Weekly Broker Wrap: Strong AUD – More Curse Than Blessing?

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By Andrew Nelson

Operational performances over the reporting season were there for the most part, but margins, and thus earnings, continued to disappoint. Forecast downgrades persisted and while earnings growth is expected through this calendar year, the market remains skeptical.

Analysts at RBS found the 1H reporting broadly disappointing at the net profit line, citing an average of 3.4% earnings downgrades across the market for the FY. While the broker was expecting to see some sort of downside to consensus estimates, the cuts were deeper than it was expecting. To blame: the persistently strong AUD.

The silver lining, in the eyes of RBS, was that average reaction to earnings disappointment was muted, with investors looking beyond near-term earnings weakness and focusing on the improving confidence about the global macro backdrop.

Wrapping up the season, RBS notes industrials was one of the best looking sectors, with a run of upgrades booked over the period. Outlook statements from the mining services and engineering construction sectors especially, were very positive. The broker continues to like the industrials, citing an increasingly strong pipeline of mining investment and production volumes.

Materials and Energy stocks were the slackers, booking earnings downgrades for FY12 and FY13 on the back of weaker commodity prices and the high AUD, which forced up costs and cut down margins. The banks also missed estimates for the most part, notes the broker, citing weaker net interest margins as one of the main culprits. That said, the broker thinks the major banks are next in line to start an earnings upgrade cycle.

Deutsche Bank points out that valuations are still attractive, with the Australian market trading on a 12 month forward PE Ratio of around 11x. The problem is: forecast downgrades could persist, which would continue to justify the discount. Earnings were meant to rebound in FY10 and then in FY11, but still, the broker notes that at least the earnings revision ratio is improving.

On the whole, Deutsche is reasonably upbeat about Australian shares in the year ahead, noting margin forecasts are looking a lot more realistic, weak financial markets are improving and the increasing prospect of M&A activity and buybacks will also help growth, predicts the broker.

Much of the broker’s optimism is centered on the Industrials. Deutsche predicts resource capex will probably remain the dominant driver of the economy for some time to come and while mining services stocks have performed well, the broker thinks valuations are still attractive.

The broker also likes Resources, noting the Chinese economy seems to be bottoming at what is a still fairly solid rate of growth. Inflation also seems to be easing, which sees upgrades to the broker’s forecasts.

Deutsche also likes the banks, noting margin concerns should lessen as banks start become a bit more independent about interest rate settings, while trading income should improve along with global markets.

UBS lays the general underperformance of Australian corporate earnings and comparatively, the Australian market, squarely at the foot of the AUD.

The broker notes global equities have jumped over 20% from last year’s October lows on the back of an improving outlook for the Eurozone and a better than expected run of US economic data. In the meantime, Australian equities have lagged significantly, picking up just under 10% in local currency terms.

Thus, the market looks cheap, says UBS, while noting the earnings cycle still doesn’t look very convincing given the AUD problem. If anything, this has intensified of late, proving even more resilient than commodities. Now if the local currency has peaked, the broker notes it will be less of a drag on earnings going forward. That said, a continuance of the currently high level will remain a problem for import competing businesses.

UBS thinks that a move back below parity is what is needed to restore local market competitiveness and for an improvement in earnings. That’s as long as commodities prices don’t head south with it. The problem is, the broker thinks along with a stronger US economy, or RBA rate cuts, lower commodity prices would be one of the main drivers of a lower Aussie.

RBA rate cuts are not on the cards for 2012 unless, postulates UBS, unemployment edges back up to 5.5%, then the likelihood of 1-2 cuts will rise significantly. The broker thinks this would help ease AUD pressure and provide at least a little relief to the earnings cycle.

The broker isn’t completely pessimistic, but it has still trimmed its year-end ASX200 market target to 4700 from 4900 on the back of weaker than hoped for earnings post the February reporting season. The broker sees a further 5% downside risk to forward earnings, but it still retains its hope for a 12x year-end multiple.

Analysts at Macquarie, however, think there’s still more to come from the Aussie. The broker notes that over the last year, the AUD has rallied despite the lack of support from higher commodity prices, which is normally one of the main drivers.

A “rock solid” AAA credit rating, relatively high interest rates and increased interest from official investors like central banks and sovereign wealth funds are held to blame. Aggressive quantitative easing from central banks in some the world’s major market are just intensifying these pressures, says Macquarie.

The broker expects these factors will probably remain until at least 2015, which it notes would imply that the AUD could well trade close to US$1.10 for an extended period of time, with that level the broker’s target for the end of 2012. As a result, Macquarie’s overall FY12 EPS forecast has now fallen in the negative (-0.2%) while the forecast for the June half has declined to 1% growth from 5.5% previously.

The broker points out that the traditional positive relationship between the AUD and commodity prices has weakened, thus its negative earnings view is largely driven by Resources, with some modest downgrades to the Industrials sector as well. That said, the broker has lowered its EPS outlook across all major sectors.

For the big miners, Macquarie thinks Chinese growth will remain both a powerful driver and an insulating factor. This should help sustain commodity prices over the next few years. Thus, the broker sees fundamental medium- and long term valuation support for both BHP Billiton ((BHP)) and Rio Tinto ((RIO)), although FY12-14 EPS forecasts are cut between 2%-6% to account for the AUD.

 

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