Insights

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.

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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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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As interest rates normalise and economic growth moderates, earnings quality, market positioning and balance sheet strength will play an important role in distinguishing companies from their peers. We think stocks will continue to diverge in performance at the market and sector level, and investors need to take a more active approach than usual to manage portfolios. We add MA Financial Group to our list this month.

October best ideas

MA Financial (MAF) - ADD

Small cap | Financial Services

MA Financial is a diversified financial services firm specialising in managing alternative assets, lending, corporate advisory and equities with a strong focus on growth. Despite some recent share price strength MAF is still on 15.0x 12mf PE. Importantly, we believe that earnings number is a cyclically depressed number given the weakness in transactional business. The key drivers here being: an expected higher revenue margin and the benefit of recent flows in Asset Management, a halving of investment spend, MA Money becoming earnings break-even, and an uplift in corporate advisory. Management noted that MA Money remains on track to achieve break-even profitability by October, and the company is about hitting its A$4bn loan book target by FY26. While all this has been going on, the company has built up an impressive and more recurring funds management and lending businesses.

Outlook commentary:

The bottom appears in for earnings: It seems clear that the 1H24 result will mark the low point for MAF earnings, with management noting it expects solid 2H24 underlying EPS growth vs 1H24.

MA Money tracking well: Management noted that MA Money remains on track to achieve break-even profitability by October, and the company is “very confident” about hitting its A$4bn loan book target by FY26.

Asset Management franchise continues to see good flows: Highlighting MA’s success in building out its domestic distribution channels, domestic flows were up 52% on the pcp, and represented 65% of total AM gross flows.

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Across this disparate group of businesses, we continue focus on those alternative asset managers growing FUM (RPL, QAL) and the materials businesses growing earnings (in what remains a shrinking investable universe). The more cyclically exposed construction linked stocks of MGH, JHX and QAL saw a positive price response, despite EPS declines as investors look through any short-term ‘air-pocket’ of demand to a potentially improved housing market (both domestically and in the US) on the back of lower interest rates. Within the context of recent trading performance, implied multiples, and estimated TSR, we call out RPL, QAL and MGH our key picks post results.

Regal Partners (RPL)

Normalised 1H24 NPAT of $59.0m was 23% above our forecasts and 15% above consensus. The key area of outperformance was other income at $28.4m (vs our forecasts of $15.5m), a function of co-investment mark-to-market gains and cash received as dividends. The key to earnings growth remains FUM growth, with 1H24 seeing net inflows of +$0.7bn and a further +$1.2bn of growth via investment performance - we factor in something similar for 2H24. Average management fees (both $ and %) should increase in 2HCY24, as RPL receives full contributions from the higher fee businesses of Merricks and Argyle.

Investment view:

• Strong investment performance, fund inflows and acquisitions have seen the business grow FUM 133% pa since Jun-22, when Regal Funds Management merged with VGI Partners.  
• RPL can continue to grow FUM as performance persists and the alternative managers reach scale.

Qualitas (QAL)

FY25 guidance for NPBT of $49-$55m reflects growth of c.26% to 41% (vs pcp), with base management fees and balance sheet co-investments to deliver the bulk of the growth. Management commented that its current cash balance should be sufficient to see it reach the aspirational target of $18bn FUM by FY28. Deployments should continue to grow, albeit at a slower pace, with the proportion of net to gross loans likely to remain similar.

Investment view:

• QAL is well-positioned to increase market share in debt funding for affordable multi-unit metro developments.
• Management’s FY28 FUM target of $18bn, the reduced reliance on performance fees and a build-to-rent portfolio which remains a future growth driver.

MAAS Group (MGH)

Underlying EBITDA (equity share) was up 27% to $207.3m, at the top end of guidance ($190m-$210m) and in line with consensus. Underlying result included $30m revaluations gains and a $10m of gain on sale. Construction Materials, the highest multiple segment in the MGH business, grew 58% (vs pcp), with existing businesses (acquired pre Jul-22) driving approximately half of the increase. The quarry business continues to grow volumes, along with ASP increases and COB reductions. Residential real estate remains a challenge, with allotment sales volumes to be muted in FY25.

Investment view:

• Management expecting continued revenue and profit growth in FY25.
• The business continues to demonstrate a transition away from real estate towards a construction materials, namely quarry, lead industrial business – construction materials grew FY25 EBITDA 54% (existing businesses grew 44%).

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For the last couple of months, I've been putting the view that I think the beginning of a new up move in commodity prices. There are two ways you can approach that.

One is the simple argument that we're at the beginning of an extended period of rate cuts by the Federal Reserve. That period of rate cuts has already started. We will have a further 25 basis point rate cut in November and another 25-basis point rate cut in December. Those rate cuts will continue as we go through next year. As a result of that, the U.S. dollar will fall. You'll see the DXY index of U.S. dollars continue to decline.  Then after the lag, what you will see is that fall in the $US will really start to bite, and commodity prices will go up. That's the simple argument in terms of the world trade cycle.

But this morning what I want to look at, is the structure of demand and where I think the structure of demand will be coming from. For that, what I want to do is look at not just the Chinese steel industry. It is not the domestic economy that I'm interested in. What I'm interested in is the very rapid growth of Chinese steel exports and where those exports are going to.

For the discussion on Chinese domestic demand, which is like I say, I rely on paper that's published by BHP. But for the discussion on Chinese steel exports, I'm relying on the US International Trade Administration and their statistics that they've got on Chinese exports.

In 2023, China produced, over a billion tons of steel. I mean, you know, imagine how much that would hurt if you dropped it on your foot. Domestic demand was 911 million tons, and that's up 50% from the 609 million tonnes 13 years ago.

Now, what's interesting about that, and I'm referring to this BHP paper, is that the structure of domestic demand has changed. We think of all that steel going into buildings. Back in 2010, 42% of the steel was going into the buildings. That has fallen, pretty much reversing those numbers from 42% falling to 24%. So, building demand is a much smaller proportion of steel demand in China. What has changed dramatically is there's a lot more building of machines and machinery in China, and that has generated a change of demand from 20% of total production, 13 years ago to 30% now. Steel demand for infrastructure has changed from 13 % then to 17% now.

It is true that the Chinese economy is slowing down this year. The Chinese government said that we're going to grow at 5%. But the International Monetary Fund in April said that that wasn't going to happen, that we're going to grow by 4.6%. The International Monetary Fund was the closest to it. Then that number that the International Monetary Fund is forecasting drops a year by year through to the end of the decade to about 3%.

But what's interesting, as that's happening, there's still a growth in demand for Chinese steel. That's because there's been a quite remarkable increase in exports of steel. Where I want to look at now. I want, to look at is the top ten markets for Chinese steel exports. Now, these are not countries you would think of. You would think of, you know, big demand with going to places like The United States or maybe, Germany or, you know, France or someplace like that.

That's not where the growth in the world economy is. The growth the world economy is, is in a place north of us called the Indo-Pacific. The Indo-Pacific name came from Shinzo Abe, who was the longest serving prime minister, Japanese prime minister since World War two. Sadly, he is no longer with us.

So, the fastest growth, in last year's was a country called Vietnam. Vietnam absorbed 9.2 million tonnes of Chinese steel, which is 10% of total exports. South Korea absorbed 8.4 million tonnes, which was 9% of exports. Thailand absorbed 4.9 million tonnes, which was 5.3% of exports. And the Philippines 4.8 million tonnes. That's not the United States. It's not Germany, it's not France. It's countries north of us which are using all that steel because the growth rate is so good, is so strong. The Philippines absorbed 4.9 million tonnes. Indonesia absorbed 4.2 million tonnes. Turkey, not north of us, but to the west absorbed 4 million tons, the UAE 3.7 million tonnes. And India, even though it has its own steel manufacturing industry, which is growing incredibly rapidly, absorbed 3 million tonnes.

What I want to do now is go out in some of those countries where we saw that rapid demand and look at GDP growth. I want to look at four of them and what the GDP growth is and what the size of those economies are.

Vietnam, which had the strongest growth. The point about Vietnam is that Vietnam is where a lot of what's happened. In China is wages have gone up so much that they've been priced themselves out of the manufacturing business. A lot of that manufacturing is now going to Vietnam. So, it's now moving to Vietnam. So, what you're having is the roll out of factory building in Vietnam as manufacturing moves there from China now.

What's interesting is that if Vietnam has 100 million people, the size of its economy is $US 0.5 trillion, and that economy grew by 6.9% this year. That's the kind of growth rate that China used to have. The IMF thinks it's going to grow by 6.9% next year as well.  Another country is the Philippines. The Philippines has 117 million people in it. It also has an economy of just over $US 0.5 trillion dollars. It's growing at 5.7% this year. The IMF thinks it's going to grow by 5.9% next year.

Indonesia is an enormous country. 280 million people, almost as many, as many people as the United States. It's income of $US1.5 trillion U.S. dollars and it grew at 5% this year, a touch faster than China annual growth, 5.1% next year and keep growing at that because its populations continue to grow, unlike China.

India, of course, the which is the big guy in the Indo-Pacific, it grew by 6.9% this year. It'll grow by 6.7% next year, according to the IMF. It of course, has a population of 1.4 trillion people bigger than China. And its economy this year was $US3.9 trillion. I compare that to a little country in the South Pacific, a small open economy, as economists say, which has only 27 million people in it. You're right. Australia. And we have an economy of $US1.8 trillion.

What you've got here are two stories for recovery in commodities. First, you have a financial story, which is obvious. The Fed is going to cut rates. The U.S. dollar will fall, after a lag commodity prices will go up. But what's really important is that this commodity market has strong structural demand, and that strong structural demand is coming not from strong growth in China anymore, but from very strong growth in the Indo-Pacific, particularly strong growth in Vietnam, particularly strong growth in the Philippines, strong growth in Indonesia. And of course, the big guy in the block, strong growth in India.