Week Ending 26.04.2019
- Inflation is front stage after the weak print in Australia for Q1. Financial markets have rushed into predicting a rate cut, while the few (including ourselves) that see this as unlikely point to the relatively robust employment data as a reason for the RBA to talk but not walk on rate cuts.
Can, or should, central banks obsess about inflation, or rather work on employment, output and imbalances as the criteria for setting interest rates? At least the RBA is not alone in this debate, with inflation unmoved in almost every country regardless of the level of real interest rates.
The ABS has been adjusting the CPI to better reflect the spending mix across the community. As at the end of 2018 the weights housing, health and alcohol/tobacco (which are subject to annual regulated price increases) rose, while food, clothing and furnishing proportionately declined.
This first quarter CPI had a relatively wide array of results from the subsectors. Most will not be surprised to see that food prices rose by 2.3% year on year, driven by fruit and vegetables, which was up 5.3%. Seasonal cost adjustments in education based on the rise in secondary school fees is also evident. Healthcare and property rates have persisted, with annual increases above the average, though the impact on the quarter is low given these are put through once a year.
The drag to headline inflation was due to fuel prices in the quarter (likely to reverse into this quarter) and the persistence of falling prices in apparel, furnishings and electronic equipment. More surprising was the decline in domestic travel and accommodation, an issue that has also featured in a profit downgrade from Flight Centre. Housing and related costs are flat-lining over the quarter and only up 0.8% year on year.
Back to the question, will the RBA reconsider its approach to monetary policy? Our argument is that it will not achieve the outcome the central bank would want. Given household debt, a rate cut does have a potentially positive impact on disposable income. But that assumes banks pass on a meaningful amount, while the offset through lower deposit rates tends to mute the net benefit. It could also induce another bout of house price rises, something the RBA (along with APRA) have been aiming to avoid.
For prices to rise outside the seasonal variations in food, fuel and regulated costs (education, healthcare, tobacco, childcare - which, as an aside, is within furnishing, household equipment and services) requires heavy lifting from housing, recreational spending and transport.
Even higher wages are not a full solution. The US is evidence that wage growth of 3%+ may not result in higher prices across the board. The solution to suboptimal inflation is far from obvious.
- Corporations are benefitting from low costs, but are also bereft of demand where they rely on discretionary spending. If the disinflationary trend continues, the equity pattern of the past few years is likely to be sustained, that is, companies able to take share and approach their industry from a differentiated perspective.
- Oil markets have gone through a period of considerable volatility over the last several months, with geopolitical and supply/demand factors at play. Energy equities have lagged the rebound this calendar year, although latent supply in the oil market has tempered expectations for an extended rally.
After a sharp correction in the final months of 2018 (where benchmark prices fell by ~40%), oil has staged a rebound in 2019 to be one of the better performing commodities during this period. The decline was driven by both demand and supply factors. Slowing demand in the wake of softening global growth expectations and amid trade tensions was the primary influence, particularly given that the market was seen as relatively well supplied. On the supply side, geopolitical uncertainty was then created by US sanctions on Iran, with waivers granted to countries helping to support Iran’s current level ~1.2m b/d of exports.
The catalyst for oil’s turnaround was the OPEC decision (and Russia, which has recently been allied with the cartel) last December to cut production levels by 1.2m b/d. Importantly, this has been met with high compliance to the new output targets. Other supplies have also been disrupted, including in Libya and Venezuela due to internal issues.
A shift towards a more dovish tone from central banks globally has helped the demand outlook in the first quarter of 2019, while trade fears have been easing as the US and China edge towards an expected deal. Finally, oil has moved higher over the last couple of weeks following the US’s decision to withdraw its waivers next month, which would penalise countries including China, Japan, India and South Korea if they continue to import Iranian oil.
While the above has had the effect of lifting oil prices back to similar levels prior to the correction in the second half of 2018 and the short term risk is likely to be upside, there has been little change to the longer term outlook, with the market now in backwardation (i.e. spot prices are above futures prices). The key variable is a relatively high level of spare capacity (particularly from OPEC members and Russia) which could be quickly returned to the market. A sustained higher pricing environment could also result in higher levels of activity in the US shale industry, which on aggregate, is now a significant swing producer. OPEC itself will be wary of incentivising further US supply and therefore current pricing may provide sufficient motivation to wind back on its production cuts at its next meeting in June.
How have these developments been reflected in the earnings and share price performance of they key energy stocks on the domestic market over the last several months? The energy sector was key in leading the index lower over October to December, with the four big cap stocks (Oil Search, Woodside, Santos and Origin) falling by 20-30% in the final quarter. Despite the rebound in oil this year, however, only Santos has outperformed the ASX 200 materially, having risen more than 30%.
The change in earnings revisions over this financial year goes some way to explaining this situation, with 12 month forward estimates for Santos rising more than 30%, helped by a better outlook following the company’s February result.
The relationship with oil prices is not entirely straightforward for several reasons. Firstly, the large Australian energy companies are predominantly LNG rather than oil producers, and while contract LNG pricing is typically linked to oil, it is often with a lag. Secondly, the LNG spot market has been particularly weak of late and uncontracted volumes (which can be 10-15% of overall production) have been generating lower revenues. Oil Search is viewed as the best protected in this scenario. Thirdly, the domestic gas market, which has its own supply/demand characteristics, is important for some producers, particularly Santos. Lastly, changes in earnings will often lag sharp price movements given that analysts only typically review pricing assumptions on a less frequent basis.
Putting all of this together, Santos has seen the largest earnings upgrades through this financial year, a function of a) its higher cost base and hence operating leverage b) upgrades following its full year result in February and c) the higher liquids content of its portfolio.
The earnings path for lower cost producers Oil Search and Woodside has followed a similar pattern, although the lack of upgrades in this calendar year reflects some of the other factors noted above. Origin is the other key domestic energy stock, however issues in its integrated utilities division have been behind the downgrades to its forward earnings. With our domestic model portfolio, our preference has been for Oil Search, which strikes the best balance between high cash generating assets and expansion optionality in PNG.
Energy Sector: 12 Month Forward EPS Revisions