I want to continue with the East Coast cyclical recovery theme again today, but this time focus bottom up on a trio of mid-cap industrials that have clear leverage to the theme.
But firstly, I just want to add a couple of top-down points that add to my conviction on this recovery.
Around 85% of residential mortgages in Australia are variable rate. Unlike the USA, where fixed rates set off the 30-year bond yield dominate, in Australia, mortgage rates are a function of the RBA cash rate and bank wholesale funding costs.
On the other side of that, cash management trusts generally offer an interest rate equivalent to the cash rate, while term deposit rates are set at a small premium to cash rates.
My point is cash rate cuts are extremely effective in Australia to both increase free cash flow to mortgagee households and reduce the return on cash deposits. In Australia, long bond rates really don’t mean much directly for households. It’s all about cash rates.
Yield rotation
The initial reaction to 175b of cash rate cuts to a 70-year low of 2.50% has been a rotation to high fully-franked dividend yield domestic equities by SMSF trustees, who need income to fund their retirement lifestyle ambitions, alongside strongly increased demand for residential property, for both investment and primary residence. The property price and volume reaction is both a reaction to record low mortgage rates (affordability) and investors seeking income.
The secondary reaction to the rise in equity prices and property prices is a cyclical activity response. This is exactly how the USA playbook worked two years ahead of us. Next comes a home building cycle, a home renovation cycle and a consumer discretionary spending cycle. That, in turn, drives business confidence and the capex cycle.
Alongside this will be a major upgrade in nation building infrastructure projects, again adding to the cyclical multiplier.
But the very good news is that while Australian long bond yields are rising to reflect this brighter growth outlook, the all-important RBA cash rate is going nowhere (potentially even lower), while the rates offered on term deposits continue to fall right as $600 billion is parked in them, earning a negative real after-tax return.
Rate outlook
I see absolutely zero chance of the RBA raising rates, or even diverting from an easing bias, while the AUD/USD cross rate remains above 90 US cents and inflation is subdued. The RBA, like all of us, wants the AUD/USD down. They know it is a key required element of the East Coast recovery and rebalancing of the Australian economy.
That steepening Australian yield curve is telling you to be bullish East Coast cyclicals, where top line and bottom line leverage remains badly underestimated by the consensus setting analysts. There was a textbook example of that in CSR yesterday.
CSR stock chart
Along with JB Hi-Fi and Bendigo Bank, CSR suffers from consensus scepticism but these three stocks are some of the best placed to benefit from the East Coast recovery.
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Also in the Switzer Super Report:
- Penny Pryor: Buy, Sell, Hold – what the brokers say [1]
- Ron Bewley: Why I’m changing my sector allocation [2]
- Penny Pryor: Short n’ Sweet – IPO watch [3]
- Tony Negline: Don’t let inflation be a distraction [4]
- Paul Rickard: NAB’s new hybrid security [5]
- Tony Negline: Set your kids up financially… for life – Part 1 [6]
- Question of the week: What’s in a short? [7]