FYI | Jan 29 2009
By Chris Shaw
As Andrew Pease, Australasia investment strategist for Russell Investments notes, the start of 2009 is presenting investors with the most dismal global economic environment imaginable given many indicators are at either multi-year or all-time lows. It is thus not difficult to see why commentators describe the current economic downturn as the worst since the Great Depression.
Some of the numbers certainly support this view as household spending is falling and unemployment is increasing around the world, all at the same time as banks are hesitant to lend and corporate debt markets show few signs of life. But as Pease points out, there is also a huge global policy response to the problems with interest rates falling and rescue packages popping up in many countries around the world.
While these measures won’t be enough to prevent a further deterioration in economic conditions in the first half of this year, Pease suggests there are signs the measures are having some impact as global credit markets are beginning to stabilise.
With economic conditions continuing to get worse, it is reasonable for equity investors to be nervous, but according to Pease global equity markets are now cheap given they are down 50% from their peaks of last year. This means there is a fair chance equities have in fact seen their lows, especially as markets are forward looking and usually bottom anything up to six months before a recession ends.
The key signals will be the unfreezing of credit markets and indications policy measures are beginning to impact, at which time Pease expects markets will enjoy a sustained recovery. More needs to be done before this point is reached in his view, as while the proposed US$775 billion package announced in the US is a start it may need to be increased. Meanwhile, Europe is still struggling to deliver an adequate and coordinated fiscal plan.
Equally important, according to Pease, will be further monetary policy measures, as for example even though interest rates in the US are effectively at zero the Federal Reserve can still lower market rates by measures such as buying mortgage securities or bonds. This has the effect of feeding more funds directly into the economy.
The downturn has brought deflationary fears, but Pease expects these to be addressed, with US Federal Reserve chairman Ben Bernanke expected to work hard to ensure deflation doesn’t become entrenched in the economy.
Turning to the Australian economy, Pease agrees the outlook has deteriorated as global conditions have worsened. Despite this, he expects any downturn here will be milder than elsewhere as the Reserve Bank of Australia still has significant policy options at its disposal and Australian banks are in better shape than their global peers.
As noted, Pease sees equity markets as cheap at current levels, arguing markets are now pricing in a lot of bad news with respect to corporate earnings.
He suggests dividend yield is a very good indicator of value for Australian equities as the market yield was 6.5% in the middle of January, putting it above the long-term government bond yield for the first time since late in the 1960s. While dividends are likely to come under pressure as lower earnings are reported, the fact the yield is above that of bonds also shows how much bad news the market has now factored into equity prices.
As an example of how lower earnings expectations have been factored in of late, Pease points out in September of last year the market was forecasting earnings growth for Australian diversified resource companies of around 50% over the next 12 months. This time around, the worsening outlook for commodity prices means expectations have fallen to a decline of 0.1% over the next year.
The Russell Investment’s model for the Australian equity market supports Pease’s view the Australian market offers value, as having suggested equities were 20% overvalued in October of 2007, it now indicates the market is undervalued by around 45%. The model takes into account forward earnings, government bonds and earnings deviations from long-term trends.
One point worthy of note is after underperforming by 16% in 2008, small cap stocks in the Australian market are now trading at a P/E discount of 22% compared to their large cap counterparts. This suggests smaller cap stocks should outperform once the equity market does turn more positive.
The outlook for bonds is less attractive as in Pease’s view the bond market runs the risk of a sell-off once the market sees an economic recovery as likely. In contrast, corporate bonds appear very cheap as the spread between them and government bonds has blown out in recent months on increased fears of more corporations defaulting on their obligations.
The collapse in the Australian dollar from near parity against the US dollar in July to around US65c now has brought it back to around fair value level, in Pease’s view, meaning there are arguments for both further strength and further weakness from current levels. On balance he expects some modest strength as the market begins to factor in an economic recovery, which would also suggest higher commodity prices and therefore some flow through benefits for the Aussie currency.
On balance, Pease takes the view the current environment shows better returns are likely from risk assets, as the returns on safer assets such as cash and government bonds are now not attractive when compared to more risky alternatives.
This leads Pease to conclude while 2008 was a terrible one for most in the market, the conditions are falling into place for 2009 to be a more rewarding year.
