ASX Market Update 19th May 2021

ASX200 (XJO)

· The XJO managed to snap a 3-day losing streak with some positive movements on Friday but it was not enough to stop it from having a 66.60 point or 0.94% loss for the week.

· The high was 7,172.80 on Monday and the low was 6,966.50 on Thursday. The XJO has managed to gain 6.48% for the calendar year to date.

· The XJO was able to make a new closing high of 7,172.80 on Monday but did not breech the intraday high it made in February 2020.

Market Commentary

Momentum to the upside continues to dominate global equity markets with the S&P500, DOW JONES & NASDAQ all reaching record highs since we last spoke. The XJO even pushed to a new closing high last week but remained below intra-day highs set in February 2020.

Markets are now looking towards macro data and earnings more as an indicator for direction as we still move through this pandemic. The talk of stimulus seems to create little excitement for the markets these days, which overall is a positive sentiment.

Again, its inflation and real yields that are having most influence on markets for in recent weeks. Overall bonds have been rallying and yields have been falling since the end of March, but we did get some surprises along the way. We received two weak data sets in the US last week with employment data and retail sales missing forecasts by a long way. This seemed to fit the Fed’s narrative that there was a lot to do still in the economy and that rates would remain lower for longer. However, we got some very unexpected inflation data last week that spooked the market somewhat. Inflation for April came in at +0.8% vs +0.2% expected and year on year headline inflation rose to +4.2%. This is the highest it has been since 2008. Core inflation also saw a large beat coming in at +3.0% vs +2.3% expected. Markets came off hard on the back of this with the S&P500 having its worst day since February. What was also revealed in the data was the price rises were broad based and not just concentrated to a select few sectors. This suggests prices are rising through all facets of the economy. The Fed brushed this off as ‘transitory’ inflation and it would settle down to its 2% target within a year. 10yr yields spiked to 1.70% on the back of this news, from 1.56%, but have again settled down to around 1.64% today.

You all know which side I sit on the inflation ledger. I believe inflation has returned and is here to stay on the back of huge consumer driven demand and commodity prices. Now I’m not talking rampant hyperinflation, but a consistent level of inflation we haven’t seen in a decade or more. I would say core CPI in the US, and Australia, will consistently see 2.5-3.0% levels over the next few years. This may not seem much, but we have been living in a world with inflation close to 1.5% for some time, so for me the inflation rate will double. Now in the grand scheme of things this is good news. We may get sharp small sell offs like we saw last week as inflation data looks set to consistently beat forecasts, but in the end, inflation is good news for earnings and wages.

Rising inflation and yields aren’t as positive for Growth stocks and tech in particular. This is as the cost of debt increases, which growth stocks rely on heavily, thus expanding earnings at rates they have achieved in the past decade are much more of a challenge. We will find that tech stocks will be valued at lower multiples than they had in previous years. For instance, last year Apple was valued at 30x+ forward earnings whereas now it is at approx. 25x. Nothing has really changed for Apple in that time, and in fact its earnings outlook has probably strengthened, but the market is valuing in differently now. As you can see from the above the Nasdaq100 has underperformed other markets still 6% below recent highs. However, I still believe that growth and in particular tech stocks, will continue to perform well and are worth accumulating on dips. Again, my preferred exposure in the space is HNDQ which is the Betashares Nasdaq100 passive ETF, which is also hedged against the AUD. This helps protect the investor from a rising AUD.

Market Outlook

Whilst the XJO continue its solid uptrend we are now, as of today (-2% thus far), testing that trend (green) plus back testing previous highs (blue) we broke out from in February. To me we should again bounce and continue our way up as analyst earnings forecasts continue to be revised up and confession season should see upgrades to FY20/21 earnings. Our next big test on the upside is the longer-term trend (orange) we have adhered to since our lows in 2009. At this point it is around the 7400-7500 index level which I would not mind betting we touch before the end of 2021. Remember the chart above is weekly based so each candle represents one week. The other side of the coin is our risk to the downside. If we can’t hold support through 6,700 then we will test our 200dma again at around 6,200. At this stage I see little reason to expect a major downside move given how well earnings are tracking. A major spike in yields could cause this, but since their movements earlier in the year they have been relatively tame and on a slight downward trajectory. I feel the market is comfortable with rising yields as long as its gradual and the message from the Fed, and RBA, remains the same.

Iron Ore

Iron ore has grabbed all the headlines in recent weeks as the price continue to soar (around $US220t). From my perspective its mainly on the back of strong supply/demand fundamentals but the tail end of this price action did see some speculation. Fundamentally iron ore demand is being driven by China, via steel production, as they came through their seasonally soft period of the year with relative strength. March iron ore imports saw seasonally adjusted records for China and April maintained that trend. Iron ore imports for April were +3%y/y and remain +6.8% year to date. This all obviously comes back to Chinese Steel production which also saw seasonally adjusted records in March and was only 1% off nominal highs. This is all after China declared it told major steel producers in its largest steel producing province, they need to cut emissions by 30% in the coming years.

The big question is can iron ore maintain these price levels? Over the longer term the simple answer is no. Even though increased steel prices are being passed onto customers and steel margins are close to record highs eventually they will have to give way. Since 2018 iron ore supply has fallen by 0.25% per annum whilst Chinese demand has risen by 5% per annum. This is mainly on the back of the Vale tailing dam disaster and their inability to get production back to previous levels. Eventually more supply will enter the market. BHP are looking to add another 90mt by 2023. Vale are predicting production FY22 to be back at 400mt so around 50-70mt above 2021 levels. Even Mineral Resources are seeing their production lift from 20mt to 90mt by 2025. However, if China continues to grow demand at 5%pa and then the rest of the world ramps up its steel demand via their infrastructure stimulus plans there will remain a large upward pressure on demand. Now commodities analysts and even iron ore producers themselves are terrible at forecasting prices, so I am not going to try and do it myself, however I feel we will not see iron ore below $100t for a couple of years at least.

In the shorter term Q2 & Q3 are generally the strong quarters for steel production in China as infrastructure construction ramps up. Thus, for the immediate term I cannot see a material correction in iron ore prices until at least the fourth quarter this year.

So let’s talk exposure. The obvious, and probably safest plays, in the sector are BHP ($48.92) & RIO ($123.54). They should see some capital appreciation over the coming year + provide an extremely healthy 6-7% yield (fully franked). FY19/20 was an excellent year for the iron ore miners, but FY20/21 will be better again as the iron ore price has been even better. Add in some diversification via copper, met coal and alumina and you should see some bonanza dividends coming investor’s way. Again, these are the lower risk plays in the sector, but obviously price takers in the commodity markets. Hence if we see a material fall in commodity prices then their share prices will also correct. Below are a few other iron ore stocks I feel that could provide larger gains but do sit on the higher side of the risk spectrum, thus please keep this in mind.

Fortescue Metals Group FMG ($22.79)- Australia’s third largest iron ore producer looking to produce around 178-182t of iron ore in FY21. Net debt of $1bill with $3.6bill in cash. Have recently refinanced some debt at much lower rates thus don’t see any debt maturing in the coming years. Forecast to yield 10%+ over the coming 12 months (fully franked) with aspirations to be the world’s largest green hydrogen producer by 2030. Received $US143t for its produce in Q3 compared to around $89t in Q3 20. Did have some capital blow outs for its new Iron Ridge mine, but these are one off instance and easily covered via cash flows and debt. The risk on the upside and downside for FMG comes from its higher correlation to the iron ore price than BHP or RIO as it is a single commodity producer. However, I can see the price climbing back to previous highs around $26 over the coming months.

Mineral Resources MIN ($44.85)- A much smaller iron ore producer at 20mt pa but ramping that up to 90mt pa within 5 years. Add in its mining services division + lithium and you have an extremely attractive company. MIN are smart operators. They have a history of developing solid commodity projects and then selling off majority stakes only to receive the life of mine services contract as part of the deal. Revenue for 1H21 was $1.5bill with operating cash flow at $500mill+. They carry $1.1bill in cash and $900mill in debt. Projected earnings have them at 7.4x & 8.9x PE for FY21 & FY22 respectively. They are also forecasted to pay a 6% yield with just a 43% payout ratio. I like the diversification you get with MIN especially since they expect their mining services division to double in the next 5 years + produce 60,000t+ of Lithium Hydroxide by 2028. A real value add proposition to their current lithium spodumene production. Macquarie has a price target of $61 on MIN which I feel is possible in the next 12 months.

Tombador Iron TI1 ($0.099)- Small soon to be iron ore producer in Brazil. Have a tiny, 10mt, high grade (67%+ Fe) resource sitting on the surface in northern Brazil. Plan to produce 1mtpa this quarter and at $US120t iron ore prices forecasted $80mill in free cash flow. Of course, iron ore is above $200t these days and they will receive a premium to that price due to their higher grades so that FCF figure will be much better to begin with. Drilling is in place to expand the resource but at this stage it’s a 10-year mine life. The directors have stated they have a large focus on returning value to shareholders via dividends and at $100mill market cap I feel these guys are undervalued. Due to its size and lack of earnings TI1 are a high risk speculative proposition so please keep that in mind.

GWR Group GWR ($0.30)- Again like TI1 they are small operator who began their iron ore production in January this year. Received $22mill in revenue in Q1 and look to easily surpass that in Q2. In fact, their latest shipment in April received $US195t. Have overall iron ore resources of 131mt at around a 60% grade and looking to produce 7mtpa once in full production. Their projects are in WA with excellent access to infrastructure they are looking at an opex of $AUD120t. Thus, are a higher cost producer but still with large margins to play with. Again, only capped at $100mill makes them a high-risk speculative option, so keep that in mind.

I feel like this is a good place to wrap things up, but first a few personal items. I got news last week that I had passed my FASEA Ethics & regulations exam that I sat way back in March. This is a huge relief as all financial advisors in Australia must pass this exam by the end of the year if they wish to remain authorised. This is a huge weight off my shoulders. I am also still doing my regular Ausbiz Tv interviews every fortnight. My latest interview can be found here. I feel much more comfortable in front of the camera and am really enjoying sharing my views with Australia.

Finally, our eldest son turns 5 this Saturday. I cannot wait to spoil him rotten and celebrate the day with him. Watching him grow up into the little boy he has become has been such a precious gift and being able to be a Father to two of the sweetest boys is nothing I will ever take for granted. Being able to work from home means I get to see them grow up and not miss anything. From new phrases they learn to sharing in their little successes each day its such a joy. I could gush about my two little men all day but then I’m afraid I would become one of ‘those’ parents 😊.

I hope you all have a safe and wonderful week and I look forward to speaking with you all soon. Go Crows!

heath@hlminvestments.com.au

0413 799 315

Important Notice

Any advice in this article should be considered General Advice only and does not take into account your personal needs and objectives or your financial circumstances. You should therefore consider these matters yourself before deciding whether the advice is appropriate to you and whether you should act upon it. I am happy to assist you in this process. To do so, I will need to collect personal and financial details from you before providing my recommendations. Please note the author may own shares in the companies mentioned in the above blog.