Gottliebsen's Week: Gold, BHP and Qantas, CBA

Last Night

Dow Jones, down ~0.2%
S&P 500, up ~0.02%
Nasdaq, up ~0.3%
Aust dollar, US71.2c

Gold

Today I want you to meet Mr Gold and we will discuss the present and future role of gold in the community. I also want to talk about BHP and Qantas and I will be raising some significant BHP issues. And finally I will return to a subject I have discussed many times – the trashing of CBA and the other banks' shares. 

In years gone by, gold shares attracted what was called a ‘halo’ and their earnings were given a far greater premium than any other activity. And so, in the 1980s BHP floated off its gold interests as a separate company (BHP Gold) because its gold mines, when buried in the Big Australian, saw their premium squashed by the other BHP assets.

BHP Gold was eventually taken over by Newmont and became a part of what is now Newcrest. But in the years that were to follow that ‘halo’ disappeared and indeed gold for many years was a poor cousin to 'exciting' minerals such as iron ore, copper and oil.

In recent times gold has developed a fascinating role in our stockmarkets. When there is great fear in the stockmarket, and resource shares are being hit hard, gold tends to rise in price. Conversely, when the crisis is over and the stockmarkets are rising, gold is often a lot softer.

In other words it is a perfect hedge in the current environment.

As we all know, markets are very fickle and it is possible that in a few years’ time gold will not be as popular. But the advent of negative interest rates, which means that cash in many countries becomes a cost, adds a whole new dimension to investing in gold.

At the Melbourne Mining Club this week I met ‘Mr Gold’, David Harquail, CEO of Franco Nevada.

I must confess that until I received the Mining Club invitation I was unfamiliar with the activities of Franco Nevada. But over many decades the company has assembled a series of more than 40 royalty arrangements, mainly with gold miners. The original royalties came out of the empire created by Robert de Crespigny.

For many miners, selling a royalty of, say, about 2 per cent to Franco Nevada is a lot more attractive than borrowing large amounts of money or issuing new shares. And with the slump in mining, Franco Nevada is being approached by many miners seeking to help fund their operations by selling royalties. But in the process Franco Nevada shares have indeed created a halo effect and risen sharply in price. 

Harquail believes that the market support he has received will spread through the gold industry. Franco Nevada, with no mines and a small staff, presents a wonderful model, albeit the shares are not cheap.

Harquail told me that in his view gold was likely to be in short supply for some time because existing mines were running down production and important new mines were a long way off. He is a long-term bull in the gold market, given the current interest rate environment, but Harquail has a warning – if the current market trashing of banks is indeed a forerunner of a major financial crash on the back of large energy and emerging country bad debts, then the gold price will fall as it did in the global financial crisis.

Harquail has a long-term plan and he says the price will recover quite quickly after such an event. He points out that in many areas of mineral development, including gold, there has been very little exploration in recent times and most companies have bowed to the demands of institutions and run their businesses as cash generators rather than as long-term accumulators of mineral wealth. 

But he is seeing a change in North America and interest in exploration is increasing. He thinks that change will spread to Australia, particularly in areas around Kalgoorlie and Laverton, where cities have not been built on top of gold reserves, as happened in places like Ballarat.

About half of the demand for gold comes from India and China. At the moment the Chinese are very reluctant to bid up gold prices. When the Chinese are big gold buyers Singapore prices are at a premium to the LME. That is not currently the case, indicating that there is some caution in China. 

BHP and Qantas

When I first saw the BHP results I was relieved that the company was on the track of developing a much more sustainable business. But since then I have been thinking about the BHP situation and comparing it to Qantas.

Both Qantas and BHP had a deep-seated culture based on arrogance. In the case of Qantas it stemmed from the fact that it was once a government organisation and the government culture of high cost and bad work practices was deeply ingrained in the company.

It took the combination of chairman Leigh Clifford and CEO Alan Joyce and a crisis to shock the company into realising it was vulnerable and the government would no longer bail it out.

It was then possible to lower the cost structure and change the culture. The company is now much better placed than it has ever been.

BHP was, of course, never a government organisation but its origins stem from manufacturing dominance in the days of Essington Lewis and Ian McLennan. Its sheer dominance in Australia created an aura of invincibility, which, like Qantas, translated into a high-cost culture. 

The company received a shock in the 1980s when a series of projects went belly up but the work of Don Argus and others, plus the big jump in Chinese demand for iron ore, saw the company’s fortunes soar.

BHP didn’t have a long enough period in the doldrums to change the culture. And so, when BHP bought WMC Resources it more than doubled the staff at Olympic Dam because, unlike WMC, it simply did not know how to mine on a low-cost basis.

In 2011, BHP bought back $6 billion of stock at over $40 per share and therefore burned close to $4 billion of shareholder money on that transaction alone.

The company’s high-cost mining practices were displayed to the BHP board in the Rio Tinto merger negotiations but nothing much was done about it. BHP covered the bad work practices by having better ore. As late as last year the company was still preaching high dividends even though mineral prices were collapsing all around them.

It was a sign the company’s culture of arrogant invincibility still had not been purged, because the culture ran deep. In other words, BHP had not 'done a Qantas'.

CEO Andrew Mackenzie, on the surface at least, has done a good job but the real test is whether the company can operate well under the new lower-cost structures he has introduced. My guess is that it is going to be tougher than BHP expects because there has been a substantial reduction in staff levels. (Olympic Dam costs are getting closer to WMC levels but there is still a way to go for BHP to match Rio Tinto in iron ore because Rio has not stood still.) 

In time the culture will change but if the company suddenly embarks on major new activities then the opportunity to change its culture presented by the current situation will be lost. BHP should be looking for large undeveloped deposits that will be required decades ahead. It’s a low-cost protection strategy. The real priority is to change the culture now and manage better over the long term.

Meanwhile, the significance of the Australian wealth destruction caused by the fall in BHP shares from above $40 to below $16 is almost immeasurable. BHP was a cornerstone stock in many portfolios. People looked to BHP for their retirement and gave it a status that no other company has had. BHP has let them down. It now has a lot of work to do to recover its standing, but I think it will be done. 

CBA

For some reason the Commonwealth Bank has never had the aura of BHP. It was, after all, a banker rather than a miner. 

Commonwealth Bank shares have just gone through another thrashing, mostly for reasons I have set out in previous Eureka Report articles. But there is an extra dimension to the latest fall.

First, the company’s shares have fallen below last year’s issue price of $71.50 and the latest fall comes after a tirade by various overseas analysts on the vulnerability of the Australian housing market.

In my view, in the absence of a global calamity and provided we keep up migration, I don’t think we are going to see a collapse in the housing market, although there might be a correction in certain markets where there has been oversupply.

Melbourne is the favourite to suffer a substantial correction but if migration stays strong the current oversupply will be absorbed.

Nevertheless, Eureka Report readers would have read countless articles and other media about the imminent fall in the dwelling market, particularly in Sydney and Melbourne.

A lot of it comes because journalists can no longer see a wide career path towards the level of salary that enables them to buy suitable dwellings at current prices.

That means they seize on articles and predictions of problems with the housing market. If there is a global financial crisis or if there is a substantial rise in unemployment we will see a fall in house prices but it will take an event that is rather different to the current environment.

I am much more concerned about the unknowns involved in the potential US banking crisis caused by loans for energy and loans to emerging economies. But so far it hasn’t happened. 

Readings & Viewings

Malcolm Turnbull should announce the government’s tax policy pronto.

Four forces investors must watch closely.

Martin Wolf: No simple solutions for the global economic imbalances of today exist, only palliatives. (Paywall)

Who sank Dick Smith?

The US election and the global economy.

David Cameron’s gamble could destroy the EU.

Beijing is now the billionaire capital of the world.

Mark Rothko on how the emotional exaltation of art mirrors human relationships.

Ahead of Oscars, on the making of The Big Short.

Why Netflix's ratings don't matter.

Finally, a jab at Trump's business record.

A must watch: A Game of Thrones mashup featuring Donald Trump. Aptly titled, ‘Winter is Trumping’.

Last Week

By Shane Oliver, AMP

The bounce back in global shares continued over the last week led by the US share market which has broken above its 50 day moving average and cut its year to date decline to -4.5 per cent from -10.5 per cent. This was helped by higher oil prices and metal prices also gained. However, Australian and Chinese shares fell, bond yields mostly fell and despite a slight rise in the US dollar the Australian dollar also managed to rise.

Will there be a crash in Australian property prices? Foreign hedge funds and various commentators have been calling such an event for a decade or so now and have proved wide of the mark.

Yes, Australian home prices are likely to see yet another 5-10 per cent cyclical fall at some point in the next few years and yes home prices are overvalued posing a downside risk, but a 50 per cent crash is unlikely. The latest crash call aired on 60 Minutes has raised nothing that wasn’t already well known.

Australian property is no more overvalued than it was a decade or so ago. The ratio of household debt to income is about the same as it was prior to the GFC, but interest costs have collapsed and there are no signs that Australians are having trouble servicing their debts. Sure there has been some easing in lending standards – but I just don’t accept that Australian banks don’t regularly check for proof of income (mine does) in processing loan applications, particularly with APRA breathing down their necks on “bubble” worries.

To get a crash we will either need a massive rise in interest rates (which is unlikely because the RBA is not stupid) or a deep recession in the economy which seems unlikely. Seems to me that some people have just seen the Big Short and want to be film stars (or least are desperate to find the next big short). The trouble is that shorting Australian banks is becoming a rather crowded trade.

Major global economic events and implications

US economic news was a mixed bag. On the down side February data showed falls in consumer confidence and the Markit manufacturing and services conditions PMIs. These could all be in response to recent share market turbulence and bad weather or they could be indicative of a fundamental deterioration in the economy.

On the upside though, durable goods orders rebounded in January and existing home sales and home prices are solid and the trend in unemployment claims is continuing to reverse the rise seen into January. Given the mixed data though and ongoing global uncertainties it still makes sense for the Fed to back off on raising rates. The market is attaching a 10 per cent probability to a March hike.

Eurozone PMIs also dipped in February adding to the case for the ECB to ramp up its stimulus next month, even though the level of the PMIs is still consistent with reasonable growth. Bank lending picked up in January but it’s too early to see the effect of recent market turmoil on bank lending.

Japan’s manufacturing conditions PMI also fell in February, and with core inflation falling to 0.7 per cent year on year pressure remains on the Bank of Japan to provide more stimulus.

China’s stimulus efforts can be seen in a blowout in its budget deficit to a record -3.5 per cent of GDP last year from -1.8 per cent of GDP in 2014. Over the year to January public spending is up 24 per cent year on year versus just 6 per cent for revenues.

Australian economic events and implications

In Australia, wages growth slowed further in the December quarter and the business investment outlook remains weak, but it’s not all bad. Low wages growth partly reflects the loss of high paying mining jobs but the creation of lower (more normally) paid jobs in Sydney and Melbourne. It means that there is no inflation pressie from labour costs but has also allowed jobs growth to be higher than might otherwise have been the case.

The message from business investment plans is that the unwind of the mining investment boom is continuing at the rate of about -35 per cent pa. However, by the end of the next financial year this will have largely run its course, so the drag on GDP will abate. And the good news is that the capex plans point to a rise in non-mining investment next financial year.   

The Australian December half profits reporting season is now basically done. As always the quality of the results tailed off through the last week, but overall results were much better than feared.

Forty-seven per cent of results have bettered expectations (against a norm of 44 per cent) with only 21 per cent coming in worse than expected (against a norm of 25 per cent), 66 per cent have seen profits up on a year ago and 64 per cent have raised their dividends (against a norm of 62 per cent).

It’s tough out there for resources stocks but no more than expected. Meanwhile, most of the big banks are seeing reasonable results and stocks exposed to the Australian economy, led by housing and the consumer, are doing well.

The better than feared nature of the results to date has been reflected in 64 per cent of stocks seeing their share price outperform the market the day results were released. Overall profits are on track to fall around 5 per cent this financial year but this is due to a 65 per cent slump in resources profits. Outside of resources, profits are rising by around 5 per cent.

Next Week

By Savanth Sebastisan, CommSec

Every change in season is ushered in by a raft of data releases. So get set for the ‘Autumn Avalanche’. Over the next fortnight over a dozen pieces of economic data will be released together with a meeting of the Reserve Bank Board.

In Australia, the week kicks off on Monday with the release of the inflation gauge, data on private sector credit as the Business Indicators publication from the Bureau of Statistics (ABS).

There are no standouts from these releases. The inflation gauge is important in determining inflation settings; data on private borrowings is likely to be driven by the business sector; and the Business Indicators includes figures on profits, inventories and sales.

On Tuesday, no fewer than five indicators are set for release alongside the Reserve Bank Board meeting to decide interest rate settings. While we can’t totally rule out a rate cut from the Reserve Bank, it is almost certain that they will keep rates on hold and maintain its quasi-easing bias – suggesting rates could fall in coming months. The Reserve Bank Board is likely to highlight the need to assess more data to see how the economy is performing early in the New Year. Financial markets believe there is only a 6 per cent chance of a 25 basis point rate cut at the meeting.

In terms of economic statistics on Tuesday, data on building approvals is expected with government finance, the balance of payments, the monthly Performance of Manufacturing index and the CoreLogic RP Data home value index. The figures on government finance and the exports & imports figures will give some sense of how fast the economy grew in the December quarter. However the focus is likely to be on the home price data given the recent discussion on capital gains tax reform and recent consolidation in the sector.

The economic growth figures for the quarter are actually released the next day – on Wednesday. In the September quarter growth lifted by 0.9 per cent to be up 2.5 per cent over the year. ‘Normal’ economic growth is closer to 3 per cent and the ‘speed limit’ for growth – the speed that the economy could grow without generating inflation – is probably closer to 4 per cent. So a soft economic growth outcome will keep the Reserve Bank on an implicit easing bias. The February data on new car sales will also be released on Wednesday.

On Thursday the ABS releases data on international trade. Also the Housing Industry Association will release figure on new home sales alongside the performance of services index. On Friday retail trade figures will garner plenty of interest given the slowdown in retail activity in December.

US employment under the spotlight

There is plenty of data to watch in the US, however the “star” of the US monthly economic data calendar is the non-farm payrolls (employment) figures. And those jobs figures are released in the coming week on Friday.

Economists expect that the good run of results continued in February with 195,000 jobs created. Apart from the jobless rate, the other indicator in the report that will be scrutinised will be the measure of wages. If wages are starting to lift, the Federal Reserve will feel more comfortable continuing the process of “normalising” interest rates.

In terms of the other indicators, the procession starts on Monday with data on pending home sales and the Chicago Purchasing Manager index slated for release alongside the influential regional Dallas Fed manufacturing index.

Also keep an eye out on Monday for the Chinese manufacturing data. Both measures - the National Bureau of Statistics and Caixin gauges measure activity in manufacturing sector. The service sector data is slated for release on Wednesday.

On Tuesday, data on new auto sales (cars and trucks) are released together with construction spending  figures and the usual weekly data on chain store sales and the ISM manufacturing survey. In politics, ‘Super Tuesday’ will see voting for Presidential candidates in 12 states and one territory.

On Wednesday, the ISM New York survey is released together with the Federal Reserve Beige Book. The Beige Book is the usual ‘qualitative’ survey of economic conditions released ahead of Federal Reserve interest rate decisions.

Also on Wednesday the February figures on private sector employment from ADP. Economists tip an 185,000 rise in private sector jobs.

On Thursday, data on factory orders is issued together with the usual weekly data on claims for unemployment insurance, Challenger job lay-offs, the ISM services survey for February and productivity/labour costs data.

And on Friday, the February data on employment is released – the non-farm payrolls data. As stated earlier economists expect that a 198,000 new jobs created in February. While the unemployment rate may have held steady at 4.9 per cent. Also on Friday the international trade data (exports and imports) is released with consumer credit (lending figures).

In the coming week, the profit-reporting or earnings season is transformed into the ‘economic reporting season’. And clearly the raft of figures will be important in dictating direction for interest rate and currency markets. At present financial markets have fully priced in another rate cut to occur within seven months.

No one can claim it with any certainty – but the oil price does seem to be gyrating around $US30 a barrel. Whether oil holds at these levels is important not just for the energy stocks but also for the financial sector.