Weekly Broker Wrap: The Beginning Of The End Of The Mining Boom

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-Merrills urges caution post boom
-Consensus on safe havens questioned
-Surge in fund cash balances
-Macquarie's index on cash rate impact
-Pondering government plans with taxes
 

By Eva Brocklehurst

It is the beginning of the end. The mining boom that is. Stocks in mining services and resources are already pricing this in but there's more to be done in other sectors. The end of the boom reaches further than many think.

Previous booms provoked a subsequent rise in the Australian market and banks outperformed until employment levels started to fracture. Industrials were the best performers as were building materials that benefitted from rising household leverage. In resources, energy was better but the miners underperformed, largely because commodity demand turned out to be weaker than what was expected when the new projects started. All familiar? It is to BA-Merrill Lynch.

What may be different this time is the Australian dollar, which was not fully floating in times of other booms. A falling Australian dollar should benefit offshore industrials such as Brambles ((BXB)), James Hardie ((JHX)), Ramsay Health Care ((RHC)), CSL ((CSL)), Computershare ((CPU)) and QBE ((QBE)). Potential losers are Qantas ((QAN)) and discretionary retailers that may struggle to pass on the higher costs of doing business.

What is of concern to Merrills is that sector performance ahead of the 2013 peak in mining investment was similar to previous booms. Households are the most indebted in Australia's history, and business leverage is above average. At best, this suggests banks and domestic industrials are in for a long period of low growth. Hence, consensus forecasts for banks, Harvey Norman ((HVN)), Myer ((MYR)), Toll Holdings ((TOL)), Coca-Cola Amatil ((CCL)), Metcash ((MTS)) and Woolworths ((WOW)) are worth looking at and the broker finds they do not reflect what's coming. Of greatest concern is the perception about safe havens, such as banks, when the reality may be quite different.

The broker is Overweight on those offshore earners and those with structural growth, such as Rio Tinto ((RIO)), for steel mill inventory re-stocking, and carsales.com ((CRZ)), Ramsay Health and CSL for their structural earnings growth. Offshore exposure supports Brambles, James Hardie and Crown ((CWN)). Beyond that neither banks nor miners are seen as compelling.

Merrills has taken two things from the latest global fund managers survey. Firstly, there's been a surge in cash balances. This has delivered a contrarian equity "buy" signal where short-term pain for long-term gain remains the motive, particularly in emerging markets. China is the biggest macro concern for investors and there has been a sharp reversal in those expecting stronger growth there. Second item: a net 83% of investors in the survey expect the US dollar to appreciate in the next 12 months. Equity investors are long on US and Japanese stocks and short on commodities and emerging market equities. The most popular equity sector is technology and the least popular is utilities. Investors have reduced exposure to banks and staples to the largest Underweight in two years.

Citi has returned from China where the rising cost of capital is a concern. Premier Li Keqiang, in a speech last week, signalled the government may put growth ahead of reform. Citi reports that many experts believe 7.5% growth is the likely floor for this year although they concede the target could be reduced to 7% next year. The liquidity squeeze that occurred in June could push risk premiums in financial market higher and, with the real cost of funding in the industrial sector around 9%, this should force de-leveraging in the economy and increase the risk of deflation.

The broker cites a need for China to undertake de-leveraging in the financial market and in the local government sector and reduce capacity in the real economy. The GDP growth rate in the second half is expected to be slower than the first half. Boosting investment in social housing, railways, environment related activities, urban infrastructure and IT are seen as the near-term remedies. Citi also thinks fiscal policy could become more proactive with the government mobilising RMB1 trillion in idle money.

Elsewhere on the continent, South East Asian nations have reasonable growth prospects. Macquarie finds that, near-term, the region is entering a modest downgrade cycle relative to expectations. This then favours developed rather than emerging markets. The analysts believe this trend is likely to continue until credit growth and the various economies have adjusted to lower liquidity. Longer-term growth is dependent on increasing the momentum in reforms. The analysts find, on that basis, the greatest adjustments are being made by Indonesia, followed by Malaysia.

Macquarie has downgraded 2013 GDP forecasts for Thailand to 4.3% from 5.1%. The country is undergoing an economic downgrade cycle and the export sector is lacklustre because of the weak external demand. Consumption growth has also slowed because of the ending of government stimulus measures. Despite this, the analysts remain constructive on the economy because of strong income growth and a tight labour market. The Bank of Thailand has kept a tight rein on monetary conditions and therefore the same level of correction in credit growth is not expected in Thailand as elsewhere in the region.

Malaysian forecasts have also been downgraded for 2013, to GDP growth of 4.6% against 4.8%, and for Singapore to 1.5% from 1.7%. These changes reflect weak exports and a pull back in liquidity. This is particularly the case for Malaysia where the household and government debt cycle has been more aggressive.

In Australia, Macquarie has reviewed a Reserve Bank research paper which suggests that a one percentage point fall in the cash rate will boost GDP by around the same factor over three years. The impact is not linear. It starts off small and then accelerates around the middle – 18 months – before tapering off. Thinking about the past series of cash rate reductions Macquarie sees little impact so far from the May 2013 rate cut on this basis, a large impact is happening from the two rate cuts in mid 2012 and there is a waning influence from the cuts that occurred at the end of 2011.

With this pattern in mind the analysts calibrated an index that accords with peaks and troughs. Macquarie acknowledges that this sort of index tends to focus attention on changes in the cash rate rather than the actual level of interest rates. The RBA governor has been adamant that it's the level that matters most. For Macquarie, the measure is still useful. The impact of monetary policy on household cash flow is affected by the changes in rates. An example: If mortgage rates fall to 5% from 7% then during that period interest payments fall and disposable income rises, enabling more household spending. If rates remain at 5% thereafter and there's no change in wages growth then disposable income will decline back to the level of wages growth. Hence the stimulatory impact will lessen.

Simple. Let's make it more complicated. If mortgage rates are low when rental yields are high the demand for housing could increase sharply, pushing up house prices and the perceived return on owning property. A sustained low level of interest rates could result in an ongoing boost to housing demand, at least until rental yields decline to very low levels and housing affordability pushes out the marginal buyer. In this case the LEVEL of rates is important. If both the level and change in rates determine the size of the stimulus there will be a point at which the stimulus from past rate cut peaks and then declines.

In the current case, the peak in stimulus can be expected for this cycle in the next three months. This is coupling with recent indicators on the economy which suggest growth is weakening. So, as the stimulatory impacts of the 2012 cash rate cuts are also weakening those looking for a dramatic turnaround in the economy's growth momentum may be disappointed. To draw the obvious conclusion from the index: if the RBA continued to ease the cash over the rest of 2013 to 2% – and this was fully passed on to mortgage rates – policy would not be more stimulatory. It's just the stimulus would be sustained for a much longer timeframe.

Now for something simpler. Perhaps. The changes the Australian government intends to make to the carbon pricing mechanism, if re-elected, include bringing forward the floating price (ETS) by one year to start July 1 2014. The government does not intend to change the household assistance package and expects the move to a floating price will ease the cost of living. Australian corporates under the current 3-year fixed scheme would have paid $25.40 per carbon dioxide equivalent tonne in FY15. The floating price is now expected to be more aligned to the European carbon price which stands at around EUR4/t. Goldman Sachs thinks the proposed cost savings are immaterial to listed equities.

Another tax item where change is mooted is the Fringe Benefit Tax concessions. Goldman Sachs believes, at face value, the changes are negative for McMillan Shakespeare ((MMS)) as they may reduce the attractiveness of novated leases where the vehicle is used predominantly for private purposes. In other matters of government, AGL Energy's ((AGK)) Loy Yang A was a beneficiary of the Energy Security Fund. The early exit from this program may affect the free carbon permits the company expected to receive from the government. These changes are all dependent on the government being returned.

If the Coalition form the next government they have indicated the carbon tax and ETS will be repealed entirely.
 

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