Insights

In recent weeks, we've been discussing growth in the Indo-Pacific, specifically Southeast Asia and India. We believe that growth in this area will replace the growth in demand that has traditionally been provided by China, particularly for the kinds of products that Australia exports.

In this issue I will examine some recent slides from the International Energy Agency's, World Energy Outlook report. The first slide outlines projections for world oil demand between now and 2030. Demand which is expected to reach just under 104 million barrels per day by 2030. Recently, oil demand has been growing by around a million barrels a day, but that growth has recently slowed to about 0.8 million barrels per day. Even with this slower growth, our projections suggest oil demand could reach 105 million barrels a day by 2030, indicating that the IEA estimates might be slightly conservative. Still, they still show a steady increase in demand for oil.

From 2015 to 2023, the biggest single increase in oil demand came from China, with an increase of 5 million barrels per day, followed by India, which saw growth of over 1 million barrels per day. Southeast Asia and Africa also contributed, each with increases of about 0.3 million barrels per day. Conversely, demand in Europe has decreased by about 0.9 million barrels per day, while North America has seen steady demand and Japan and Korea have experienced declines.

Looking ahead, the landscape of oil demand is changing significantly. The International Energy Agency notes that the rapid growth in oil demand in China has come to an end, largely due to the electrification of vehicles powered by a dramatic expansion of nuclear power and renewables. While oil demand in China may stabilise, there is a rapidly increasing demand in India, projected to grow by 2 million barrels a day. Southeast Asia and Africa will also experience growth, each by about 1.3 million barrels per day.

Between 2015 and 2023 the demand for liquefied natural gas (LNG) also rose. Between 2015 and 2023, the European Union saw a demand increase of over 100 billion cubic meters, followed by China with a growth of 74 billion cubic meters. India had smaller growth, while Southeast Asia's demand was flat. Japan’s demand fell.

The future looks different, with significant demand growth expected in the Indo-Pacific. From 2023 to 2025, China will still see a rise in demand of just under 50 billion cubic meters.

Indian LNG demand is projected to grow by about 54 billion cubic meters by 2035, and Southeast Asia, driven by increased manufacturing, is expected to see a rise of 104 billion cubic meters in demand by 2035. Japan is anticipated to see a decline in the demand for natural gas.

Overall, global LNG production is set to increase dramatically, from 600 billion cubic meters in 2024 to about 840 billion cubic meters by 2035. Australia, as a major LNG exporter, will play a crucial role in meeting rising demand, particularly driven by manufacturing growth in the Indo-Pacific, including in countries like Vietnam, the Philippines, and Indonesia.

Over the past couple of years, I've been very interested in that there’s been a US consensus of economists that the US was about to go into recession. The majority of market economists believed that for the previous couple of years. The reason for that was that the yield curve was inverted. Short term rates were higher than long term rates.

My argument was that even in that circumstance, you couldn't have a U.S. recession because the budget deficit was so large. There was so much stimulus being provided to the U.S. economy that it would keep growth strong. I talked about it as being “a wartime stimulus in a peacetime economy”.

Now, the rather startling result of that US budget stimulus, particularly the Inflation Reduction Act, which encourages building electric cars in the United States and spending on the energy transition and the Chips Act is that you've had an enormous explosion in expenditure on Factory building. Here's the chart shown from the Federal Reserve Economic Database showing that dramatic explosion. There are a number of different slides which are less dramatic, but I thought that this would be showing how heroic this amount of spending was.

The rise of factory building, in the scenario that I provided a couple of months ago, was supposed to top out in the second quarter of this year and then start falling. Unfortunately, it decided to continue to go up. We think that after a 31% annualized growth in this spending in the first quarter, this was followed by a 22% growth in annualised spending in the second quarter. Hopefully in the part of the chart you can't see because it hasn't happened yet, the current scenario now is that this forms a plateau. It drops from about 20% growth to about 1% growth and no growth in the final quarter, and then next year, it begins to decline.

The rate of decline of this manufacturing construction spending in 2025 is pretty significant: 24% annualised in the first quarter, 12% in the second quarter, and 12% in the third quarter and then gradually, it drips away. As that happens, the U.S. economy slows down. So, the U.S. economy in the second quarter of 2024 grew faster than we thought, 3% annualised. That should slow to 2.8% annualized in the third quarter, 1.9% annualised in the fourth quarter.

What that means is that for a full year in 2024, the annual growth rate of GDP is 2.7%, and that drops to 2.1% next year.

Well, that’s stronger growth. I thought does that knock over our forecast for cuts in the Fed Funds? So, I ran the Fed funds rate model.

Our Fed funds rate is still allowing for very significant cuts in the short term because it's not about growth. It's about the falling inflation, which is driving the Fed funds rate model down.

So, the fed funds rate currently stands at 485 basis points, which is after a 50-basis point cut. Our model says fair value is 349 basis points. That means a cut of 1.35% from where we are now. I think rates will fall at 25 basis points every meeting pretty until we reach that level near 3.50%.

We compare that to our RBA model, where the model is at 4.2% and the actual rate is 4.35%. So, there's really no prospect of rate cuts in Australia for the next couple of quarters.

For those interested in policy or prospective policy in the US election, I'll do more about this in future meetings. But there was a terrific interview, which you can find on YouTube, between Trump and John Micklethwait, who is one of the toughest guys on Bloomberg. It was interesting for me because it was for the Economic Club of Chicago. If you've been to Chicago, you've seen the Trump Tower. You'll see Trump has a significant presence in Chicago. It was an extremely interesting discussion about tariffs.

John Micklethwait took up the issue that there's a economists' consensus that inflation will be higher under Trump than under Biden Harris. That is not my view. I have written about this before. If you look at the record, when Trump was doing the exact same sort of policies that he's talking about introducing now, in his first term, the average inflation rate was 1.8%. But running the numbers this morning again, prices were up so far by 22.2% under Biden/ Harris. And the average inflation rate is 4.4%. The Biden /Harris level of inflation is two and a half times the level under Trump.  

That happens because of very large amounts of Biden/Harris deficit spending.

This is providing “A wartime stimulus in a peacetime economy”.

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Investment Watch is a quarterly publication produced by Morgans that delves into key insights for equity and economic strategy.

This latest publication covers

• Economics – A brighter outlook for Australian resources
• Fixed Interest Opportunities – 2024 Additions
• Asset Allocation – A decisive turn in the global rate cutting cycle
• Equity Strategy – Reweighting ASX 20 exposures
• Resources and Energy – China monetary stimulus impact
• Travel - Demand trends still solid
• Technology - Rate cuts lend support but fully valued overall
• Telco - Still seeing better value elsewhere
• Property - Nearing the peak

It has paid off to put cash to work this year with equity markets touching all-time highs and bonds benefitting from rate cut expectations. Looking ahead, the fundamentals remain supportive. The US economy is slowing but not stalling. Employment is also slowing but job losses are still minimal, while consumer spending is boosted by falling inflation. In our view, this is not the time to play defence and we continue to expect growth assets such as equities and real assets to do well. This quarter, we look at tactical opportunities on the back of a global push for policy stimulus which include: commodities, emerging market equities, and across the Australian equity market (resources, agriculture, travel and technology).

A brighter outlook for Australian resources

There has been much discussion about the slowdown in growth in China. Last year, Chinese GDP grew by 5.2%. We think growth will slow to 4.6% in 2024, just short of the official 5.0% target. However, it is still growing much faster than the United States, Japan or any major Western European economy. China has the largest steel industry in the world. This industry produces a little over half of all the steel in the world annually.  Chinese steel production indeed peaked in May 2021 at an all-time high of 99.5 million tonnes per month, and production has moved sideways since then. Yet, this still generates a very strong demand for Australian iron ore. Our model estimate for the equilibrium price of iron ore in August 2024 was $US106.42.

The standout economy is India. India will be the strongest and the most rapidly growing economy this year. In 2023, GDP grew by 7.8% and is expected to grow 6.8% this year. However, India is not the only economy producing this kind of growth and in fact this rate of growth has been produced by other countries in the Indo Pacific.  One historian has referred to these countries as the “Indosphere”.* This group of rapidly growing countries includes Vietnam, the Philippines and Indonesia. Vietnam is expected to grow by 6.0% this year and 6.4% next year. The Philippines is expected to grow by 5.7% this year and 5.9% next year. Indonesia is expected to grow by 5.7% this year and 5.1% next year.

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Most results were thereabouts against expectations which saw the sector perform broadly in line with the index (All Ords flat since 1 August vs mining services -2%). Exploration activity remains soft despite positive macro-trends, though we expect market volatility to weigh on junior miner raisings in the near term. The development pipeline is experiencing wobbles given lithium project cancellations but still has breadth and depth in gold, iron ore, gas and wind. Production was varied with strength in bulks (though weakness in iron ore price presents a risk to high-cost projects) and continued softness in battery metals (lithium and nickel). Top picks are ALQ (multi-year margin recovery in Life Sciences will be supplemented by an eventual cyclical volume recovery in Commodities) and CVL (too cheap with strong cash generation and multi-faceted growth potential).

ALS Limited (ALQ)

ALQ looks poised to benefit from margin recovery in Life Sciences as well as a cyclical volume recovery in Commodities. Timing around the latter is less certain though our analysis indicates we may not be too far away (3- 12 months). In addition, commodity prices are supportive with both gold & copper around all-time highs at US$2650/oz & US$4.50/lb respectively.

Investment view:

ALQ is the dominant global leader in geochemistry testing (~50% market share), which is highly cash generative and is little chance of being competed away for a variety of reasons. The excess capital from Commodities is used to fund capital driven earnings growth in Life Sciences.

Civmec (CVL)

CVL reported a strong FY24 with EBITDA +11% YoY and NPAT +12% YoY. Although some large projects roll off in FY25, management sounded a confident tone that it could continue to deliver revenue and earnings growth, albeit at more modest rates. Margins in FY25 will serve to benefit YoY from the re-domicile costs ($1m) and additional overheads ($2-3m) which were carried in FY24, as well as potentially conservative margin recognition in 4Q24.  The valuation is compelling at 5x FY25 EBIT and 15% FCF yield, which undervalues a business of CVL’s quality.

Investment view:

CVL is a founder-led engineering & construction business with leading margins (EBIT ~10%), high ROE (~15%), best-in-class facilities, a robust balance sheet (net cash), a history of strong cash flows (conversion >100%) and multi-faceted growth potential.

The stock is trading on attractive valuation metrics at ~5x FY25 EBIT and 11-15% FCF yield in FY25-27. This undervalues a business of CVL’s quality, however, a discount exists due to liquidity constraints.

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Oil demand is tracking modestly ahead of expectations, while robust supply is failing to keep pace. We expect the oil market to enter a deficit supply balance during 2H 2024. The oil market may be pricing in some demand destruction, but if that does not materialise, we expect Brent oil to recover to >$80/bbl in the next 1-3 months. Forced ranking of our oil-exposed coverage at current share prices: #1 WDS, #2 KAR, #3 BPT, and #4 STO.

Woodside Energy (WDS)

The tide is certainly out in terms of investor sentiment on WDS. Despite Brent oil trading in line with our long-term forecast, WDS’ share price implies a near cycle-low oil price level. We do not see this as capable of being explained by WDS’ growth profile (comfortably funded) or risks around non-core assets such as Browse. While the share price performance has been disappointing, supported by a strong balance sheet and high margins, we see WDS investors as capable of being patient.

Investment view:

We maintain an ADD recommendation believing WDS offers attractive long-term value.

Karoon Energy (KAR)

Supported by a strong balance sheet (amassing cash), and a modest capex profile, KAR remains ideally positioned to re-rate off a recovery in oil market expectations. The issue has been the steady string of disappointing operational performances and guidance downgrades. However, combined with a new 5% dividend yield and active on-market share buybacks, we have conviction that KAR will start to turn things around and are attracted to its discounted price which we believe has significant value buffer in it.

Investment view:

Trading at a large discount to our target price, we maintain an ADD recommendation.

Beach Energy (BPT)

New management has had three attempts in 2024 of ‘clearing the decks’ and resetting a baseline for market expectations. But the numerous downgrades, combined with consistent optimistic messaging, has gradually eroded investor confidence in BPT’s ability to execute on its plans and its valuation re-rate as a result. Similar to the market’s apparent concerns, we also hold some reservations over short-term execution risks but do view BPT as trading at deep value levels.

Investment view:

We maintain an ADD rating but continue to caution that patience may be required.

Santos (STO)

Selling pressure has pushed STO’s share price modestly below our A$7.50 valuation, but this still appears within a reasonably close range to our base STO and pricing assumptions. While pleasing for shareholders, it is at odds with the discount that has appeared in STO’s ASX-listed peers and leaves us viewing its investment profile as relatively less appealing as a result. This is also demonstrated by the smaller distance to its high case scenario valuation versus larger/safer peer WDS.

Investment view:

With its investment phase progressing successfully, we maintain a HOLD rating, but a deeper selloff could present interesting value.

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I was enormously relieved to see a survey released this week showing that the consensus of Australian economists is that rates will begin to fall in February next year. The reason I was relieved is because I found that I'm not in the consensus; in fact, I think it's practically impossible for rates to fall in the first half of next year. I've got rates beginning to fall, perhaps in the third quarter of next year. The reason for that, as you will see as we go through the presentation, involves some awfully clever decisions made by Jim Chalmers, stemming from the fact that he has a PhD in politics but no PhD in economics. Otherwise, he might have made those decisions differently.

First, I want to touch on the US employment report from Friday. The US employment number last week surprised on the upside, with growth in payroll jobs at 159,105 which was higher than consensus.

Importantly, in terms or model for the Fed funds rate, it reduced unemployment. Falling unemployment pushes up the equilibrium level of the Fed funds rate. I've shown before that the Fed will cut rates as long as the year-on-year rate of growth of employment is below the long-term median.

In today's slides, I've focused on what's been happening this year rather than the full decade. Here, you have a chart of U.S. payroll employment year-on-year growth. Historically, the Fed tends to hike rates when year-on-year employment growth is stronger than the long-term median and tends to cut when it's lower than the long-term median. In August, year-on-year U.S. Employment growth rate fell below the long-term median to 1.55%, just below the long-term median growth rate of 1.6%. This set up the Fed to cut rates by 50 basis points.

Does the September employment number stop the Fed from giving us more cuts? No, even though it's a stronger-than-anticipated number, it's not a substantial increase. Employment growth is still lower than the long-term median. Moving to our model of the Fed funds rate, we find that the Fed has been able to bring down inflation because the Fed funds rate has been much higher than the Australian cash rate. In the previous cycle, back in 2007, The Fed raised rates to exactly the same level, 535 basis points, while we raised rates to 475 basis points. This time, they raised rates to 535 basis points, while we only reached 435 basis points, almost half a percent below where we were before.

When we look at our model of the Fed funds rate as opposed to where the Fed funds rate actually is, their estimate is 3.4%. This is 140 basis points lower than the current rate. So, there’s plenty of room for the Fed yet, which is why they will continue to cut rates next month and the month after. We anticipate a cut of 25 basis points in November and a further cut of 25 basis points in December.

Let's examine the situation in Australia. We have a much lower cash rate, and our cash rate model suggests it should be much higher than our Fed Model, swinging above and below the equilibrium cash rate. The reason for this is that core inflation is much higher in Australia, about 70 basis points higher, so our model's equilibrium level is about 70 basis points higher than in the U.S.

The major reason our interest rates didn’t go as high is due to conditions set by Jim Chalmers, who imposed limits on the RBA at the beginning of this current government. These conditions allowed the RBA to focus on bringing down inflation but restricted them from raising rates to a level that would jeopardise employment gained in the previous expansion. As a result, the RBA only reached a peak level of 4.35%. The problem with not being able to raise rates higher is that it prevents generating real interest rates high enough to exert downward pressure on inflation.

Thus, the upper limits set by the Treasurer have made it much more difficult for the RBA to reduce inflation. This, in turn has made it more difficult for the RBA to cut rates.

Moving on to fiscal policy, we see a table from the budget papers that will be updated in December. Jim Chalmers has been talking about the surpluses he achieved, which were indeed significant due to historically high commodity prices. However, as commodity prices fall, he is projecting deficits. These are: $28 billion in 2024-25 and $42 billion in 2025-26, resulting in 1.1% and 1.5% deficits of GDP, respectively. This increased spending provides stimulus to the economy, getting in the way of the RBA's efforts to raise interest rates enough to combat inflation.

Therefore, it makes it extremely difficult for the RBA to bring down inflation this year, next year, or even in the second half of next year. I believe that with luck, circumstances might allow them to cut rates in the second half of next year, but not before August 2025.