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The Wrap: Global And Local Economic Outlooks; Supermarkets

Weekly Reports | Jun 28 2019

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Analysts put forward their views on both the global and Australian economies going forward, while Citi is downbeat on the big supermarkets.

-Trade war, Brexit remain swing factors
-Central bank policy critical
-Australia to outperform?
-Beware of foreigners selling groceries

By Greg Peel

The Global View

At the beginning of 2019, Legg Mason was expecting trend growth for the US economy supported by a more dovish Fed policy stance, stabilisation and then improvement in the Chinese economy aided by a lessening of trade tensions, and stabilisation in European growth, while avoiding a “hard” Brexit.

Up until a few weeks ago, things looked like they were going to plan.

But so far, Fed rhetoric may have become more dovish but no actual policy action has been taken, G20 meeting this weekend not withstanding there has been no resolution on US-China trade, and with May out and Johnson assumed to be coming in, a “hard” Brexit remains a possibility.

The good news, suggests Legg Mason, is that global growth has actually improved from the worst case fears of December 2018, and a number of central banks have been straightforward in articulating a need to extend the expansion (through easier policy if needed). The bad news is abovementioned risks remain.

The Fed is “monitoring closely”, but data suggest such monitoring should now be with a view as to whether to ease policy, the analysts believe. They still believe a US-China deal will ultimately be forthcoming, but if not, they believe Chinese growth will be lower but remain “sturdy”, supported by government stimulus.

European growth has been very poor but the backdrop is quietly improving. Legg Mason had expected a return to modest levels of growth but Brexit remains the swing factor. Despite the risk of a “hard” Brexit having increased, the analysts still assume a “mutually palatable” deal can be reached, but will take time and weigh on investor sentiment in the interim.

Citi’s analysts note that Fed rate cuts typically drive the US stock and bond markets higher (lower yields). While trade negotiations continue, Citi prefers defensive equities that will benefit from improved productivity from a rate cut and ongoing earnings growth supported by a weaker US dollar.

Citi states the obvious that a combination of a Fed rate cut and trade resolution would be positive and a combination of no cut and no resolution would be negative. The analysts have not here explored the middle ground:

A trade resolution is reached, so the Fed doesn’t cut. A trade resolution is not reached, so the Fed cuts. These scenarios are more likely outcomes than double-whammies in either direction.

The Local Outlook

Morgan Stanley had held an Underweight rating on Australian equities in its model portfolios for some time, and indeed this has proven the right call until recently. The Australian market is up 20% for 2019 and the global market is a few percentage points behind.

Morgan Stanley has since moved to “mildly” Overweight.

Risks are building around a global economic slowdown, the analysts note, compounded by trade tensions, leading to reduced corporate confidence. Australia, too, is slowing, but this is mitigated by several factors.

Fiscal spending on infrastructure and tax cuts, our proximity to China and its demand for commodities, quality high yielding shares, and the potential for more tax cuts puts Australia in a relatively better position compared with the rest of the world at this time.”

 In the context, the analysts recommend a defensive posture. They suggest investors focus on stocks with low or negative correlation with equity benchmarks (low or negative beta), companies with good visibility on profits, and by extension, dividends, companies operating in industries in which trading conditions remain strong, and traditional safe haven assets.

Wilsons is also tipping Australian outperformance to continue.

Wilsons specifically singles out RBA rate cuts. While the rest of the world (with exceptions, eg US) has been dominated by unconventional interest rate policy, the RBA kept its rate on hold all the way from mid-2016 to last month. Further cuts are likely, and these will support equity market valuations.

Wilsons echoes Morgan Stanley in pointing to fiscal stimulus, and further notes house prices are likely to stabilise on a combination of the election victory, lower RBA rates and more relaxed lending standards following regulatory changes (APRA).

The analysts also note that while Australian industrials have suffered earnings downgrades, in line with the rest of the world, the resources sectors have enjoyed upgrades on stronger commodity prices, providing the offset.

Australia is thus comparatively well positioned, Wilsons believes. Few other countries are combining monetary and fiscal stimulus. A lower Aussie will provide further stimulus. The analysts also suggest Australia is “relatively immune” to a direct economic impact of the US-China trade war, were things to escalate.

Not So Super

Citi analysts locally have drilled down into expectations for the Australian listed supermarkets.

Both Coles ((COL)) and Woolworths ((WOW)) have indicated they expect at least 3% growth for the sector ahead. Citi is more optimistic at 4%, assuming a step-up in packaged grocery inflation. Currently growth is running at around 4.5%, supported by a fresh burst of inflation.

However, it comes down to how that growth is distributed.

Assuming Aldi, Costco and Kaufland absorb a net 1.1% of growth, and new store space another 0.6%, Woolworths and Coles will be fighting for 1.8% sales growth, Citi suggests, including online. A slowing down of store space growth, to a forecast 1.5% from 2.7% over the past decade, should at least help alleviate pressure on returns.

Both supermarkets are now making a concerted effort to increase online penetration, and Citi forecasts online sales to grow from 2.1% of total sales in FY18 to 5% by 2025. However not only are online sales dilutive to margins, but store profits may fall because store-based sales growth is running below underlying store-based cost growth.

Citi does not believe downside risk to margins is reflected in current PE multiples. Going out three years, Kaufland offers further margin pressure through online margin dilution and higher wage costs. The locals must deliver on intended cost savings to offset this pressure.

Citi has Sell ratings on Woolworths and Metcash ((MTS)) and a Neutral rating on Coles.

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