Five key charts on whether to buy Australian shares now

Photo of John Abernethy, Clime Asset Management By John Abernethy, Clime Asset Management

min read

Patience required in 2019 to buy quality companies at possibly cheaper entry points.

In speculating on the outlook for Australian shares in 2019, I do so with some trepidation.

I have always suggested, and I think it is a well accepted principle, that it is easier to forecast the performance of asset markets over a longer period (three to five 5 years) than it is over the short term (one year).

This is because the short term is subjected to price volatility driven by daily noise and the perceptions of traders and speculators. Today, these market players dominate short-term price movements so their analysis and trading corresponds to the immediate feel of tailwinds and headwinds.

Having made those points, with its implicit disclaimer, I will enter the world of speculation and present five charts that are influencing my thought process.

Chart 1: 2018 has been a bad year for most investment assets.

The first chart tracks the returns on US-dollar investment assets for the past 118 years and we can see that 2018 has been an extraordinarily poor year; indeed, the worst on record.

The multi-asset US-dollar returns (across equities, bonds, debt and property, etc.) that capture returns across the world, show that more than 90 per cent of asset classes have recorded negative returns.

However, 2017 showed the complete opposite, with virtually every US-dollar asset class rising.

Why is this important to note? Simply, because markets move faster than human perceptions of change, and the above chart shows that markets have moved in anticipation of bad economic outcomes.

From an Australian shares perspective, I note at the time of writing that the S&P/ASX 200 index has declined by more than 6 per cent in 2018. To some extent, bad news is already priced into markets.

Further, the price index is lower than it was three years ago, suggesting there is generally not much bullishness in Australian equity prices. That suggests some support for equities in 2019.

Chart 2: US government debt is a growing problem

My next chart focuses on the burgeoning US government debt that is now accelerating under President Trump. It compares the make-up of total US debt from 2007 to 2018.

Source. Haver Analytics, CIBC

While total US debt as a percentage of US Gross Domestic Product has not increased (and that’s good), it is very concerning that the level of US government debt (the yellow section on the above chart) has ballooned from about 50 per cent of GDP to about 100 per cent.

These levels of government debt could see bond yields rise dramatically, as the creation of debt (bonds) exceeds the capacity of markets to consume it.

Indeed, such debt levels have seen dramatic credit rating downgrades across southern Europe, as it is perceived that the budgets of these countries are ruined by ongoing interest payment requirements.

The offset is, of course, the creation of fabricated demand by the utilisation of government quantitive easing (QE) – the printing of money. This in turn holds down interest rates, maintains the solvency of government and stimulates shares and other risk assets.

Could there be a return to QE in the US in 2019 and what would that mean for assets (like equities) across the world? While that is speculation, you can see the thread of my thoughts.

Chart 3: What does price-earnings (PE) ratio contraction in 2018 means for 2019?

Again, I am focusing on the US because its sharemarket drives the sentiment for the Australian equity market.

The following chart shows the interesting interplay between earnings-per-share (EPS) growth, Price Earnings (PE) movements and dividends, that determine the total yearly returns from the US equity market.

A similar analysis could also apply to other equity markets across the world.

As at this report, the return on the S&P500 index in the US for 2018 is flat, but trending negative. The growth in earnings (about 20 per cent) has been totally offset by PE contraction (shrinking PE multiples). This is the opposite of the 2017 outcome, when earnings growth was enhanced by PE expansion.

In forecasting equity performance in 2019, we must have a view on earnings growth and PE movements. Further, we have to determine by how much the market has already adjusted to perceived outcomes.

Finally, the PE will be directly affected by bond yields. A higher bond yield should push PEs lower, while lower bond yields will push PEs higher.

Thus, we come to the problem of today’s forecasting. Are US bond yields (and Australian bond yields) about to fall or rise? The supply of bonds (the burgeoning US debt) suggests US bond yields will rise and US PEs are going to fall.

A recession in the US, leading to lower bond yields or an introduction of QE4 (a new round of quantitative easing or money printing), could suggest PEs will rise as earnings come under pressure.
In the latter scenario, PE expansion offsets earnings decline for a “ho-hum” outcome for global shares.

Chart 4: World equity earnings are currently forecast to rise in 2019

My next chart highlights the current earnings achieved for 2018 and the current forecasts for 2019.

Earnings have lifted substantially in 2018 and are forecast to have a moderate rise in 2019 (at this point).

It is important to note that the dramatic lift in earnings for 2018 has been strongly affected by the Trump tax cuts. The US equity market accounts for more than 60 per cent of the world index and so world earnings growth is substantially attributed to US earnings growth, particularly by its massive multinationals.

Looking forward to 2019 we see that market analysts are trimming forecast earnings growth.

The interplay of earnings growth and PEs is that earnings growth of about 8 per cent does not support PEs of 17 to 18 times unless bond yields are heading lower.

But given that bond yields are already historically low and bond debt is growing faster than GDP (particularly in the US), I suspect that PE compression will continue in 2019. That is not a bullish scenario for equities in Australia. 

Chart 5: Australian earnings growth

My final chart focuses on Australian earnings growth projections, currently being subjected to sober readjustments by equity analysts.

We are halfway through financial year 2019 and can see that market earnings growth is moderating towards 6 per cent, and I have little confidence that this growth can be achieved.

Thus, it seems to me that the correction in our equity market, driven by US PE contraction in the December quarter of 2018, has correctly adjusted to a flat earnings outlook for the Australian market.

However, the market will, from about February, become focused on the outlook for the 2020 financial year. On this interplay, I am currently suggesting that retail investors maintain a patient attitude to equity investment and accumulation.

For the past five years, Australian market analysts have been excessively bullish on earnings growth in Australia and have therefore contributed to the volatile ride for equity prices.

Therefore, my conclusion and speculative forecast for 2019 is that flat Australian earnings will be compounded by declining PEs, and the macro environment will be driven by higher bond yields caused by ill-conceived fiscal policies in the US.

There will be plenty of opportunities in 2019 to buy quality Australian equities at cheap entry points as prices oscillate, given all the uncertainties. These include ongoing US–China trade disputes, Brexit, Chinese growth slowing, taxation changes in Australia if there is a change in government, and who knows what else?

The short-term outlook is never clear and packed with uncertainty. Buyers of Australian equities in 2019 will need to be patient and focused on the undeniable growth that seems assured for Australia over the next five to 10 years.

 

About the author

John Abernethy is Chief Investment Officer at Clime Asset Management, one of Australia’s most respected fund Managers.

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