Weekly Broker Wrap: Oz Economy Soft, Rate Cut?

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-RBA cash rate could be cut again
-Hard to raise building material prices
-Housing recovery patchy at best
-AUD/USD could weaken with equities
 

By Eva Brocklehurst

National Australia Bank economists suspect a weaker economy and benign inflation will compel the Reserve Bank to cut the cash rate again. A May rate cut is viewed as too early but if there is another month or so of weaker activity data then June or July is likely. The economists suspect the RBA will be wary of pushing the rate so low that house prices move sharply higher, but exactly at what point that occurs is hard to estimate. It's difficult to envisage a cut of any more than the 50 basis points the economists are forecasting. This means a cash rate of 2.5% is about as low as it should go. The scenario does present a problem for the RBA. Indeed, a similar problem is faced by Canada, New Zealand and Switzerland.

Quantitative Easing from the likes of Europe, US and Japan is being imported into the non-crisis countries via a push higher in their respective currencies. NAB envisages the RBA may be forced to choose between the short term gain of stemming a rise in the unemployment rate and the negative impact of rising house prices as well as longer term risks for household and the financial system. If the US Federal Reserve's QE was to stop soon then the US dollar would bounce and this could help the Australian dollar fall, taking pressure off the RBA to ease again. In NAB's view, the RBA will not ignore the long-term consequences of rapid asset price increases. In this respect the central bank is expected to accept the short run cost of higher unemployment as a price worth paying for the longer-term health of the financial system.

The driver behind housing activity has been the significant cuts to the cash rate, which has mortgage rates down at 50-year lows, with exception of the short time directly after the GFC. UBS has recently upgraded expectations for housing starts to 152,000 in 2013 and 160,000 in 2014. House price growth is expected to be faster than income growth in 2013. Household confidence in investing in real estate has improved and affordability is now the best in a decade. Rental yields on investment properties are also rising, to be only just below the highest level in a decade in the analysts' view. Residential building approvals are rising, as are prices. The recovery may differ to prior cycles in that UBS expects only a moderate upswing, but a recovery is, nonetheless, underway. Of note, activity in medium density housing is rising much more strongly than detached houses.

Citi took a look at building material companies and their ability to manage price increases. The broker does not rate the chances of success highly. The fact is, producers have historically failed to set selling prices and are mostly price takers. Factors making it difficult are shrinking end markets, intense competition, new entrants, imports, and a consolidating customer base. The factors that support price retention include rationalised capacity and industry acknowledgment of a need to offset the step-change in energy costs.

Success is expected to vary by production and region. Producers of aggregates are seen retaining just 50-60% of their hoped-for 10-15% price increases, while cement suppliers haven't even tried to raise prices. Pre-mixed concrete providers are expected to retain about 40-50%. For asphalt it is a similar story. Plasterboard products are expected to retain 20-30%, an effective 1-3% increase, while bricks are expected to retain 40-50%, roofing 20-30% and masonry 30-40%.

Industry feedback from developers, builders and suppliers is that the recovery in residential and non-residential activity is patchy at best. Combined with the structural challenges of a changing housing mix to the less material-intensive multi-dwelling sector, increased manufacturing costs and increased competition, the risk to underlying earnings is on the downside. In the building materials sector Citi only has Buy ratings for Adelaide Brighton ((ABC)) and Brickworks ((BKW)). On the Sell side are Fletcher Building ((FBU)), CSR ((CSR)), James Hardie ((JHX)) and Boral ((BLD)).

Citi notes non-residential activity has delivered an important but volatile contribution to Australia's economic growth over time. A combination of factors is now likely to see the smallest contribution to GDP in over 30 years. The factors include limited growth in white collar employment, little financial incentive to build and a decline in retailer profitability, which reduces demand for space. Governments have also spent 8-9 years worth of education budgets over 2010/11, restricting further construction from that quarter in the near term. Health is the potential bright spot, but the industrial and accommodation sectors have been crowded out by a high Australian dollar. Citi expects non-residential construction spending to fall by at least 10% in FY13.

The recent price action in some asset markets has suggested the global economy is about to take a tumble. Commonwealth Bank strategists have noticed the monthly average of an "economic surprise index" for the G10 economies has turned negative in April. Although all economic data is important, it is the surprises that tend to generate a bigger reaction and shift sentiment. Ahead of this potential soft patch, the analysts find not all markets are in sync. There is a divergence between global commodity markets, equities and bond yields. There is a risk these close ranks over coming months and, should this happen via a correction in global equities, there would be implications for the FX markets.

The strategists suggest the NZD/USD, USD/JPY and AUD/USD are the major currencies most sensitive to changes in global equities. The most sensitive of the pairs is NZD/USD, while the NZD/JPY is the major cross rate with the highest sensitivity to global equities. If the US equity market converges with other asset markets because of increased global economic uncertainty the strategists expect the first two major pairs, and to a lesser extent the AUD/USD, could be at risk of some downward pressure. They suggest buying on any dip driven by a short-lived negative turn in the broader market sentiment.

Mining and resources have also been disappointing this year, after a strong start. Cyclical stocks may have underperformed globally since mid February but UBS notes mining has been the worst. Mining services as well. The sector appears oversold but is now running into the prospect of seasonal weakness in the iron ore market in the September quarter. Iron ore prices are resilient, for now, but UBS expects them to dip to US$80 a tonne free-on-board and then rebound to just above US$100 in the December quarter. Value may exist in the sector but the near-term conditions make it less than ideal, particularly for iron ore. As a result, the broker has exited Fortescue Metals ((FMG)) and switched the majority of the rating to the heavyweights BHP Billiton ((BHP)) and Rio Tinto ((RIO)). The broker suggests Woodside Petroleum's ((WPL)) choice to increase dividends rather than add to project expansion is a template the latter two can follow.

The broker finds a strong link between the yield trade in equities and bond yields. This is partly a relative value impact and partly a signal of shifting market risk aversion. Yield generally outperforms when risk aversion rises, although the resilience of yield stocks in periods of improving risk aversion suggest structural demand for yield is strong. This is therefore likely to persist until confidence builds to the extent that bonds show signs of a significant sell-off. The broker thinks there is still opportunities in growth stocks but moderate growth and low interest rates should favour higher quality franchises with above-market prospects, particular those with lower volatile cash flows. So, in this way, the growth/quality trade is not overbought.
 

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