The Big Confusion

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

By Rudi Filapek-Vandyck, Editor FNArena

The world is expecting an acceleration in economic growth in the quarters ahead. Delayed by extremely bad US weather at the start of 2014, and supported by further infrastructure stimulus in China, global activity is projected to rise between the second quarter and the end of this calendar year. If some of the optimistic views prove correct, the difference in pace could be significant (especially in the US).

No wonder thus, investment strategists at major investment bankers and global wealth managers are sticking to their mantra that "growth" and "risk" remain the key ingredients for investor portfolio performance in the year ahead, regardless of the somewhat disappointing results witnessed for global equity markets thus far.

Overall enthusiasm for stocks and assets leveraged to higher economic growth is further fuelled by up-trending indices for commodities, such as the Thomson Reuters/Jefferies CRB Commodities Index which has now, according to chartists, broken out to the upside, indicating a new period of outperformance for the sector has begun.

And yet, not everybody is making that same connection when it comes to local and global equities and where investors should allocate their money. Take UBS, for instance. The global wealth manager distributed a 42 pages strategy report to its wealthy clients last week, in strong defence of the ongoing attractiveness of global equities. It contains sentences such as:

"While some fear that the impressive run for stocks may be growing a bit long in the tooth, we argue that bull markets simply don’t die of old age. Keep in mind that valuations are far from stretched, the growth outlook continues to improve, and the policy backdrop is still supportive."

Despite geopolitical uncertainties, UBS strategists expect the global economy to accelerate this year, providing support to US and eurozone equities as well as high yield bonds.

The tactical asset allocation overview included with the report clearly shows UBS prefers small and mid-cap stocks in developed markets, and the US dollar, as well as large cap growth stocks, but NO COMMODITIES. UBS advises investors to remain Underweight Commodities.

Global Strategists at Citi equally updated their recommendations recently. At least they put Resources Stocks on Marketweight, but dig deeper and we find this is because Citi likes the big, diversified conglomerates that are spending less on capex and will be pleasing shareholders with buy backs, asset sales and extra dividends. Hardly a strong endorsement to embrace the sector when the two largest economies of the present day world are about to show healthier growth numbers.

But what about the CRB index that is breaking out to the upside?

A recent report by Reorient Financial Markets states that, year to date, no less than 32 commodities have contributed to the upswing in the CRB index. Apart from ethanol, up 65% since late February, this group includes cement, soya beans, wheat, milk, butter, coffee, cheese, sugar, cotton, lamb, US beef, lean hogs, chickens, orange juice, rubber, cocoa, fatty acid, gold, tallow fiber, platinum, palladium, rhodium, tin, nickel, aluminum, aluminum alloy, natural gas, bismuth, cobalt, antimony, stainless steel and iridium.

I don't want to be disrespectful, but most investors in Australia would find it very hard, if not plain impossible, to seek exposure to most of the commodities mentioned, with exception of stainless steel, aluminium and nickel. Gold is hardly a leverage to better economic growth and the natural gas contract is US-centric so doesn't apply anywhere else.

What remains absent on the list are the larger commodities markets that are so often used as leading indicators for the global economy's well-being and that have a dominant reach among resources stocks on the Australian share market (as well as elsewhere): crude oil, copper, coal and iron ore. All have made a lacklustre entry into 2014 and if recent commodity prices updates by sector analysts are anything to go by, none of these markets will be shooting the lights out this year or next.

It's going to be an interesting kerkuffle in the months ahead between, on one hand, the eternal commodity bulls, supported by technical analysts who take direction from the CRB Index and its equivalents, and, on the opposite side, sector analysts and strategists such as the ones mentioned above, who see markets that are well-supplied with not enough growth in demand to create widening deficits.

Further complicating this battle of opposite minds is the fact that -bigger cycle picture- it seems rather logical to expect crude oil, copper and iron ore to go through a similar down-cycle as most other industrial materials have gone through in years past.

In the absence of a strong, broadly carried upturn for commodities in general, like we last witnessed in 2009-2010, investors will have to be mindful of the higher risk involved while relying on specific stock picking talent and the occasional touch by Dame Fortuna to separate the winners from the dogs in this always volatile segment in the months ahead.

Recent updates on commodities price forecasts by analysts have not only generated a slew of rating upgrades for small and mid-cap mining and energy stocks (suggesting they'd been sold off too far, even in the face of lower prices), they have also impacted on forecasts for industry bellwether BHP Billiton ((BHP)). The consensus forecast for the present fiscal year to June 2014 has fallen a few percentage points in recent weeks but still suggests BHP's FY14 result should reveal a healthy improvement on last year's disappointment to the tune of 24% growth in earnings per share.

However, consensus for FY15, which, if you think about it, should now be the all-important benchmark for investors, is showing negative 5% growth, suggesting, again, that lowering costs and growing production can only offset falling prices for so long. For Rio Tinto ((RIO)), whose financial year runs from January to December, comparable growth projections are 6.7% and 8.9%. For Fortescue Metals ((FMG)), the prognosis is for 97% growth, and then a negative 2.6%. For Mount Gibson Iron ((MGX)), the numbers are plus 6%, then negative 53%.

Of course, the validity of these numbers still has to be proven but, thus far, the trend is to the downside. All this also explains as to why capital management is now high on company board's priority lists, and why the upper echelon of Australia's resources stocks is becoming less and less volatile. Growth numbers in double digits are becoming more exception than rule and investors have started to realise that dividends are forthcoming, and they will increase in the years ahead, while growth is not a given.

The poster child example for this transformation is Woodside Petroleum ((WPL)), whose outlook is now dominated by two key factors:

1. Revenues and profits are expected to peak in the present year, and then gradually slide downwards
2. Shareholders should see hefty dividend payments

While speculation about the sustainability of Woodside dividends continues, fact remains the share price has moved sideways since August last year between $37 and $39.50 which, from a historical point of view, is exceptionally placid for an oil and gas levered asset. However, if we accept that the Woodside narrative has now become more about dividend/yield than it is about growth, then this sideways pattern makes all the sense in the world. Even if Woodside cuts its dividend in 2015, as market consensus is suggesting, the shares still offer more than 6% yield for that year.

A similar pattern seems to be emerging for BHP Billiton, which should be the first "next Woodside" in a growing list for the years ahead that also includes Fortescue Metals, Rio Tinto, Oil Search ((OSH)), Santos ((STO)) and possibly even Origin Energy ((ORG)). While further-out projections for heavy investment-dependent commodity producers always remain vulnerable to shocks and changes, in particular with debt-laden China the all-important factor, the odds still very much remain in favour of several more large caps in the space turning into a "Woodside" in the coming years.

This essentially means less volatility and strong support to the downside but also less growth overall, both for profits as well as for the share price.

Those who still think the BHP share price will be at $50 in 18 months' time clearly have a different world in mind, possibly the one that existed between 2004-2007 and that made a brief come-back in 2009-2010. (Those are also the ones that don't like to be reminded that BHP shares were trading at today's level in 2009 – 4.5 years ago).

Note how BHP shares have tracked sideways between $35-$39 since August last year. Rio Tinto shares, which still have a lot of catching up to do on the yield offering in comparison with Woodside and BHP, traded below $60 and above $70 during that same period. Fortescue shares, which only started offering a decent yield this year, have over that same period traded between $3.67 and $6.00. Next year the yield could be comparable to the banks.

Aussie, Schmaussie For Australia's Exporters

Healthcare stocks in Australia are mostly exporters and/or multinational operators. As such, they are the easiest identifiable sector in the share market to be impacted by changes on currency markets. No surprise thus, a stronger-for-longer AUD, taking guidance from interest rate differentials and renewed support from Beijing, has now triggered the first FX-inspired sector updates among stockbrokers.

Judging from the table below, taken from UBS' latest update, the overall negative impact remains rather benign. Healthcare is simply the first off the rank when it comes to updating forecasts for FX adjustments. The rest of the market is about to receive similar scrutiny in the weeks ahead.

(This story was written on Monday, 07 April 2014. It was published in the form of an email to paying subscribers on that day).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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YOUR EDITOR ON BONDS VERSUS EQUITIES

Fixed income specialist Fiig has uploaded a recorded version of Your Money, Your Call – Bonds versus Equities from March 21st on YouTube and this means it can still be viewed by investors who missed the original broadcast. What turned out a highly enjoyable and informative program comes with a total duration of approximately 48 minutes of uninterrupted talks and discussions about yield, growth, portfolio balance, security and protection for SMSF trustees and other investors.

The broadcast in full can be viewed via YouTube:

http://youtu.be/5X_Q28xbcZs

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RUDI ON TOUR

I have accepted an invitation from the Australian Shareholders' Association (ASA) to present to members (and others) in Wollongong on June 10. Title of my presentation: The Share Market: Always The Same, Always Different.

Click to view our Glossary of Financial Terms