Options Commentary

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.


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by Raymond Chan

The growing move towards negative yields sparks the global pursuit of infrastructure assets. This brought us to the topic of Ausgrid’s saga. Latte with Ray was interviewed by SBS Television last week on Morrison blocking State Grid and CKI’s bids for majority stake of Ausgrid.

To understand the importance of Ausgrid, we need to first understand the electricity generation industry. There’re four key components: (1) Genaration – unregulated, (2) Transmission – regulated e.g. Transgrid (sold last year), (3) Distribution – regulated e.g. Ausgrid (used to be part of Energy Australia) and (4) Retailing – unregulated e.g. AGL & Origin. Augrid is the traditional “pole and wire” business and its revenue (i.e. return) is government-regulated, long life, predictable, and inflation linked.

However, investors normally won’t pay more than 1 time RAB (Regulated Asset Base) for regulated assets but investors (like Sovereign Funds, SOE) access to a much lower cost of capital can afford to bid MORE (Media suggests the Chinese is bidding at 1.5 times. If successful, this would have been a good outcome for NSW government).

To be honest, the Ausgrid sale process has been going for 9 months and there’s NO SHORTAGE of potential buyers (such as Super Funds). However, when those buyers heard both State Grid & CKI showing interests, Latte with Ray would imagine that they might just gave up as they didn’t want to waste time completing with State Grid and CKI (with ultra low cost of capital).

Anyway, for NSW government, given the attractiveness of Ausgrid, there’ll be other buyers for the assets (at a lower price) even in absence of both State Grid and CKI.

It’s just a matter of time. 


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