Fixed Interest

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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