Options Commentary

The Chinese-Russian tie is remarkable

by Raymond Chan

After spending a week in Moscow I observed Chinese tourists everywhere in the city, while it is very common for Russians to take Mandarin lessons at universities. Since the dissolution of territorial disputes between China and Russia during the Jiang Zemin’s era, the relations between the two countries have been developing remarkably rapidly. Undoubtedly, rich resources from Russia is beneficial to China while high productivity and sufficient capital from China are beneficial to Russia.

China remains the largest trading partner of Russia
"China is Russia's largest trading partner," indicated Kirill Dmitriev, Head of the Russian Direct Investment Fund (RDIF), at the latest BRICS Summit held in Xiamen. Last year saw a 12 percent growth in Chinese direct investment in Russia. Kirill Dmitriev considers the Chinese-Russian tie greatly positive. The RDIF recently has announced a partnership with the China Development Bank (CDB) and is expected to provide an opportunity for Chinese investors to directly invest with settlements in yuan (RMB).

Although the total trade volume between China and Russia was affected by the collapse of commodity prices, China remains the largest trading partner of Russia, reflecting a good foundation of the bilateral trade. The bilateral trade volume is expected to exceed 80 billion US dollars; not only limited to minerals, a significant amount of agricultural products are also being exported from Russia to China.

With the painful experience of the global financial crisis in 2008, economists generally agree that development in a multipolar global economy is more desirable than merely relying on America’s "unipolar".

China’s high productivity is unquestionable. So, the question is, "does Russia deserve Chinese investment?"

A mutually beneficial relationship is built between the nations
A few years ago, Russia implemented an integrated Arctic strategy. The country ambitiously extracted natural gas from the Arctic and constructed an airport and a military base in Alexandra Land. 100,000 tons of building materials and 140,000 tons of equipment were delivered to the area. Forecasting China's demand and funding would continue to grow, Russia had already realised that the commitment to the mining development in the Arctic could bring a mutual interest between the nation and China. Russia benefits from the infrastructure brought by China’s One Belt One Road (OBOR) strategy while China can enjoy the low cost of the natural mineral and gas resources from Russia – the real mutual benefits, no aggression nor hegemony is called for.

China’s OBOR strategy has a positive role in promoting economic and trade co-operations with Russia; the amount of human resources and funds invested in the collaboration between the two countries for the mining development in the Arctic is unprecedented. The dissolution of territorial disputes between China and Russia gives way for better China-Russia trade relations.

Political issues do matter
In Australia, analysts do not put much emphasis on the economic and trade co-operations among BRICS countries, that is, Russia, India, Chinese, Brazil and South Africa. In fact, analysts should not only pay attention to stock markets or statistics but also political issues.

The Russian Far East strategy is not simply about the relationship with China, but with North Korea and Japan as well. North Korea is facing United Nations sanctions for its escalating nuclear and missile programs; local resources are in short supply, not to mention funds for overseas investments. As for Japan, right-wing populism has put the plan for systematic co-operation with Russia to death. The nation tried to create a comprehensive logistic chain between the two countries, but to no avail. Therefore, politics always decides the prospects for economic and trade relations between nations.

China-Russia trade relationship is essential for the world
Moreover, Chinese-Russian ties have often been overlooked in multinational trade. Research scholars in China believe enhancing the economic and trade relations with Russia will help revitalize the old industrial bases in the northeast.

Australian media hardly mentioned that the RDIF and the CDB have agreed to establish a Russian-Chinese investment fund worth 68 billion RMB. The funding from the 15-year-agreement will be spent on development of the Far East and Siberia for energy, transportation, industry, power facilities and cross-border projects.

At the moment, Russia has stepped out of the financial crisis and entered a period of economic growth. China and Russia do not purely care about whether the trades are settled in yuan or ruble; according to the officials, the two nations are doing their best to prevent the negative impact of trade activities by fluctuations in foreign exchange markets. In other words, to exclude the US dollar factor and prevent the problematic impacts of the hedge funds on financial markets again.

The aftermath of the world economic crisis is not scattered and the global economic growth recovery is slow and weak. It is necessary to put the old rules aside and seek new directions.

In 2016, China's total crude oil imports from Russia reached 52.3 million tons. Russia overtook Saudi Arabia to become China's biggest crude oil supplier for the first year ever. In the first five months of this year, bilateral trade between China and Russia has skyrocketed with an increase of over 33%. A close China-Russia trade relationship is essential for us, and for the world.

Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so. 

Trump Speech

by Raymond Chan

Our Strategist Michael Knox and Strategy Team came up with an excellent piece of research, upon Trump Speech.

Donald Trump delivering his first speech to congress

The content of today's speech will be pored over by financial journalists in coming days and is an important market in the context of the S&P500's record run. We thought it was timely to circulate Michael Knox's views on Trump's agenda and the enthusiasm already built into US equities, arguably with flow on effects to Australian shares.

Our Strategist Michael Knox's view in a nutshell
The outlook for the US economy is good and the outlook for US earnings even better. However the US equities market is now pricing itself very fully on the prospect of better earnings in the future. Part of the reason for that optimism is the prospect of much lower corporate tax rates. We think that these tax reforms are guaranteed a noisy passage through the US Senate and that this could easily give inflated equity markets a scare.

Michael's views in more detail - "Too much good news"

Since the US presidential election in November, the US stock market has been rising strongly. This rise has been followed by a similar rise in Australian equities. Part of this, reflects better fundamentals but much more of this rise simply reflects better sentiment.

A stronger US Economy

In 2016, the US economy was relatively soft. GDP grew at only 1.6% for the full year. The reason for the weakness was a slowdown in non-residential construction. Very low oil prices in the beginning of 2016 meant a much lower level of investment in oil drilling, gas drilling, and energy infrastructure such as gas pipelines. Improving energy prices in the second half of 2016 caused the beginning of a recovery in the same non-residential construction. In 2017 the US economy should accelerate to 2.3%. In 2018 growth should pick up further to 2.7%. This improving economic outlook has generated a remarkable scenario for operating earnings per share of US corporations.

However US stocks look to have overshot our model of the S&P500

With stronger growth and the prospect of much better earnings, it is not surprising that the US stock market has risen. The question is has it risen too much? We model the S&P500 based on the level of operating earnings per share and US 10 year bond yields. This gives us a pretty good model explaining more than 80% of monthly variation.

S&P 500 Operating Earnings

The problem is what the model now tells us. Based on the current level of earnings per share and bond yield, our fair value for the S&P500 in February 2017 is only 1916 points. At the time of writing, the market is way above that at 2351 points. In the future, earnings will justify such a level of the S&P500 at a level of bond yields around where they are now. The problem is how far in the future it will be before earnings provide that justification.

Our model tells us that even with the much better earnings expected in the future, fair value of the S&P500 does not reach a fair value of 2338 until the third quarter of 2018 and 2394 until the fourth quarter of 2018. That means that the S&P500 is currently trading at fair value based on earnings that do not arrive until the third and the fourth quarter of 2018.

Rotation from debt to equity has been driving equity prices

Why is this happening? We think that the US market is receiving a flood of liquidity from the US corporate debt market. The difference between US corporate yields and US sovereign yields has fallen dramatically since February 2016. Where previously investors might have bought corporate debt, the decline in the yield on that debt is now leading investors to switch from corporate to corporate equity. The money from the corporate debt market is flooding into equity prices and driving equities to a level that the market does not yet justify.

And of course euphoria around promised tax rate cuts

In addition to liquidity the market is being supported by sentiment. Much of this sentiment is driven by the prospect that the new Republican administration will cut corporate tax rates. We have written before about the proposal to cut US corporate tax rates from 35% to 20% and maybe even to 15%. These corporate tax cuts are possible through the elimination of most of the corporate tax deductions that currently exist in the tax code. In addition, revenue is raised through a border adjustment tax. The elimination of tax deductions for corporate imports provides an effective revenue tariff of 20%, assuming a corporate tax rate of 20%.

The problem is that even though those proposals have the support of the House of Representatives and the American President, they have yet to gain the support of the American Senate. US elections are much more open to the operation of lobbyists than is the case in Australia. This is primarily because of the very large cost of running elections in the US. This in turn is due in part to the high cost of advertising to very large populations.

There is no doubt that some Republican donors currently feel that the businesses that they are engaged in, will lose out through the introduction of the Border Adjustment Tax. Our understanding is that this has resulted in heavy lobbying against the Border Adjustment Tax in the US Senate.

The problem is that without the Border Adjustment Tax, there is not enough revenue to support a cut in the corporate tax rate. Without the Border Adjustment Tax a cut in the corporate tax rate will result in a large budget deficit.

The stock market is banking on a cut in the corporate tax rate. Unfortunately the passage of the corporate tax cut through the US senate is likely to be achieved only after much public argument. As the market sees those corporate tax cuts at risk, it is possible that its reaction could be both volatile and negative.

Trump Presidency & Infrastructure Stocks

by Raymond Chan

What has happened?

Latte with Ray first heard of Donald Trump from Anthony Robbins’ “Unleash The Power Within”, that described how the real estate mogul went almost broke, owed several billions in debts from 1990 US recession and made a comeback in his own biography book “Art of the Comeback” in 1997 – well before his famous appearance on “The Apprentice” in 2004.

On 8th November, the underdog Donald Trump defeated Hilary Clinton in the US presidential election and will become the 45th President of United State of Amercia. He made his 2nd major comeback.

What are Trump’s policies?

Our Economist Michael Knox suggested Trump’s current policies show the significant influence of Speaker of the House, Paul Ryan. Paul Ryan is known as “a policy wonk”. In Australian English we might say he is a policy “nerd”. Ryan rose to prominence as Chairman of the Budget Committee of the House of Representatives. Economic management is his specialist area. The central part of Paul Ryan’s program is to reduce corporate taxation from 35% to 15% and eliminate most tax break. The purpose of this reduction is to make sure that US multinational companies bring their funds back to the US and reinvest it domestically in the US economy. He will also cut individual tax rates. Last but not least, he also proposed a number of tax reforms for manufacturers, increased military spending. If proceed, the total program would cost $4.55 “trillion” and push the US federal budget deficit to 4.5% of GDP. The US corporate tax rates proposed within the Trump program would also increase US private fixed capital investment in the Australian economy. This would also be enormously beneficial for the Australian economy.

Having said that, in near term, Latte with Ray can’t rule out that the US ecomomy will still go into a soft growth given Trump’s policy uncertainties and geo-political risks.

How does Trump impact our stock market?

Over the week, ASX 200 +3.7% 5,370 points, Dow Jones +5.4%, S&P500 +3.8%, NASDAQ +3.8%, Nikkei +2.8%, Hang Seng -0.5%, Shanghai +2.3%, FTSE +0.6%, TSE +0.3%, AUD/USD -1.7% $0.7546, Brent -2.2% $44.5, Iron Ore +15% $74, Gold -6% $1227, Coal +4.6% $111, US 10 year bond yield +21% at 2.2%, Australian 10 year bond yield +10% at 2.6%

As you would imagine how defensive the fund managers were positioning prior to the election day, the “unexpected” stock market “V-sharp” rally meant violent shorting covering and portfolio re-balancing. The only market that didn’t go up last week was Hang Seng, which was down -0.5% on concerns over US / China trade relationships in Trump era. RMB hit 6 year low.

Latte with Ray summarizes my thoughts here:

1. The stock market may not be completely out of the wood yet. The key risk will be the upcoming FOMC meeting in early December. Technically speaking, ASX 200 making new low (5,052 points) could mean we’ve not seen the bottom of recent correction yet. The ASX 200 will remain volatile and this is still a stock-picker market.

2. We need to watch the global bond market closely given bond selloff (i.e. bond prices going down, bond yields going up).

3. A rotation of fund flow from Bonds into Equities has commenced. Fund manager cash position likely to fall from highest level since 2001.

4. Federal Reserve will now hike rate in December. USD to strengthen.

5. US reporting seasons has been well received. (71% exceeded market expectation according to FactSet) .. favouring companies with offshore earnings.

6. Bond selloff triggering the selldown in Infrastructure / Yield Stocks. This may present us with buying opportunities.

Infrastructure Stocks (APA, AST, DUE, MQA, TCL, SYD all got smashed this week) …

Last month, we suggested

“In this low interest rate and low growth environment, we think infrastructure assets are “core portfolio holdings”. Having said that, while we like the infrastructure stocks as an asset class, we don’t agree on the current pricings. Even after recent price correction, the PE on infrastructure stocks remains elevated. Among the infrastructure stocks, Latte with Ray prefers TCL (already a Core Portfolio holdings), SYD (we see 2nd Sydney airport announcement as upcoming catalyst) … We would love to top up TCL below $10.00 and buy into SYD below $6.00.”

One month on, both TCL and SYD have NOW fallen within our accumulation zone, at $9.58 and $5.95 respectively.


Postcard from London

by Raymond Chan

Latte with Ray wrote this article at Hathrow Airport, awaiting flight back to Sydney. We spent a week here visiting our UK clients.

Our thoughts on Europe Financial Markets … The European Economy remains weak. The financial markets here are having ongoing issues. Over past two weeks, we had Deustche Bank stock price reaching record low, Commerzbank (2nd largest German bank) cutting 9,600 jobs (or 20% of workforce) and ING trimming another 5,000 jobs. When we talked to our contacts over here, they were all looking for job opportunities either in Asia and Australia.

It's not just a "Deutsche Bank specific" issue … On Deustche Bank, an insto client commented that the situation is definitely much worse than what the mkt is pricing in right now. Everybody is relying on State support for a rescue plan but the German govt is bounded by the EU bail-in law which restrict direct intervention. [EU regulations prevents European Bank Bailout by ECB & other Central Banks, unless a risk of “very extraordinary” systemic stress.] The announcement by Commerzbank last week highlighted that it may not be a Deutsche Bank specific problem. Most likely will see more asset sales and even deep discount rights issue. But UK banks taking over iconic German bank seems quite far-fetched at this moment given Brexit and national pride. Like all previous bailouts, we need to see much worse mkt movement before a solution would come up. Expect more volatilities over the next few months.

Brexit … As you know, Brexit introduces uncertainty to UK economy. This week, the GBP reached new 31 years low against USD. Well, it’s definitely great for Inbound Tourists and Overseas Property Buyers here given the 20% “currency” discount. However, this does not help business confidence. We think this week’s Henderson taking over Janus Capital is interesting. Henderson was a spin off out of AMP Capital now dual-listed in UK and Australia. Under the proposed takeover, if successful, we will see Henderson to de-list from UK and move its primary listing to US. We can’t help but feel the Brexit may have something to do with the proposal.

What does it mean for our Australian Portfolio? Europe is a significant economy and one of biggest trading partners to China. In turn, China is Australia’s biggest trading partner. With economy going soft here, Latte with Ray maintains that the ECB will have no choice but maintain its easing bias (despite some “European experts” here calling for ECB QE tapering). In US, it’s without doubt the FED is now pushing back the tightening timetable. This week, our new RBA governor Phillip Lowe holds rate at 1.5% and still easing. In this low interest rate and low growth environment, we think infrastructure assets are “core portfolio holdings”. Having said that, while we like the infrastructure stocks as an asset class, we don’t agree on the current pricings. Even after recent price correction, the PE on infrastructure stocks remains elevated.

Among the infrastructure stocks, Latte with Ray prefers TCL (already a Core Portfolio holdings), SYD (we see 2nd Sydney airport announcement as upcoming catalyst) and Magellan Infrastructure Fund MICH (ETF listed on ASX). We would love to top up TCL below $10.00 and buy into SYD below $6.00. We expect both TCL & SYD can generate growing dividend returns over next few years. On Magellan Infrastructure Fund, the ETF offers us global diversification in infrastructure assets and more importantly “AUD hedged” return.

When to buy? We don’t think we have seen the bottom of infrastructure stock correction yet, it’s likely to see further selling pressure when the market starts talking up the prospect of Fed rate December hike. As you know, the performance of infrastructure stocks are negatively correlatd with 10 year US (and Aussie) bond yield. The higher the bond yields, the less attractive the infrastructure stocks are going to be. However, in our opinion, price weakness will present us with the opportunity to buy. We expect both TCL & SYD to generate growing dividend returns for Long Term Investors.

September Market Condition

by Raymond Chan

Market Conditions

The ASX 200 has corrected -7% since its recent peak of 5,600 points on August 1. We think it makes sense to re-visit the market fundamentals.

To better understand the fundamental value of our stock market, we need to review the Australian reporting season just passed. Our strategy team made the following comments on the reporting season:

Evidence of a softening domestic economy

Economic bellwether CBA noted the slow ongoing transition of the Australian economy. It sees stable (albeit weak) underlying GDP growth and stable employment, but notes that households and business are hesitant to respond to monetary stimulus. CBA expects ‘more of the same’ as the most likely scenario, but with risks skewed to the downside.

Fewer large cap hits

Far fewer large-cap companies beat market expectations compared with recent reporting periods, with only 11% of ASX50 Industrials stocks surprising the market to the upside. This reflects deflationary economic forces and sector specific issues (e.g. intensifying supermarket competition) making it harder for Australia’s largest corporates to grow.

But fewer misses

Conversely, the proportion of disappointing results was significantly lower for both large and small caps. This isn’t too surprising as:

1) Expectations had been progressively lowered heading into August;

2) Consensus expectations were more tightly dispersed than usual; and

3) Corporates are cycling flatter (more predictable) outlook guidance.

Tepid profit growth

Results met expectations overall, however, industrials companies will only record profit growth of around 5% in FY16, which looks uninspiring when measured against a forward price-to-earnings multiple of over 16 times.

Corporate confidence eroding

The quality of company outlook statements and earnings guidance continues to deteriorate. We reported a sharp step-up in companies now either not quantifying or not offering forward guidance. Again this reflects higher economic fragility/uncertainty.

Given current high PE’s on the ASX 200, it’s reasonable to see a bit of breather on stock markets in September ahead of two key macro events - the FOMC meeting on 20-21 September, and the US presidential election in 60 days.

These two events are related. Let me explain.

The market is currently pricing in just 20% chance of FOMC rate hike. It’s basically telling me that if the Federal Reserve goes for a rate hike next week, it will be a big surprise to the stock market (and the Fed will get cursed like the RBA did when it hiked rates before 2007 Federal Election). The US stock market could then get sold off more heavily, given its high PE. The panic could create market volatility to our Australian Stock Market.

However, this market volatility does not really change the fundamental value of our ASX 200. Based on reported earnings, the fair value of ASX 200 is valued at 5,460 points and as such, the selloff could be seen as buying opportunities. When to buy? I will be adding to equity positions once the index falls below 5,200.


This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.


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