Treasure Chest: Time To Buy Cyclicals?

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By Greg Peel

The global economy is being hit with a fresh round of attempted reflation. The Fed has now decided to stop fannying about and has declared its third round of QE to be unlimited. The ECB has declared it will do “whatever it takes” when, and if, it ever gets the chance to do so. China is relying on fiscal stimulus through infrastructure projects but has been a bit tardy on the monetary front, although the upcoming change of regime is believed to be providing only a postponement. Japan will continue to print money as long as the US does, to protect its export markets. QE is ongoing in the UK. Elsewhere in the world forms of easing are occurring and in Australia, the RBA is tipped to make further rate cuts before year-end.

Reflation is typically positive for equities, given equities provide an inflation hedge through earnings and distributions while inflation undermines real returns on fixed interest investments. Equity values will nevertheless ever remain beholden to earnings and earnings growth, as at the end of the day it is this which translates into value. However if sentiment improves, the market will invest in equities ahead of any expected recovery in earnings. An improvement in sentiment has the power to increase price/earnings ratios even as earnings are fixed, which implies higher prices.

Those stocks most beholden to improved economic sentiment are the cyclicals – the good time stocks – which replace a preference for defensives – the bad time stocks – under such circumstances. The world has been chasing yield through both classic defensives and high dividend-paying cashflow stocks over the past couple of years, to the point many such stocks have become overvalued as far as analysts are concerned. The question now is thus: is it time to switch out of defensives and into cyclicals?

UBS notes the cyclical/reflation trade has “clearly regained the ascendancy globally” even if Australia has been a bit slow off the mark. The analysts expect the reflation trade should extend through to year-end, however upside from here is undermined by the fact so much anticipation was built into prices from June and into the September quarter, particularly in the US. Current valuations nevertheless support a rotation away from safety and defensives, UBS believes.

If you compare equities to bonds in the current low-yield environment, equities look cheap, UBS acknowledges. It is hard to see anything other than moderate single-digit earnings growth, but ultra low rates and monetary stimulus can improve PEs. The analysts still believe, however, we need to see improvement in growth momentum – at least in the US and preferably in China and Europe as well.

UBS believes the resource sector will continue to outperform over the December quarter, given reflation and a recovering iron ore price. Defensives look expensive, particularly consumer staples and REITs. In the ongoing tough earnings backdrop, UBS prefers what it calls “GARP” stocks (growth at a reasonable price) over low quality industrials.

Citi has also been exploring the rotation theme – out of defensives and into cyclicals – as risk appetite starts to pick up. 

Defensive stocks are now attracting premium multiples (PE) even on modest earnings growth, and increased prices mean the dividend yields on such stocks (for new buyers) have fallen back to the pack. Citi believes such outperformance can only be sustained if earnings continue to fall in other parts of the market.

Resource stocks have bounced, Citi notes, but only in terms of recovering losses on the recent commodity price fall impact. The analysts suggest prices can rise further as Fed and ECB policy initiatives take effect, and if China's growth stabilises and can begin to tick up on increased infrastructure spend and some improvement in the property market. A sustained improvement in commodity prices would thus follow, and so too stock prices.

There are some industrial stocks facing better prospects since the RBA started cutting rates, and may yet cut further, Citi acknowledges. On the other hand, there is still a risk of rising unemployment and further spending cuts from a government determined to deliver a surplus at any cost. Citi's economists do not expect another RBA rate cut in the short term, but if there is, and thus the Aussie weakens, foreign earnings will improve and the housing market should improve to offset the inevitable peak in resource sector capex spend.

Deutsche Bank is more inclined to believe the RBA will cut sooner rather than later, given the central bank's recent rhetoric. Either China will provide further easing or the RBA will because China hasn't, Deutsche suggests, albeit cuts won't be aggressive in the near term. The analysts note that the spot iron ore price is around US$20/t higher than it was at the last RBA meeting.

A noticeable impact on the terms of trade is required before the RBA jumps in, Deutsche believes, and as such the economists suggest consumer spending will continue to soften and any housing market pick-up over the next 6-12 months will be mild at best.

“Thus,” says Deutsche, “we are reluctant to add cyclical exposure just yet”.

Having said that, Deutsche notes a return to “normal” GDP contributions from the consumer and housing markets, offsetting the current overweighting of resource sector capex, would imply a 5% increase in consumer spending and a 15% increase in housing's contribution. The stocks of most interest to the Deutsch analysts would then be Stockland ((SGP)), Adelaide Brighton ((ABC)), Fletcher Building ((FBU)), CSR ((CSR)), Boral ((BLD)) and Asciano ((AIO)), with retailers providing trading (rather than investing) opportunities.

If interest rates fall, high yield stocks will continue to find support, Deutsche suggests. Many of these have run hard, but the analysts still see potential in stocks which have been a little left behind, being AGL ((AGK)), Primary Healthcare ((PRY)), Insurance Australia Group ((IAG)), Metcash ((MTS)) and Suncorp ((SUN)).

Given the “normal” correlation between the Aussie and commodity prices has broken down, for now, the Macquarie quant boffins have decided to run some sensitivities to determine which stocks would benefit most and least from a lower currency. In this case Macquarie has chosen US$0.90.

The greatest beneficiaries, according to quant analysis, would be CSL ((CSL)), Treasury Wine ((TWE)), Sonic Healthcare ((SHL)), Amcor ((AMC)), ResMed ((RMD)), Aristocrat ((ALL)), Aurora Oil & Gas ((AUT)), Navitas ((NVT)), ARB Corp ((ARP)) and Domino's Pizza ((DMP)).

The casualties would be PanAust ((PNA)), Fortescue ((FMG)), Atlas Iron ((AGO)), Tap Oil ((TAP)), BC Iron ((BCI)), Mt Gibson Iron ((MGX)), Mirabela Nickel ((MBN)), and Blackthorn Resources ((BTR)). It might seem counterintuitive that commodity exporters would suffer from a lower Aussie, but all the above companies report in US dollars.

In a final note, the Macquarie fundamental analysts have removed Oil Search ((OSH)) from their “Marquee Ideas” conviction list given its recent outperformance and replaced it with Charter Hall ((CHC)), given a positive backdrop for wholesale property funds with earnings leverage to improving asset values.
 

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