Australia Update: Equity Market

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: