Macro: Sandcastle economics
Invest wisely in Q3 2024: Discover SaxoStrats' insights on navigating a stable yet fragile global economy.
Market Strategist
Summary: As we look ahead for what to expect in this quarter we must reflect on what’s at hand. The energy crisis has seen a huge lack of global resources (supply) and rising global energy demands. This has caused energy prices like oil and gas to spike and taken energy stocks along for the northbound ride. Not only that, but much of the world has committed to net-zero emissions by 2050 while federal investment into clean energy remains paper thin; this has also pushed up the prices for lithium and many lithium stocks. Much of these constraints will likely continue in Q1 and Q2. We cover what has been affected, what to watch ahead and some potential investment ideas.
So how has this affected Australian markets?
So far in 2022, the Aussie share market has outperformed global equities and produced better returns than the S&P500 and the Nasdaq. This is thanks to the Aussie market riding on energy prices that are soaring to records and iron ore prices rising out of a bear market. At the time of writing, the ASX200 is trading flat on the year, just a 2 percent sneeze from its all-time high. While the global benchmark, the MSCI World Index, is 2 percent lower, the US benchmark’s S&P500 is 1 percent lower, and Nasdaq is 3 percent down YTD.
So, what’s fuelling the ASX charge? Natural gas prices are up 10 percent for the month and rose 50 percent last year; coal is up 23 percent this January and rose 130 percent last year; and electricity prices at all-time highs. Australia’s biggest electricity seller AGL Energy’s shares are rallying off their low, up 15 percent year to date, and Whitehaven Coal trades 11 percent higher. Meanwhile, iron ore is rallying off its low with players like Champion Iron up 14 percent and Fortescue Metals up 9 percent YTD. Green-energy stocks like lithium giant Pilbara Minerals trade 12 percent higher and rare-earth giant Lynas Rare Earths is up 9 percent YTD, all supporting the ASX200. Separately, as the market begins to price in the likelihood that interest rates will rise three times this year, tech companies that typically carry higher debt to earnings have been sold down: family tracking app Life360 and buy-now-pay-later company Afterpay have both fallen 10 percent year to date.
As the market moves to a new cycle of higher interest rates while grappling with higher energy prices, volatility will continue.
Investment opportunities could lie in the commodity and energy sector, but also in quality and value names; companies that have strong repeatable cashflows and are growing their market share in their field. Why? Interest rates are rising for the time in a decade in Australia, and ‘quality names’ have a history of outperforming the market. When rates rise and growth slows, given they typically carry less debt vs their earnings they do well; companies with the reverse, or those that don’t make a profit, will likely feel the pinch, as illustrated above.
Separately, there will be opportunities in the logistics and cyber security themes as the world heads into the third year of flexible working arrangements amid Covid and increases its reliance on companies in these sectors.
Elsewhere, opportunities will also be in NextGen Medicine and, of course, in banking and insurance as margins (profits) increase as rates rise. Remember that Australian banks make up the second biggest part of the Aussie share market, behind iron ore miners. The market expects three rate hikes in 2022 and for the headline interest rate to sit at 0.8 percent by the end of 2022. This will likely boost banks’ profitability, dividend payouts and insurance companies’ earnings.
Above all, consider working toward building balance in your portfolio, possibly with a mix of growth and defensive names and securities, to weather different investment cycles.
Iron ore
Iron ore is Australia’s biggest export and contributes 5 percent to Australia’s GDP. It’s the key ingredient in making steel. Iron ore traders are seeing some excitement come back into the sector; the sleeping giant commodity has risen up 40 percent from its November low, trading back at $129—its highest level since October. This is also exciting for investors in BHP and Rio as it boosts their profitability.
For iron ore itself, there’s talk that if positive developments continue in China, iron ore could claw out of its bear market and head back to the $220 mark, where it traded in May 2021. Here are some of the recent positive developments:
On the negative side, China’s property sector is looking shaky and keeping gains in check; China’s biggest developers are in financial distress. Evergrande has recommenced work on over 60 major projects, but we still don’t know the fate of China’s property sector, if it will more or less collapse or continue on some sort of growth trajectory, supported by China’s bank cutting interest rates.
Either way, the world’s biggest miner, and the biggest stock on the ASX, BHP is about to get bigger by market size as it closes down its UK entity and unites the group on the ASX. BHP could rise from being 6 percent of the ASX200 to being 10 percent of the market. For shareholders, they can expect higher dividends as the group brings forward $6 billion of franking credits.
The biggest catalyst for the BHP share price is a rise in the iron ore price. In 2021, BHP made 58 percent of its revenue from iron ore, 26 percent from copper, 9 percent from coal and 7 percent from petroleum. BHP’s coal and petrol revenue is being boosted by record prices, but remember that this will reduce after BHP divests oil assets this year, followed by coal in 15 months’ time.
BHP sees iron ore demand picking up, expecting China’s GDP to grow by up to 6 percent this year. BHP will continue to focus on helping the world urbanise—supplying iron ore, while also helping decarbonising efforts—supplying copper, nickel and potash.
BHP’s shares are priced to perfection at these levels if you believe iron ore, copper, coal and petrol revenue will continue to rise. BHP shares gained 30 percent from November to $45.12, after the iron ore price jumped 40 percent in that time. But can BHP get back to its August 2021 high of $54? Many think it can.
Another stock to watch is Rio Tinto. Rio shares rocketed up 20 percent from $88.56 in November to $106.41. Can it get back to the $135 high it hit in July 2021? The jury doesn’t think so, as it’s been facing a backlash about potentially building a $3 billion lithium mine in Serbia. Either way, tailwinds supporting Rio’s share price growth come from the way it’s currently generating revenue. But the market seems to have mispriced that. In 2021, 56 percent of revenue was from iron ore, 23 percent from aluminium, 11 percent from copper and diamonds, and 10 percent from energy; all commodity prices are moving up.
Oil and oil stocks will also likely continue to dominate, given oil is likely to rise from the $80s to $100 amid rising demand as the world’s winters and summers become more extreme.
Woodside Petroleum is a stock to watch, as it’s set to become the world’s 10th biggest oil and gas producer, following the merger with BHP’s petrol business in Q2. Woodside produces 20 percent of Australian gas, competing with Chevron, Santos, ExxonMobile and Shell.
And keep a look out for federal stimulus on the lithium and hydrogen sectors closer to the election in May. Stocks to watch include Pilbara Minerals, Allkem and Fortescue Metals (for its Hydrogen exposure).