Australian Market Summary (Issue 371) – 1 October 2015

An early missive from us this week given the rather odd new public holiday us Victorians have been gifted this Friday.

There are a few things to cover, including an update on my market expectations and some key issues we all should be focused upon.

Much the same as the past 2 months, trading activity this week has again felt like the lunatics have the keys to the asylum.

Volatility has again been massive, and the ASX200 has regularly traded well over a 2% range intra-day, indicative of a market truly lacking in conviction and direction.

I have a simple explanation for this to help you understand precisely what is occurring in equity markets, and why.

What the heck is going on?

Let’s take a step back to take a step forward…

Since the implosion in asset markets post the GFC, global monetary policy has been extremely loose. For all intents and purposes, the cost of debt has plummeted to extraordinarily low levels, compelling anyone with a sufficient credit rating to borrow and invest in a broad suite of assets capable of delivering returns in excess of the cost of debt.

Financial markets have been enormous beneficiaries of this.

Confidence in this leverage was bolstered by improvements in global economic growth across both developed and developing markets. This economic growth underpinned the cash-flows of corporates and individuals allowing them to service this debt.

More recently, after 8 years of virtually zero US interest rates, the US Federal Reserve have finally signalled that US interest rates will begin to normalise. By normalise, we probably expect to see rates rise 1-1.5% over time.

Alongside the rising base rates, the Federal Reserve is also reversing gear in another crucial way. The core policy mechanism for ‘Quantitative Easing’ since the GFC was where the Federal Reserve bought US government debt, effectively thrusting money into the financial system by way of these purchases.

As part of its policy reversal, the Federal Reserve will now begin to allow these bonds to mature, effectively getting back the capital it had ‘lent’ to the system and draining these monetary reserves from markets.

These two reversing actions will suck capital from the system, and it is in advance of this that markets in recent months have begun to ease.

Financial market participants are rapidly seeking to reign in this leverage in lieu of the changing circumstances.

In addition, there has been a marked slow-down in the rate of economic growth from emerging markets, with the core of that being China.

The combined issues of leverage, contracting liquidity and slowing economic growth are causing investors to reign in risk.

Specific Examples – Glencore (GLEN), Origin Energy (ORG) & SANTOS (STO)

With China at the heart of the slowdown in growth, it’s no wonder that commodity markets have been hardest hit in recent months.

In the UK, one of the world’s largest commodity players has seen its share price fall by 2/3rds in under 6 months due to the impact of high debt and falling commodity prices.

Earlier this month Glencore (GLEN) raised US$2.5bn in a rescue rights issue, with the intention of alleviating stresses on its balance sheet. Further to this, GLEN propose to spin out their Agricultural business in a deal valued at US$12bn.

Lastly, it suspended its dividend.

Even post the raising, GLEN still carries US$22bn in net debt and a soon-to-be junk credit rating. It is far from out of the woods.

The rapid descent in GLEN has shone a light on ‘leverage’ that we would all do well to acknowledge.

Only a year ago, GLEN was rumoured to be a potential buyer for Rio Tinto (RIO) – a rumour admittedly we struggled to contain ourselves from laughing out aloud at.

The similarities between GLEN in the UK and now Origin Energy (ORG) and SANTOS (STO) is startling.

ORG this week announced a much-needed $2.5bn capital raising (4 for 7 shares at $4.00), a dramatic reduction in forecast capital expenditure, and, wait for it A DRAMATIC CUT IN FORECAST DIVIDEND PAYMENTS.

Post these moves, ORG will still hold $9bn in net debt.

ORG is yet to re-quote, but will likely be down 10% or so on this news when it does. Undeniably the capital raising is a necessary evil, but the scale of it at $2.5bn is significant, and moreover the dividend reduction will be a real kick in the teeth to sentiment.

SANTOS are in an even bigger pickle.

Their market value has fallen to $4bn as at Wednesday close (it was $15bn a year ago), and SANTOS need to raise north of $2bn by way of asset sale or equity.

It is getting skinny. Very.

Lessons or Observances to take out of this … BHP (BHP) & Rio Tinto (RIO)

There will undoubtedly be more situations like ORG & STO in the weeks and months ahead, though perhaps not as extreme.

First, we all need to mindful of leverage. Amongst our recommendations this past couple of years, only Crown Resorts (CWN) displays a higher level of leverage than the norm – albeit we remain very comfortable with CWN as an investment.

Second, look forward, not back.

I have had a modest change of heart in this past week insofar as BHP’s dividend stability, and where I previously felt the 2016 dividend would be stable at US$1.24 I now see little justification for that view.

The previous dividend policy was constructed in a time of sounder commodity markets and simply makes no sense in the current environment.

The BHP dividend should and will be cut, potentially as much as in half.

It is common-sense, and significantly ‘priced-in’ to the shares, but all the same is something we should all be expecting.

So what are we doing?

The same as always.

We want to be buying sound, growing businesses with excellent cash metrics and clean balance sheets.

I am itching to float some new ideas past you and to rotate portfolios a little more towards domestic Australian ‘service’ businesses, but the stars are yet to align.

It is frustrating, but if we rush it, we will muck it up, so once again this week I am advocating for sitting on our hands.

The market is closer to a bottom than not. But to buy the market, we also want a market that is set to push higher with some vigour, and on that front, the outlook is vague.

In the US, Europe and Asia this past month or two there have been myriad number of profit warnings across the industrial and technology sectors, indicative of a world that is adjusting to slowing emerging market growth.

Further, the calls on investor capital continue. Origin (ORG) this week with their $2.5bn raising is not to be sniffed at, and remember Westpac (WBC) early next month should seek to raise north of $3bn.

Patience will reward us in the end.

Quick Stock Update

Lastly, I know when I go off on a tangent I sometimes miss covering the minutiae on stocks we all own and hold.

So to that end, a quick re-cap on a few.

RESMED (RMD) report on the 18th of October and should be a sound set of figures. We continue to like it.

Telstra (TLS) continues to play a stalwart role in portfolios as a defensive, but again I have an eye on it to reduce in time. Mobile margins have peaked, and I am not convinced the emerging data & network businesses can grow fast enough to fill that hole. Again, for now however, we wait.

Banks in general offer up value (ex CBA) with dividend yields pushing 10% with franking. But the fact remains, most portfolios still have too many banks, so we really need to resist going more overweight. Don’t forget Westpac (WBC) capital raising will be a nuisance in November.

Oil-Search (OSH) we wait on for more news from Woodside (WPL), but are hopeful and expectant of an improvement on terms.

Adelaide Brighton (ABC) has been a rock-star in this market, and should continue to be sound up to the high $4’s.

Computershare (CPU) after its recent disappointment has rebounded like a trooper, and regained almost 75% of the relative performance lost. We remain strong in the belief CPU is a cheap share, and that we will make a positive return on the name in the months to come. (CAR) has also been magic in a falling market, and remains a solid and sound investment. Enough said there.

Key Dates: Australian Companies

Mon 5th Oct
AGM: Djerriwarrh (DJW)
Div Pay Date: Tatts (TTS), Fortescue (FMG)
Tue 6th Oct
Dividend Pay Date: Coca Cola Amatil (CCL), Mantra Hotels (MTR)
Wed 7th Oct

Dividend Pay Date: Insurance Australia Group (IAG)
Thu 8th Oct
AGM: Ansell (ANN)
Dividend Pay Date: Brambles (BXB)
Fri 9th Oct
Dividend Pay Date: Adelaide Brighton Cement (ABC), AMP (AMP), Crown Resorts (CWN), Seven West Media (SWM), Woolworths (WOW)


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