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Australia Update: Equity Market
Summary: Over the last 12 months, investors have had a lot to contend with, from a tumultuous political environment, to Brexit (or lack of) and the simmering unresolved trade tensions. All this manifesting against a backdrop of business cycle momentum that has weakened sharply, mounting disinflationary pressures and an economic cycle in its last innings.
The outlook in Australia has improved since the beginning of the year, the recent election win for the Liberal-National Coalition reduced policy uncertainty and eliminating the threat of negative gearing changes has removed a significant tail risk for the housing market and shored up the sentiment. Additionally, APRAs changes to the serviceability buffer will boost borrowing potential for some buyers. Globally central banks remain dovish and are ready to fire on stimulus measures. The Morrison government's $158bn tax cuts passed Parliament, meaning tax refunds worth up to $1080 will be passed on to about 10mn people who earned less than $126,000 in the last financial year, with approximately 4.5mn set to receive the full $1080, depending on their tax affairs. These refund payments will hit bank accounts once tax returns are filed, for most late July/August, so could provide a boost to discretionary spending throughout August and September.
Despite these positive factors, growth still remains below trend with plenty of spare capacity remaining and the threat of a global slowdown lingers. Labour market slack as measured by both unemployment and underemployment needs to fall substantially before wages, the largest component of household incomes, can rise and take the pressure off debt-laden households. Given the recent dent to consumer sentiment, high household debt levels and low levels of saving amongst Australian consumers the propensity to spend the extra cash from the government’s tax cuts could be diminished. Business conditions, as measured by the NAB Business surveys, have retracted the post-election bounce and remain weak. Economic growth remains below trend and this is likely to manifest in employment growth slowing in coming months. Given that the unemployment rate currently sits at 5.2%, above the RBA’s forecast of 5.0% and updated NAIRU estimate of 4.5%, the RBA will continue to ease policy. The RBA has already cut the official cash rate twice this year, to a new record low of 1.00% and we expect further easing in the 4th quarter of this year, most likely November, taking the cash rate to 0.75%. Against this backdrop, the current low growth, low inflation, low-interest rate environment is set to continue, which means the prospects for earnings growth and above-average returns are challenged. Thus, an element of caution is warranted in asset allocation decisions with defensive positioning and a focus on capital preservation likely to be rewarded in the late-cycle circumstances.
Despite sluggish economic growth softening profit outlooks, lower interest rates also feed into share price valuations. Whereby a lower discount rate increases the present value of future cash flows, justifying higher valuations as interest rates fall, even when economic and earnings growth may be weak. This is one reason why the ASX200 has climbed 19% YTD despite slowing growth as bond yields have plunged to record lows and the RBA have cut the official cash rate to a record low of 1.0%. The index looks determined to take a shot at fresh all-time highs and wipe out the Nov 2007 peak. However, what lies beyond taking out a fresh record high is less certain, and the market could be ripe for a retracement. As the ASX200 nears new all-time highs it could be a good idea to take profits where possible, raising cash levels ready to deploy on a downside correction.
ASX 200 dividend yield premium vs. bond yields at decade highs:
Despite these positive factors, growth still remains below trend with plenty of spare capacity remaining and the threat of a global slowdown lingers. Labour market slack as measured by both unemployment and underemployment needs to fall substantially before wages, the largest component of household incomes, can rise and take the pressure off debt-laden households. Given the recent dent to consumer sentiment, high household debt levels and low levels of saving amongst Australian consumers the propensity to spend the extra cash from the government’s tax cuts could be diminished. Business conditions, as measured by the NAB Business surveys, have retracted the post-election bounce and remain weak. Economic growth remains below trend and this is likely to manifest in employment growth slowing in coming months. Given that the unemployment rate currently sits at 5.2%, above the RBA’s forecast of 5.0% and updated NAIRU estimate of 4.5%, the RBA will continue to ease policy. The RBA has already cut the official cash rate twice this year, to a new record low of 1.00% and we expect further easing in the 4th quarter of this year, most likely November, taking the cash rate to 0.75%. Against this backdrop, the current low growth, low inflation, low-interest rate environment is set to continue, which means the prospects for earnings growth and above-average returns are challenged. Thus, an element of caution is warranted in asset allocation decisions with defensive positioning and a focus on capital preservation likely to be rewarded in the late-cycle circumstances.
Despite sluggish economic growth softening profit outlooks, lower interest rates also feed into share price valuations. Whereby a lower discount rate increases the present value of future cash flows, justifying higher valuations as interest rates fall, even when economic and earnings growth may be weak. This is one reason why the ASX200 has climbed 19% YTD despite slowing growth as bond yields have plunged to record lows and the RBA have cut the official cash rate to a record low of 1.0%. The index looks determined to take a shot at fresh all-time highs and wipe out the Nov 2007 peak. However, what lies beyond taking out a fresh record high is less certain, and the market could be ripe for a retracement. As the ASX200 nears new all-time highs it could be a good idea to take profits where possible, raising cash levels ready to deploy on a downside correction.
ASX 200 dividend yield premium vs. bond yields at decade highs:
This means equity markets have been propelled to fresh all-time highs off the promise of central bank stimulus rather than a healthy economy and robust corporate earnings. Growth, inflation/inflation expectations and earnings are all slowing, meanwhile economic growth in China (the global credit engine) is languishing. But equities are running off the fumes of stimulus and the lust for lower rates driving investors up the risk spectrum and fuelling multiple expansion. This is generating a false stability, that as quickly as the market rallies on rate cuts, can be flipped on its head. Risk builds up gradually and happens instantaneously. Eventually, the equity market will respond to bad news and weak fundamentals will catch up with the equity market.
ASX200 rally has been based on expanding price to earnings multiples rather than earnings growth:
ASX200 rally has been based on expanding price to earnings multiples rather than earnings growth:
Valuations are stretched relative to the outlook for earnings growth and historical PE ratio. The environment for corporate earnings growth is lackluster and the deteriorating growth outlook is largely ignored at current equity prices. The anticipation of central bank support is already formidable given that the swaps market is looking for a terminal rate of less than 1%, with the current implied policy curve suggesting an implied rate of 0.68% in Australia by July 2020. This leaves little else to propel the multiple expansion given plenty of policy easing is already priced in without a real material uplift in corporate earnings growth. The biggest risk to this view is the fact that those expectations are not high for company reports. At an index level earnings per share growth over the next 12 months are forecast at 1.5% and many companies have already downgraded guidance earlier in the year so the bar to surprise is very low.
PE expansion over 1 standard deviation from the average 12-month forward PE is historically unsustainable:
PE expansion over 1 standard deviation from the average 12-month forward PE is historically unsustainable:
As yields head lower, bond proxy stocks outperform, something we flagged back in January in our Q1 outlook. This includes infrastructure companies like Transurban (TCL), utilities such as APA Group (APA) and REITS like Stockland (SGP) and Goodman Group (GMG). These stocks have already been bid up substantially and performed well over the past 6months delivering +30% returns outperforming the ASX200 index. It is likely investors will have to be more selective throughout the second half of this year. Both bonds and equities have delivered outsized returns to date, but someone is going to end up spectacularly wrong as the performances are pricing different realities, sending diverging signals to investors. Bond yields are screaming slowing growth, along with manufacturing PMIs and ISM surveys, whilst equities are pricing a growth rebound.
In the period ahead investors will do well to tilt defensively and focus on low volatility/low beta companies earning quality cashflows, reliable dividend growth and stable defensive income streams to limit downside risk as part of a diversified portfolio. Within that diversified portfolio also having exposure to long term secular growth themes such e-commerce, automation/digitisation, emerging market consumer growth and ageing populations can also help boost returns in a low growth environment.
In the period ahead investors will do well to tilt defensively and focus on low volatility/low beta companies earning quality cashflows, reliable dividend growth and stable defensive income streams to limit downside risk as part of a diversified portfolio. Within that diversified portfolio also having exposure to long term secular growth themes such e-commerce, automation/digitisation, emerging market consumer growth and ageing populations can also help boost returns in a low growth environment.