Australian Market Strategist, Saxo Bank Group
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.
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:
ASX200 rally has been based on expanding price to earnings multiples rather than earnings growth:
PE expansion over 1 standard deviation from the average 12-month forward PE is historically unsustainable:
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.
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