The Wrap: Banks, REITs & Explosives

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Three positive components in the federal budget sure to benefit the banking sector; Morgan Stanley prefers diversified over pure-play iron ore stocks; higher import volumes expected for ammonium nitrate.

-Banks: this week’s budget provides reasons to cheer
-Iron ore surplus looming
-Explosives sector: consumers value reliability over price
-US election: how long the battle for the soul of the nation?

By Angelique Thakur

Not all that bad

Upon initial assessment, it would seem this week’s federal budget provides banks with little reason to cheer. But this first impression is not entirely true, say Bell Potter analysts, as there are plenty of indirect ways the budget will help the sector.

Bell Potter highlights three components of the budget that are highly positive for banks in the current setting.

The first component pertains to measures for supporting businesses and investment. Bell Potter asserts these measures would indirectly benefit banks that lend in the SME/mid-market and smaller corporate space.

Some business support measures include wage subsidies, loss carry-back for companies with turnover of up to $5bn, small business tax concessions and loan guarantee scheme. Investment measures include the likes of temporary tax incentives and infrastructure stimulus.

Bell Potter is of the view these measures will benefit the four major banks, in particular ANZ Bank ((ANZ)) and National Australia Bank ((NAB)).

Macquarie Group ((MQG)) is equally on the list, as are regional banks Bendigo and Adelaide Bank ((BEN)), Bank of Queensland ((BOQ)) and Suncorp Group ((SUN))).

The next indirect positive stems from support for consumers in the form of lower taxes and wage subsidies. This is likely to indirectly benefit banks engaged in mortgage and consumer lending, suggest the analysts, and would include the major banks especially Commonwealth Bank ((CBA)) and Westpac ((WBC)).

Regionals expected to benefit include Bendigo & Adelaide, Suncorp , Auswide Bank ((ABA)) and MyState ((MYS)).

The third component relates to Australia’s AAA sovereign rating. Bell Potter sees no immediate threat from the budget. Since the sovereign rating affects the major banks’ own credit ratings, the broker expects wholesale funding costs to remain stable for now.

All things considered, Bell Potter’s sector top pick is Macquarie Group with ANZ and CBA the preferred majors and Suncorp the preferred regional lender.

Too good to last

Morgan Stanley forecasts iron ore to return to surplus in the fourth quarter of 2020. The global market has been supported so far by strong Chinese demand and weaker Vale shipments.

China’s second-half steel output is forecast to grow 7%, but slowing thereafter for the rest of the year as the country enters the seasonally weaker winter period.

In the fourth quarter, Morgan Stanley expects China’s steel output to be -3.3% lower versus the third quarter.

Add Vale’s higher shipments on top and Morgan Stanley pegs the surplus for iron ore at 16mt by the fourth quarter. This is expected to result in a price decline to US$100/t.

Morgan Stanley points out China’s hot metal output (which is basically production using iron ore) is currently close to its upper limit. In 2021, this hot metal output is expected to decline by -1.4%.

Similar to 2020, Morgan Stanley assumes Vale’s production will increase in 2021, leading the market into a surplus of 32mt while driving down iron ore price to US$70/t.

Diversified producers are preferred over pure-plays and Morgan Stanley is currently Underweight on Mineral Resources ((MIN)) and Fortescue Metals Group ((FMG)). Instead, BHP Group ((BHP)) is preferred with its exposure to copper over the aluminium-exposed Rio Tinto ((RIO)).

Strong demand outlook for ammonium nitrate

Ammonium nitrate (AN) data for August 2020 show the average import price in August fell for the first time in nine months (versus last year). Pricing has now fallen each month since June.

However, a longer-term perspective shows for the 11 months ending August, ammonium nitrate prices increased 10% while volumes were up 37% versus last year. Stronger volumes indicate strong demand in the domestic market, states Citi.

This has prompted the broker to forecast FY20 import volumes of circa 195kt, up from FY19’s circa 140kt.

Citi feels higher ammonium nitrate import prices bode well for Orica ((ORI)) and Incitec Pivot ((IPL)) with respect to future price negotiation and margin expansion.

While the ability to sell technology had been hampered due to restricted mine access limiting trials (also offsetting margin expansion), with technology trials for Dyno Nobel (a wholly-owned subsidiary of Incitec Pivot) recommencing in the USA, Citi expects trials in Chile to commence later this year. 

On a different but related matter, a survey by Citi of 30 mining professionals engaged in drill and blast procurement across Australia and North America finds safety to be the key driver of explosive technology adoption.

This is good news for Orica, Citi believes, which is the market leader in wireless technology (WebGen). Having said that, the survey indicates Orica needs to invest more in education, marketing and trials to convince the end customer.

Another finding of the survey relates to the key attribute miners look for in their explosives supplier. The survey found supplier reliability to be the key factor while price turned out to be a minor consideration.

Citi concludes the survey indicates a strong medium-term outlook for both companies, but the broker also cautions both companies will need to work to retain customers with switching likely to occur.

Citi’s Buy thesis for Orica is based on the company’s globally diversified earnings, underpinned by multi-year contracts; its leverage to intellectual property and a positive end market outlook.

Incitec Pivot is also rated as Buy and Citi sees the company’s fertiliser division well placed to benefit from more advantageous Australian weather and cropping conditions as compared to last year.

A shift towards metropolitan office REITs:

Ord Minnett has initiated coverage on two metropolitan office REITs: the Elanor Commercial Property Fund ((ECF)) and the Australian Unity Office Fund ((AOF)).

Covid-19 has negatively impacted office markets, especially in Sydney and Melbourne. There has been an acceleration in work-from-home (WFH) plans leading to a flurry of subleasing space.

This new business dynamic has forced many organisations to re-think supply chains and workplace strategies with the focus shifting to reducing costs.

Analysing the top 40 companies in Australia and their workplace strategy, Ord Minnett notes there is considerable scope for more decentralisation. 50% of Australia’s top companies have adopted some form of the hub and spoke model.

Although the true quantum of the impact remains uncertain, Ord Minnett assesses Sydney’s CBD has experienced the biggest contraction.

But that does not mean investing in office REITs is dead. Ord Minnett sees value in office REITs that have minimal exposure to CBDs.

Vacancy rates are expected to rise across most office markets over the next three years, but Ord Minnett believes the impact of covid-19 will be much more subdued for the metropolitan office markets. Thus, investors looking for exposure to office REITs should target REITs focused on metropolitan markets.

Apart from the fact that yields have held firm in the metro markets, there are other factors supporting the metropolitan office markets; namely the rise of the hub and spoke model, investor demand for metropolitan assets, and the focus on cost-cutting.

Ord Minnett likes both Australian Unity Office Fund and Elanor Commercial Property Fund.

Where the former offers 59% exposure to metro and fringe markets, the latter has an exposure of 69%. Neither have any exposure to the Sydney or Melbourne CBD.

Elanor Commercial Property Fund recorded the highest rent collection (98%) of all its office peers. Given its focus on quality tenants, fewer leases expiring over the next two years than peers and its exposure to metropolitan locations, Ord Minnett feels Elanor's is one of the better-placed office REITs.

What attracts the broker to Australian Unity Office Fund is the REIT’s exposure to Parramatta and Macquarie Park; markets expected to benefit from decentralisation.

US presidential election

The US presidential election will have far-reaching consequence, whatever the outcome. According to an Ipsos poll, a majority of US voters consider the election as a “battle for the soul of the nation”.

Unless Biden can claim a conclusive victory, things might yet get a lot more complicated, as incumbent Trump is more likely than not to dispute the outcome.

If such dispute drags into 2021, it would stall the handover and pose serious economic risks, suggests the Economist Intelligence Unit (EIU).

Latest poll numbers put Biden 8% ahead of Trump while at this point in 2016, democratic candidate Clinton led Trump by just 3%.

As of October 5, Biden was in the lead in aggregate polling in the four most important states – Michigan, Wisconsin, Pennsylvania and Florida.

Citi asserts this indicates the increasing likelihood of a Blue Wave and it looks like equity markets are less concerned about the chances of a contested election dragging on for weeks.

According to the Economist Intelligence Unit, Trump’s core support base, responsible for leading him into victory in 2016, has not expanded beyond the levels seen in his first term and will most probably not be enough to ensure a victory in the Electoral College this time around. 

Due to the unique polling situation created by the pandemic, the EIU does not expect results to be declared for several days, which leaves the door open for the results to be disputed.

Elaborating on this, the EIU expects Trump to take a lead with in-person voting results; a potential premature victory if the postal votes shift the balance to the challenger. Trump might call foul play and contest the result.

The ensuing series of lawsuits in the battleground states between Trump and Biden could set the stage for a dispute that would probably go on well into December.

The worst-case scenario, according to EIU, would be a deadlock while the losing candidate refuses to formally concede defeat.

If Trump refuses to leave office, the Democrats in Congress may refuse to move the legislative agenda forward. With budgetary decisions suspended, this would lead to a government shutdown by early 2021.

This remains an extreme scenario and EIU thinks it is rather unlikely, instead expecting a clear election outcome, or one candidate will back down before Inauguration Day.

Citi notes investors are leaning towards cyclicals including industrials, materials and financials over technology, heading into 2021. Notably, investors appear to be less focused on dividends and more on the appreciation potential of stocks.

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