North Korea, CBA, Triguboff and BHP

A series of events over the weekend and this week made me a tad nervous about the Australian share market in domestic industrial securities. 

As I will point out later, that does not include BHP and companies that are deeply involved in the export trade, which require their own evaluation.  

Let me start by going through the events of this week. The first came from a most surprising source – former Treasurer and Prime Minister Paul Keating, who does have an excellent eye for what is happening in Asia and other parts of the world. 

North Korea

Keating explained that North Korea's leader Kim Jong-un cannot afford to back down to the US on the nuclear issue. If he does, it will undermine his own regime and he will have a limited future. Keating says the US and the rest of the world should recognise this and accommodate North Korea as a nuclear power and try to contain that situation.  

But the US has stated in the clearest possible terms that if North Korea keeps firing missiles towards US territory, and/or keeps threatening the US, it will launch a powerful air attack that might include nuclear weapons – even though this is probably unlikely. China understands the threat and is implementing trade sanctions against North Korea but, as we have seen so many times before, sanctions don't work. As well, given the Keating scenario, trade sanctions might even make things worse. 

Right now, the market does not believe a war will break out. The US has stated that a war is not imminent. But if Keating is right and we have two leaders that can't back down, that's the precise situation that has created wars for countless centuries.

I think there is risk of war that is not priced into the market.  

Commonwealth Bank

Secondly, the Commonwealth Bank affair is not finished. The remarks of RBA Governor Phillip Lowe that Commonwealth Bank will need to be held to account in the courts (subject, of course, to the facts) made for a chilling statement. Clearly, I don't know the level of fines that will be imposed on the bank. The market assumes that it will be less than $500 million and therefore not being a major detriment to the share price. Perhaps the market is right, but Lowe's statement, along with that of ASIC Chair Greg Medcraft, and the suddenness of Commonwealth Bank Chair Catherine Livingstone changing her mind in having Ian Narev continuing as CEO, tells us there are plenty more problems to come.  

Like the risk of war, the Commonwealth Bank affair is an unknown that has not been priced into the market.  

Australian apartments

Moving on, during the week I got a call from developer Harry Triguboff who told me the Brisbane apartment market was very depressed and he expected a big fall in Brisbane construction activity. And in Sydney, construction activity might fall between 25 and 33 per cent. 

Australia has been riding on the dwelling construction boom since the collapse of the mining investment boom. The housing market is different and may help cushion the apartment downtrend, but these are nonetheless dangerous numbers. Melbourne also has a set of problems which will cause a fall in construction. 

In that context, it was fascinating to see a recent ANZ report exploring problem mortgages where repayments have fallen behind, which are increasing in number. And guess where they came from? First from WA – no surprise there because it is a depressed economy – but second was Queensland, so confirming Triguboff's advice. If that Brisbane trend spreads to Sydney and Melbourne the domestic outlook changes considerably.  

Meanwhile, salaries are rising among public servants but not for those employed in the private sector. This is squeezing a lot of people who have borrowed large sums on the expectation their salaries would rise, and suddenly costs like power, health insurance and private school fees start to make things much tougher. I fear we have a domestic industrial market that has not priced in clear risks. Or maybe those risks won't be translated into events. In other words, the market could be right, but we all need to be aware of the situation and comfortable with our equity exposure. 

And what's on the cards for BHP?

And then I come to BHP. We have stock that is under pressure from the US corporate raider Elliott Management and I think next week it will come out with a strong cash flow and almost certainly goodies for shareholders. I think it is going to put its shale and oil US interests on the market and will sell it if the price is right. By contrast, BHP plans to increase its thrust into the Gulf of Mexico where it has very good acreage and, of course, it bought a known oil field which it is now exploring and developing. 

BHP feels much more comfortable with conventional oil – don't be surprised if there is more good news on that front.  

There has been enormous cost cutting at BHP, but there are more productivity moves to come and the company is looking much more closely to technology that can be transferred amongst its mining operations to further improve mining productivity. This will also give BHP the opportunity to develop mines.

As I have written many times before, BHP is also a fan of copper and it has two major resources that are underdeveloped. The first is the dormant Resolution mine in the US and the second is Olympic Dam in South Australia, which BHP has announced it is considering expanding. 

When BHP visited then US President-elect Donald Trump I thought the Resolution mine would come to pass before Olympic Dam. I am not sure that is right and I think the "Big Australian" may go for Olympic Dam first. Both copper and iron ore are benefitting from the Chinese reducing pollution by shutting steel and copper plants that rely on scrap, thereby increasing their demand for iron ore, metallurgical coal and  copper concentrates. That helps the copper price and helps BHP's bottom line. But all this will become much clearer next week when BHP announces its profit. Markets often move ahead of good news but if you are a long-term BHP shareholder I think you will be smiling after the profit announcement.