Weekly Broker Wrap: Getting Better, With Ongoing Headwinds

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By Chris Shaw

Global equity markets have risen by nearly 20% over the past four months, UBS attributing the gains to a combination of positive developments to the economic backdrop and some relief the European debt crisis has not worsened.

While the improvements are encouraging UBS continues to see headwinds to growth and returns, enough to warrant the continuation of a balanced investment approach. As cyclical earnings growth slows, and UBS expects earnings growth in the low single digit range this year, yield and valuation will become more meaningful as drivers of total returns.

In defining quality, UBS looks for strong returns on capital, the appropriate use of leverage, strength and sustainability of a company's earnings, strong dividend policies and valuation.

Among Australian stocks under coverage by UBS, only CSL ((CSL)) and BHP Billiton ((BHP)) make the broker's global equity strategy high quality stock list. UBS rates BHP as a Buy and CSL as Neutral, having downgraded from a Buy this week on valuation grounds.

Having assessed the outlook for Australian equities relative to bonds, Goldman Sachs argues equity prices are currently discounting unrealistically low growth rates into the future, valuations remain attractive across equities as determined by a number of valuation metrics and annualised four-year returns are currently cycling the worst period for equities since the early to mid 1970s.

This follows an extended period of outperformance by Australian bonds, a trend that has been consistent with other markets around the world. This has meant the bond yield to equities earnings yield has moved to an extreme level.

This leads Goldman Sachs to suggest the prospects for future returns in equities relative to bonds are as good as they have been for many years (echoing similar sentiment as expressed by colleagues in Europe). Favoured stocks are those with low earnings volatility given strong operational strategies. Goldman Sachs also recommends investors increase their US dollar exposure across portfolios.

Key picks in terms of solid earnings profiles are Wesfarmers ((WES)), Brambles ((BXB)), News Corporation ((NWS)) and CSL. Among mining stocks preferred exposure is companies exposed to increases in volumes and those with low risk LNG expansion opportunities. For Goldman Sachs these include Orica ((ORI)), Asciano ((AIO)), Oil Search ((OSH)), Woodside ((WPL)) and WorleyParsons ((WOR)).

Among the deep-value plays Goldman Sachs suggest cyclical stocks offer the greatest upside leverage to improving markets. In this category the broker's key picks are Qantas ((QAN)), Lend Lease ((LLC)), Suncorp ((SUN)) and OneSteel ((OST)).

Goldman Sachs continues to favour banks over resources at present, this reflecting the increasing risk profile for resource stocks as earnings growth drivers move from price to volumes. Preferred major bank exposures for Goldman Sachs are National Australia Bank ((NAB)) and ANZ Banking Group ((ANZ).

In the view of JP Morgan, the US GDP story is starting to wane in terms of being a positive story for equity markets as the good news is now well known and fiscal policy continues to limit the potential for upside surprises.

At the same time, JP Morgan's view is investors should not assume US corporate returns offer further upside, especially given corporate margins are already quite high. This implies US exposure in an Australian portfolio should be more selective going forward, especially given the still strong Australian dollar (even despite last week's sell-off).

JP Morgan suggests investors focus on companies that stand to gain in profit terms from an improvement in US activity and where this is not priced into the stock at present. Examples of this scenario include Sims Metal ((SGM)), Aristocrat Leisure ((ALL) and Computershare ((CPU)).

At the other end of the spectrum, JP Morgan suggests a cautious view on James Hardie ((JHX)), as despite the recovery potential of the US housing market the broker sees risks from cost and capital intensity increases and higher levels of competition going forward.

JP Morgan has Overweight ratings on Sims, Aristocrat and Computershare and rates James Hardie as Underweight, these ratings are equivalents respectively of "Buy" and "Sell".

As part of an update on the Small Cap end of the market, Credit Suisse listed its top five picks as rated by expected total shareholder return. The top five are Alliance Aviation ((AQZ)), Mermaid Marine ((MRM)), SAI Global ((SAI)), Carsales.com ((CRZ)) and Flexigroup ((FXL)).

Oroton ((ORL)) has been rated a Buy but Credit Suisse recently downgraded to a Neutral rating on the back of share price outperformance. While a strong brand and management should deliver superior earnings and returns, the stock now appears fair value in the broker's view. The analysts do advise investors should look to buy into dips as the good news story is likely to continue.

Citi notes Australian LNG exports are expected to increase from around 20 million tonnes per year last year to more than 80 million tonnes annually by 2018 as measured by approved projects only. This will make Australia one of the world's major LNG exporters.

Citi estimates the direct contribution of approved LNG capex to GDP growth in the first four years of this decade at around two percentage points or 0.5% per year, but could add as much as 3.5 percentage points in 2015-2019. This equates to around 20% of economic growth over these five years.

Capex and exports associated with LNG projects will put a floor under Australia's economic outlook according to Citi, increasing the likelihood the 20-year expansion of the economy can continue through the end of the decade.

PNG projects shifting from the capex phase to the export phase should be reflected in faster productivity growth in the mining and energy sectors, which should benefit the economy overall. As Citi suggests, if other sectors can also lift their productivity in coming years, the impact of any prospective loss of national income as commodity prices and the terms of trade normalise can be moderated.

Assessing the market overall, Deutsche Bank notes the ASX200 index is 10% lower than its level both one year and two years ago. Fortunately for investors looking to re-enter, further gains are expected this year. Deutsche is forecasting a year end level for the index of 4,700.

This is despite earnings still being under pressure, which is not a major issues in Deutsche's view. The reason is a lack of earnings momentum hasn't impacted on equity markets globally, as gains over the past six months have come entirely from PE re-ratings as forward earnings have fallen.

As well, Deutsche notes equity market rallies driven by PE re-ratings have been the historical norm for Australia, as in 1993, 2003 and 2009 a rising earnings multiple has delivered 75% of the market gains in the first six months of the rally. In the resource sector this impact is even more pronounced as a rising multiple has delivered around 95% of the gains over the first six months.

The underperformance in Australia of late can likely be explained by a lack of conviction earnings will recover anytime soon in Deutsche's view. This negative view is likely overstating the case, as Deutsche notes industrial earnings have been impacted by factors such as natural disasters and falling financial markets, which are not permanent factors.

As well, Deutsche notes a range of indicators suggest Chinese and global economies should accelerate in coming months, which should see commodity prices edge higher. This would be a further boost for Australian equities.

With earnings multiples across the market being compressed, Deutsche suggests the market overall is on the cheap side, which means it won't require the cheapest sectors to do all the work in terms of lifting the index.

Given an optimistic view of the market outlook and applying this to its model portfolio, Deutsche Bank is most overweight the Energy, Mining and Contractors sectors, while underweight positions are largest in the Telcos, property and food retailing sectors.

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