Too Early To Worry About Rate Hikes

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In this week's Weekly Insights:

– Too Early To Worry About Rate Hikes
– Mining Services: Worst Yet To Come?
– Capital Management From Big Miners: Too High Expectations?
– Aussie Banks: Don't Say "There's No Upside Left"

Too Early To Worry About Rate Hikes

By Rudi Filapek-Vandyck, Editor FNArena

One could be forgiven for thinking the prospect of interest rate hikes from the RBA is going to spell bad news for the Australian share market.

After all, it was only weeks ago the Fed's Janet Yellen made an "oh, six months or so" slip of the tongue and US equities found themselves in instant turmoil.

Observe how many times funds managers, stock brokers and other market commentators predict that once interest rates are on the rise again, those investors seeking yield in the share market today will again abandon ship and flee towards the safety of government bonds and term deposits, to the detriment of banks, consumer staples, Telstra ((TLS)) and other yield stocks in the share market.

What these forecasters don't mention is that a general consensus appears to be in the making that, even after some recalibration by central banks here and in the US, interest rates are likely going to stay lower for longer. Plus history shows rate hikes are not by definition bad news for equities. As a matter of fact, US equities tend to perform well in the lead-in to a new tightening cycle by the Federal Reserve, more on that below.

First, how concerned should investors in Australia be about the RBA tightening later this year?

Economists' views and predictions remain divided on the issue, but some, like the economists at UBS, recently made a switch to the less hawkish side because, as UBS explained on Monday, forward looking indicators for consumer confidence, housing and the jobs market are now universally pointing towards "at least a couple of softer months in Australia's data flow ahead". UBS is projecting the first RBA rate hike for the first quarter of 2015, but now acknowledges the timing might prove too optimistic if Australia is cycling through some weaker quarters between now and year-end.

This is why some economists still haven't given up on the potential for yet one more rate cut instead.

For the share market, including those investors worried about their dividend stocks, this prospect is not universally good news. The medium term status quo on the RBA cash rate might provide more comfort, rightly or wrongly, but the reason as to why there likely won't be any rate hikes this year is already impacting on the outlook for the local share market today.

Deutsche Bank strategists have cut their targets for the ASX200 to 5700 by year-end, from 6000 previously, and to 5900 by mid next year (from 6200). The index is now expected to reach 6100 by late 2015. In simple terms this indicates the potential initially on the table for 2014 now seems to have been spread over 2014-2015. This also implies that, despite all horror predictions for yield stocks in the market, twice-per-year dividend pay-outs are likely to remain important in the bigger scheme of things.

Last week I reported the trend for earnings estimates in Australia had now turned negative (less growth ahead with expectations trending south) on the back of disappointing company updates, sooner-than-anticipated sub-US$100/tonne prices for iron ore and a stubbornly high Aussie dollar, even though most forecasters maintain the outlook is for weakness. Westpac, however, is toying with the idea for yet another surge to USD-parity in 2016 and beyond. That would further cut earnings growth potential for the Australian share market (including for miners).

In its latest strategy update, Deutsche Bank explicitly acknowledges the weakening in the local earnings "pulse" on the back of reduced pricing for iron ore and, yes, also because of that stubborn Aussie dollar. While earnings momentum is expected to remain weak for the next few months, Deutsche Bank also believes a stronger earnings momentum is likely to emerge later this year. That should push the ASX200 onwards and upwards towards the 6000 mark.

In the meantime, Deutsche Bank has cut the mining sector to small Underweight from Overweight previously, while keeping Energy stocks on Overweight and banks Underweight. Because banks' valuations are currently above historical averages, the strategists "prefer to get defensiveness and yield elsewhere". Among industrials, Deutsche Bank likes exposure to housing, general insurers, real estate, healthcare and utilities (the latter are the best performing sector thus far in Australia and Deutsche Bank is happy to stay Overweight).

The bottom line, in Deutsche Bank's view, is to take some risk off the table, without moving too far into defensive mode.

All this still leaves the question unanswered: what about the prospect for rate hikes?

Let's turn to the mightiest of all central banks in the modern era: the US Federal Reserve. Analysts at Macquarie studied all 18 easing and tightening cycles by the Fed since 1954. Their conclusion:

"Don't think about reducing exposure to equities just because the Fed is likely to start hiking rates in 2015. Equity returns are usually strong in the lead-up the 1st hike, and then slow gradually with each subsequent rate hike".

And here's the message all investors might want to take into account:

"The 1st rate hike is unlikely to put an end to the equity bull market. If you look at past cycles, stocks are more likely to rise over 20% than they are to fall in the year after the 1st hike. Stocks normally stay attractive until the third rate hike, after which time treasury bonds will likely outperform".

Macquarie's advice:

"Reduce cyclical risk in early 2015 as the 1st hike looms. We are likely to see a shift in market leadership away from cyclicals after the 1st hike as defensives like Staples, Health and REITs outperform. Investors should cut exposure to interest rate-sensitive cyclical sectors like Autos and Durables after the 1st hike and also switch from corporate to treasury bonds."

So while it is true that -all else being equal- equity market returns tend to shrink over the complete tightening cycle, Macquarie's research suggests this is seldom the case in the early stages of central bank tightening. Plus, of course, we yet have to find out exactly what lower-for-longer means in terms of official interest rates and bond yields.

With both the RBA and the US Fed likely to remain on hold this year, it seems far too early for investors to worry about rising interest rates and possible implications just yet. In particular if we look at the following observation made in the Macquarie report:

"Equity returns in the year after the 1st hike are stronger than you might think".

Mining Services: Worst Yet To Come?

Surely, the thought must have crossed many an investor's mind: when are those beaten down mining services companies going to offer more reward than risk? Is the turning point soon?

For those investors, CLSA's latest visit to mining services in and around Perth provides but an ice cold shower. Brrrr. No reason to be there yet. Analyst Oscar Oberg returned with the view that feedback from mining services companies has never been as bad since he started covering the sector. When exactly Oberg did start remains unclear, but maybe investors better focus on what CLSA is trying to say: things are not getting better. If anything, it appears tough market dynamics are still getting tougher.

Amongst the snippets CLSA reported from various company visits is it appears Forge (remember them?) is still heavily undercutting competitor's bids for jobs, while miners are showing no loyalty or respect for quality and/or reputation: the lowest bid gets the job, it's that straightforward. One company indicated all cost savings had been transferred on to costumers, so management needs to find more savings in the year ahead.

Needless to say, CLSA doesn't think investors need to be here, but for those who think they do, the stockbroker puts forward Decmil ((DCG)) as one that "looks ok". CLSA is also of the view the market is too sceptical about Mermaid Marine ((MRM)), seen as a good business undervalued, while investors are advised to put Imdex ((IMD)) on their watchlist, potentially for after the upcoming results release in August. Analysts cannot visit Perth and return completely empty-handed, of course.

Capital Management From Big Miners: Too High Expectations?

The BHP Billiton ((BHP)) share price has remained remarkably stable in the face of carnage throughout the sector of iron ore-producing Australian miners, with the Chinese import price for the highest quality 62% product finding it hard to rally back above US$100/tonne. The reason is, of course, market expectations that the upcoming FY14 report shall be accompanied by some form of capital management (probably a share buyback) and the relative resilience in BHP's share price can serve as an indication there's not too many around who doubt management's intentions on this.

But are investors missing something? A report by analysts at Goldman Sachs thinks the answer to the question is yes. Boards at both Rio Tinto ((RIO)) and at BHP have clearly indicated, points out Goldmans, that reducing debt has the highest priority and giving back some of the excess cash flows to shareholders comes second. BHP is on record for saying debt has to be pulled back below US$25bn before capital management can be considered. For RIO the magical debt number is a little less precise ("mid-teens") but Goldmans believes it sits around US$16bn.

Falling prices for coal and iron ore can potentially already have had an impact on capital management prospects for both, says the Goldmans report, as the analysts calculate the targeted debt level may not be achieved until late 2015, while for RIO it may not happen until early 2017. Goldman Sachs' projections for iron ore prices are probably the lowest in the market, so those projections might be too bearish, but that doesn't mean the report should be dismissed. Lower iron ore prices and no impact on capital management for both companies? Really? Prices better start moving higher, or else.

Aussie Banks: Don't Say "There's No Upside Left"

Aussie banks. Always a good opener to get a decent conversation going between investors and share market experts of all colours and stripes. For those all too convinced the only way is down, banking analysts at Deutsche Bank believe the recent reporting season showed sufficient momentum for yet another year of double-digit total investment returns ahead for all major banks, except laggard National Australia Bank ((NAB)) – see table below.

Their peers at Morgan Stanley, however, also issued a report to warn about a general de-rating for the sector as "trading multiples are full, volume growth is hard to find, competition is increasing and loan losses are near the bottom of the cycle".

The two reports by Deutsche and MS symbolise the present dilemma for investors: if banks can hold on to their current elevated multiples, shareholders stand to enjoy yet another year of double-digit returns. If, however, that long-awaited de-rating finally arrives, things might look a lot different, at least in the time that de-rating takes place. But when, oh when?

Deutsche Bank's sector analysts don't seem too worried, but Deutsche Bank's investment strategists are less confident. They prefer to remain Underweight the sector, for exactly the reasons mentioned by MS.
 

(This story was written on Monday, 26 May 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(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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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