Why BHP’s Result is Good for Australia

Wall Street returned from a public holiday and posted another record close overnight. The Dow Jones index finished up 126 points to 20,750, while the S&P 500 rose 13 points to 2,356.

Expect the Aussie market to follow that positive lead today. However, given the onslaught of earnings announcements, the overall mood will depend on the quality of the results, not on Wall Street.

One of our biggest stocks, BHP Billiton [ASX:BHP] set a positive tone on this front, reporting a big increase in profits after the market closed yesterday. Underlying profits, as reflected in EBITDA (earnings before interest, tax and depreciation and amortisation), jumped 65% compared to last year.

The big increase is due to a turnaround in commodity prices, as well as productivity enhancements BHP made during the downturn.

If there’s one good thing about a bear market in commodity prices, it’s that it makes companies operate leaner and smarter. When the upturn in prices comes, well managed companies get the full benefit of this improved productivity.

Given the strong run in BHP’s share price over the past year (up more than 90% from the low in early 2016) the response to the results was muted. In London trade overnight, BHP’s shares finished up 0.4%.

Cash flow and debt reduction was better than expected, as was the dividend.

Still early in the cycle

What I thought was interesting were comments from boss Andrew Mackenzie that cautioned against the recent strong run up in prices. Whether he is correct or not, I don’t know. But it’s a good measure of sentiment.

That is, in the early stages of a cycle, sentiment is cautious. The memory of the bear market and the squeeze on cash is still strong. You don’t want to get carried away with the rise in prices. You believe they will revert to lower levels, and warn shareholders to keep expectations in check.

Compare that to the top of the cycle thinking. Remember that? It was all about China and the commodity super cycle.

That should give you some comfort then that this run up in commodity prices isn’t about to collapse. Sure, you should certainly expect to see prices correct lower…after all, commodities like iron ore and coal (which BHP produce in abundance) have had a tremendous rally.

But the emotion of the market isn’t anywhere near a market top.

By the way, my mate Jason Stevenson, editor of Resource Speculator, has just published a special report identifying a couple of crucial but little known commodities in the early stages of a bubble…or what Jason believes will turn into a bubble. He reckons if you get on board early, there is plenty of money to be made. Check out Jason’s work here.

Good news for Australia

As I pointed out yesterday, strong commodity prices (as evidenced by BHP’s result) are good news for Australia. Australia’s economy is built on dirt and debt. First we get income from producing dirt, then we leverage this income by taking on debt and ploughing it into house prices.

Those ‘in’ the housing market sit back and marvel at how easy it is to get rich. Those out of the market try and cook up easy ways to get into the market, which eventually pushes it higher and higher.

How high can it go? I have no idea.

But you can be pretty confident that the housing market won’t suffer a downturn in the midst of a national income boost from rising dirt prices.

The only other thing that could hurt the housing market is rising interest rates. But the RBA will be reluctant to raise rates unless it is absolutely necessary. That is, they will only act once inflation starts to pick up.

The general rule of interest rates in this day and age of debt dependency is that you cut in anticipation of weakness and raise rates only when you are absolutely sure that you must.

Let me show you what I mean. Let’s use the iron ore price as a proxy for Aussie dirt prices.

Iron ore peaked in February 2011. It pulled back and then drifted sideways for months, but was still very strong. Then in September 2011 it broke sharply lower.

In November, the RBA cut interest rates…and they kept on cutting all through the dirt price bear market. In October 2011, the official interest rate was 4.75%. By August 2016 — the last interest rate cut — the official rate sat at 1.5%.

The dirt price bear market ended in early 2016. Prices have been rising for more than a year. That translates into a rising terms of trade and rising national income for Australia. Yet there hasn’t even been a hint of an interest rate rise.

That’s despite the risk that the rise in national incomes could be inflationary. The post 2009 (China led) resource boom and rise in national income saw the RBA raise rates from a low of 3% in September 2009 (emergency lows, remember?) to 4.75% by November 2010.

Yet here we are, 12 months into a rising dirt price cycle, and the RBA doesn’t look like raising rates. In fact, it saw the need to cut rates during the upswing, in August last year.

This goes to show you just how fragile the economy is. Because Australia now carries a whole lot more debt than during the last cycle, interest rate rises are a lot riskier.

In addition, there is no resources investment boom to contend with this time around. That is, there are no obvious growth drivers for the economy right now…apart from rising house prices and the wealth effect on consumption.

That means you should continue to expect low interest rates, perhaps with one timid increase this year. This, along with the inflow of income from healthy dirt prices and a decent global economy, should keep the Aussie economy’s head above water.

That’s a good combination for stocks. Which is why you should expect the bull market to continue in 2017.


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Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

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