Good afternoon,

ASX 200 marginally lower for the week, banks down, energy and defensives up.

Where are we in the cycle?

We are getting a little bit macro this week, looking at some of the critical markers. Long story short, I reckon this is shaping up to be the top of the market before a little correction turns up and this reporting season should/could prove an inflection point.

Why do I think this? Let’s revisit our primary indicators of where we are in the business cycle.

1. ISM / PMI’s

  • ISM’s non-manufacturing index for July registered at 55.7, down from prior month’s 59.1 and below consensus for 58.6. New orders dipped markedly, Business activity was also weaker m/m, at 56.5 against June’s 63.9.
  • ISM’s manufacturing index for July fell to 58.1 from 60.2 in June.

2. Yield Curve
Has got a bit steeper lately (positive) though still very flat in the scheme of things. An inverted yield curve has been a good predictor of recessions in the past. Many argue distortion created by central banks make “this time” different. Even in my short career, I’ve learned it’s safer to assume the contrary.

3. Earnings
US earnings season has been mixed at best. Growth has been fine, helped by tax cuts and a stronger economy. Though investors are a clever bunch. We know (or suspect) that this growth can’t continue as interest rates go up and are prepared to pay less for earnings growth than before, valuations contracting.

What slows the Fed from it’s current path? Probably a decent market correction and a breach of the 3rd mandate of the Federal Reserve “stable financial conditions”.

House Prices…ouch!

House prices are getting clipped! Brisbane seems to the only place to escape the sell-off.

And it’s a function of income growth being pretty weak… and that means we can’t borrow as much money…

And the banks aren’t lending as much money, particularly to investors…

And it’s because they are losing money every week…

Finally, just one for my Perth buddies, prices have been on a steady decline in The West since 2015.

I saw something on Livewire this morning from Tim Hannon at Newgate Capital Partners, he writes a pretty similar thesis to me and goes into detail on how and why the banks aren’t lending. Worth a read here if you’re interested.

Our conclusions are largely the same. Property isn’t a great asset class to be over-exposed and leveraged to at this point in the cycle. Consumer spending is, and will continue to be, hampered by the cost of servicing huge mortgages from flat wages and the ‘wealth effect’ we’ve seen over the last 15 years (financing consumption through redrawing on housing equity) will cease.

Reporting Season has begun!

Arguably the busiest and most important time on the investor calendar has arrived and we’ve got off to an OK-ish start. The market is expecting 8% earnings growth on this time last year and excluding resources, that’s more like 5%. Excluding banks as well however (which are battling) show that industrials are on 18x with 10.7% consensus earnings growth.

I had a little sniff around the market for where I see a few potential positive surprises. Lots of people with lots of conflicting views and variety of biases. My list, like all others is not free from my own biases.

  • Breville (BRG) – good retail sales number locally today and decent recent results from consumer sector in the US. High quality business that has a history of under-promising and over-delivering. Expect the result mid-August (17th)
  • Amcor (AMC) – share price is moving already, up 6% this quarter to date. Suggest recent cyclical weakness in earnings growth, fuelled by high raw materials prices, will start to subside. Orora (ORA) also a candidate in a similar vein. (I wrote this on Friday, more on Amcor’s takeover of Bemis next week… but let’s just say it’s smart and AMC very well managed, well positioned business.)
  • QBE Insurance (QBE) – I can’t believe I’m typing this. But not beyond the realms of possibility. All they need to do is not completely stuff up (again). Market will probably like anything resembling ‘competence’.
  • Codan (CDA) – Metal detectors. Who would have thunk it? Got a stack of earnings momentum and could surprise to the upside despite recent upgrade to guidance.
  • Ansell (ANN) – another one that’s already started to move higher but has a nice currency tailwind.
  • Computershare (CPU) – call it a gut feeling. Call it conservative guidance and a bunch of analysts upgrades. I’ve got no actual reason to think they’ll surprise to the upside than that I reckon they probably will.
  • Boral (BLD) – coming off a bit of a dodgy result last time, housing starts actually picked up recently and I reckon they’ve got more exposure to east coast infrastructure than people realise. No reason this can’t re-rate from 16x to 18x again on the back of a decent result.

Supermarkets (WOW, WES)

I love it when investment professionals get there hands dirty! Tom Kierath over at Morgan Stanley goes to Costco & Aldi every month to see how much cheaper it is on a basket of goods vs the major incumbents (Woolies, Coles). It’s super insightful.

Tom found that the “price gap” has recently been getting wider. Costco was c.20% cheaper in October 2017 and is now c. 28% cheaper than Coles/Woolies. He found that Aldi also has twice as many price reductions year-on-year vs the majors.

From my perspective, this is a pretty good lead indicator to the new international players gaining greater market share or further “investment in price” from Coles and Woolies (i.e. margin-eroding discounts).

And whilst this is a concern short-term, Woolworths (WOW) is the most expensive supermarket comparable globally, trading on 20.4x fwd earnings. WES not far behind on 19x (just 3rd, behind Morrison’s).

So yes fundies, I understand why you want to own staples over discretionary (see property market comments above) and yep, both WOW and WES screen very well at the moment. But I’m not sure how much higher the valuation can go, so upside is going to be on earnings acceleration alone… which personally, I’m sketching on (that’s Gen-Y for “skeptical of” for those born pre-1980).

Big moves for the week

Blue Sky (BLA) on a bit of a bounce after speculation they’ll do some sort of funding deal with Howard Marks’ Oaktree (you should subscribe to his infrequent but informative blog as an aside). Sampling business ALS (ALQ) up on strong earnings, as was GUD Holdings (GUD).

Platform businesses HUB24 (HUB), Netwealth (NWL) continue to de-rate as everyone figures out that business is a race to the bottom now that bulk of the market is captured. Can’t see any significant innovation being worth any significant premium in pricing.

Seek (SEK) slapped on an earnings miss this morning. (REA) down on what I see as an obvious pairs trade with Domain (DHG).

Have a good week,