Twenty years in the making
Global equities mostly advanced further in the first quarter of 2021, marking the fourth straight quarter. The gains came on the back an accelerating vaccine rollout, a strong outlook for a global economic rebound this year and continued accommodative measures from governments and central banks. Most of the pain was felt in the bond market, with yields rising on the rapid vaccine rollout in the US and UK and expectations of further US stimulus, which was forthcoming. Australian shares edged up in the first quarter and have since pushed higher to a new record high on Monday (yesterday), driven by the twin engines of banks and resources – more on that later.
US President Biden signed into a law a massive $1.9 trillion relief bill, keeping money flowing through the economy. Not to be left out, the European Parliament approved a €672.5 billion Recovery and Resilience Facility to provide grants and loans to help EU countries mitigate the impact of the coronavirus pandemic. In Australia, where the pandemic was contained much better than in most countries, stimulus is set to wind down in 2021 as the economy has rebounded strongly. Australian equities edged higher in the first quarter
Massive stimulus, significant pent-up savings and supply-chain disruptions though have combined to prompt inflationary fears around the globe. Although the most closely followed surveys in major economies have only shown inflation reaching modest levels to date purchasing manager indexes and commentary from a raft of companies implies we are on the cusp of a period of higher inflation. Whether this will be transitory as some suggest (with the Fed being a key player maintaining that view), or not remains to be seen.
Now in May, we have seen most companies around the world post better-than-expected first quarter results. In the US reporting season, Refinitiv estimates S&P500 first quarter earnings to date are up 50% year-on-year, marking the highest growth rate since the first quarter of 2010. Companies are bouncing back stronger than anticipated, not only in the US and but in many locales, including in Australia. Country and regional GDP forecasts have been revised upwards.
At the US Fed’s meeting in April, easy monetary policy was maintained, and the central bank signalled it isn’t in a rush to change that. Last Friday’s disappointing non-farm payrolls report dampened expectations of any hikes in interest rates sooner than the market was expecting. The US economy expanded at an annualized 6.4% pace in the first quarter of 2021 according to an advance estimate and that followed on the heels of 4.3% growth in 4Q20. The 1Q21 increase was the biggest first quarter growth rate since 1984. For the year, economists polled by Reuters estimate US growth could top 7% this year, which would also be the fastest since 1984 and follows on the heels of the 3.5% contraction in 2020, the worst performance in 74 years. This is important for the global economy and hence Australia and stock markets.
Importantly China, which remains critical for Australia’s economy despite rising tensions between the two countries, has rebounded strongly. The Chinese economy expanded 18.3% year-on-year in the March, accelerating sharply from the 6.5% pace in the fourth quarter and a little below the market consensus of 19.0%. It was the strongest pace of growth since the data series began in 1992. The latest print was up against a low base a year ago when Covid-19 froze activity and supported by a strong rebound in domestic growth, a recovery in global demand and domestic monetary measures. Chinese authorities have a 6.0% growth target for 2021, which I suspect will easily be exceeded and follows on the heels of 2.3% growth in 2020 when the Chinese economy was one of the few economies to log growth.
Australia experienced a more modest drawdown in economic growth in 2020 than most other developed countries due to its lower Covid-19 infection rates. Despite several minor flare-ups this year, Australia has still managed to maintain case rates at very low levels and the Australia/New Zealand travel bubble was a first step towards reopening borders, although there has been a few ‘pauses’ there and a broader reopening is still some ways off. The vaccine rollout has also been relatively slow.
Still, the Australian economy has rebounded strongly in early 2021, with momentum improving rapidly. At its May 4 meeting, the RBA upgraded economic growth and employment forecasts yet maintained a commitment to keep rates where they are for the next two years, and despite acknowledging the inflationary pressures that are clearly pushing through the system.
The RBA’s central scenario for GDP growth has been revised up further, with growth of 4.75% anticipated over 2021, followed by 3.5% in 2022. A pick-up in business investment is expected, with household spending to be supported by the strengthening in balance sheets over the past year. The unemployment rate is expected to continue to decline, to be around 5% at the end of 2021 and at 4.5% by the end of 2022.
We note that the unemployment rate had fallen to 5.6% in March, from 5.8% in February and a recent peak of 7.5% in July 2020. The fall in unemployment was despite the participation rate ticking higher to 66.3%. Total employment rose by 71,000 during the month, although the numbers were taken prior to the end of JobKeeper so there will be a lot of interest in next month’s print. We don’t think we will see a massive reversal and given a number of economic tailwinds coming through.
The number of jobs in the economy has surged past pre-COVID-19 levels with more than 2000 new jobs returned per day. The recovery has certainly been stellar with Treasurer Josh Frydenberg noting that “Australia’s labour market is recovering 4.5 times faster than the experience of the labour market during the 1990s recession.” There are now more Australians in work today than at any time in history.
Australia unemployment rate
At the May RBA meeting, Governor Philip Lowe wrote, “Despite the strong recovery in economic activity, the recent CPI data confirmed that inflation pressures remain subdued in most parts of the Australian economy. A pick-up in inflation and wages growth is expected, but it is likely to be only gradual and modest. In the central scenario, inflation in underlying terms is expected to be 1½ per cent in 2021 and 2 per cent in mid 2023. In the short term, CPI inflation is expected to rise temporarily to be above 3 per cent in the June quarter because of the reversal of some COVID-19-related price reductions.”
Monetary policy is set to remain accommodative for some time, with significantly higher wages and further tightening of jobs market conditions. The RBA believes tightening is likely years in the future (2024) and has placed a high priority on full employment.
IHS Markit PMI survey data for April showed a significant upturn in manufacturing and services activity at the national level. There were early signs of a renewed expansion of exports, although tourism and education will continue to face headwinds for a while yet.
The economy and the stock market can be two very different beasts sometimes though, so it is pleasing to see that Australian equities advanced modestly in the first quarter and have pushed higher since, setting a record high on Monday (yesterday). The new record has been powered by the twin engines of banks and resources. While we believe a retest of the breakout level at 6800 is plausible this month, we expect the market to continue moving higher.
We believe the market can push on much further in the months ahead after we get through May. This is as the ‘V’ shaped economic recovery, which we called during the COVID lows last year, continues to gain momentum. Outcomes continue to be better than feared across the board, thanks to how effectively Australia has dealt with the pandemic, both from a health and economic perspective.
Rising commodity prices have played a big part in the resurgence of the economy, and not least of which is iron ore that has been rising at a breakneck pace. This is clearly going to be a big feature of tonight’s budget and given the government has vastly underestimated the pricing strength of the steel-making ingredient. In December the Treasury’s mid-year economic and fiscal outlook included a forecast that iron ore prices would decline to around US$55 a tonne.
With a near 50% leap in iron ore prices since the start of the year, the budget is therefore going to look a look healthier than was anticipated. This is as both China and the world looks to undergo an economic reboot following Covid, through massive infrastructure investment initiatives.
This is all obviously great for the iron ore producers BHP, Fortescue and Rio which rose by 3.1%, 7.9%, and 4.6% respectively yesterday, making record highs in the process. BHP is a member of our Income Portfolio.
ASX 200 resources sector
A rebounding economy has not surprisingly increased confidence, on the part of investors, consumers, and businesses. The NAB’s business conditions and confidence levels have both hit new record highs in April. And while the ‘sugar rush’ has moderated a bit, the consumer is in a good place as well – March retail sales rose 1.3% month on month.
Increasing confidence in the economic recovery is manifesting itself in rising levels of M&A activity. The stakes have been raised for casino operator Crown as Star Entertainment has proposed a merger – which values Crown at over $14 a share. This trumps a revised bid from US global investment business Blackstone at $12.35 a share, made yesterday morning. We think a bidding war is about to ensue now that James Packer is a seller.
As noted above, a strong rebound in bank shares has been a key driver of the Australian market as well, with the financial sector the largest in the Australian share market by market capitalization. Fears about bad debts have proved excessive and three of the big banks recent reported upbeat results. Provisions are being released and dividends are firmly back on the table, while government bond yields have risen this year, boding well for higher profits on loans. Banks form the backbone of the Income Portfolio, with ANZ, Westpac, NAB and Bank of Queensland all constituents. The other financial constituents, QBE Insurance and Suncorp have also re-rated upwards over the past year.
ASX 200 banking sector
The upshot of this has been that markets have ticked up 4% since our last Income Portfolio review in February, with the record high reached yesterday.
The results season has confirmed many doing well, although there is a clear bifurcation with the likes of tourism still struggling given an effective border closure, although the travel bubble with New Zealand is a welcome development for the sector.
Our notional portfolio of income stocks has also performed well in that time, led by the banks/financials and strong cameos by the likes of BHP, Collins Foods and James Hardie.
The A$ has strengthened a smidgen to US$0.78 (from US$0.77) since our last review, and the 10-year Aussie bond yield has risen materially to 1.66% (from 1.23%), although much of the rise was in late February and the yield has effectively traded in range since.
Interest rates aren’t about to shoot up any time soon and this combined with solidly improving fundamentals for the economy and corporates, in our view continues to underpin the case for holding a high-quality portfolio of strongly yielding income stocks.
Income Portfolio Performance
As summarised below, we have updated the Fat Prophets Income portfolio using stock and index prices as at the close of ASX trading on the 10th of May 2021.
On the income front the portfolio has a return to date of 22.7%. It should be noted that this is an average income return, and it has inched higher from the 22.3% level at the last update, which we view as solid given the influx of new constituents over the past year.
A re-rating in share price values has also seen the average capital return improve from 22.3% at the last review, to 26.4% at this update. The total return on the portfolio has also increased to 48.6%, versus 44.1% at our last update.
Portfolio performance table
(Note to Members, please click here to download the file)
The average yield (FY21) sits at 4.4%, and is 4.6% for FY22 which is impressive given the share price appreciation that has been seen. The average yield has pushed up materially since our last review (the FY21 yield was 4.0% back in February), with the banks and BHP driving the show. The portfolios yield is some way above that for the ASX200 which is at 3.8%, as tech and growth stocks don’t tend to have dividends, or if they do, very low yielding ones. We are comfortable with the positioning of the Income Portfolio on the dividend side overall.
Portfolio composition table
(Note to Members, please click here to download the file)
We remain positive on the banks with our investment stance predicated on an ongoing ‘V’ shaped economic recovery, and a robust property market. The long-end of the yield curve (which the RBA cannot control) has risen this year and this will support bread-and-butter banking operations.
Our thesis of better than feared bad debts (and rising dividends) from Covid-19 has been playing out and we have seen this in the recent reports from the big banks. Last week, ANZ released a significant $491 million net provisions release and announced a bigger-than-expected 70 cents interim dividend (fully franked).
The financials have been strong since our last review, with ANZ (we issued a note on ANZ’s interim result today) rising 8%, NAB up 6%, Bank of Queensland advancing 7% and Westpac the strongest, gaining nearly 18%. Amongst the insurers Suncorp (also part bank) ticked up 4%, while QBE put in an impressive 26% upward spurt. Hardening premium rates are a major supportive factor for QBE (and other insurers like Suncorp), along with likely improved investment income. QBE’s investment income has been pressured by falling interest rates, but for QBE what is more relevant is the yields on longer dated bonds (to where the portfolio is tilted). These have already inflected higher in 2021 and the trend could gain further momentum. This bodes well for QBE’s investment income and bottom line going forward. The appointment of a high-quality CEO to join in September was welcome news and provides what had been a missing part of the puzzle.
BHP is a prime beneficiary from the booming commodities market and particularly the surge in iron ore prices we discussed above. A strong economic recovery playing out in China should dovetail with a broader global economic recovery this year as the vaccine rollout has been rapid in the US and UK, and is progressing throughout Europe. BHP shares are up 17% since the February review.
Shares of KFC and Taco Bell operator Collins Foods have advanced 11% since our February review. Although full year results aren’t due until June, we remain bullish about the long-term investment case and along with the growth we believe is on the way, should come higher dividends over time. The company in our view has a long runway for growth, both in Australia and as management continue the European expansion post COVID-19. KFC demand has been very strong during the pandemic, amid a significant advertising campaign, and increasing brand awareness. This should set up for a strong set of numbers when full year results are released.
James Hardie shares have advanced 7% since our February Income Portfolio report and we have been more than content with its operational and financial execution. We view the rise as justified as the core US housing market continues to look robust and James Hardie has continued to pick up market share, with more likely to come. Under CEO Jack Truong, the operational and financial performance has continued to impress, with cost-out manufacturing initiatives combined with strong sales boosting margins. New product initiatives should boost sales further in upcoming years.
Low interest rates and bond yields have supported REITs, including Scentre Group and Stockland although both are relatively little changed from our February review (when they had pushed higher). We added Vicinity Centres to the Income Portfolio in February, as a reopening play given that occupancy rates were holding up well without the foreign tourists, and with the domestic consumer in an upbeat mode – something that has continued. We also cited an attractive yield and discount to net assets. The shares are little changed from February, and we believe the positive investment case is intact.
The telcos Telstra and Spark New Zealand have been a mixed bag since February, with Telstra advancing 10% and Spark sliding 6%. Rolling out 5G networks bodes well for both businesses with prospects to improved ARPU (average revenue per user), key to growth and supporting dividends.
All in all, the Income portfolio appears to be doing its job quite well, and providing exposure to companies that have made it through the pandemic in reasonable shape (and excellent in some cases). We remain comfortable that the basket of stocks provides strong exposure to companies with robust cash flows, and dividends, along with the prospect of some share price upside.
We would once again like to remind our Members that it is up to them to decide how they make use of the Fat Prophets Income portfolio that is discussed in this report.
Investors should be aware of the 45-day rule as a relevant factor. This rule requires investors to hold a stock for at least 45 days (including the ex-dividend day) to be entitled to the franking credits attached to a dividend payment.
A self-managed Superannuation Fund (SMSF) must also hold company shares for the 45-day period (plus the day of purchase and day of disposal) to be entitled to the franking credits. However, the 45-day rule does not apply to individuals whose total franking credit entitlement for a financial year is below $5,000. All SMSFs must adhere to it though, irrespective of the size of the franking credit amount.
Fat Prophets has made every effort to ensure the reliability of the views and recommendations expressed in the reports published on its websites. Fat Prophets research is based upon information known to us or which was obtained from sources which we believed to be reliable and accurate at time of publication. However, like the markets, we are not perfect. This report is prepared for general information only, and as such, the specific needs, investment objectives or financial situation of any particular user have not been taken into consideration. Individuals should therefore discuss, with their financial planner or advisor, the merits of each recommendation for their own specific circumstances and realise that not all investments will be appropriate for all subscribers. To the extent permitted by law, Fat Prophets and its employees, agents and authorised representatives exclude all liability for any loss or damage (including indirect, special, or consequential loss or damage) arising from the use of, or reliance on, any information within the report whether or not caused by any negligent act or omission. If the law prohibits the exclusion of such liability, Fat Prophets hereby limits its liability, to the extent permitted by law, to the resupply of the said information or the cost of the said resupply.
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