Engineering A Recovery

Broader industrial valuations are becoming stretched, and I think you can see the market starting to acknowledge the somewhat stretched nature of valuations for those who offer obvious Earnings Per Share (EPS) growth, and investors are now exploring pretty much everything industrial that has been left out of the party.

Over the last few days the market was given five macroeconomic excuses to go exploring in beaten up domestic cyclical's.

1. June retail sales beat headline expectations.
2. The NSW Government abolished the Vendor Tax on investment property sales.
3. The economy added another 42,000 jobs in June.
4. Building Approvals beat expectations, and
5. Bank Bill and Long Bond yields jumped.

While I think the bidding up of domestic cyclical is premature ahead of what will be a moderate full year 05 reporting and outlook commentary season, you can see that the next major move domestic investors are going to make is from "low growth industrial yield" stocks into beaten up domestic industrial cyclical's.


Keep a very close eye on Bond yields

I think you need to see domestic 10yr Bond yields rise to above 5.75% to trigger this rotation on a large scale, as that's the bond level where the unfranked bond yield becomes competitive with grossed up yields available in the equity market. Interestingly, 90-Day Bank bill futures hit that level this week, so while the domestic yield curve remains inverted, the shorter end of the curve is rising sharply, signalling some degree of economic growth rebound in fy06.

My long held view remains that headline Australian Gross Domestic Product (GDP) growth readings will start recovering in the fourth quarter of calendar 05, with the rebalancing of the economy leading to investment spending, agricultural production, and export growth offsetting a flat consumer and property sector. The headline GDP growth recovery will drive domestic bond yields higher, closer to 6.00% later this year, and that will have large ramifications for portfolio construction inside the very bond sensitive ASX200.


The home equity ATM needs refilling

I don't, however, subscribe to the view that we are on the cusp of some miraculous consumer and property sector led rebound. We believe the consumer sector will "find an activity level", yet that sustainable level will be well down on previous corresponding period as households have exhausted the "home equity ATM". We think residential property prices are also in the process of "finding a level", yet we don't see a quick recovery in prices. We think you will see some building activity pick up once residential prices flatten out, but to think we are headed straight back to the glorious days of the property market 2 years ago, would be making an error.

We want to stay focused on this "rebalancing", while the "hoopla" in retail and property stocks over the last two sessions suggests that the market hasn't quite worked out that the sectorial drivers of GDP growth are changing.


Infrastructure spend is a 5 to 10 year story

Buoyant Engineering Outlook

Source: Construction Forecasting Council

The chart above paints a very clear picture, and it seems the new NSW Premier, Morris Iemma wants to accelerate critical infrastructure spend. That's good in theory, but where is he going to get the equipment or skilled labour to build these projects any quicker than they are currently scheduled?

The June quarter saw a big jump in the total value of major resource and infrastructure projects announced, with the total jumping by 17% to $375bil. A fresh $37.5bil of new projects were announced in the June quarter, and its now fair to say there is a decade of work ahead for the Australian engineering and contracting sectors. This decade of work will create some great industrial companies if they reinvest the profits sensibly. The profitability shouldn't be an issue, as these companies have moved to "cost " arrangements with their underlying customers, which greatly reduces the risk.

Names like Coates Hire (COA), United Group (UGL), PCH Group (PCG), Verticon Group (VGP), Boom Logistics (BOL), Worley Parsons (WOR), Transfield Services (TSE), Downer EDI, and even Leighton Holdings (LEI) all have ongoing leverage to this strong theme.

However, we believe the market is overlooking the leverage in less obvious beneficiaries such as the domestic steel stocks, BlueScope (BSL), Smorgon Steel (SSX), and OneSteel (OST), with just about every announced infrastructure project being "steel intense" to some degree.

We also feel that "urban renewal" of Government housing is a big part of the long term infrastructure upgrade story, and the best play on "urban renewal" remains the cheap and broadly disliked Lend Lease (LLC).