Insights

Investing in abnormal markets

Australian banks and high yielders enjoyed a relief rally post the surprise Australian Federal election result, but Australian long bond rates plummeting to record lows (below 1.3%) has been the major driver of Australian equities to near record highs. This is a pure yield arbitrage story. With Australian equity yields (ex-Resources) at decade lows (4.3%), their premium over long bond rates (roughly 3%) is currently at decade highs, supporting the share push to extreme valuations (currently >17.5x 12-month forward).

What worries us is the ongoing erosion in profit growth expectations. This was a difficult 'Confession season' this year with several larger stocks downgrading earnings guidance. That said, with the removal of Federal Election uncertainty, and with forecast FY19 earnings growth now at zero, the market has set itself a very low hurdle to clear heading toward August results.

Highlighting four standout opportunities over a 12 month period

Our Sector Analysts have provided an update on key dynamics, the outlook and have nominated their preferred picks per ASX sector.

We highlight four standout opportunities below, including our forecast 12-month return:

• Westpac Banking Corporation (WBC) – 27% forecast 12-month return
• Orora Limited (ORA) – 13%
• Treasury Wine Estates Limited (TWE) – 26%
• Oil Search Limited (OSH) – 48%

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

With the election out of the way and Labor's more disruptive reforms defeated, market sentiment has clearly taken a turn for the better. Looking ahead, the most likely scenario is that the domestic and global economy will find ways to grind higher, although the likely pace of business activity now looks slower than previously expected.

Political certainty provides some relief but more will be needed

The Coalition victory is undoubtedly positive for the equity market and particularly domestic cyclicals. We note that the market had already priced in the risks that a Labor Government and their 'controversial' policies posed. Banks had their best week in over three years, up 8.1% the week following the election. While investor sentiment has improved and will continue to buoy the market over the short term, we think a clear agenda for stimulating economic growth, other than solely relying on tax cuts and monetary policy, will be necessary to sustain further gains.

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Two changes to our High Conviction picks this month

We have removed Reliance Worldwide (RWC) from our list due to the weaker-than-expected downgrade in May and our subsequent change in recommendation to Hold. While the absence of a freeze event in the US was in line with our expectations, we are concerned about the downturn in multi-res in Australia and the increase on US tariffs on imports from China that could negatively impact FY20 earnings.

We have added OZ Minerals (OZL) given the near 20% correction from its early April peak. In our view this looks far too overdone versus a less dramatic adjustment in A$ copper fundamentals.

Five high conviction ASX100 stocks in June

Our high conviction stocks are those that we think offer the highest risk-adjusted returns over a 12-month timeframe, supported by a higher-than-average level of confidence. They are typically our preferred sector exposures.

Five high conviction ASX100 stocks in June:

1. OZ Minerals (OZL)
2. Oil Search (OSH)
3. ResMed (RMD)
4. Sonic Healthcare (SHL)
5. Westpac Bank (WBC)

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

Disclosure of interest: Morgans may from time to time hold an interest in any security referred to in this report and may, as principal or agent, sell such interests. Morgans may previously have acted as manager or co-manager of a public offering of any such securities. Morgans affiliates may provide or have provided banking services or corporate finance to the companies referred to in the report. The knowledge of affiliates concerning such services may not be reflected in this report. Morgans advises that it may earn brokerage, commissions, fees or other benefits and advantages, direct or indirect, in connection with the making of a recommendation or a dealing by a client in these securities. Some or all of Morgans Authorised Representatives may be remunerated wholly or partly by way of commission.

In its statement on 20 March 2019, the Open Market Committee of the Federal Reserve noted "on a 12 month basis, overall inflation has declined, largely as a result of lower energy prices; inflation for items other than food and energy, remains near 2 percent". This means that the Fed now believes it has hit its inflation target. In the following two paragraphs, the Fed twice made reference to their "symmetric 2 percent objective".

The first time was in the sentence "the committee continues to view sustained expansion of economic activity, strong labour market conditions, and inflation near the committee's symmetric 2 percent objective as the most likely outcomes". This means that the Fed believes it is also achieving its full employment objectives at the same time as hitting its inflation target.

Since the Fed is now hitting both of its targets, the right thing to do should be to do absolutely nothing. This is what they decided to do by leaving the Fed Funds rate unchanged. In the third paragraph of the statement, the Open Market Committee of the Fed said that it would continue to assess "expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective".

Symmetric Inflation Objectives

I was not aware that the Fed had changed its statement of inflation targeting to that of a symmetric inflation target until I attended a presentation by Jay Powell, Chairman of the Federal Reserve, in Atlanta in January 2019. What does the Fed mean by "symmetric"?

In October 2017, former chairman Ben Bernanke published a paper showing that because the Fed had been underachieving its 2 percent inflation target for some years, the increase in the price index for the personal consumption deflator was now around 5% lower than it would be, had the target been achieved. This suggested that the Fed could allow inflation to run above the 2 percent target for a number of years, in order to increase the personal consumption deflator to the level that it would be, if the 2 percent target had been hit each year. Other economists had achieved this same position by suggesting that the price level, rather than just the inflation rate, should be part of the target.

The idea of the symmetric target then came into the Fed statements. It means that over the coming years, the Fed may allow the personal consumption deflator to run higher than its 2 percent annual target, in order to allow the price level to rise towards a long term target.

The Benefit of Symmetrical Inflation Targeting

The Fed believes, and we believe, that the US economy will go into a soft landing or growth recession between the middle of 2020 and the beginning of 2021. As the US economy slows into that growth recession, it is important that the growth remains still positive, even though unemployment goes up. The increase in unemployment that the Fed is seeking to achieve by this slowdown would only raise US unemployment from 3.7% to 4.3%.

The difficult thing in the slowdown is stopping it from being a full blown recession. A smart way to prevent a sharper than desired deceleration of growth in 2020 and 2021 is to be reducing the real Fed Funds rate as we enter 2020. Interestingly, this is exactly what will happen if the Fed keeps the Fed Funds rate exactly where it is and allows the inflation rate to rise for a small period above its inflation target. The decline in the real Fed Funds rate in 2020 and 2021, will provide the support that the US economy will need to prevent further deceleration.

The Fed Outlook

The mid points of the economic projections of the Federal Reserve Board members and Federal Reserve presidents in March 2019, is shown in Figure 1 below:

The median expectation is for US growth to slow to 2.1% in 2019 from the 3.1% growth that was achieved in 2018. They believe that growth will continue to decline to 1.9% in 2020 and 1.8% in 2021.

As this gradual slowdown occurs, they believe that unemployment will rise from 3.7% in 2019 to 3.8% in 2020 and 3.9% in 2021. In the long term, they think that unemployment will stabilise at 4.3%. We point out that if the Fed achieves this low level of unemployment in 2019, 2020 and 2021, they will achieve the lowest level of sustained unemployment the US economy has seen since 1968 and 1969.

The Fed believes the core personal consumption deflator will hit its 2% target in 2019, 2020 and 2021. We believe it will overshoot in 2020 and 2021 and the Fed in response, will do nothing. By doing nothing at that time, they reduce the real Fed Funds rate to put a floor under growth in 2021.

The median expectation, is that the Fed thinks there will be no increases in the Fed Funds rate in 2019, there will be one increase in the Fed Funds rate in 2020, but in the long term, beyond 2021, the Fed Funds rate will settle at a long term equilibrium point around 50 basis points higher than the current level.

Conclusion

The Open Market Committee of the Federal Reserve now believes that they have achieved their objective of a 2% inflation target and full employment. Not wishing to mess up a good thing, they have decided that the best thing to do is nothing.

Interestingly, their inflation target is now stated as "symmetric'. By allowing inflation to run above its objective for a short time, they might be reducing the real Fed Funds rate ahead of an anticipated slowdown in 2020 and 2021. This means that inflation might help the Fed in providing support for a softer US economy in 2021.

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

Reporting season in a nutshell

In our reporting season preview we noted that the spread in consensus forecasts was very narrow and the potential for beats and misses versus market expectations was lower than normal. It is this dynamic that foreshadowed many of the results across our coverage universe, where results were mostly in line with expectations.

Earnings momentum was mixed with no clear directional trend and it is clear market rotation rather than breakout has defined the FY18 reporting season – we are still waiting for the circuit breaker.

Pleasingly, results mostly shrugged off the systemic risks that posed a threat to earnings heading into August (e.g. housing slowdown, weak consumer confidence, intensifying regulatory concerns and political risk). No bad news was welcome news and investors put cash to work by backing solid inline results.

Investors have to be more tactical given the current market settings of elevated valuations and cautious sentiment.

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Three changes to our list this month

We add Australian Finance Group (AFG) and Noni B (NBL) to our list in September.

For AFG, we believe concerns about regulatory risk regarding broker remuneration models as well as consternation about the cooling housing market are overdone. Such concerns have resulted in this stock offering good value and an attractive dividend yield.

Noni B now commands approximately A$1bn of sales and a material portion of the womenswear market. This should enable NBL to rationalise an industry which has been primarily focused on volumes and discounting, and in doing so increase profitability over time.

We remove Suncorp Group (SUN) this month following the solid result in August and the completion of the Life Business sale. Despite the removal, Suncorp still remains our preferred exposure in the large-cap diversified financials and insurance space.

Nine high conviction stocks in September

Our high conviction stocks are those that we think offer the highest risk-adjusted returns over a 12-month timeframe, supported by a higher-than-average level of confidence. They are typically our preferred sector exposures.

Here are our seven high conviction stock picks this month:

1. Atlas Arteria (ALX)
2. OZ Minerals (OZL)
3. Westpac Bank (WBC)
4. Australian Finance Group (AFG)
5. Noni B (NBL)
6. CML Group (CGR)
7. Kina Securities (KSL)
8. PWR Holdings (PWH)
9. Volpara Health Technologies (VHT)

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

Disclosure of interest: Morgans may from time to time hold an interest in any security referred to in this report and may, as principal or agent, sell such interests. Morgans may previously have acted as manager or co-manager of a public offering of any such securities. Morgans affiliates may provide or have provided banking services or corporate finance to the companies referred to in the report. The knowledge of affiliates concerning such services may not be reflected in this report. Morgans advises that it may earn brokerage, commissions, fees or other benefits and advantages, direct or indirect, in connection with the making of a recommendation or a dealing by a client in these securities. Some or all of Morgans Authorised Representatives may be remunerated wholly or partly by way of commission.

The A2 Milk Company (ASX:A2M) has concluded FY18 with a robust performance, surpassing recent guidance and consensus expectations. Notably, underlying NPAT soared by 116% to NZ$195.7 million, while underlying EBITDA witnessed a remarkable 101% increase to NZ$283.0 million. This impressive growth was propelled by a significant surge in revenue (+68%), primarily driven by the stellar performance of infant formula, constituting 79% of group sales.

Strong Market Presence

Australia/New Zealand

The region witnessed a remarkable 69% EBITDA growth, with a2 Platinum commanding a market share of 32% in Australian supermarkets, marking a notable increase from previous periods.

China and Other Asia

Similarly, China and other Asian markets reported robust results, with EBITDA soaring by 148%. Notably, a2 Platinum's market share by value in China witnessed a rapid ascent, reaching 5.1% over the year and 5.4% by 4Q18.

Financial Strength and Outlook

Cashflow Performance

Operating cashflow surged by 131% to NZ$231.1 million, significantly surpassing expectations. This strong cash generation has bolstered A2M's balance sheet, culminating in a net cash position of NZ$340.5 million, or 47 cents per share.

Growth Prospects

While A2M refrained from providing formal FY19 earnings guidance, its outlook commentary remained optimistic. Forecasts anticipate robust NPAT growth of 37.0% in FY19 and 29.4% in FY20, driven by further market share gains, recent price adjustments, and expansion into new products and markets, particularly in China.

Investment Perspective

Strategic Investments

A2M continues to invest in long-term profitability through heightened marketing efforts to enhance brand awareness, expansion into new territories such as the UK and USA, and innovation in product development. While these endeavors may temporarily impact profitability, the company's strong balance sheet augments its ability to drive additional earnings growth over the long term.

Investment Insights

Trading at a PEG ratio of 0.9x in FY19 and FY20, A2M maintains an Add recommendation, reflecting its robust performance and promising growth prospects. Additionally, the share price target has been revised upwards, signaling confidence in the company's trajectory.

In summary, The A2 Milk Company's stellar performance in FY18 underscores its resilience and market leadership. With a solid foundation and strategic initiatives in place, A2M is well-positioned for sustained growth and value creation in the evolving dairy industry landscape.

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

Reporting season playbook

Investors are waiting for a circuit-breaker. Stretched valuations limit upside potential for a further re-rating of the market multiple (15.8x 12month forward PE, Industrials ex-Financials at 21.8x) and without clear earnings momentum in either direction the market is likely to remain rangebound.

We prefer to err on the side of caution and take profits where prices have run ahead of fundamentals (CSL, DMP, BKL, BAL and CGC) and think rotation within the market rather than a clear breakout will define FY18 reporting season. We stick by our conviction calls and supplement them with higher-than-average cash levels. This will give investors capacity to deploy capital into the inevitable bouts of volatility.

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Three additions to our list this month

We add OZ Minerals (OZL), Atlas Arteria (ALX) and Volpara Health Technologies (VHT) to our list in August 2018.

OZ Minerals (OZL) enjoys robust cashflows from an established production base in copper, which has among the best outlooks in the commodities suite, driven by electrification of the developing world. OZL's counter-cyclical growth strategy will be rewarded as the Carrapateena development project is gradually de-risked in the coming 1-2 years, and could justify valuations closer to $12.50 per share upon successful commissioning.

Atlas Arteria (ALX) offers valuation support and strong potential distribution growth over coming years. French tollroad APRR is ALX's key asset. Cashflows are driven by growing toll revenues, cost containment, substantial decline in debt service and legislated corporate tax rate cuts.

Volpara Health Technologies (VHT) is a leading IT healthcare provider aiming to improve early detection of breast cancer. Volpara's SaaS model is linked to a growing medical need. Volpara's market share of breast screening in the US is currently 3.7% with a pathway to grow to 9% in FY19. VHT have a business model leveraged to growing and reoccurring revenue (FY19 guidance of NZ$9.0m) with the ability to pass on improved pricing over time.

Eight high conviction stocks in August

Our high conviction stocks are those that we think offer the highest risk-adjusted returns over a 12-month timeframe, supported by a higher-than-average level of confidence. They are typically our preferred sector exposures.

Here are our eight high conviction stock picks this month:

1. Westpac Bank (WBC)
2. Suncorp (SUN)
3. OZ Minerals (OZL)
4. Atlas Arteria (ALX)
5. Volpara Health Technologies (VHT)
6. Kina Securities (KSL)
7. CML Group (CGR)
8. PWR Holdings (PWH)

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

Disclosure of interest: Morgans may from time to time hold an interest in any security referred to in this report and may, as principal or agent, sell such interests. Morgans may previously have acted as manager or co-manager of a public offering of any such securities. Morgans affiliates may provide or have provided banking services or corporate finance to the companies referred to in the report. The knowledge of affiliates concerning such services may not be reflected in this report. Morgans advises that it may earn brokerage, commissions, fees or other benefits and advantages, direct or indirect, in connection with the making of a recommendation or a dealing by a client in these securities. Some or all of Morgans Authorised Representatives may be remunerated wholly or partly by way of commission.