ASX Weekly Wrap 25/06 - 29/06

Before we get stuck into the ‘meat and potatoes’ of this week’s email I want to apologise for how late this is getting out to you all. I have been battling a bad case of the ‘man flu’ and also dealing with a lot of paperwork in readiness for the ANZ to CMC platform transition which takes place next Monday 9th July. I also knew this week’s note would be short and sweet as there isn’t much to write about on a macro or corporate level. Regardless let’s get stuck right into it.

The XJO had its second negative week in a row losing 30.60 points or 0.49% on concerns over ‘trade wars’ between China and USA spreading to the EU. Also concerns over debt levels within emerging markets have seen commodity prices come off as well as equity markets. Our high was 6,250.80 on Monday and our low was 6,161.10 on Tuesday.

First off we will touch on emerging markets (EM) and the increased risks we are seeing in that region of the financial markets. When we talk about EM we are talking about economies/countries such as Brazil, Mexico, and Indonesia etc. These are developing nations that rely heavily on trade and exports from their own country and are immature in nature when compared to developed economies such as the USA, Australia, Canada, most of the EU etc. The problem at the moment in EM surrounds rates and debt. My colleague, James Whelan of VFS Group, has put together a very good write up about the situation unfolding and its impacts on the global economy. His write up can be found here, but I will try and summarise it here myself.

With rates in the US going up it has put a lot of pressure on central banks in EM to also raise their own rates, but why? Most EM debt is funding by the US or denominated in US dollars thus if they don’t increase their rates alongside the US it will devalue their own currencies and increase the size of their debt. To explain this further, hypothetically let’s say your EM currency is at parity with the USD and you have $1bill in US debt. You owe $1bill in USD or 1bill in your own currency to pay that off. However if your currency devalues to say 0.80 vs 1 USD you still owe $US1bill in debt, but it will now cost you 1.25bill in your own currency to pay that off. Essentially your debt has grown 25% due to your currency devaluation.

So why is this a bad situation if EM central banks are just going to lift rates to keep up with the US cash rate? Well as my friend James Whelan put it, essentially it’s a lose/lose situation for EM countries and a double edged sword at the moment. Due to the potential ‘trade war’ between China and the US the value of the Yuan, China’s currency, has been falling vs the USD. Now most EM are competing with China for exports of their goods and if their currency is falling and making goods in China cheaper to buy, whilst your currency is becoming elevated and more expensive, then importers can easily just go to China to get the same goods but cheaper. This means EM economies are at risk of slowing significantly as they export less goods. This increases the chances of them defaulting on debt and/or the global economy slowing as EM make up around 60% of the world’s GDP.

Now I want to be clear. My last statement is a worst case scenario and risks have only increased at this stage. Remember we have gone from an environment with little to no risk to one with some elevated risks in trade wars and the EM situation, thus global equity markets are adjusting for this. Central banks have to find a healthy balance to manage their debt in USD and keeping their economy attractive enough for importers. Also if the trade war between the US and China were to subside, which I feel they eventually will, then it would solve a lot of problems as well. On the flip side if China sees a bump in its exports due to a devalued Yuan then this will help prop up world growth as well. It’s something to keep on the radar for now, but not become too concerned about at this point.

The second topic I want to touch upon, and I spoke about last week, is Oil markets. We all know OPEC increased output of oil production by 1mb/d just over a week ago but in nominal terms it will probably only end up being 600,000b/d due to capacity constraints. This is the theme I want to concentrate on, capacity.

Donald Trump recently tweeted he had an agreement from the king of Saudi Arabia to increase its oil production by 2millon barrels per day if needed. This was later refuted by the white house, but caused a small slump in the oil price before the latest rally. But why does Trump want Saudi Arabia to increase oil production? Well there is a major capacity problem in the oil markets at the moment. Due to the fact that oil hit lows of $26 per barrel as recently as 2016 there has been no major investment in oil production capacity as it wasn’t economical. This low price was caused by a major glut of oil in the market due to over production during the GFC and a slowing global economy. Since then the US has rebounded strongly along with EM, China and Asia and along with that demand for oil. This is so much so that the glut of oil in the market is basically gone and it looks as if we could be headed for a deficit as soon as this year.

Now if you look at the capacity available via OPEC you have Saudi Arabia with about 2mb/d available to increase, and that’s basically where it stops. The US has nothing else it can really bring online either as most of their production comes from shale, which is expensive to increase production of and again suffered from under investment as well. Exploration and investment in new oil fields globally has been low for some time and a major new discovery hasn’t been found in some years. It would take a decade or more from find to production of any major field.

This hurts Trump’s plans as he wishes to rip up the agreement they have with Iran and place heavy sanctions on them again. In doing so though, he would take 2million+ barrels of oil per day out of the market. This could cause oil to surge to $100 again, which in turn increases inflation, forces rates up faster and slows the US economy. Trump can’t have his economy running at 4% per annum and have oil at $100 both at the same time. Thus this causes significant upside risk to the oil price in the near term. My favourite exposure in the energy markets on the ASX remain Woodside (WPL) and Oilsearch (OSH) even though they are predominately LNG. If oil prices are to surge, so will LNG, as demand spills over. There is also an ETF by Betashares with the code ‘OOO’ which tracks the crude oil price and is currency hedged against the AUD/USD, which is another possible exposure. Finally there is another ETF, also by Betashares, which invests in a basket of energy companies (Ex-Australia) listed on global exchanges. This goes by the ASX code ‘FUEL’ and is obviously another option.

The final topic for this week is a brief summary for the EOFY 17/18. I usually do this for a calendar year but felt it would useful since our financial year is obviously different and more important. The chart above gives a brief description of all the major events that occurred during our financial year. Here is a quick summary of the market performance in FY 2017/18:

· The XJO index increased +8.3% and the XAO increased +9.1%

· Total returns on the All Ordinaries Accumulation Index, which includes dividends, were +13.7%

· Only 5 of 21 sub sectors in the XJO declined throughout the year

· Best performers were Auto & Components (+41.8%), Pharma & Biotech (+39.0%) & Energy (+38.2%)

· Worst performers were Telecom (-35%), Banks (-6.7%) & Utilities (-5.7%)

· Sub-index wise the Small Ordinaries increased +21% and the Mid-Cap 50 +10.6%

· The best and worst performing stocks can be seen on the chart below.

I think I will end it here. I will leave the technical analysis for the XJO for next week as not much has changed since last, it’s still looking very bullish. The US has it 4th of July celebrations and public holiday this week so markets are likely to be quieter than usual. No corporate news scheduled but there is a host of macro news for Australia this week. ANZ job ads, retail sales, trade balance, RBA meeting & manufacturing/services PMI all due out this week. We also have the US jobs data read on Friday night to round it off. Was a quiet weekend for me just gone as the house has been sick with a cold, including myself. Not much planned for this weekend coming either as we catch up with friends and I plan for my wife’s birthday which is the middle of next week. I hope you have a wonderful week, what’s left of it anyway, and stay safe. I will 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.