- The ‘housing bubble’ is a sideshow and the real concern is the pressure that lower commodity prices are placing on the budget and terms of trade.
- This means interest rates will be on hold for longer and the Aussie dollar will continue to come under pressure.
- Time to buy US dollar exposed assets, or the hard currency, and Telstra still has value.
There were a series of events yesterday that pretty much encapsulated what is going on in Australia currently.
A day in review
The Medibank Private IPO range was lifted, due to strong demand, while the IPH IPO opened up a whopping 48%. This again reminds you that IPOs are a source of portfolio alpha in a broader Australian equity market that is range-bound.
The spot iron ore price fell to a five-year low, taking the entire Australian mining sector down with it. Oil prices continued to fall, while thermal coal and gold prices are also tracking at multi-year lows.
There was a guidance downgrade from Seven Group (SVW) due to weak capital equipment sales in Western Australia, which triggered a further de-rating of the listed mining services stocks.
Virgin Australia said “domestic market competition is moderating” and Qantas (QAN) shares rose to a fresh multi-year high.
By the end of the session the Aussie/US dollar had lost 1 US cent, the ASX200 had drifted down another 30 points to 5368, both unable to fight the macro sentiment pressure of falling commodity prices. On the other side, non-bank industrial yield stocks, US dollar industrial earners, and recent IPO’s outperformed.
The speed and scale of the price falls in Australia’s key commodity price exports means I need to reassess my interest rate outlook for Australia. These price falls in iron ore, coal, oil and gold are a very significant event for Australia’s terms of trade, Federal Budget deficit, state government royalties, equity earnings growth outlook, inflation, unemployment rate and GDP growth.
What this all means is that the Federal Budget deficit hole is going to be much bigger than expected and Treasurer Hockey is going to have to cut spending even harder. Getting a few more bucks for Medibank won’t offset the effect of collapsing commodity prices. That fiscal austerity, when combined with rising unemployment and weak wages growth, ensures the heavy lifting will have to be done by the RBA with monetary policy.
The more I sit here, the more I think 3yr government bond yields at 2.53% are sending us the right message about the medium-term interest rate outlook in Australia. In the medium-term I see no risk to the upside in Australian cash rates, and growing risks to the downside.
Low for longer
Forget the “housing bubble” arguments, they are a sideshow. The commodity prices we see today are a big issue for the Australian economy and will lead to an extended period of ultra-low or even lower cash rates.
This leads me to reinforcing my Australian equity strategy of being overweight US dollar earners and non-bank industrial yield stocks. It also leads to a positive disposition to domestic interest rate sensitivities such as discretionary retailers, building materials and infrastructure.
One thing I feel very certain of is the Australian dollar is about to have its legs chopped off (again). There is absolutely no way that with the action in commodity prices and changing views on the domestic interest rate outlook that the Aussie/US dollar cross will hold current prices. The Aussie/US dollar is poised for its next drop of 6 US cents and it could happen very quickly. I can’t stress enough my strategy of physically getting some money into US dollars or buying US dollar earnings equities.
The ONLY thing recently holding the Aussie dollar up has been carry trade support from Japanese investors getting out of the depreciating yen. I have one piece of advice: sell to the Japanese.
Every gain we have made via shorting Aussie dollar this year (and last) has been shorting to carry traders who, to me, continue to overpay for the Australia’s current, and I stress current, yield advantage to their home currency. The Australian Dollar is NOT a yield currency: it is a commodity currency and is in the process of becoming a commodity currency again.
I think near-term support around 85.60 will crack in the Aussie/US dollar cross and the next stop is 80 US cents. In all model portfolios I am short Aussie/US dollar as an overlay.
Stock weightings
Outside of bringing forward the timing of the next leg down in the Australian Dollar what other actions do my changing domestic interest rate views trigger?
Increasing weightings in non-bank industrial yield stocks where I see EPS and DPS growth over the next few years.
You can see the demand for Medibank and it’s telling you something about what attributes investors are seeking.
However, the top 20 ASX stock with the greatest leverage to domestic interest rate expectations remains Telstra (TLS).
On the 15th of October I upgraded my Telstra recommendation back to buy at $5.29. At the end of that note I wrote:
Obviously most private domestic investors, the investors who dominate Telstra’s register, are in it for the fully franked dividend. Those investors can look forward to another annual dividend lift this year. To me that means how Telstra’s share price performs comes simply down to what price domestic SMSF’s will pay for Telstra’s likely 31 cent fully franked dividend in FY15. Clearly that will be driven by sentiment towards global and local cash rates.
6.00% yield = $5.16
5.50% yield = $5.63
5.00% yield = $6.20
I suspect given flat domestic cash rates, volatile equity markets and volatile bond markets, that Telstra prospective dividend yield will settle in the 6.00% fully franked to 5.50% fully franked band over the year ahead. With the stock at the bottom end of that prospective yield trading range (5.86%/8.37% grossed up @$5.29) I am upgrading it to buy today, expecting a 12 month total return of 10% to 14% including the value of franking credits.
I actually wasn’t bullish enough in that Telstra upgrade but anyone who followed it has still made 8.6% in a month.
Telstra upgrade
Today, given my changing views on domestic interest rates, I am going to UPGRADE my Telstra target trading range to 5.50% to 5.00%. That equates to a $5.63 to $6.20 share price range, based off a 31 cent fully franked FY15 dividend forecasts.
Telstra recently hosted an analyst day, which gave me even greater confidence in their earnings outlook. That in turn gives me greater confidence in their dividend outlook.
Similarly, Apple’s hugely successful iPhone sales are a positive for Telstra in terms of increased mobile data usage. Interestingly, Apple and Telstra shares have a strong correlation (below) which actually makes fundamental sense.
Apple leads Telstra
Telstra’s “lost decade” has ended and we are moving into a new higher trading range. Again, this fundamentally makes sense.
Once you have shorted more Australian dollars go and buy a few more Telstra. I think the yield will get bid down to 5.00%ff on FY15, which equates to a $6.20 price target. At $6.20, on 18.6x, they’d still be on a P/E discount to Medibank.
Go Australia, Charlie
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