This article appeared in the April 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
There is no shortage of risks for global sharemarkets. But an improving United States economy and the fact that so many investors are still on the sidelines could propel the Australian market to 5,500 points, says Mike Hawkins of Evans & Partners. This article outlines key issues affecting share prices, such as interest rates, currencies and China.
By Mike Hawkins, Evans & Partners
This time last year my target range for the S&P/ASX 200 was between 5250 and 5350 by April 2011. However lower-than-anticipated valuation multiples (price-earnings ratios) and lower than expected profit growth have ruined a good story.
In this business, story-telling always comes with a large margin of error but the story tellers never have to write a final chapter because the plot is effectively endless. What follows is our story for the S&P/ASX 200 in the year ahead.
Australia can do better but a lot has to go right
We are comfortable with the proposition that the Australian sharemarket, although again lagging behind the global market, can do better. We are, however, inclined to be more cautious than some about the size of the potential gain.
We think index targets of 5500-plus are credible, but a lot will have to go right to get there. If the market is to have a stellar year, at least eight preconditions will have to fall into place. Such an outcome looks difficult, if not impossible. Each of the eight is a big topic in its own right, so this is a brief overview of what needs to happen.
1) Valuation multiples improve
Given the world we now live in, the rational investor should take a conservative approach to the pricing of risk. This means that relative to the past, valuation multiples should be lower. There is still a long list of "known knowns" to worry about:
- fiscal repair in Europe and the US
- bank vulnerability in Europe
- inflation in emerging economies and in Australia; and
- conflict in Korea, North Africa, the Middle East and elsewhere.
Any one of these could trigger a wave of risk aversion similar to what we saw in April and May 2010.
On the other hand there are two related factors that could provide a positive offset:
- US economy strengthening
The US economy - more so its private sector - is strengthening. US interest rates are unlikely to rise significantly before 2012 and the benchmark for global valuation, the S&P 500 price-earnings (PE) multiple, could easily fall back to around 14 times from around 13 times currently. (Editor's note: A lower PE suggests the valuation of that market is cheaper).
- Many are yet to re-enter the market
The second driver is the simple observation that the crowd is yet to return to equities as an asset class. Instead they have been sitting in fixed-interest markets, commodities and emerging markets. If the risks noted above can be contained, the crowd will eventually return to the sharemarket.
The broader economic influences in Australia are less conducive to higher PE ratios. But given that the starting point is conservative, there is scope for any favourable global trends to at least partially flow through into higher local sharemarket valuations.
2) Australian dollar weakness
An overvalued currency, higher interest rates and tighter access to credit are dampeners on performance. A stellar year on ASX would require financial conditions to ease, with the Australian dollar probably having to do most of the work. We retain the view that ongoing gains are unlikely because the reasons for the Aussie dollar's appreciation are now in the past. For the Australian dollar to fall, the US-dollar must strengthen. We are confident this will come. Then we would need to see lower local interest rates. This may prove to be a story for 2012.
Industrial stocks with international exposure account for around 13 per cent of Australian market capitalisation. In the absence of Australian-dollar weakness share prices of industrial companies will remain range-bound (moving flat or sideways).
3) A change of view from the Reserve Bank
The sharemarket will only benefit from a falling Australian dollar if the fall is consistent with the outcomes sought by the Reserve Bank. If the currency falls at a time when the Reserve Bank wants a higher value then it would be an incentive for the RBA to lift interest rates so any sharemarket benefit would be short-lived. (Editor's note: a lower currency makes imports dearer and adds to expectations of higher inflation. The RBA uses higher interest rates to dampen inflation).
It is going to take a fair bit for the RBA to adopt a more accommodative view on interest rates because we are facing a fully employed economy, cost pressures and an inflation forecast that says it gets worse from here. The most likely catalysts for lower rates would be:
- A material tightening in fiscal policy (less government spending). Unlikely.
- Evidence that the mining-related capital expenditure boom is going to be delayed and/or compromised by capacity limitations and rising costs, which seems unlikely.
- Deterioration in the outlook for the global economy. Unlikely at this point and even if it were to eventuate, what the equity market would receive through industrial stocks would, in all likelihood, be lost through lower prices for resource shares.
In summary, the RBA remains a major impediment to a stellar-year scenario.
4) Earnings outlook for the major banks
The S&P/ASX 200 is not going to hit around 5500 points without a solid contribution from the major banks.
For most of 2010, FY2011 and FY2012 earnings estimates from sharebroking analysts for the banks steadily declined. Although this phase looks to be coming to an end, there is still little to inspire optimism: negligible revenue growth; limited cost-out capacity; a fading positive contribution from lower impairment charges; rising average funding costs; a very competitive deposit market and agitated politicians. One potential area of positive surprise is a recovery in credit demand. This would probably be viewed by the RBA as a reason to lift rates.
If the banks are going to make a reasonable contribution to aggregate market performance in 2011 it is likely to come late in the year on confirmation that average wholesale funding costs have peaked. The market may then be prepared to price-in better times in 2012.
5) Optimal cost control
We see little reason for optimism. The broader economic environment is clearly defined by:
- insipid productivity growth
- capacity limitations, wage pressure and regressive labour market reforms
- excessive regulation
- rising gas, electricity and water prices, and
- imported inflation from China.
A superficial analysis at the micro level leads to the same conclusion.
- Many companies, particularly domestic manufacturers and distributors, achieved impressive cost savings in FY2008 and FY2009. There is little scope for further big gains.
- One unusual and under-appreciated dynamic in Australia is the number of sectors engaged in aggressive market-share battles which could adversely affect earnings. This includes grocery, pathology, electronics retailing, retail bank deposits, energy retailing, telecommunications and transport. Although the participants may see better cost outcomes through economies of scale and process improvement, they are unlikely to be in a position to compromise on client service. Competitive pressures may yet be a source of earnings disappointment across these sectors.
6) Go China!
The resource sector accounts for around 34 per cent of market capitalisation and the S&P/ASX 200 would struggle if the market's enthusiasm for China and commodities were to wane.
In this regard, inflationary pressures across the emerging economies are entrenched - higher interest rates, particularly in China are inevitable. If this were to be the story throughout the first half of 2011, it is conceivable that the sharemarket would become increasingly wary about commodity demand in 2012.
A positive offset could come through our expectation that the US will do better than expected, which is particularly important for copper and oil prices.
In the event that 'Go China!' comes to pass and resources perform strongly in 2011, the easing in financial conditions that is so critical for industrial companies would probably not occur. This is because commodities strength would probably result in the Australian dollar remaining elevated. The RBA would then be more likely to continue a tight policy by lifting rates.
7) Equity market strength builds investor confidence, stimulates market activity and attracts new money
Fund managers, investment banks and financial transaction platforms account for about 7 per cent of market capitalisation. When the equity market is flowing, so are their businesses and so is the valuation multiple the market is prepared to pay for their shares. A stellar year would need to see this virtuous cycle kick-in. (Editor's note. A virtuous cycle has one influence having a positive effect on the next which in turn has a positive influence on the next).
8) A little love from offshore investors
Although the Australian industrial market is not as expensive relatively as this time last year, there is little to attract offshore investors back in, particularly if the outlook for the region remains sound. Offshore investors have been steady sellers of Australia over the past 18 months. That is a reflection of better quality, value and opportunity offshore; a "house price bubble" fixation; a growing and valid concern around political risk; and, lately, an opportunity to cash-in on a significant currency gain.
Domestic fund flows into the sharemarket remain robust on the back of superannuation, Australian fund managers are losing share to self-managed super and allocating more into offshore markets. It is questionable whether they can play the "marginal buyer role" to any great effect. It will probably fall to the private investor and an asset allocation shift away from cash and term deposits into shares, to drive the market higher.
What it means for the Australian sharemarket
The target of around 5500 points is accessible for the S&P/ASX 200 in the year ahead but it would require an element of good fortune for all the preconditions to play out.
The RBA remains the major impediment. Rate increases may be limited but they will always be threatening. This would only change if the global outlook deteriorated, in which case the S&P/ASX 200 performance would be hit through a resource sector decline.
We are also sceptical about the capacity for significant cost containment in a market where market-share battles are commonplace, and about the ability of the major banks to deliver share price gains of 10 per cent or more.
Price-earnings multiples expansion through a strong global lead could yet surprise on the upside, but we question how sustainable such gains would be, given the myriad economic and political challenges that will inevitably trigger periods of risk aversion.
About the author
Mike Hawkins is chief investment officer at Evans & Partners, a leading wealth-management firm.
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