By Tracy Askew (Guest Blogger from Super Equity)
In this report, we outline the key themes which we believe will impact the Australian market in 2018. All else being equal, we expect the Australian market to lag its global peers but still deliver relatively solid growth in 2018 – we expect the market to deliver total return of approximately 10%. Momentum in global economic activity should have a positive impact on business investment domestically, which should drive earnings growth.
- Increased investment should drive earnings. The momentum in global economic growth looks set to continue in 2018, with solid domestic growth being experienced in most regions. On the back of this momentum we expect (and subject to no major economic shocks – such as a potential China hard landing) this global growth to have a positive impact on Australian companies’ capital expenditure plans. Our analysis of ASX200 companies point to a notable lift in investments when compared to recent years.
- Infrastructure to be supportive of economic activity. The significant amount of infrastructure work in the pipeline is staggering and we expect this to be a positive earnings and stock price driver. One particular area we highlight is the number of transport projects in the pipeline across Australia, which is expected to peak in 2020 according to Macromonitor. This should also be a positive for employment as the current housing construction cycle slows down and mining capital expenditure stabilizes.
- RBA to raise rates. The Reserve Bank of Australia (RBA) cash rate has been stationary at the 1.50% level for the best part of two years now. In our view, the RBA could be pressed to raise cash rates from historical lows as the momentum in global growth and low unemployment lifts wage growth in Australia and inflation moves towards the bottom end of RBA’s target range of 2-3%.
- Lower AUD vs USD. We expect the AUD to be lower in 2018: (1) moderating economic growth in China: (2) implementation of previously promised tax cuts and other pro-growth policies in the US likely to drive economic growth, placing further upward pressure on interest rates; and (3) the US Fed is expected to raise interest rates three times in 2018 and two times each in 2019 & 2020 versus Australia potentially one rate rise (on our expectations).
- Key Stock picks 2018. Our key picks on a 12-month view are: Amcor, Aveo Group, Afterpay Touch, Brambles, Clydesdale Bank, Mayne Pharma, Qantas, QBE Insurance, Nufarm, HT & E.
The ASX200 delivered a solid return in 2017 calendar year, albeit most of this performance was delivered in the back half of the year. In any case, a solid performance especially considering the restless political landscape, ongoing speculation around housing bubble and subdued consumer confidence. What also helped total returns is the relatively high dividend yield of the domestic market versus other developed market peers.
So, where to from here? In our view, stock prices inevitably follow company fundamentals (that is, earnings growth) and therefore in order to best understand ASX’s prospects for 2018 we need to analyse where the growth in earnings will come from. By way of a quick reminder, in the chart in figure 2 below we have provided a breakdown of the ASX200 by market capitalization. It should not come as a surprise that the earnings growth of ASX200 is largely dependent on Financials (33%) and Materials (18%), which combined make up 51% of the ASX200 index.
Therefore, the lacklustre earnings growth expectations for the overall market should not come as a surprise given these two sectors are expected to deliver approximately mid-single digit earnings growth over the next three years. This in turn will see the overall market deliver approximately mid-single earnings growth over the short term. Our expectation is for the ASX200 to deliver 8-10% total return in Calendar Year 2018.
Overall, conditions in Australia remain supportive of growth – low interest rates, debt remains cheap and business conditions surveys show near term highs. The table in figure 3 below provides consensus forward estimates for ASX200 and respective sectors.
Concerted global growth good for all. The momentum in global economic growth looks set to continue in 2018, with domestic growth in most regions experiencing solid demand. Key regional PMIs (figure 4 below) continue to point to healthy levels of activity and although we may be approaching peaks levels here, we do not see activity falling off the cliff even if that is the case.
Increased capex should be positive for earnings. On the back of this momentum we expect (and subject to no major economic shocks) this global growth to have a positive impact on Australian companies’ capital expenditure plans. Increased investment invariably leads to improved earnings outlook. In the chart below, we have provided the aggregate capital expenditure (historical & consensus estimates) of select ASX200 companies. Whilst we can argue the bankability of FY20 estimate numbers, certainly FY18 estimates & FY19 estimates suggest a notable lift in investments from recent years.
However, we believe investors looking to leverage this thematic need to be selective and we prefer companies which are leveraged to business growth (that is, products being sold to other businesses), especially offshore, rather than leveraged to improved spending by the Australian consumer. We continue to see the Australian consumer as largely constrained.
Elevated infrastructure activity to support Australian economic growth. We see this theme continue to play an important part in the markets over 2018 (and 2019).
The significant amount of infrastructure work in the pipeline is staggering and we expect this to be a positive earnings and stock price driver. One particular area we highlight is the number of transport projects in the pipeline across Australia, which is expected to peak in 2020 according to Macromonitor (figure 6 above). This should also be a positive for employment as the current housing construction cycle slows down and mining capital expenditure stabilizes.
RBA cash rate to move higher in 2018. The RBA cash rate has been stationary at the 1.50% level for the best part of two years now. In our view, the RBA could be pressed to raise cash rates from historical lows as the momentum in global growth and low unemployment lifts wage growth in Australia and inflation moves towards the bottom end of RBA’s target range of 2-3%. A quick peruse of key economic data (and outlook) suggests historical low rates are no longer warranted:
(1) unemployment rate was 5.5% for the Sep-17 quarter (with consensus forecasting it to decline to 5.2% by 2019);
(2) consensus is forecasting Inflation to be within the RBA’s target range of 2-3% in 2018 (estimate 2.2%), with inflation (excluding volatile items) at 1.9% as at Sep-17 quarter; and
(3) GDP growth is expected to steadily increase from 2.8% in 2018 and 2.9% in 2019. Whilst one quarter does not make a trend, we note that the Australian wage growth in the Sep-17 quarter improved to 2.0% (from 1.9%) after being stagnate for previous four quarters. This may suggest tight labour markets may just be starting to have a positive impact on wages growth. However, it is worth noting that low wage growth is a global issue, with the US also experiencing low wage growth despite very solid economic growth.
Australian consumer will remain constraint. Despite the low unemployment rate, we continue to see little wiggle room for the Australian consumer in 2018 given high household debt levels and reduced household savings level. As a consequence, we see retail sales (and therefore the retail sector in general) under pressure.
We do see improvement in wage growth from current historical lows, however we believe this will not return to historical high levels for the following reasons:
(1) technological advancements will see fewer jobs and the competition for those jobs increase;
(2) while unemployment is low, in our view, this is skewed towards part-time positions, with most part timers still seeking full-time positions; and (3) population growth (birth rate + immigration) is also likely provide downward pressure.
Australian dollar (AUD) to decline against the USD. We expect the Australian dollar to be weaker over 2018, but over the long-run still expect it to settle around its long-term average of 0.75. It is worth noting that the AUD’s strength in 2017 was more about the weakness in US dollar (USD) than anything else.
The USD had rallied post President Trump being elected into office on the expectation that pro-growth and inflationary policies could see the US Fed raise interest rate faster than expected (which would close the interest rate differential). However, President Trump’s administration (besides other chaotic sideshows) failed to deliver on key policies such as healthcare, significant infrastructure expenditure and tax-cut reforms (which were only passed by the US Senate at the end of 2017).
Key drivers of a lower AUD/USD in 2018:
(1) moderating economic growth in China:
(2) implementation of previously promised tax cuts and other pro-growth policies in the US is likely to drive economic growth and expectations of future interest rate increases; and
(3) the US Fed is expected to raise interest rates three times in 2018 and two times each in 2019 & 2020 versus Australia potentially one rate rise (on our expectations) in 2018.
Iron ore producers to be supported by elevated iron ore price. As we have highlighted earlier in this report, the momentum in the global economy and buoyant activity (as measured by regional manufacturing PMIs) is expected to continue in 2018, which will be supportive of commodity prices including iron ore.
Further, leading commodities expert CRU is forecasting a 14 million metric tonne (adjusted for 62% iron) drop in China’s iron ore output in 2018. Further, China’s steel production could surprise on the upside in 2018 given high mill margins will incentivise existing producers to increase utilisation as new capacity comes online. According to Steelhome, greater than 8 million metric tons p.a. of electric arc furnace (EAF) will come online until 2020. For iron ore price to be supported at above US$60/t level, steel production (demand) needs to grow above 2% p.a. and according to forecasts by MySteel, steel output production is expected to rise by +2.7% in 2018.
One of the investor concerns with the iron ore sector is the imminent new supply from major miners, with Brazil’s Vale expected to double its output (from 22 million tonnes to 50-55 million tonnes) at its S11D mine. However, new supply from the major miners may not cause a significant supply glut given output from India is estimated to reduce by 8 million tonnes in 2018.
Australian housing – interest-only loans. The endless conjecture on this subject is fatiguing, however it remains a key risk and warrants some thought. Investors, the world over since the GFC, have debated this topic and provided arguments for why Australian housing is different (to avoid a US-style housing crash) or has the same hallmarks (to experience the same brutal meltdown). We are not going to repeat these arguments. What we would like to briefly note is how one of the macroprudential restrictions introduced last year by APRA, to avoid a potential meltdown in Australian house prices, could impact the market in the future.
APRA introduced a restriction on interest-only loans. In March 2017, APRA introduced lending restrictions on Australian banks to limit interest-only loans, to contain risky lending by major institutions. APRA has imposed a cap of 30% on new loans which are allowed to be interest-only loan.
Interest-only loans. As the name suggests, interest-only loans allow borrowers to reduce the upfront mortgage repayments during the initial period (typically 5 years), after which the repayments increase. Hence, borrowers may be tempted to take out larger loans given the initial lower repayments.
Impact so far. Since the introduction, Australian housing financing growth has slowed (was in fact negative in Oct-17, reporting a decline of -0.23%), with loan growth in interest-only loan segment plunging recently (in Sept-17 quarter, it dropped 49% on previous month and down 58% on previous corresponding period). Further, the growth in Australian house prices (as measured by Australia House Price Index for Established Homes) also moderated over 2017.
Key issue going forward. The issue going forward is that interest-only loans are refinanced after the initial period, to avoid repayments increasing. With the restrictions on new interest-only loans, refinancing may become difficult and therefore could lead to mortgage stress in some parts of the market. Whilst this dynamic is worth keeping a close eye on. On a positive note, we welcome the slowdown in interest-only loans (and cooling off in house prices) as a result of APRA’s restrictions. Further, this also supports our view that loan growth for the major banks will be subdued in 2018.
Key picks for 2018…
Our key picks on a 12-month view are presented in the table below.
Amcor (AMC). With a lackluster performance over 2017 due to concerns around cost pressures and weaker emerging markets demand, we believe the current valuation provides investors an attractive entry point. In our view, emerging markets demand should improve from current levels and US demand should also pick as consumer confidence gets a boost from recently passed tax reforms. We like the improving free cash flow profile of the company, which provides AMC the flexibility to undertake value-accretive acquisitions and capital management initiatives. While emerging market performance remains mixed, we agree with management’s long-term strategy to acquire businesses in emerging markets in weak economic conditions to build strong market position for the eventual uptick in economic activity.
AVEO Group (AOG). AOG had a rough 2017 following a media investigation by Fairfax Media-Four Corners in late June, which placed Aveo (AOG) and its revenue model (especially deferred management fee model) in a negative light. AOG’s management has addressed some of the issues by introducing new measures brought in such as changes to contracts with customers. Whilst we do expect some reputational damage, we believe much has already been factored into the share price. We like AOG for the following reasons:
(1) remains an attractive thematic play on ageing Australian population which provides continuing demand;
(2) strong development pipeline to drive future earnings;
(3) good track record for margin expansions expected to continue; and
(4) share buyback supportive of the share price.
Afterpay Touch Group (APT). Whilst APT was a strong performer in 2017, we believe there is more upside to this stock. APT provides a “buy now, take now and pay later” business model. Merchants sign up to Afterpay which enables their retail customers to pay for purchases in four instalments without interest. APT pays merchants upfront, and takes the credit and fraud risk upon themselves. Customers can pay by debit or credit card – for this reason, APT considers banks and credit card providers to be “collaborators” instead of competitors. Merchants benefit because they are able to increase sales to customers who would normally cannot afford to make the purchase in a single lump sum. For this, merchants pay a margin (approximately 4%) and small transaction fee on each transaction processed using Afterpay. In a matter of years, APT has built up 1.3 million customers (89% repeat customers) and over 10,000 retail partnerships. Key catalysts:
(1) increasing online penetration but also going after in-store sales;
(2) moving into new verticals, such as domestic travel (partnership with Jetstar); and
(3) significant retail spending/consumer data monetization.
Brambles (BXB). BXB is a solid business with attractive market positions which we would characterize has having high barriers to entry. Whilst low volume growth has hurt margins, we believe volume growth should return in FY18. The other key issue is the threat of Amazon, which we believe presents both threat and opportunity for BXB. In our view, the use of pallets (even by Fast Moving Consumer Goods customers using Amazon’s fulfillment centres) will not totally disappear and believe pallet volumes can continue to grow (the UK market is a case study of this). With 60% of the business (excluding US) performing in line with expectations, we expect the US Pallet segment to stabilize from here.
CYBG Plc (CYB). The Company is going through a transitional period, but continues to deliver on medium term key priorities (such as cost reduction). Further, management’s intentions to improve Return on Equity to double digits and dividend payout to 50% by FY19 represents significant upside. Whilst the Company struck a cautious outlook post recent results update, we believe the current valuation (trading on 0.9x price to tangible book value ratio) is adequately accounting for this. Further, we believe CYB provides investors diversification from domestic Australian banks, which are experiencing regulatory risks and low credit growth environment.
Mayne Pharma Group (MYX). MYX is a specialty pharmaceutical company focused on applying its drug delivery expertise to commercialise branded and generic pharmaceuticals. Unfortunately, MYX’s recent “opportunistic” acquisition in the US generics market was subsequently followed by a period of significant industry pressure, which saw price deflation run into double digits and is expected to run ahead of historical 5% p.a. averages for some time yet. In our view, a flat year-on-year outcome for FY18 earnings would be a great result. We believe investors need to take a multi-year view on this stock, with FY18 likely to be a reflection point and the share price likely to find a floor around current levels, all else being equal. On the positive side, new product launches should help offset some of the pain being felt in generics, the Company has a healthy development pipeline and working capital is expected to normalize over FY18.
QBE Insurance (QBE). Whilst short term headwinds are likely to persist for the company, we believe the current valuation is adequately accounting for these. There is the risk of the new CEO and CFO to clean the slate and re-set company targets set by previous management (such as Combined Operating Ratio – CoR). This may see the share come under pressure, however we believe this would represent a good buying opportunity. The global insurance cycle and upward pressure on US bond yields remain positive catalysts for the stock. Trading on a 2-year forward blended PE-multiple of 10.9x and yield of 5.9% represents good value, in our view.
Qantas Airways (QAN). QAN’s share price has come under selling pressure and we believe this offers investors an attractive entry point. We like QAN for:
(1) its strong position in the domestic market (with its dual brand strategy continuing to be effective with stable margins);
(2) Jetstar is well positioned for growth in Asia;
(3) partnership with Woolworths bodes well for membership and earnings in Qantas Loyalty; and
(4) oil prices expected to be stable.
Nufarm (NUF). Nufarm is a global agri business involved in the manufacture and supplies of agri chemicals used by farmers to protect crops from damage caused by weeds (herbicides), pests (insecticides) and diseases (fungicides). We see the following key positives for the stock:
(1) transformation in the business mix (lower leverage to glyphosates) has also improved NUF’s balance sheet (lower gearing);
(2) recent acquisitions of Century and FMC in Europe provides increased scale in Europe and positive growth drivers over the long-term;
(3) Omega-3 canola seed project is close to commercialization, which is looking to take advantage of the global deficit in fish oil supply; and
(4) M&A and consolidation in the industry could also be positive driver of share price.
HT&E Limited (HT1). HTI provides an attractive exposure to the outdoor advertising market and radio, which remain one of the few segments in the media sector with a positive outlook. In a recent trading update the company noted that the Company is “on track to meet EBITDA consensus for the year of $118-119m”. The loss of Yarra Trams contract and $150m tax dispute with ATO is currently an overhang on the stock. Having said that, the current depressed share price may give rise to M&A activity, especially given that now the media ownership laws have been relaxed. We note the Company recently denied that the Group had presented to Private Equity investors, which was reported in The Australian.
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