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Stock selection in a lower growth economy

With the Reserve Bank of Australia (RBA) increasing interest rates for the first time since December 2003, investors might well be asking themselves how this will affect the market?  What should investors consider when evaluating stocks in a lower growth economy?

In this article Scott Marshall, SHAW's Head of Industrial Research looks at the current economic environment and what these changes are likely to mean for investors.

The latest GDP growth figures from the Australian Bureau of Statistics show a clear fall in the growth in the Australian economy, from the 4-4.5% we had expected to be the norm only a year ago, to below 2%. The general consensus of the market is that Australia’s GDP will be 2-2.5% in calendar 2005. This will result in an increase in the unemployment rate, and hence a reduction in consumer spending.

Right now the RBA is in a tightening interest rate cycle and in the medium term at least this is expected to continue. The RBA’s primary mandate to contain inflation, and its main weapon is the setting of interest rates. Unfortunately a component of oncoming inflation increases will be due to factors outside the control of the RBA, such as higher commodity and oil prices and interest rates will be ineffective against this component of inflation. Also while inflation is starting to increase and the RBA is increasing interest rates, it is not optimal to raise rates while the economy is slowing as this will only exacerbate the slowdown.

The feeling in the current climate is that any rate rise to be temporary with interest rate reductions possible near the end of calendar 2005. Higher interest rates do have a direct impact of several sectors of the market including property trusts, as higher interest rates tend to lead to yield gap compression, and housing stocks because higher interest rates tend to lead to a slowdown in activity.

The slower growth rate will have an impact on consumer and business behaviours that will reduce the demand for products and services sold by several companies.

One obvious and personally immediate impact of the slowing economy is that consumers become more aware of the need to repay loans, and the level of uncertainty increases regarding their ability to repay consumer debt. As a result discretionary spending may fall, and concerns in this regard result in a selldown in discretionary and volatile, or “cyclical” stocks. This could include some retailers, building stocks and some services companies.

Typically media stocks would be included in this list, with media being a discretionary spend item, however with the unrelenting appetite for entertainment products owned or distributed by media companies, plus the impending media law changes, this sector is moving to a different tune this cycle.

The sectors that typically do well in a slower growth economy include those that can demonstrate growth irrespective of the economy. These stocks include those with market strength and sector dominance, based on the assumption they will fare better than weaker competitors in a mild downturn; utility companies that have guaranteed long term revenue contracts, say 10 years; and stocks with significant international operations. We could also include consumer staple companies such as food retailers and food manufacturers, as consumers are unlikely to stop eating, though they may move to lower margin food brands.

It is always a controversial topic as to whether financial companies perform well or not in a mild downturn and in particular the impact of the interest rate cycle, whether going up or down. It is generally accepted that, while banks are impacted by rapidly rising interest rates, their current restructuring programs and increasing exposure to wealth products will offset a part of this negative impact in the current cycle. Also if any housing downturn is short term and not severe, say a short term 20% fall in new loans, then the weight of the existing loan balances will carry the banks through the downturn.

Even in good times, stocks that generate strong cash flow and pay growing, fully franked dividends are sought by the market. In periods of weakness, even if temporary and mild as the current weakness is expected to be, these stocks are especially sought as a method to reduce the risk profile of portfolios.

Contrarian investors will see the fall in share prices of strong companies as a good longer term buying opportunity, on the assumption that the Australian economy is fundamentally sound and adapts well to downturns. Well managed stocks can experience share price falls in downturns, but with time the strong management and strong market positions will lead to share price strength as the recovery begins.

Further with the weakening of the residential investment sector, which has been a primary target of the RBA, monies that have recently been funding the housing bubble have now been directed into equities. This, combined with the steady flow of superannuation funds into equities and the difficulty in using superannuation funds to buy investment housing, has helped the share market rally strongly over the past 6 months. Should the funds that switched from the property market revert back to property, then there will be weakness in the equity market.

Currently marching to their own tune are the resources sector and oil stocks. With the much talked about demand for commodities from Asia and in particular China there is a shortage of supply for many commodities. Commodity prices and share prices have increased recently. We expect resource stock prices to remain strong for several years. Oil has another issue to address, with several industry experts predicting a terminal decline in oil supply with global peak production probably already passed. If this is the case then oil prices will maintain strength for the long term with persistent strength in oil related stocks.

So in summary, with the slowing growth rate for the Australian economy and perhaps temporarily higher interest rates, the market has become slightly more defensive, and has an increased focus on companies that generate excess cash flow. The resources stocks continue to rally in an environment dominated by stronger global demand and so are protected from any local weakness.

Article written by Scott Marshall, Head of Industrial Research with SHAW Stockbroking. He can be contacted via the Egoli website: www.egoli.com.au

(c) All rights reserved 2005. This article has been prepared by SHAW Stockbroking and licensed to ASX. The views are those of the author and not necessarily of ASX. This material is educational and it is not intended to constitute financial advice. It has been prepared without taking account of any person's objectives, financial situation or needs and because of that, any person should, before making an investment decision, consider the appropriateness of the advice having regard to their objectives, financial situation and needs.

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