The Industrials Show Us the Effects of Rising Energy Costs in the Real Economy

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Congratulations Aussie dollar. You’ve made a 24-year high. The terms of trade is throwing you a party later this year. Will you be brining parity with you?

Also, welcome back 6,000. Won’t you stay awhile this time? There were quite a few new 52-week highs set last week, including BHP Billiton, Coal and Allied, Oil Search, Fleix Resources, Macarthur Coal, Australian Worldwide Exploration, Western Areas, and Steamships Trading Company.

Do you notice a trend there?

The All Ordinaries finished last week at 6,006. That’s a 16% rally from the March 18th lowly low of 5,163. It erases most of the 20% year-to-date deficit. But it’s still down 12% from last year’s all-time high at 6,835 (on November 1st) and 6.46% for the year.

Does the index even matter? If you own a share portfolio that passively tracks the performance of the All Ords, we suppose it does. But you have to wonder if the All Ords are doomed to indirection, like Siamese twins trying to run in opposite directions at the same time. For investors, maybe the smartest thing to do is cut them apart and let them go their own way.

By “them” we mean the resource, energy, and basic material stocks in the one camp, and the consumer discretionary, listed property trusts, and financial stocks in the other camp. The energy sector is up on the year by nearly 20%. Materials are up about 14%. Meanwhile, consumer discretionary stocks are down by 26%, financials down by 17.4%, and listed property trusts (now called A-REITS) down 19.4%. Industrials are down 17.3% as well.

You don’t need to be DaVinci to decode this performance do you? Resource and energy producers are up with higher oil and bulk commodity prices (and probably some hot foreign money). Financials are down as investors wonder how banks will grow earnings in 2008. The consumer discretionary sector is the market shrieking in horror at the effect of all the interest rate rises on the Aussie consumer (not to mention food and fuel inflation).

The two sectors with the most questions are the A-REITS and industrials. Bottom-fishing contrarians would be attracted by the dismal performance of each. But let’s not forget the two big issues that hover over the property market: valuations and leverage. If property prices slump or simply grow less fast, this hurts the A-REITs. And leverage? You’ve seen what happens when it works in reverse.

The industrials—more than any other sector—show us the effects of rising energy costs in the real economy. These companies are unable to pass on the rising costs to customers. Margins are crunched. A fall in the oil price that lasted for a quarter or so might lead to a nice recovery in these stocks—or at least a tradeable move.

“Hey Gabriel?”

“Oui?”

“If you had to make one long and one short trade on ASX sectors today, what would they be?”

“May I have a moment to look at the charts?”

“Bien sur.”

After a few moments, he replied.

“ LONG on the Industrials sector. The Index has lost 32% between November and March, found a good support and rebounded on the previous low that was posted before the strong rise between August and November 2007. Here’s the chart:

“The decrease of 32% occurred in a bearish channel. The price action cleared this channel on the upside recently, which argues for a further momentum up. The 14-day RSI is well-oriented, therefore more upside to come before a potential overbought situation. 5,650 pts then 6,000 pts the next targets (23.6% and 38.2% retracement levels).

And short?

“The Utilities sector. The Index has rebounded 23% in 2 months, now the momentum is slowing and a few indicators argue for a shift in the price action in the near-term. Look at the chart.”

“The Bollinger Bands and the stochastic oscillator show an overbought situation. If we consider the bullish trend from March 11 until now, today there is a bearish divergence. The Index price posted a higher high last week that isn’t confirmed by a higher high in the Ultimate Oscillator. Target of 5,550 points roughly as it’s is both the 50% retracement level of the current rise and the lower band of Bollinger.”

Sometimes French is easier to understand than the language of Technical Analysis. But that is why we are glad to have Gabriel on-board. He is fluent in both languages, while we are mostly illiterate in both.

The direct conclusion from all that is that is that it’s a stock pickers market because it’s still a bull market in resources. This is forcing a gradual revaluation of the big companies like BHP and Rio, and its creating large open doors for new producers (like Fortescue or Santos and Origin in coal-seam-methane) to step in. It all changes if the resource bull market suddenly ends or there is some massive and unanticipated rally in the U.S. dollar.

What could cause an end to the resource bull market or a massive rally in the U.S. dollar? Black Swans. Things we haven’t thought about because they are so unlikely that you can’t create a probability for them. You can plan for them, but only really by owning long-term put options on the market.

If we can’t specify causes, what effects are we realistically talking about? In China, some sort of break down in social order that leads to a complete interruption in China’s industrial production and resource demand, or, some major social or geopolitical event (or events) in Europe that cause investors to shift away from Euros and back to dollars (terrorism, riots in the streets, etc).

By the way, we certainly don’t wish for any of these things to happen. There is plenty of China-bashing in the U.S. press, including some snickering that the Chinese aren’t really capitalists yet and that China’s financial system is not ready for prime time, or that its manufacturing economy is riddled with inefficiencies and unsustainable subsidies that undermine its long-term competitiveness.

Time will tell how durable China’s productive capacity is. But from our perspective the problem is simple: how you reconcile the imperative for employment and growth with social stability and order? Strictly speaking, the two goals are at logger-heads.

And like all major institutions, China’s government has the gargantuan task of providing timely services to a demanding public. The U.S. Federal government struggled to manage a hurricane in New Orleans. Will China’s government do any better with an earthquake?

In any event, the two big threats to the resource bull (a China collapse or a dollar rally) are for traders and speculators. On the ground in the real economy, the great game to control Australia’s actual resources (and the earnings that flow from them) is playing out.

Here’s a question: are Chinese firms buying Aussie shares because they want leverage over prices, or do they simply want an equity stake to take the sting out of higher prices that are beyond their control? It depends on the firm we reckon.

But Kevin Andrusiak reports in the Australian, that, “Leading Chinese steel player Shougang tried to negotiate a discount to benchmark iron ore prices in a rejected deal with rising West Australian iron ore miner Mount Gibson last year. At the time, Shougang was a minority shareholder in Mt Gibson and wanted to use that holding as leverage to get a 10 per cent discount for Mount Gibson’s high-grade ore. “

We’ve heard of ‘mate’s rates’ before in Australia. But as an American, we don’t recall getting them. “Friends with benefits” is another term that might apply.

George Bush can’t get ‘mates rates’ from Saudi Arabia either. The forty-third President of the United States travelled in his big blue Boeing to the Kingdom of Saudi Arabia to ask for more oil. If he had a hat on his head, it would have been in his hand.

The Saudis, for the second time in four months, politely declined. Saudi Minister Ali al-Naimi said the Kindgom would go ahead and increase production by 300k barrels per day, but that this was not in response to the U.S. request and had been decided beforehand.

The Bushs and the Saudis go back. Houston, Texas might as well be Riyadh West. But what good are friends if they never have your back when you need it? Could it be that in world of global petroleum in the early 21st century, there are no friends, just customers with good money and customers with bad money?

Bush told the Saudis that high gasoline prices would crimp American demand for Saudi crude. He seems to think the American motorist is the only consumer of crude oil in the world. This, of course, is no longer true. As recently as the mid 1980s, the health of the American consumer was a big concern to Saudi producers.

Today, though, there are plenty of people in the world willing to buy Saudi crude—even at the current market price. The President was correct in saying that America should either drill for more oil or seek alternatives. But we suspect neither will happen. The morons who run U.S. energy policy seem to think cheap oil is an American birthright. Instead of preparing for a world with more expensive energy, they are quibbling over details.

The real question is where future oil production is going to come from. Higher prices will probably curb demand. But with International Energy Agency forecasting the world will need another 31mbdp in oil by 2030, we need another OPEC. More on this later this week.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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