Weekly Broker Wrap: The Gap Between Defensives And Cyclicals

This story features WHITEHAVEN COAL LIMITED, and other companies. For more info SHARE ANALYSIS: WHC

By Andrew Nelson

Greece may have formed a new government last week, but few euro questions have been answered as to the fate of the continent. The US economic recovery also showed more signs of cooling, while markets worldwide both rallied and tanked. With little firm in the macro world to work with, Australian brokers did what they could to divine a clearer outlook for the domestic scene.

Analysts at Citi began last week with a look at the decreasing amount of value in defensive plays and provided a bit of hope for cyclical stocks, noting the recent  outperformance of the more defensive sectors  is starting to look like what happened in 2008/09.

Thus, points out Citi, the traditionally defensive sectors are now trading on multiples that are at least as large a premium to the more cyclical sectors as they were in early 2009 and late 2011. However, those premiums subsequently unwound a little and cyclical stocks recovered for at least a little while.

Yet while the broker admits that recent developments around the globe have increased the level of uncertainty and the perception of risk, it feels this might be a bit overdone and be pricing in eventualities that are even direr than currently warranted.

Despite offering little in the way of earnings growth in many cases, the broker notes the premium at which some defensives are treading seems to be implying significant earnings declines in cyclical sectors and while Citi admits this may happen, it feels such downside is now pretty much priced in at current prices and multiples.

In a way, this is good news, says the broker, as even a small run of good news could bring valuations back from the fairly low point to which they have fallen.  This has the broker seeing some positive signs for a potential recovery in the resource sector, as global growth hasn’t really slowed that much, while commodity prices have fallen significantly.

Once realised, the broker hopes this actuality will help to lift the local market, which in turn would provide some decent upside benefit to financial stocks. The broker is less confident about bounces in other domestic cyclical sectors given the ongoing structural change they are facing.

In the meantime, Macquarie updated its Australian equity market outlook, which fits in with Citi's view a little as Macquarie isn’t expecting great times any time soon, but nor does the investment banker anticipate the end of the world as we know it.

For the 12 months ahead, Macquarie is forecasting total shareholder returns for the S&P/ASX 200 of around 10.7%, which sees the June 2013 index target at 4323. This return includes 5.2% in share price growth and a dividend yield of 5.5%.

Unlike Citi, Macquarie doesn’t see the bulk of the upside coming from the Resources sector, which it expects to deliver a total return of 8.8% versus the broader Market ex Resources at 11.4%. On the Small Ords, Macquarie expects total shareholder returns of 11%, with 5.2% coming from capital growth and yields at 5.7%. Within this, the broker predicts the Small Industrials will deliver a capital return of 5.1% versus the Small Resources at 5.5%.

While Macquarie admits that Price to Earnings Ratios may increase from currently depressed levels, it believes that any expansion will probably be limited given the lack of any solid evidence pointing to any sort of strong or sustained earnings recovery.

It goes without saying that such a sustained recovery is very important when discussing the economic prospects for Australia as a whole. Nothing bears this truism out better than UBS’s dissection of recent Australian employment figures.

A couple of weeks back saw the release of May jobs data, which booked its third consecutive monthly gain and made for the strongest 3 months period in over a year. But it wasn’t until last week that UBS got a look at quarterly jobs by-industry data, so the broker could see where the jobs actually came from. Unsurprisingly, most of the upside came from mining and mining related industries, which have increased year on year job growth to over 8%.

Not a bad number, but UBS sees little help from other sectors and that’s where the problem is. The broker notes while public sector employment growth remained at what seems a solid 3%, the flat outcome has the broker expecting a slowing trend for this sector in the year ahead.

There was worse news from the private other sector, which UBS notes is mostly comprised of domestic cyclical. This group did book a minor improvement on a year on year basis, but UBS notes it is still looking quite anaemic given there were no net jobs created in the quarter. Meanwhile, the deep cyclicals, such as construction, real estate and manufacturing posted significant declines.

Thus while the top line read may well have shown much hoped for growth, the broker notes the slowing in government jobs on top of the increasing weakness in the non-mining private sector will do little to increase the confidence of Joe Consumer. The broker’s claim is further supported by its new measure of employment weighted wages, which shows the remaining 63% of the workforce outside of mining and government are sharing less than a quarter of the increase in wages.

With resources and related companies carrying such a large national burden, RBS’s downgrading of its commodity price forecasts and the subsequent lowering of sector earnings was certainly not great news. The broker notes that continued global macro uncertainty is providing some major headwinds for both the global economy and thus for commodity prices.

Concerns about energy demand have seen increasingly lower prices, which has ultimately lead to energy prices falling faster than metals. The broker notes oil and gas prices are now well down from the start of the year, with gas down around 18% and thermal coal down a whopping 25%.

Among metals, both aluminium and nickel prices have slid 6-8%, with capacity additions in nickel seeing stockpiles increase, thus an increase in demand is desperately needed to help stabilise prices, which the broker finds unlikely in the current environment. The ongoing erosion of copper stocks, despite a weak EU and slowing China, has at least put a temporary floor under the copper price, notes RBS.

The broker downgraded its thermal coal prices, although it does expect the market will gradually tighten later in the year. Aluminium and alumina prices were cut by 5%-10% over the next few years, nickel price forecasts were cut by 10%-17% over the next three years. Copper price forecasts remained pretty much unchanged. 

Ultimately, the broker expects sentiment towards the sector will begin to turn, and once this begins, even the better plays in the sector are likely to significantly re-rate.

Right now, RBS likes Rio Tinto (( RIO)) better than BHP Billiton (( BHP)) given its view the recent  weakness in RIO’s share price provides decent investment opportunity, especially given the iron ore spot price is still in good shape.  The broker notes Alacer Gold ((AQG)) has a few catalysts ahead on the cards in the year ahead and thus remains the broker’s top pick in the gold sector. RBS also sees material upside in Atlas Iron ((AGO)) at the current price.

Macquarie saw a little ray of sunshine in the sector last week, adding Whitehaven Coal ((WHC)) to its list of Marquee Ideas. The broker notes the stock continues to trade at a discount to valuation given weakness in the thermal coal market, but with Macquarie expecting suitor Nathan Tinkler to follow up on last week’s incomplete non-binding proposal, the M&A upside is at least significant.

Reinforcing the view of a weak outlook for domestic cyclicals, UBS last week reviewed the IT sector. The broker noted the poor macro outlook is pushing back projects starts, thus deferring potential revenue and offering little in the way of clarity for FY13.

If IT is a sector investors are seeking exposure to, the broker likes SMS Management ((SMX)) given a strong balance sheet, a higher end industry position and an attractive valuation. In software, UBS prefers Technology One ((TNE)) with 13% per year earnings growth expected over the next 3 years and, of course, an attractive valuation.

 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms