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Weekly market update - Election edition 20th of May 2019

Written and accurate as at: May 20, 2019 Current Stats & Facts

Federal election impact

The Federal election result has come as a surprise. Almost without exception, every company we speak to was expecting a Labor win.

The market is likely to enjoy a near-term relief rally as the uncertainty around the effect of Labor policies on the market disappears.

We note offshore investors had taken a very cautious view on Bill Shorten. His party’s failure may prompt some flows from international investors.

There are some sectors which may enjoy some relief.

The threat of a bank levy is now gone. So too is the plan to cap private health insurance premiums, removing a headwind for the insurers and the private hospital operators.  

We may see some rotation here – perhaps from some of the more defensive sectors where investors were parked ahead of the election.

Second-order effects will take longer to emerge.

There is an argument that the retention of negative gearing may see investors return to the housing market, which may feed through to sustained support or banks and housing stocks.

We remain very cautious on this view, particularly on the banks given the multitude of issues they face and the significant levels of debt sitting within Australian households whilst without a rise in salary.

Nevertheless, trends among property investors remain important to watch. There may also be a pick-up in mining developments which could benefit mining services and the economy more broadly.

We have witnessed a marked economic deceleration in recent weeks. A key question is how much of this is due to the “election effect” and how much reflects broader underlying weakness.

This remains a key question in the near term, although speculation that the government might accelerate their tax cuts may provide a boost to economic activity.

Last week’s gains

The S&P/ASX 300 index gained +0.9% in terms of price returns last week. While the banks and cyclicals dragged, resources and growth stocks did well.

The banks fell as ANZ (ANZ, -6.0%), National Australia Bank (NAB, -7.8%) and Westpac (WBC, -6.7%) paid dividends.

The bank sub-sector was off – 3.5% in terms of aggregate total return, although these distributions boosted the S&P/ASX 300’s total returns to +1.4%.

The price of iron ore topped US$100 a tonne, helping Fortescue Metals (FMG, +18.7%), Rio Tinto (RIO, +6.4%) and BHP (BHP, +4.5%) finish among the market’s best.

FMG’s return was boosted by the announcement of a 60c-a-share special dividend.

Iron ore sweet spot

Iron ore miners are enjoying a particularly sweet spot at the confluence of a number of macro and stock-specific factors.

Reasonable Chinese demand and a reduction in Brazilian production is supporting prices at a far higher level than the market expected.

The last time the iron ore price was anywhere near this level, the AUD was trading at parity with the USD, while today it’s below 70c.

Throw in the fact miners have been able to reduce their cost base by around US$20 a tonne and are spending less than $US10 a tonne on capex – versus $30-$40 a few years ago – and we are seeing the sector producing enormous cash flow.

FMG’s decision to issue its special dividend before the end of the financial year now looks like a moot point in terms of franking credits, given the election result.

Nevertheless, it does emphasise the sector’s strong cash flow and management discipline.

FMG’s total yield, including special dividends and buy-backs, is now running at about ~20%, providing plenty of stock support despite its recent strong run.

Earnings downgrade

Plumbing equipment maker Reliance Worldwide (RWC, -16.7%) was the weakest stock in the ASX100 after management downgraded earnings by ~7%.

Several factors were cited, including a relatively mild winter in the US and a slowdown in Australia.

This also illustrates the risks that emerge when a company which has undoubtedly executed well in a particular niche – in this case, the Shark Bite product – starts to diversify into new areas. RWC has been a favourite for many investors but we see better opportunities elsewhere.

Otherwise, it was the banks which were weakest as they paid out dividends.

There was also pressure from the RBNZ, which revoked ANZ’s advanced accreditation, meaning it will no longer be allowed to calculate its own operational risk capital with regard to its New Zealand subsidiary.

The net effect is likely to be an increase in its capital reserve. It also serves as a reminder that the issue of additional capital reserves against Kiwi lending remains live for the banking sector.

While the banks are likely to enjoy a relief rally on news of a Coalition victory in the federal election, the spectre of additional capital is one of several headwinds that persist over the medium term.

Qantas outlook

Qantas (QAN) was down -3.3%, possibly in sympathy with a profit warning from domestic competitor Virgin Australia (VAH).

Many believe this is good news for QAN.

Its most recent update highlighted a weaker outlook for domestic corporate travel, but also that it could offset these trends by stronger international volumes.

VAH does not have this offset and, as such, we think will continue to cut domestic capacity in order to preserve cash flows. This continues to underpin the stable domestic duopoly and QAN’s ability to grow revenue via less ticket discounting.

Beyond the iron ore miners, we also saw strength in South32 (S32, +7.0%) and other plays in the aluminum complex on news of production curtailments on at least two refineries in China following an environmental breach.

Weaker global data also helped support the gold price – and miners such as Evolution (EVN, +11.1%).

Elsewhere Lendlease (LLC, +11.5%) gained on speculation that it was being targeted for takeover by a Japanese firm.

REA Group’s (REA,  +7.1%) quarterly update revealed a poor environment for house listings, however, the market has been forgiving as REA is demonstrating their ability to offset this via pricing power and other initiatives.

Numbers add up for Xero

Accounting software company Xero (XRO, +11.2%) delivered a well-received result providing some comfort around valuation.

The key factor is subscription growth as it rolls out to the UK and US a model which has been successful in Australia and New Zealand.

They have found particular traction in the UK in the most recent half, which is important given the one-off opportunity provided by the shift to an online tax system.

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