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Week Commencing May 19, 2014

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This week we look at the following topics:•Impact from the Aussie budgetWhat it means for the Australian dollar and certain parts of the stock market.•Update on our key 2014 stock picksReviewing the performance of key stocks we picked at the beginning of the year. How are they traveling?•Client question & answer – Westfield GroupA very good question on a recent note we wrote from a savvy client. We share our answer for all to learn.•Euro technical outlookWhat the recent fall means for the Euro against Us dollar.

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Impact from the Aussie budget

By now you would have already heard most of the major points which have come out from the Australian Federal Budget. There’s no point in really going through each measure, the major media channels have done this well, perhaps too well. Some of you might be completely over the whole budget coverage by the time you read this note.

We’re talking about a national economy which has GDP over a trillion and a half dollars as at the last estimate and so the fiscal deficit peak itself is still a relatively small proportion of GDP and well below other developed nations who face similar fiscal challenges. The Abbott government was voted in with a mandate to fix the debt situation – even though most economists agree it isn’t necessarily a sovereign economic problem yet – and so the government has sought to act. With a few broken promises in-between, but that’s just politics.

So our purpose here is to talk through the impact of the budget on your investments. We’ll provide a key map of how we think it will impact markets – if any impact at all. We won’t be going into a political argument on which parts needed to be in the budget and which parts didn’t’. From a fiscal perspective, the budget itself doesn’t pose a real threat to the overall economic growth story. Australia is expecting to see the budget halve from around $50bn of deficits in the 2014 financial year.

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The most important impact of the budget is that an attempt to rein in the deficit – tight fiscal stance – means the Reserve Bank of Australia (RBA) can continue to maintain rates at historically low levels for a little longer. This will take some steam out of the resurgent Australian dollar. The market has already started to pare back some earlier assumptions of rate rises this year. It’s unclear when rates will start rising but it is pretty fair to say that this should occur within the next 12-18 months. The RBA has breathing room for now but we will discuss below why this won’t be the case for long. The attempt to halve the fiscal deficit over the next year means the RBA can wait until inflation starts to move, so far it hasn’t been the issue.

But inflation might start to rise if the infrastructure measures announced in the budget start flowing through the economy. Treasurer Joe Hockey has said he wants to see cranes hovering over all major metropolitan cities across the country. Roads are the key initiative. The second airport in Sydney has already been announced, this is a long dated projected. Infrastructure Prime Minister Tony Abbott will be pushing hard to work with the states in getting infrastructure projects off the ground. The key winners from this will be companies listed on the stock exchange which have a strong focus on the infrastructure market. We identify these companies as follows:

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It’s hard to say which company will be the major beneficiary - the largest are the most obvious, but with the recent takeover on Leighton shares - we think the other names provide a more compelling list. Stocks like Boom Logistics (BOL) have been in the dog house for the better part of two years and over exposure to mining stocks has seen contracts being lost – the most recent in Queensland as coal prices continue falling. The good thing about cranes – the type and fleet which Boom manages – is that they will become in large demand when roads, bridges and highways are expanded.

The pipeline is looking healthy, businesses like Boom Logistics can quickly deploy and on a large scale. It’s not the only crane hire business in the country, but it is the only one with the scale and diversity of products on offer. Other larger groups like Downer and United Group are in a similarly strong position, able to pick off large contracts as they are announced. In a nutshell, there is plenty of work coming to this sector over the next few years.

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The job creation from infrastructure projects is significant, they will have a spill over impact on the economy just as development and construction projects peak thanks to record low interest rates. The problem though is the RBA will see the scope of capital projects as potential threats to relatively benign inflation. We have written about the New Zealand experience several times in recent months. So while the budget provides room for low interest rates in the short term, in the medium term the RBA will be looking out cautiously knowing very well that consequences of maintaining rates too low for too long. For currency traders, this is the most important thing to watch.

The second part of the budget which investors should take note of is the creation of a Medical Research Fund potentially worth up to $20bn. We don’t know too much detail as at the time of writing but what we do know is that the government will use the $7 GP co-payment to fund this venture. The hope of the fund is to breed the next generation of Australian medical breakthroughs. We already have some strong names on our market – Cochlear, Resmed and CSL to name a few. These three have all grown into significant global companies, changing people’s lives and contributing to health wellbeing. The actual official name of the fund is the “Medical Research Future Fund”.

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The Australian Minister of Finance has stated the following details of the fund on the ministry’s website:

“Every dollar of estimated savings in health expenditure announced in the 2014-15 Budget will be invested into the Medical Research Future Fund, until the value of the new fund reaches $20 billion. Funding for the new Medical Research Future Fund will also include $1 billion of uncommitted funds within the existing Health and Hospital Fund.

The new fund will help realise the huge opportunities for research to boost illness prevention and promote early intervention, reducing health costs while improving health outcomes and delivering better quality of life. The Medical Research Future Fund will be invested and managed by the Future Fund Board of Guardians, which has a proven track record in managing investment portfolios on behalf of the Government and maximising returns over the long term.

The net earnings from the new Medical Research Future Fund for a given year will be available in the following year to fund medical research priorities, including through payments to the National Health and Medical Research Council. Payments will commence in 2015-16. The capital and any ongoing capital gains of the new Medical Research Future Fund will be preserved in perpetuity. Existing commitments related to projects currently approved for funding from the Health and Hospital Fund will continue to be paid from that fund until its abolition and subsequently through new special appropriation provisions managed by the Department of Health. “

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If this fund lives up to the expectations above, it could potentially become a huge venture capital fund for Australian based biotech and medical companies. We could potentially see a whole industry build from this, the biotech space on the market could thrive and the impact on the public health system from successful technology investment will become significant. This is the second most important part of the budget in terms of investment.

It’s a big promise, is long dated and we all know that many government long term ambitions don’t necessarily eventuate – like the Green Investment Fund announced by the former government – but there is a glimmer of hope. The medical industry has embraced it as a step in the right direction. Keep an eye on this.

The last point of the budget was the fact that the superannuation system was left relatively untouched. This was a promise which the government kept. It’s likely to remain a positive driver for the financial services industry and will continue to see the pool of Australian pension earnings growing in line with prior estimates. We think that the superannuation system will eventually be raided – in some form or another. The amount of money there and the current taxation structure makes it hard to resist for any government looking at reigning in spending and reducing the debt burden. For the time being, the longer it remains unchanged, the better it stays for the financial services firms.

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Update on our key 2014 stock picks

We released a 2014 forecast guide in January this year and pointed to a list of companies we thought had good underlying businesses but had somewhat lost their way over the past two years. We said that we think 2014 would be better for these companies and as a combined list, the stocks would be suitable in a well-diversified portfolio. With reporting season and the federal budget out of the way, we think it would be a good opportunity to see how the list was performing before the end of financial year. Keep in mind that this list is different from the three portfolios we run and update at the beginning of each month. Below is a screenshot from the forecast guide highlighting the stocks.

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We’re pleased to say that most of the stocks on the list have been reasonably positive performers. Not all on the list have been perfect but we are less than half way through the year. The performance is as follows:

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Client question & answer – Westfield Group

We recently received a question from Andrew in Melbourne who points to an article we previously wrote on Westfield Group. We have also written about Westfield previously as it forms part of our Wealth Preservation portfolio. Andrew’s question and our answer are listed below.

Hi Peter

I thought I would email you in relation to your article titles and notes on Westfield. In relation to Westfield you mention, “reasonable earnings growth”, but take a look at the Morningstar table attached (below), which shows earnings have fallen 13% and dividends even more over the past 10 years! I think the article needs updating.

Kind RegardsAndrew

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Hi Andrew,

Westfield report two types of earnings – statutory earnings and funds from operation. We consider the later the more appropriate measure of earnings. Property trusts can sometimes be subject to fair value adjustments which means they are taken through the profit and loss statement, incorrectly reducing earnings. We saw this during the GFC. I’m not sure which method of earnings Morningstar uses for its calculations and I don’t have time to check the table. Perhaps something for you to double check. That’s the first point.

It’s also worth noting that WRT was split out of WDC and so the earnings reduced, but you need to make the adjustments for the complete investment if using history as a guide. This is the second and very important point.

Regards,Peter Esho – Chief Market Analyst

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Euro technical outlook

Image: EURUSD daily chart via Invast MT4 platform

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The short term trend for the EUR/USD remains to the downside, with the pair failing to push above 1.4000 and in the process taking out support at 1.3800. From the daily perspective the rally towards 1.4000 actually fails at 1.3900. There hasn’t been a daily close above 1.3925 which is considered to be the psychological barrier to 1.3900. The recent drop in EUR/USD is currently finding support at 1.3675, which is a key pivot level for the EUR/USD from back in October 2013. A confirmed daily close (break and re-test) below 1.3675 will leave the EUR/USD open for a further drop, as there is no significant support until 1.3500 where the low in February 2014 is located.

While the market remains bearish, we think there is a potential for the EUR/USD to be range traded between 1.3675 and 1.3825 in the coming week. Stochastic Oscillator is indicating a potential oversold condition and typically this resulted in the currency pair bouncing back up a little before any further drop is possible.

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On the much larger picture, more room to the downside is possible. The weekly chart just came off the overbought condition and stochastic still suggests more downside momentum. The key support trend line from October 2013, was also broken last week. This is in line with our bearish bias on the EUR/USD, that further losses are possible in the coming weeks.

Image: EURUSD weekly chart via Invast MT4 platform

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