A Better Year For Oz Equities Ahead?

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By Greg Peel

Australia's ASX 200 ended 2009 on 4870 and ended 2010 on 4745 for a loss of 2.5%. By contrast, the US S&P 500 ended 2009 on 1115 and 2010 on 1257 for a 13% gain. Now, remind us again – which is the country that weathered the GFC storm and is hellbent on being in budget surplus in a couple of years, and which is the country that spent half of 2010 fretting over a double dip and is so up to its neck in debt there is never any real intention of seeing a return to budget surplus?

A certain amount of explanation can be found in the comparable movements of the previous year. The ASX 200 gained 31% in 2009 while the S&P 500 saw only 23%. The Australian result reflected, as it should, forward earnings forecasts which at the time were optimistically representative of a substantial “V” bounce. Those forecasts were later pared back, most notably around the middle of last year. US earnings forecasts on the other hand just kept shifting up from low bases, and then along came QE2 to add that extra bit of spice.

Aside from some substantially wrong calls from stock analysts in the earlier part of 2010 (business credit demand would bounce and soar, retail spending would quickly bounce back to pre-crisis frenzy levels, for example) a major swing factor has been the Aussie dollar – the plaything of foreign hedge funds and a proxy for China. Remember that if a US hedge fund buys BHP and the stock price rises, if the Aussie rises as well that hedge fund wins twice. Vice versa on the downside. BHP jumped in 2009 as the commodity price bounce was priced in, then sat largely steady for most of last year. The Aussie ran from US60c at its nadir to parity. From a US point of view, BHP in Aussie dollars currently represents little upside and a screaming void of a downside were anything to go substantially wrong in the world again (European debt, for example) or if Beijing accidentally brought China in for a hard landing.

In the year to September 2009, notes Deutsche Bank, foreign investors injected US$60bn into Australian equities representing 5.6% of total market cap and reached about a 40% holding. In the same period of 2010, they withdrew US$2.5bn.

The question now is: what will the year 2011 bring?

Deutsche notes that while 2010 saw a slight net withdrawal, foreign flows into Australian equities were nevertheless positive in the September quarter and have again been positive in the December quarter. Has the tide turned? Deutsche believes it has. Indeed, Deutsche is forecasting a 15% rise in the ASX 200 over calendar 2011.

Deutsche believes the earnings downgrade cycle in Australia should now have ended (notwithstanding immediate weather impacts). Listed companies missed the bulk of the government stimulus provided since 2009 (small builders were winners for example, retail had an initial spurt from hand-outs but then consumer demand fell away except for larger items like cars). Mining companies have been making grand expansion and general spending plans since 2009 but the mining tax debate meant a lot of those projects were stalled. While the mining tax issue is not yet fully resolved, resource companies should feel sufficiently confident to roll out the capex this year given commodity price rises at the very least.

The mining tax issue was clearly another reason why foreign investors backed out of Australia in 2010, or stopped buying, as was the general uncertainty caused by political turmoil.

Australian direct equity investors are remaining shy post-GFC. The popularity of self-managed super has risen dramatically but funds have found their way into cash deposits and other yield instruments rather than risk stocks. But households in general are still making what Deutsche suggests are “substantial” contributions to superannuation funds both at the mandatory and discretionary levels.

Australia's underperformance is also a reflection of Australia's two-speed economy. The resource sector may have been booming, mostly at the smaller cap level, but this has been offset by disappointment, some might even say recession, elsewhere. The retail sector is the obvious example. Can the resource sector continue to boom?

With a thinly veiled air of world-weariness, Goldman Sachs has once again increased its shorter term commodity price forecasts. “Another year and another round of upgrades,” notes GS in a report this week. Short term price forecasts are now more than double long term forecasts, the analysts note, for both iron ore and copper. For the majors, such prices represent substantial short term cashflow. BHP Billiton ((BHP)) derives 37% of earnings from iron ore and 24% from copper (2011 forward basis) and Rio Tinto ((RIO)) 80% and 15% respectively.

Coking coal (used in steel production) is the big mover although it has not yet reached double short/long pricing. GS sees more upside for coal than iron ore given the swing factor of Indian demand. India has no coal; China is quite well supplied albeit is now a net importer. Oil, aluminium and nickel forecasts are less divergent on the short/long basis.

BHP, Rio, and counterparts across the globe are all in the process of significant iron ore production expansions. Global supply was 1006mt in 2010 but GS sees potentially 1675mt by 2015. This would require all projects to get up and without too much delay, which is not likely, but either way GS sees a tipping point for iron ore not too far ahead with a possibly very sharp price reversal before 2015 as Chinese steel production matures.

Goldmans' advice to resource majors is to return capital to shareholders rather than look to undergo even further capacity expansions. What will Marius come up with at the upcoming result announcement?

On the assumption of reverting iron ore prices, Fortescue Metals ((FMG)) has a window of opportunity to meet expansion goals before it's too late. GS analysts support the company's expansion goal to 155mtpa as long as time and funding costs go in FMG's favour.

For coal stocks, on the other hand, the story will keep on running in Goldmans' view.

But just how much of this shorter term commodity upside is already built into share prices?

UBS analysts believe commodity prices will remain “resilient” in 2011 but resource sector stock prices look a bit overheated in their view. In early December, on this basis, UBS trimmed its Overweight ratio for the resource sector in its model portfolio from 5.5% to 2.0%. This week, UBS has actually downgraded its resource rating to Neutral. Small cap valuations seem particularly stretched, the analysts suggest.

The flipside was that UBS upgraded Australia's banking sector rating to Neutral from Underweight in December, but Neutral it will stay until there are signs of more positive credit demand growth. UBS remains Overweight industrials and Underweight REITs.

UBS has also shuffled the stocks in its model portfolio, adding Graincorp ((GNC)), Myer ((MYR)), Origin Energy ((ORG)) and Transurban ((TCL)). It has removed AGL Energy ((AGK)), Bradken ((BKN)), Gloucester Coal ((GCL)), Harvey Norman ((HVN)) and ResMed ((RMD)).

BA-Merrill Lynch has looked to global factors in reassessing its own model portfolio. Merrills sees the US economy shifting into a “Phase II” of recovery in which unemployment will begin to ease. As the US recovery broadens, lingering GFC shock and more recent sovereign debt concerns will also start to ease, the analysts suggest, and prices will react accordingly. Financials and energy stocks are Merrills' stand-outs on this assumption.

From the Australian perspective, Merrills sees a wider benefit of a Phase II US recovery than just for those stocks with direct US exposure. Easing fears should see Australian retail investors begin to rebuild those portfolios which for so long have been biased to cash. With regard to financial sector beneficiaries, Merrills sees better value outside of the Big Four banks with asset managers such as AMP ((AMP)) and Challenger Financial ((CGF)) favoured, along with small banks such as Bendigo & Adelaide ((BEN)) and investment banks such as Macquarie ((MQG)) (is there another one?).

While the oil price has run higher, it has underperformed those of bulk commodities despite oil being a closer proxy for global GDP. Merrill's thus likes the energy sector, and Woodside ((WPL)) in particular.

Summing up, Merrills has Macquarie, Bendigo and Challenger as the major “overweights” in its model portfolio, along with QBE Insurance ((QBE)), as well as Woodside and WorleyParsons ((WOR)) in the energy space. Merrills is also in favour of the consumer sectors in 2011, and as such Wesfarmers ((WES)), JB Hi-Fi ((JBH)) and David Jones ((DJS)) are also overweights.

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