAP - BAPCOR LIMITED

For more info SHARE ANALYSIS: BHP - BHP GROUP LIMITED

For more info SHARE ANALYSIS: BXB - BRAMBLES LIMITED

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

For more info SHARE ANALYSIS: CSL - CSL LIMITED

For more info SHARE ANALYSIS: DMP - DOMINO'S PIZZA ENTERPRISES LIMITED

For more info SHARE ANALYSIS: GMG - GOODMAN GROUP

For more info SHARE ANALYSIS: IPH - IPH LIMITED

For more info SHARE ANALYSIS: LLC - LENDLEASE GROUP

For more info SHARE ANALYSIS: MQG - MACQUARIE GROUP LIMITED

For more info SHARE ANALYSIS: MTR - STRATA INVESTMENT HOLDINGS PLC

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

For more info SHARE ANALYSIS: NXT - NEXTDC LIMITED

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For more info SHARE ANALYSIS: QBE - QBE INSURANCE GROUP LIMITED

For more info SHARE ANALYSIS: RIO - RIO TINTO LIMITED

For more info SHARE ANALYSIS: RMD - RESMED INC

For more info SHARE ANALYSIS: SHL - SONIC HEALTHCARE LIMITED

For more info SHARE ANALYSIS: TLS - TELSTRA GROUP LIMITED

For more info SHARE ANALYSIS: TWE - TREASURY WINE ESTATES LIMITED

For more info SHARE ANALYSIS: WBC - WESTPAC BANKING CORPORATION

For more info SHARE ANALYSIS: WES - WESFARMERS LIMITED

For more info SHARE ANALYSIS: WOW - WOOLWORTHS GROUP LIMITED