Reserve Bank of Australia Cuts Rates Ahead of Time

By David Dittman • October 4, 2012 • Pacific Digest

The S&P/Australian Securities Exchange 200 Index closed at its highest level since Aug. 1, 2011, today in Sydney, reaching a 2012 high of 4452.355 in the aftermath of the Reserve Bank of Australia’s (RBA) decision to cut its benchmark overnight interest rate by 25 basis points.

The RBA on Tuesday followed through on the message it telegraphed in its last official rate statement, released immediately following the Sept. 4 meeting, and via the minutes for that gathering, released two weeks later on Sept. 18.

The Australian dollar softened Tuesday and Wednesday to USD1.0216 from a mid-September peak of USD1.0551. The aussie is firming in Thursday trade, up to USD1.0223. The equity rally is generally positive, but the decline in the Australian dollar versus the US dollar has eroded some value for US investors who own dividend-paying Australian stocks.

It’s important to note, however, that at 3.25 percent the RBA’s policy rate is still the highest among developed world central banks; that Australia remains one of the few of those developed nations with AAA sovereign credit ratings intact; and that underlying economic fundamentals remain positive Down Under.

The RBA continues to negotiate what is likely a longer-term high-exchange-rate reality and ease the transition into this condition for Australian exporters. It has shown in the past a tolerance for higher rates of inflation than, say, central bankers in the US, reflecting perhaps another reality, that higher commodity prices, in that they bring significant wealth effects for Australians, translate into a higher but also more stable natural rate of increase in the general level of prices of goods and services over time.

Australia has managed to avoid a recession for more than two decades, including during the 2000-01 period, when a US downturn precipitated a steep decline in commodity prices as well as the amid the calamitous 2007-09 period, when a global financial crisis led to the worst worldwide stagnation since the Great Depression.

Unemployment in Australia certainly ticked up during 2000-01 and 2007-09, but only modestly and for a short duration. The RBA cut aggressively during both periods, from 6.25 percent in December 2000 to 4.25 percent by December 2001 and from 7.25 percent in August 2008 to 3.00 percent by April 2009.

The Australian Bureau of Statistics (ABS) reported Sept. 6 that Australia’s jobless rate declined to 5.1 percent in August from 5.2 percent in July due to continued hiring by miners. The ABS will report September jobs figures on Oct. 11.

In September, just ahead of the ABS released its August Labor Force reports, the RBA held its cash rate at 3.50 percent, Governor Glenn Stevens concluding his statement, “The board judged that, with inflation expected to be consistent with the target and growth close to trend, but with a more subdued international outlook than was the case a few months ago, the stance of monetary policy remained appropriate.”

This month the RBA reduced the benchmark to 3.25 percent, Mr. Stevens noting, “The Board judged that, on the back of international developments, the growth outlook for next year looked a little weaker, while inflation was expected to be consistent with the target. The Board therefore decided that it was appropriate for the stance of monetary policy to be a little more accommodative.”

Importantly, the Mr. Stevens also pointed out in his concluding paragraphs to the October statement that previous rate cuts, in May and June, totaling 75 basis points, were beginning to “tentatively” find their way into the system in the form of lower borrowing costs for consumers but that “credit growth has softened of late.”

Mr. Stevens also noted that “the exchange rate has remained higher than might have been expected, given the observed decline in export prices and the weaker global outlook.”

The day after the rate-cut announcement the ABS reported that Australia posted a seasonally adjusted trade deficit of AUD2.027 billion in August, the country’s widest monthly shortfall since March 2008. The August deficit was three times what analysts had expected, and the ABS also revised upward a July shortfall to AUD1.530 billion from AUD556 million and one for June from AUD227 million to AUD791 million.

Exports to China fell by AUD214 million, or 4 percent, in August, reducing its share of total Australian exports to 28 percent from 29 percent in July.

A 7 percent decline in in earnings from metal ore and minerals was the biggest factor in the August deficit. Iron ore, which accounts for about 20 percent of Australia’s overall exports, is trading 30 percent below its 2012 peak, established in April, and about 46 percent below its all-time high, set in in February 2011. Prices for coal, which accounts for around 10 percent of exports, are near three-year lows.

China remains the obvious point of external concern. The Middle Kingdom consistently accounts for more than a quarter of Australia’s total exports, including 70 percent of its exported iron ore. Japan and South Korea account for much of the remaining 30 percent.

As recently as June, Australia set a record for exports to China, its single biggest market, at AUD7.494 billion. The Middle Kingdom’s share of Australia’s merchandise exports was an all-time monthly high of 33 percent.

In July, however, the ABS revised downward its initial report of a AUD9 million overall surplus to a AUD227 million deficit. And July exports to China declined by 15.7 percent from June to AUD6.315 billion, reducing its overall share to 29 percent. August shipments to the Middle Kingdom were AUD5.894 billion, down 6.6 percent month over month. China accounted for 28 percent of Australia’s overall exports in August.

At the same time, however, Australia’s exports to its second-largest market, Japan, remain relatively stable. In June Japan accounted for AUD4.395 billion of Australia’s total exports, or 19 percent, in July AUD4.712 billion, or 21 percent and in August AUD4.680 billion, or 22 percent.

Liquefied natural gas (LNG) is the primary driver of Australia’s trade with the Land of the Rising Sun. Japan’s government recently announced its intention to make the country totally nuclear free over the next three decades, a consequence of the March 2011 Fukushima-Daiichi earthquake/tsunami/meltdown.

Japanese demand for Australian LNG has and will continue to rise over coming years as this transition takes place.  

China has been the most important driver of demand for Australian resources over the last two decades. But it’s not the only big market in Asia hungry for what’s in store Down Under. And iron ore isn’t the only export commodity Australia has available for its neighbors.

Although Australia has posted eight straight monthly trade deficits after posting surpluses from May 2010 through December 2011 it should also be noted that from August 2002 through August 2008 it posted deficits each month. Recent monthly deficits are in line with those posted during this long period.

Australia has been able to import more than it exports because of the wealth effects of rising commodity prices across the domestic economy. As Mr. Stevens also notes in his most recent official statement on the RBA’s interest rate policy, “Capital markets remain open to corporations and well-rated banks, and Australian banks have had no difficulty accessing funding, including on an unsecured basis.”

Funding its external debt is not yet a problem. And, as a complement to the federal government’s sound fiscal position, “Low appetite for risk has seen long-term interest rates faced by highly rated sovereigns, including Australia, remain at exceptionally low levels.”

Clearly what has been the leader of the 21st century Asian resurgence is slowing down. And the RBA remains concerned about domestic credit expansion and the impact of a strengthening currency on Australia exports. But the Land Down Under remains strong relative to other developed nations, in solid position to benefit from its neighbors’ long-term growth needs.

At least one pundit describes the RBA as “the best central bank in the world,” crediting it for the fact that Australia hasn’t suffered a recession in more than 20 years. It’s not necessary to come to those kinds of qualitative judgments, however, to support the case for investing in Australia.

The numbers continue to stand on their own.

The Roundup

Australian Edge Portfolio Conservative Holding APA Group (ASX: APA, OTC: APAJF) has extended the offer period for its takeover of Hastings Diversified Utilities Fund (ASX: HDF) from Oct. 11, 2012, to Oct. 25, 2012.

APA won the support of the Hastings Diversified board after a lengthy bidding war with a consortium including Canadian fund manager Caisse de depot et placement du Quebec and Utilities Trust of Australia, a fund managed by Hastings’ manager Hastings Funds Management. On Aug. 21, 2011 the Hastings Diversified board voted to recommend APA’s AUD1.39 billion total offer, which worked out to about AUD2.63 per share, comprised of AUD0.80 in cash and 0.39 of an APA share per Hastings share.

APA raised its offer for the energy infrastructure investment firm for a second time, to A consortium including Canadian fund manager Caisse de depot et placement du Quebec and Utilities Trust of Australia, a fund managed by Hastings’ manager Hastings Funds Management,. The consortium, Pipeline Partners Australia, had offered AUD2.43 per share, or about AUD1.28 billion, but declined to make a counteroffer.

Along with its increased bid APA announced it would waive all remaining conditions, with the exception of minimum ownership. APA said it would waive the minimum ownership condition once the total percentage of Hastings Diversified securities in which it either had a relevant interest or which were the subject of acceptance instructions related to the offer reached 50 percent.

As of Oct. 2 APA had an aggregate interest of 47.37 percent in Hastings Diversified securities, up from 45.05 percent on Sept. 27.

APA’s willingness to boost its original bid by more than 30 percent in response to the competition offered by Pipeline Partners demonstrates the value, or perceived value, of the Epic Energy assets amid a continuing gas boom in Australia.

Once completed the deal for Hastings will bolster APA’s already strong position in a domestic economy that’s now subject to one of the toughest carbon regulation schemes in the world. Clean-burning natural gas is very likely to assume a lead role in the race to replace coal as the primary feedstock for electricity generation Down Under.

According to a December 2011 white paper published by the Australian government’s Department of Resources, Energy and Tourism, Strengthening the Foundations for Australia’s Energy Future, Australia requires about AUD240 billion of investment in its gas and electricity industries alone over the next 20 years to ensure the country has reliable power supply.

That’s on top of the billions already committed to liquefied natural gas (LNG) projects.

Plenty of gas both onshore and offshore–and a massive pipeline of developments underway–most of that gas is planned for export as LNG. Australia, in fact, is home to almost half of the projects in some stage of development around the world.

Green-lighted projects worth USD150 billion would generate about 60 million tons of clean-burning gas over the next decade and push Australia past current No. 1 Qatar and make it the top LNG producer in the world.

Over the next several decades, even assuming a rapid and substantial increase in renewable energy sources, natural gas will be needed during the transition from coal-fired power generation–which now accounts for about 75 percent of Australian power generation–and later as the back-up fuel for renewable energy when the sun isn’t shining and/or the wind isn’t blowing.

The white paper concludes that that natural gas will grow to account for about 44 percent of power generation over this period.

Hastings’ AUD460 million, 15-year contract with Santos Ltd (ASX: STO, OTC: STOSF, ADR: SSLTY) to move natural gas from Moomba to Queensland on the South West Queensland Pipeline is a key element of the deal from an APA perspective.

South West Queensland will carry feedstock to Santos’ Gladstone LNG project. Hastings is in the process of upgrading South West Queensland, which ships gas east to west but will be capable of moving it both ways by 2014-15. That’s when AUD50 billion worth of liquefied natural gas (LNG) plants at Gladstone are scheduled to begin exports.

South West Queensland also connects to three APA pipelines: the Roma-Brisbane Pipeline, the Carpentaria Pipeline to Mount Isa and the Moomba Sydney Pipeline. The Santos contract, in the words of one analyst, is likely to be “highly accretive,” as it involves zero capital outlay by Hastings.

APA Group, yielding more than 7 percent, remains a strong buy under USD5.50 on the Australian Securities Exchange (ASX) using the symbol APA or on the US over-the-counter (OTC) market using the symbol APAJF.

Fellow natural gas distributor and Conservative Holding Envestra Ltd (ASX: ENV, OTC: EVSRF) was on the receiving end of a particularly harsh draft rate decision by the Australian Energy Regulator (AER) regarding its Victorian and Albury Access Arrangements for the 2013-to-2017 period.

The AER is proposing a regulatory revenue allowance of AUD897 million for Victoria and Albury over the five years, 29 percent below APA’s requested amount. The AER decision is based on the assumption of a modest decrease in Victorian network tariffs on Jul. 1, 2013, of around 0.5 percent, with inflation-based adjustments each year thereafter.

In a statement announcing the interim decision Envestra Managing Director Ian Little said, “We disagree with many of the judgments made by the AER and will be responding accordingly in our formal submission expected to be lodged with the Regulator in early November.”

Envestra also noted that the interim decision won’t impact fiscal 2013 profit and dividend guidance.

Along with its fiscal 2012 results released Aug. 23 management forecast profit after tax of AUD100 million for fiscal 2013, subject to AER’s rate decisions as well as weather, and stressed that it “remains the company’s objective to improve distributions while maintaining a prudent financial position’ and that it will review the fiscal 2013 payout policy following the regulatory action.

Total dividends paid during fiscal 2012 were AUD87.5 million, or AUD0.058 per share, while distributable cash for the year was AUD155.1 million. The cash flow-to-dividend coverage ratio for fiscal 2012 was 1.8 times, up from 1.7 times in fiscal 2011. Management remains focused on retaining cash to cover more of its ambitions capital program, as it works to improve its BBB- credit rating with Standard & Poor’s.

The final decision due in March 2013 will likely by an improvement over what was handed down Sept. 25. But that’s likely to be after Envestra releases results for the first six months of fiscal 2013 (ending Dec. 31, 2012). The company typically declares a dividend at the same time it reports interim results.

Envestra shares slumped a bit in September but are priced about 15 percent above our buy-under target at current levels. The stock, an original AE Portfolio Holding, has generated a total return in US dollar terms of 60.31 percent since Sept. 26, 2011, and is up 34.92 percent in 2012. It remains in high demand for investors seeking consistent, reliable income.

But no stock is worth chasing. We’re still looking for dividend growth to underline this strong equity performance.

Envestra is currently yielding more than 6 percent, but our advice is still to wait for a pullback to USD0.80 to buy it on the ASX using the symbol ENV or on the US OTC market using the symbol EVSRF.

Following are links to our discussion and analysis of the most recently announced financial and operating results for Portfolio Holdings.

Conservative Holdings

Aggressive Holdings

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