ASX Weekly Wrap 17/06 - 21/06

It was another strong week for the XJO closing up 96.80 points or 1.48%. This follows on from a 1.7% rise last week. Our high was 6,691.50 on Friday and our low was 6,527.00 on Monday. The XJO was on a streak of several days of gains before some selling on Friday saw the index close down for the day. This was over concerns of war in the middle-east between the US & Iran. Trump confirmed that strikes were ordered on several targets in Iran after they shot down an unmanned drone in international waters. He then called it off mere minutes before it was scheduled due to the possibility of civilian casualties.

It’s been a few weeks since my last newsletter just due to the lack of news at the moment, but we do have a few topics to cover today; most with a commodity theme. I will also touch on why the XJO has been so strong and why we haven’t seen such bullish conditions like this since pre-GFC.

Iron Ore has continued it stellar run in 2019 as the 62% Fe grade looks set to touch the $120US/t level soon and even the lower grade 58% Fe grade cracked $100US/t in Friday trade. It all comes on the back of more supply disruption during the week as RIO Tinto (RIO) lowered its production guidance for 2019. RIO had originally expected 333-340mt of Iron Ore production for the year, but due to some ‘mine operational challenges’ they have lowered that guidance to 320-330mt. This has further compounded iron ore supply constraints as we have already had Vale pull 6% of all seaborne iron ore out of the market due to their tailings dam bursting in Brazil, then we had cyclones shut down ports in Northern Australia at the start of the year and now we have RIO with their own operational problems. This is also all on the back of Chinese steel production hitting record levels of 1.034 billion tons on a rolling 12 month aggregate, which is 11% up on last year. This has also caused inventories at Chinese ports to shrink to their lowest levels in a few years as they are estimated to have only 130mt in stockpiles with only 40-50mt easily accessible.

Despite their production woes RIO should still post a very strong lift in earnings come reporting season, along with BHP & FMG as well. As all our iron ore producers are cash flow heavy it should see large increases in dividends along with the possibility of special dividends again, like we saw from all three earlier in the year. Most of you hold decent exposure to BHP & RIO as we went overweight towards the end of 2018 knowing that improved iron ore prices ($70US/t at the time) and high operational cash flows would mean an outperformance in the sector. We couldn’t foresee the supply disruptions to come in the iron ore space, but it has worked in our favor in a big way. It may be an area we look to take some off the top in the near future. The main reason is steel profitability margins in China are at almost all-time lows, which generally signals a short term top in the space. Brazilian courts have also given permission for Vale to reopen one of its major mines, which should help supply problems and could see iron ore prices ease. It was just coincidence that these RIO problems came at the same time, which kept prices elevated.

Along with iron ore, Gold is the talk of the town as it crossed $1,400US/oz for the first time since 2014 and it also crossed $2,000AUD/oz for the first time ever. Of course the latter is most important to our domestic producers as it sees them have much superior margins to their US counterparts. Most of the larger producers in Australia such as Northern Star (NST), Evolution Mining (EVN), Newcrest (NCM) St Barbara (SBM) etc all are now in similar situations to BHP/RIO/FMG are with iron ore, but with gold. Most of these producers are digging the precious metal out of the ground at around $1,000 AUD/oz (AISC) and selling it at $1,600-$1,800AUD/oz. Again this is proving them with large free operational cash flows that will result in increased returns to shareholders via dividends, buybacks and corporate activity. I would expect some mergers and takeovers to occur in the sector as companies remain cashed up and on the hunt to increase reserves quickly.

So why has Gold all of sudden rallied so hard over the last couple of weeks? The first being the increased global geopolitical risk via the trade war and tension between the US and Iran. The second coming from a synchronized push by central banks to cut cash rates again. In the US they are now pricing in 84bps of cuts by the end of 2019. In Australia we are expected to now cut twice more before the end of the year. In Europe they have also talked the possibility of cuts + the use of QE again. We now have $US12.5trillion worth of investments in bonds with a negative yields as well. Most of these are in Europe. Hence as rates go lower and yields fall on bonds, gold becomes more attractive as even though it yields zero it acts as a safe haven and also can produce capital gains. Thus instead of directing all of your money into say German Bonds where you have to pay to keep your money there you direct some this away into gold, and hence we get a rally.

Now most of you are severely underweight Gold, but feel this should change moving forward. Even though most of our producers are hitting record share prices I feel they have a long way to go as it seems if gold could rally to over $1,600USD/oz over the next 12 months. As long as the rhetoric is for rates to stay lower, gold should in theory continue to rally. My preference in the Gold space is as follows:

Large-Cap Producers- NST ($11.69) & EVN ($4.30)

Mid-Cap Producers- RSG ($1.21) & SBM ($2.96)

Small-Cap Explorers- EAR ($0.16), BGL ($0.69), RED ($0.20), ERX ($0.069)

Of course don’t go investing in any of the above stocks without speaking with me, or your financial advisor, first but if I am speaking to you about Gold stocks these are likely to be in the conversation.

Now let’s talk about the XJO’s performance over the last month or so and why we now sit a mere 2.6% below our all-time closing highs of 6,828.70 as of Friday’s close. The Australian economy’s landscape has changed dramatically since the election in mid-May.

· First of all we had a very strong, but unexpected, Liberal win, which meant a lot of uncertainty for the market, in terms of Government policies, was pulled right out from under it. Whilst our market had performed well in the face of a potential Labor win with their constrictive policies, a stumbling economy was soon to catch up with it. A Liberal win means its business as usual with a lot of potential for stimulus to come. It also means no tinkering with negative gearing, CGT, franking credits and inheritance.

· We had our first rate cut in three years this month with two more expected, an 80% chance, by July 2020. Some institutions, like the ANZ, believes those extra two cuts will happen by the August meeting. Obviously this is a huge stimulus for the economy with extra money in the back pocket of consumers and business. It makes debt cheaper and easier to obtain. On an average mortgage of $400,000 75bps of cuts, passed on in full, will save households $3,000 a year or $57.69 a week. This is extra money that can be spent in the economy.

· Tax cuts are due to kick in for the FY19/20 with more to come up until FY24/25

· The minimum wage has been increased by 3% starting 1st July 2019

· The Government is expected to run into surplus in 18/19 now with an extra $5-$6bill in income coming in due to commodity price rises (iron ore & LNG). This money is unallocated from a budget perspective so can be further used to stimulate the economy.

· APRA is easing lending criteria dropping almost all of its restrictions it put in place to curb the housing bubble in 2016-17. This will free up money supply and make it easier to obtain debt.

All of the above elements are a big stimulus to our economy and the market is now saying things should improve moving forward. Any data leading up to our election in May is going to be soft. When Australia sees a possible change in Government we shut up shop and stop spending. In 2016, Q3 printed our first negative quarter in some time as the election was held early July and then ran over 3-4 weeks as no Government could form due to how close it was. In Q4 of that same year when everything was said and done we printed a +1% increase in GDP for the quarter. I would expect the same this time. We already had a soft Q1 and I’d expect Q2 to be the same, however expect improvement in Q3 and a really solid result in Q4 as we open our wallets again. Ask yourself this question. If you were a business owner or a potential investor, knowing what we knew of Labor’s policies, why would you spend money or make investment decisions prior to the election? You simply wouldn’t is the answer.

Markets are always looking forward and already know and have factored in data in the past. The upcoming reporting season in Aug/Sep will be soft. Outside of Resources and Healthcare expect it to be rough, but the market already knows this and has factored it in. The market now is saying that moving forward company earnings will start to improve again and grow at above trend. I dare say it will want to see proof of this in the February reporting season in 2020 with better earnings and guidance, because if it doesn’t we will then see a market adjust itself again, but to the downside this time. I am confident we will start to see some improvement by then and I am feeling that the FY19/20 will be a strong one with FY20/21 being one of our best.

We also have a situation now where bond yields are falling, which means money needs to find some place to get a decent return. The XJO with a 4% yield and an AUD below 70c is a very attractive proposition for investors both overseas and domestically. The XJO is trading a little over 17x PE which is expensive historically, but in times like these, with a cash rate heading to 0.75% locally, rate cuts due in the US and bond yields negative across the EU one could argue it’s a fair price or even cheap. I feel a PE of 20x earnings for the XJO and yield of 3.5% could even be justified in this low rate/inflationary environment. The fact you can invest in one of the big four banks here and still easily obtain a 5-6% yield (+ Franking) is something that can’t be ignored given how historically safe they have been in the last 20+ years. If events play out the way I expect then don’t be surprised to see the XJO knocking on the door of 8,000 points in the next 12-24 months.

Ill leave this week’s wrap there. I could go on for another 2,000 words about lower rates and their implications on equity markets, but the main thing you need to take away from this is lower rates are bullish for equity markets. On the personal front we enrolled both the boys in their first school last week and both have been accepted. It’s a very happy/sad moment again as I can’t wait to see them at school, learning, participating in sport and getting involved with the school myself. However, once again, it just means they are also growing up way too fast. It’s one of life’s great tricks to play on a parent I suppose. Give you something to look forward to but at the same time also stealing something away. I’m not sure I will handle their first day at school well. I will probably be an emotional mess ha ha ha. We also took our eldest to see Toy Story 4 on the weekend. I tell you what I wasn’t expected it to tear at the heart strings like it did. Quality film though and a must see for any fans of the series. Hope you all have a wonderful and safe week and I hope to speak 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.