Treasure Chest: How To Play The RBA

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By Greg Peel

The Reserve Bank of Australia has misread the Australian economy over the past year, suggests BA-Merrill Lynch, making the assumption the mining boom would offset deterioration elsewhere. Tuesday's 50 basis point “double cut” is thus a capitulation – a concession to the fact confidence has been sorely hit by by the “huge” structural change brought about by a persistently strong currency.

Merrills sees the Aussie as the fundamental issue. The RBA made 50 points of cuts late last year yet the Aussie has remained elevated and financial conditions remain as tight as they've been for twenty years. Even the double-cut this week failed to much budge the Aussie. The problem is that the usual currency adjustment to interest rate differentials is not working in the current macro climate. With the US recovery tenuous and Europe a relentless concern, liquidity is being pumped into the system globally which devalues the relevant currencies as a result. Thus on an exchange rate basis, the Aussie has been unable to breach parity and shows no signs of doing so soon.

Goldman Sachs agrees on the currency front, suggesting a weaker Aussie remains the key to a sustained economic recovery in Australia. As the RBA's easing cycle accelerates, one can look to history as a guide as to which sectors most benefit in 6-12 months time. Equity performances can be highly variable, notes Goldmans.

The past four major RBA easing phases occurred in 1990-94, 1996-97, 2001 and 2008-09. In the past the retail sector has been the main beneficiary, Goldmans notes, with the majority of the benefit accruing after six months, while building materials also receives a boost. Banks and REITs also outperform after 6-12 months while media has historically been disappointing (given the influence of News Corp ((NWS)).

However, each of those past easing cycles has been accompanied by a fall in the Aussie dollar, and that's where the Merrills analysts have their doubts. The Goldman analysts suggest: 

“The combination of lower interest rates and a weaker AUD moving financial conditions into a more accommodative setting is the catalyst we are waiting for before becoming more bullish across the domestic cyclicals. A sustainable decline in the AUD would cause us to take a more positive view on the domestic cyclical stocks”.

In other words, don't go rushing in with history as a guide on the back of what may well be a sustained RBA easing phase. One hint of QE3 in the US, or further stimulus from the ECB (not to mention the Bank of England, Bank of Japan, Swiss National Bank – the list goes on) and the Aussie is unlikely to respond as hoped.

Merrills suggests “interest rate differentials are no longer a driver of the currency”. If you consider ongoing stimulus to be a form of rate cut, such that while the Fed rate remains at zero further stimulus equates to rates dropping further into the negative, then in reality the interest rate differential influence remains intact. We really need RBA rates to fall without other major central banks altering their stance or suggesting they might yet alter their stance before the Aussie can meaningfully break parity.

The typical equity beneficiaries of rate cuts have been the banks, consumer stocks and the building sector, notes Merrills. The analysts are assuming a benefit to banks and consumer stocks this time, but perhaps less than normal. Merrills is also looking ahead to when the first carbon tax compensation payments are made which would provide for a consumer boost a la the Rudd government's hand-outs in 2009. First to see some money flows would be low-end consumption and gambling, which would favour Wesfarmers ((WES)), Woolworths ((WOW)), Tatts ((TTS)), Tabcorp ((TAH)) and Echo Entertainment ((EGP)), Merrills suggests. The broker also has Toll Holdings ((TOL)) as an Outperform.

Consumer discretionary is not first port of call but given persistent retail weakness, this sector is the most consistently shorted in the market at present. A short squeeze may thus suggest some sharp upside potential. Banks and yield stocks are also beneficiaries of lower rates, Merrills notes.

But the analysts warn the carbon compensation boost may prove short-lived once utility bills start rising dramatically, as they are expected to do as the year progresses. Merrills is not keen on the building sector given the government spending programs of 2008-09 have run their course and in July the Victorian first home builder support scheme ends.

Goldman Sachs had argued prior to the RBA cut that it has been appropriate to maintain some exposure to the domestic cyclical theme, and has focused on building materials via OneSteel ((OST)), retail via Super Retail ((SUL)) and transport via Qantas ((QAN)).

But Goldmans still wants to see that weaker Aussie before becoming more excited.
 

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