Part 2: Preview of 2018

By now I hope you have all had time to read Part 1 of my annual newsletter ‘2017 in Review’. If you haven’t had a chance you can read the article in full here. Below is Part 2 to my annual newsletter ‘Preview of 2018’. In this section of the newsletter I will discuss the dominant themes I expect to occur during 2018 and a few forecasts surrounding the financial markets.

Please note I will mention many companies and stocks within this article, but this should in no way be construed as advice to go buy, hold or sell those individual stocks. Everything within this article should be considered general advice and does not take into account your personal circumstances, goals and/or objectives. I hope you all enjoy the article!

Reflation

It seems the reflation trade is back on after we saw a glimpse of it to end 2016. By reflation trade I mean the concept of inflation + bond yields + cash rates rising, mainly overseas. We saw towards the end of last year, after the tax legislation was approved, that bond yields in the US started to rise again. This has continued through to 2018 where we have seen the 10 year Treasury yield hit 2.90%+ and currently still sits at 2.86%. It got as low as 2.02% again in 2017 after inflation numbers continued to disappoint, but the market has seen reason for those figures to change, but why?

The first is the US economy is running at a really solid pace of +2.6% on an annualized basis. This includes an unemployment rate sitting around 4% at which most consider the economy to be fully employed. Second the tax changes are seen as expansionary meaning the economy could run hotter and may even hit the 4% growth target Trump wants. This places more demands on goods and services, which pushes prices up and eventually inflation. The third being wage inflation which saw an 8.5 year high at +2.9% in January. This has meant the market is now thinking instead of the 3-4 rate increases the US Fed has forecast for 2018 that there now could be a possible 4-5 increases instead. Obviously the higher the wages, the more people can spend, helping the economy grow faster and pushing prices/inflation up.

As I wrote to clients a few weeks ago the last point above is what triggered the aggressive selloff in markets, which saw the S&P500 off as much as 12%. It was an adjustment and movement between asset classes from equities to bonds. For many years now we have been in a low rate environment with bond yields not providing much return. This has meant most of what was invested was put into equities instead to get that better return. However as bond yields rise and the returns get better the gap between what bonds can offer and what equities can narrows. This means portfolios have to be adjusted accordingly. During 2018 I see this continuing to play out as inflation numbers climb higher, wages increase and rates are pushed higher. This also means we may have more periods of volatility as equities are sold off to accommodate for this. The good news is generally when rates are rising, equities do too. This comes down to the premise that for rates to rise the economy must be in a good position and earnings are rising strongly as well. Below is a table that illustrates the correlation well.

Infrastructure Boom?

The next theme I can see playing out in 2018 is the start of an Infrastructure boom on two fronts, here and in the US. I will start with the domestic infrastructure boom.

Here in Australia we have endured a period of above trend immigration which lead to a housing construction boom. This has then lead to our infrastructure becoming clogged and run down due to the extra burden placed upon it, hence over the next few years we should see an infrastructure boom take place. The below chart shows the work planned over the next few years here in Australia. As you can see we will run well above our average of the last few years with roughly $14-$16bill of transport projects planned per annum vs the $4-$6bill in the previous few years.

This will give a big boost to infrastructure focused construction stocks such as Boral (BLD), Lend Lease (LLC), Adelaide Brighton (ABC), CSR (CSR), CIMIC Group (CIM) and James Hardie (JHX). I am bullish such stocks over the next 2-4 years and am looking to add these to suitable portfolios. I can see earnings growing above trend within this sector.

The second arm to this is the US lead infrastructure boom. It’s no secret that Trump wants to spend a heap of cash on improving infrastructure within the US. In fact that wad of cash is expected to be about $US1.5trillion worth. We should see some plan put before congress this month regarding this and then a vote to free up some funding. If passed we could once again see some listed Australian companies benefit from the plan. Most of those mentioned above have exposure to the US so you would be covering both bases investing there.

It could also have a trickledown effect into commodity prices as demand ramps up to build the materials needed to improve the infrastructure. We do have a slight hiccup with the proposed tariffs on steel and aluminum that Trump has planned, but this has not yet been passed and we aren’t fully aware what that looks like at this point.

China

China is so important to the Australian and global economy and will largely determine how well a lot of stocks perform on a yearly basis. In 2017 China made up 1.0% of the +3.7% global growth rate, hence you can see what I mean.

Of course their main importance for us comes from their demand for our resources, food and services such as tourism. In 2017 China imported almost 1.1bill ton of Iron Ore (700mill from Australia) and had over 1mill Chinese visit our shores.

Only this week China had their annual political meeting where they set out their targets for the coming year and themes to be focused upon. The signs were encouraging with a growth target of around 6.5%. This is down from the +6.9% we saw in 2017, but do note that China also set a goal of approx. 6.5% last year as well and overshot it. They also are targeting inflation of 3% and retail sales growth of around 10%. The retail sales growth is basically the same as what they achieved in 2017 but inflation is almost double what we saw last year. Maybe they are expecting higher commodity prices to flow through to the economy moving forward. They are also aiming to cut taxes (1trill yuan worth) and fees which is expansionary in itself.

If China are able to hit these targets then it will be another bullish year for the Australian economy as they will need plenty of our resources to obtain it. Risks will come from the debt side of things as any hiccup there could send shockwaves around the globe. Be wary of any major corporation defaulting on loans or bonds as it could have a ripple effect through their system and then the globe. Overall though China is trying to reign in their debt and provide a higher quality of wealth to its citizens. Especially its middle class where wealth is growing exponentially.

How can we benefit from China on the ASX? The best and usual way is via our resources sector. The likes of BHP, RIO, OZL, FMG, S32, ORE etc should all provide decent leverage into the Chinese economy. Then there are also the mining services stocks such as MIN, MND, ASL, NWH, ORI etc should also see the benefit as well as new projects are brought on line or older ones expanded. I would expect earnings from these sectors to once again grow above trend.

Then of course there is the food and beverage sector which should also see a boost. It’s no secret the Chinese love our high quality food and drink which has seen some companies already have a massive boost in earnings. I see this theme continuing throughout 2018 as the likes of Inghams (ING), Bega (BGA), A2 Milk (A2M), Treasury Wine Estate (TWE), Costa Group (CGC) and Capilano Honey (CZZ), among others, see continued increased demand from China. Again I see earnings in this sector outperforming.

Commodities

It goes without saying that if China is to have another bullish year then commodities will too. They just go hand in hand at the moment. The bulks may underperform the rest, by that I mean the likes of Iron Ore & Coal. There are surplus supplies of both which may make it hard for any major price increases. Although if increased demand were to come from somewhere like India, where its forecast that their consumption of Iron Ore is set to triple by 2030 to 1billion tons, then this would put upward pressure on the price.

I feel commodities like copper, zinc, aluminum, tin, lithium, cobalt, nickel and graphite will continue to outperform. If I had to pick one to come out on top it would be copper. Major mines are winding down or closing and head grades are on the decline making the cost of production higher. No major new supply is coming online either. Then you have a world where the manufacturing sector is in a big bullish upswing. The developed world manufacturing PMI stands at 54.5 and the undeveloped world stands at 56.3. Any read above 50 suggests the sector is growing above trend and any read above 53 is extremely strong. The surprise in all of this is the strength of the Eurozone with the likes of Germany (63.3), France (58.8), Italy (57.4), Spain (55.8) & Ireland (59.1) all in massive expansion. In fact the whole Eurozone area has a reading of 60.6. Now this comes from a Euro that has been beaten down due to extended QE making Europe a cheaper and more attractive place to manufacture.

Copper is a very popular industrial metal and is involved in many products and machinery. Generally there is a high correlation between the copper price and an expanding manufacturing sector. Finally you will see new and increasing demand coming from the Electric Vehicle (EV) space where a lot of copper is used in EV and charging stations. A regular car uses 18-49lbs of copper but an EV uses 183lbs. Current copper consumption by the EV market is 185,000t and is set to rise to 1.7mt by 2027. Total world copper consumption is around 23mt per annum so for a market already on a knife’s edge this could be a huge tipping point.

Lithium + Battery Minerals

You all know my stance on the EV revolution to come and its impacts on certain minerals, mainly Lithium. I have written a couple of articles about it with another around the corner. I believe 2018 sees this theme continue and will remain very bullish for the likes of Lithium, Cobalt, Graphite, Nickel and the fore mentioned Copper. The world is at a tipping point with many governments setting EV production targets and the banning of fossil fueled engines in the coming years. Then you have major car manufacturers that are also setting targets for the production of EV in the near future. It’s very evident in what direction the world in now heading.

Recently the lithium sector has been sold off about 20-50% in most stocks after having a stellar run towards the end of last year. It came about as the world’s largest lithium producer, SQM, detailed plans to quadruple production by 2025 and then investment bank, Morgan Stanley, put out a report suggesting they see the Lithium price falling by 45% by 2021 due to oversupply. The Morgan Stanley report was dismissed by 99% of experts in the industry with scenarios contained within it having a less than a 1% chance of happening. SQM has then also since backed down on its expansion claims sticking to its original plan of 100kt of LCE by 2021 and then assessing the market. The sector is still sitting close to its lows, in what I believe to be an excellent buying opportunity.

Recently the major lithium producers in ALB, FMC & SQM all released earnings for 2017 in the US. There was a common theme of strong profit increases with lithium prices expected to stay elevated through 2018. In a very important statement made by both FMC & ALB they suggested we need 1mt of LCE (lithium carbonate equivalent) by 2025 to satisfy demand. In 2017 we would have likely produced 250-280kt of LCE, hence in the next 7 years we need to at least triple that production. Considering the current capacity, and the fact from find to mine usually takes 7-10 years, there simply will not be enough lithium supply out there to meet demand in the next few years. This will keep prices elevated and the sector in a bullish phase. I often compare what lithium is going through now as to what iron ore went through from 2000-2011 when price eventually peaked. We have a mineral where there is exponential growth in demand, which kept growing due to the expansion in China. Many tried to pick its peak for many years until they eventually got it right. I believe the same will happen with lithium and once again it will be driven by China. China has stated that by 2019, 10% of vehicle production within the country needs to be EV. China will produce around 30mill cars a year by then, thus this means they will produce roughly 3mill EV per annum after 2019. Last year they produced around 900k. Once again this means they will need to triple production within the next 20 months or so to meet these new regulations. Elon Musk has also been quoted as saying, back in 2016, that if they were to hit their 300k cars produced per annum target they would consume the world’s current supply of LCE. China will be producing ten times the amount of those cars. All of this does not factor in the likes of battery storage, buses, trucks and motorbike demand either.

So how am I taking advantage of this sector and investing in it for clients and personally? On the recent sell off I have taken long term positions in some near term producers in ORE, KDR, AJM, PLS & TAW and also one explorer in SYA. I believe these companies are in the best position to take advantage of near term pricing in lithium and will be re-rated as such along the way. I plan to hold these companies for 2-5 years. Other lithium companies I plan to trade on a technical basis and take advantage of short term opportunities when they present themselves.

Black Gold Comeback?

You all know my stance on renewable energies and the battery storage movement so you can understand my bearishness on oil over the longer term. However there may be cause to be bullish oil in 2018. After a terrible last few years’ oil picked itself off the canvas in 2017, from its lows around $43, to now sit around $62bl. Whilst oil is not our future it still has a huge part to play in the current world economy and is showing its hand.

OPEC and Russia met mid-way through last year to cut oil production to help stem the then oil glut caused by years of over production by OPEC and the US. It now seems these cuts are taking an effect with OPEC predicting oil will be back in deficit in the second half of 2018. This is partly due to their cuts but also due to increasing world demand as the global economy continues to accelerate. Oil and world growth generally go hand in hand. We also have a situation, like copper, where a low oil price has meant a big cutback in exploration so there isn’t any major new supply coming online in the near term.

What about shale oil in the US you ask? You have to remember most shale oil is expensive to extract and production drops off significantly after the first year (up to 75%). Whilst there is new production coming online early this year it is expected to also peak as older projects production declines and newer projects haven’t been able to secure funding to start up. Hence in the short term we could find some very favourable conditions for oil.

Looking at it from a technical perspective oil has formed a very bullish wedge at the top there and looks only a week or two from breaking out to the upside to see old highs again around $66bl. If it can then break that then $76bl is a real chance.

On the ASX there are a lot of larger cap stocks that can give you exposure to oil/gas. Woodside (WPL), Santos (STO) Oilsearch (OSH), Origin (ORG), BHP (BHP) & Beach Petroleum (BPT), but there are also a few small/mid-caps that could present large upside COE, SXY, HZN, SEA etc. Whilst oil could see bullish conditions in 2018 I do feel it’s a trading opportunity and not one I want to be in longer term. If oil were to get up to $75bl again you would see a lot more production brought online and exploration ramped up. The lower oil price has forced better extraction tech and more efficient producers so I doubt we see the $100bl prices we saw a few years ago.

XJO Technical Analysis

The chart above is a longer term one, where each bar represents a week, and it shows our move right back from 2001, through to the peak in 2007, the GFC and the grind back to where we are now. This chart is a great example of what a bubble we were in leading up to the GFC. You can see how steep the curve was and the run up to 6,800 points compared to the bull market we have had now. We are into the 9th year after our lows in 2009 and still haven’t hit our 2007 highs whereas it only took 4 years for us to surge off our lows in 2003 and hit our highs in 2007. The current bull market (defined by the orange/green tram lines), whilst lengthy, has been much more mature and littered with 20%+ pull backs. This shows me it’s much more sustainable and more correlated to company earnings rather than potential. Whilst the GFC is now the best part of a decade away it still remains strongly in our thoughts. This has meant investors have been more cautious and calculated this time around. Overall the markets remain in a very bullish up trend, one that I feel will culminate in us breaching our old highs in the next 18 months or so.

The second chart above represents the XJO on a daily basis and is much shorted dated as it only goes back to the end of 2015. We are currently trading in those blue tram lines in a short term channel. Whilst our trend is still bullish, even in the shorter term, I could maybe see one more sell off to 5,800 before our next move higher.

The next move higher will culminate with us breaking out of this trend we have been in since June last year and pushing to the top of the longer term band in orange, which you saw in the longer term chart. You will notice in the longer term chart above the band width is roughly 1,000 points right the way through, whereas this recent band is much tighter and is probably about 400 points. This signals to me we are almost in a sideways pattern still, even though we are grinding up slowly, and any breakout will be explosive and aggressive.

Last year I forecast we would see the XJO finish between 6000-6,200 points based on my technical analysis. We got that 100% right as we finished the year at 6,065.10. This year I’m forecasting we see the XJO will finish between 6,300-6,500 points. This would be represent a 4-7% gain on 2017, but also a 7-10% gain from where we are now on an index level. Adding in dividends you are looking at 8-11% return on 2017 or 11-14% from where we are now (5,916 as I speak). I feel we break our old highs in 2019 and kick on from there.

Sign off

Hope you have all enjoyed my annual articles this year. I feel it was important to break them up as together there is over 6,500 words and reading such a large body of text all in one go can be tiresome. The articles are just my point of view and won’t necessarily play out that way. I am always open to hearing opposing views on the financial markets. As always feel free to share with your family and friends and I am always open to comments and suggestions about ways to improve these articles, including the weekly wrap. I should re-start the weekly wrap newsletter next week so look out for those. I wish you all the best for 2018 and many positive returns on your investments. 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.