ASX Weekly Wrap 23/04 - 27/04

The XJO gained ground for the fourth week in a row with our best week in some time. The XJO finished +84.80 for the week or +1.44%. Our high was 5,953.60 on Friday and our low was 5,868.90 on Monday. In what was another shortened trading week, due to the ANZAC Day public holiday, there was little in the way of domestic data or corporate news to guide us. We mostly just rid the coat tails of the US markets and their earnings season, which is well under way.

The sole piece of economic data to be released were our CPI figures for Q1 this year. Both the annual and quarterly headline figures came in softer than expected with +0.4% (vs +0.5% expected) and +1.9% (vs +2.0% expected) the reads. The annualized trimmed mean figure, which many deem to be more accurate and noteworthy, actual beat forecasts. This figure came in at +1.9% YoY, when +1.8% was expected and +1.8% was the last read for Q4 in 2017. What does this mean? Not that much in the end as we need to see follow up improvements in the next few quarters to confirm the bias. It is however, a signal that inflation may be turning back up. If this is to be confirmed with further reads moving forward we could actually see the RBA lift rates in Q1 2019.

The US released its GDP figures for Q1 on Friday night with some mixed results. The year on year figure came in at +2.3%, which was higher than the +2.0% expected but lower than the +2.9% read in Q4 2017. The quarterly growth figures were much softer than expected with the US economy expanding +2.0% for the quarter when +2.2% was forecast and down from the +2.3% read last quarter. This shows the US economy could be slowing, but it is more than likely just a seasonal read. The first quarter in the US tends to be weaker due to weather events such as heavy snow in the north. Once again if we get a couple more softer reads moving forward there might be cause for concern, but going by the US earnings season this should not be the case.

As I mentioned earlier the US earnings season is well under way and showing some of the best strength we have seen in years. As you can see from the chart above the avg earnings growth sits around 30% year on year. This has been helped along with the corporate tax cuts coming into effect in the first quarter as companies are paying on average 6% less tax than they did in Q4 2017. However it’s not just earnings that is really motoring along as most metrics such as revenues, dividends and ROE are also beating forecasts comfortably. For example let’s take a look at Amazon’s Q1 results. EPS came in at $3.27 per share vs $1.26 expected. Revenue was $51.04bill vs $49.78 expected and the AWS division, which is their cloud offering similar to Microsoft’s Azure, hit $5.44bill in revenue vs $5.25bill expected. Revenues have also increased 43% year on year. This is not all just down to tax cuts, but a very strong US economy and corporate conditions. Amazon also lifted its forecasts for the second quarter well past estimates so it looks as if the good times will continue.

*Chart courtesy of Betashares (www.betashares.com.au)

Still on the topic of US earnings and valuations I wanted to quickly discuss the chart above provided by Betashares, an ETF provider, which I saw give a presentation last week. It shows the relationship between forward PE ratio (S&P 500) estimates vs the US 10 yr bond yield. Basically it says as bond yields increase then forward PE estimates decrease. This relationship is something I have been talking about for 18-24 months. It has been my view whilst bond yields remained low the US markets could trade at a premium to the long run PE. This was mainly due to the fact investors would seek higher returns via equities vs what they could get via bonds. Now as I have spoken about recently the reverse is slowly happening. As bond yields rise more funds are shifting into bonds, out of equities, for those returns as US bonds probably represent the safest investments on the globe.

Current US 10yr bond yields sit around 3% so based on the above chart you would expect the market to be trading on a forward PE ratio of roughly 16-17x. The US market is currently trading around 17x forward earnings, however this number could drop given the strength of earnings this quarter, hence we are right about where we need to be. Now over the next 2-4 years I wouldn’t expect that 10yr yield to get any higher than 4%, which means the forward PE ratio would come down to roughly 15x for fair value. The chart also shows how far away from an equities bubble we really are in relation to bond yields. You can see in Jun of 1999 the PE ratio was up around 25x forward earnings whilst bond yields were just over 6%. Also in 1987 we had a lower PE of 15x but also yields of 9%+. Both showing how dramatically overvalued the markets were before their respective crashes. Current market conditions represent nothing even close to these so whilst we may see corrections from time to time I believe we are well off any crash.

Not much corporate news around so have little to cover. I don’t think many, if any, of my clients hold Healthscope (HSO), but recent events last week make them worth covering today. HSO received a highly conditional and non-binding takeover offer from an investment consortium last week. The consortium consists of AustralianSuper and a Canadian Pension fund among others. A $2.36 all-cash offer was placed on the table for HSO by the group on Thursday last week. This represents a 16% premium to the last trading price of HSO. HSO have said for shareholders to take no action as they assess the proposal. As you can see from the chart above HSO jumped substantially on the news and now are trading around $2.48, well above the $2.36 offer. This suggest the market thinks there may be a competing offer come through or the consortium will have to increase theirs for it to be successful. Generally in these instances I tell clients to wait and see what the board says. It’s more than likely they will reject this first offer and put the ball back in the consortium’s court.

HSO has recently been hit hard by the market as earnings failed to live up to expectations. In fact it was one of the most shorted stocks on the ASX with 13% of its script shorted. This is evidence of the perils of shorting a stock. Generally they are shorted below fair value and can be more attractive to takeover. As we saw with Aconex (ACX) recently, this was even more heavily shorted than HSO, and received a takeover offer which was a 46% premium to its last traded price at the time. Of which many of my clients benefited from greatly. A lot of shorters would have lost a lot of money over ACX and now HSO.

Personally I can’t see the attractiveness of HSO in its current state. It’s no secret its private hospitals business is struggling and the pathology side it’s seeing any real growth. This consortium must feel like it can turn the ship around. A well run hospital business with a strong pathology arm should create solid, reliable and consistent earnings, which is perfect for Super/Pension funds. Sonic Healthcare is a perfect example of a pathology business run well. I will update you all on the HSO situation as it progresses.

Fortescue (FMG) released it production numbers for the last quarter last week in what was a slightly disappointing set of numbers. Total ore mined was 41.6mt, -12% from the previous quarter and -7% from the same corresponding period. FMG sighted adverse weather conditions was the reason behind the lower than expected production run. This also saw costs increase to $US13.14wmt up from $US12.08 last quarter and $US13.06 for the same quarter last year. FMG has not revised its production guidance or costs FY17/18 at this stage, but one would think there is a chance it’s on the table.

FMG also have guidance surrounding the price it is receiving for its iron ore on the spot market and in contracts with buyers. It noted it received 65% of the 62% Fe price for the quarter. This was down from the 68% it received in Q2. Over the last 18 months the gap between lower grade iron ore and higher grade iron ore has continued to grow and FMG has suffered because of this. This is mainly due to steel mills using lower grade ore in China have been shut down due to environmental reasons and most of what is stockpiled in Chinese ports is of the lower grade variety. The chart below illustrates this best.

Up until this price divergence FMG was a favourite stock of mine. Like RIO and BHP they had huge operating cash flows and were paying down debt rapidly. They still do have massive cash flows but are not in as good of a position as they once were. The good news is they have $US2.6bill in cash and only $US3.1bill in debt. They also refinanced a heap of debt during the quarter thus the next tranche due is not until 2022. I am not looking to enter FMG at this point as I want to see the chart stablise again and set up for entry. I still think FMG has a strong fundamental story but they do face some headwinds moving forward. For the market to price them at a higher multiple they will have to prove they can produce a higher grade ore, as they have planned, diversify their business, they are currently looking for lithium and for iron ore to remain around these levels. BHP & RIO remain my favoured resources companies in this space.

Energy and resources were the only sectors to fall into the red last week as commodity prices eased. Those sectors who outperformed generally had a high USD earnings exposure, such as health care, industrials and gold. Overall we are seeing a strong recovery in a lot of sectors who saw heavy losses to start the year. A lot seem to be breaking out now or on the verge of doing so. I have enjoyed seeing a lot more green on our markets the last few weeks.

XJO is looking a lot more bullish these days. We regained that upward trend channel, smashed through the 200 day moving average and now are testing that short term down trend (red line) within this bullish upward channel. I can tell you based on the price action today we have busted through it. Now it’s just a matter of holding it. I can see us consolidating at some point around here. Maybe around 6,050, which was previous support. I then believe we move strongly to 6,200 to start the second half of the year. Generally May/June are dour months for the XJO, however considering April is usually one of our best, and this year didn’t see much action, we could finish strongly into the end of the financial year. I feel it all depends on bank reporting now the royal commission hearings are over. If earnings come in line or slightly above I feel the banks bounce strongly and drive us higher. They are still all yielding 6%+ so there is an income play there still. Also I was noting to a few colleagues just last week that global equity markets seem to have a more bullish tone about them of late. The North Korea threat is all but gone, the trade war worries have fallen away, royal commission hearings are over, US earnings are strong, potential corporate tax cuts talked about here in Australia and the list goes on. Our only immediate threat, and this is more weighted towards the US, is bond yields spiking.

A pretty full on week next week as we have Australian manufacturing/services PMI released, trade balance and RBA meeting. We also have Chinese manufacturing/services PMI out and US jobs. Company wise we have ANZ and MQG kicking off earnings in the big banks plus earnings/production updates from SYR, NST, ORG, WOW and QAN. Of course I won’t be able to cover it all, but will cherry pick the more relevant news.

On a personal note we took our eldest to his first Wiggles concert on the weekend. He sat there in awe as he saw these people he’d only previously seen on TV right in front of him. He seemed to really enjoy it and we will definitely be taking him again when they next come around. On a side note he turns two in three weeks time. Those two years have flown and have been the best years of my life. Hope you all have an enjoyable week and stay safe. I will speak to you all very 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.