Does Australia Deserve Asian Valuation Multiples?

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This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, editor FNArena

Equity strategists and economists at GSJB Were updated their views on the Australian share market this week. The changes made can serve as a benchmark for the new underlying trends in the market.

GSJB Were now believes the Reserve Bank of Australia (RBA) will raise interest rates two more times by 25 basis points each at meetings in December and either February or March next year. This will take the official interest rate in Australia to 7% from the current 6.50%. The previous forecast was that one more hike to 6.75% would be sufficient to keep inflation contained.

As a direct result of this change in view, the stock broker has significantly lifted its forecasts for the Australian dollar, suggesting the Aussie still has a lot more upside from what many an economist already considers a lofty US$0.89. On GSJBW’s new assumptions the Aussie dollar will average US$0.91 in 2008 (increased from earlier forecast of US$0.84), US$0.89 in 2009 (up from US$0.80) and US$0.84 in FY10 (up from US$0.78). The new forecasts see the Australian dollar reaching as high as US$0.94 by the second quarter of next year.

The changes see the removal of ResMed ((RMD)) from the broker’s Model Portfolio, due to the company’s large exposure to USD revenues and a reduction for News Corp ((NWS)) shares, also because of USD exposure. In their places came extra shares of Qantas ((QAN)) and Origin Energy ((ORG)).

As the broker also raised its gold price forecast to a likely peak of US$900 per ounce over the next 18 months, Newcrest Mining ((NCM)) has been added to the Model Portfolio as well.

Forecast GDP growth for 2008 has been increased to 3.75% from 3.00% previously as stronger international growth, mainly throughout Asia, is expected to feed into higher demand for products of Australian companies.

All this may seem like good news for the Australian share market, but it actually isn’t. Why? Because a stronger Australian dollar translates into less profits for companies that generate revenues, and profits, in other currencies. This explains why analysts at GSJB Were have been lowering earnings estimates for most ASX-listed companies this week.

The results are quite sobering. Industrials ex-listed property trusts are now expected to achieve average EPS growth of 6.0% in 2008 – half the average 12% estimated for the current calendar year. Property trusts are expected to grow their EPS by 5% next year, but this would actually be an improvement compared with this year’s 3.5% estimate.

Resource companies would end up with an average EPS improvement of 7.5% in 2008, down from 10% this year and from 52% in 2005.

The end result is that strategist Chris Pidcock has revised his targets for the S&P/ASX200 index. They went up, but that doesn’t necessarily mean good news either. GSJBW’s new index target for December this year now stands at 6300. This becomes 6500 for mid-2008 and 6800 for December next year.

On Tuesday, the S&P/ASX200 index closed at 6,660.9. Those with a quick eye for detail will have already spotted that GSJB Were’s revised index targets leave -on balance- no room for further gains between now and mid-next year and only about 6% (2% capital appreciation plus 4% in dividends) between now and December 2008.

Not exactly a prospect that would fill an investor’s heart with lots of joy and excitement, is it?

(Not everyone agrees with all the changes made by GSJBW, but most adjustments currently made by stock brokers in the Australian market share similar trends).

So how do we get out of this impasse?

Some strategists have argued over the past few weeks that Australian shares might well deserve a higher valuation from now on as the world is seeking increasing exposure to the Asian economic growth engine. Indeed, as late as only a few weeks ago most asset strategists and financial commentators were still criticising Chinese authorities for allowing such a huge stock market bubble to form. Surely this would all end in tears very soon!

Now some of these experts predict much further gains can be expected as the world has come to realise that when it comes to economic growth prospects, it’s hard to beat Asia with many countries outside Russia, China and India also expected to grow at least at double the speed of developed economies in Europe, Japan and the US.

Asia strategists at Merrill Lynch recently put it as follows: As the twelve-month return of the MSCI Asia ex-Japan index has now surpassed the 60%, one would expect itchy trigger fingers among global fund managers. However, rather than to flee from Asian markets Merrill Lynch predicts even more money will be allocated to them, simply because Asia offers high levels of economic and corporate earnings growth – and most of the rest of the world does not.

The overall expectation is this will further drive up share market valuations.

The Australian market could benefit from this as companies such as BHP Billiton ((BHP)) and Rio Tinto ((RIO)) are seen as a “Western” entry into the Asian growth story. A fact, implicitly incorporated into GSJB Were’s targeted share market valuations, with strategist Pidcock admitting predicting Price/Earnings Ratios (PER) into the future for Australian companies is the tricky part.

So should average PE multiples rise above historical standards in Australia because of the direct link to growth sectors such as coal, uranium, iron ore, oil and other commodities?

So far, the market has shown little evidence it is willing to break loose from historical valuation barriers. Two weeks ago we argued that as most large cap stocks were trading at or above their average price targets a general retreat in share prices was likely to follow – and that’s exactly what the Australian share market has done over the past week.

There is one obvious hiatus in the argument for higher valuation multiples for the Australian share market: contrary to corporate earnings throughout Asia, the underlying trend in Australia is for declining growth, mostly because of the stronger currency, but companies such as BHP and Rio Tinto are also suffering from higher costs, in local currency. The overall market view seems to be that as long as the Federal Reserve leans towards further rate cuts the US dollar is likely to remain weak.

In Asian, where most countries peg their currencies against the greenback, a weaker USD actually stimulates economic growth (and corporate earnings) as it makes their exports cheaper.

Another way of achieving higher valuation multiples is through positive earnings surprises. The banks are due to report soon. Some analysts are expecting the best earnings results in many years. However, it will be the guidance that comes with these results that will determine whether share prices can move much higher from here on.

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