FYI | Dec 21 2012
By Andrew Nelson
Despite the twists and turns and a few kicks in the pants, 2012 was a pretty good year for equities. Some fairly strong returns were posted on the back of re-rating P/E multiples despite otherwise weak earnings contributions, with forecasts otherwise plagued by downgrades over the course of the year.
In fact, the Australian market re-rated to a far greater extent than most of its global peers despite, for the most part, continuing a protracted run of what were considerably worse earnings outcomes. Thank goodness for the defensive yield theme, as this was the main driver of Australian market performance through most of 2012.
But after all of this P/E re-rating we’re left with a market that on most measures seems to be at fair value, so what now?
Analysts from UBS expect 2013 earnings growth in the neighbourhood of 6% although the broker sounds a bit of a cautionary note given consensus estimates were still being actively trimmed as of yesterday. Still, the analysts are pencilling in an ASX/200 target of 4800, which points to an arguably normal 5% capital gain from current levels. For next year, UBS heads in Overweight resources, a little Underweight on the banks and Overweight on value/cyclical industrials as opposed to higher priced industrial safe havens.
There is an upside scenario to the broker’s thesis, which is that equities could continue to re-rate against what are some very low fixed interest yields and cash rates. The broker notes the market’s current 13x multiple is still looking a little cheap compared to its 20-year average of 14.4x, especially given a 4.9% expected dividend yield, which is still very attractive because of the low prevailing interest rates. However, we’ll need to see at least some modest earnings/dividends growth.
Analysts from Macquarie have also put their heads together to make a hit list of possible surprises for next year. The broker points out that economic forecasts are based on what is most likely to happen, but investor also have to have a handle on what might happen as well, as these issues could also have a significant impact on markets if they do play out. So pay attention, as the broker notes that in each of the last few years, at least one of its year end heads up calls has actually occurred.
First, the broker points out the fledgling US housing recovery could stall. While, admittedly unlikely, it would nonetheless be disastrous if it occurred.
What about if the price of oil were to fall by 30%? Current expectations are for oil prices to remain above US$100 per barrel (Brent) given it’s around this level that is required to maintain investment in new supply. But if demand were to disappoint then a de-stocking cycle could override organic support, much like iron ore did this year. Were said weakness to originate in a US economic stall, it would be a be negative for both inflation and interest rates, although were it to be caused by disappointing growth in emerging markets, then Macquarie sees upside for both US and European growth and a neutral impact on interest rates.
We could see a return to strong European growth, although the broker admits this is a bit of a long shot given a surprisingly resilient currency and otherwise weak global growth. Still, there is still a chance of a European rebound led by Germany, which is possible given low unemployment levels, strong population growth, low interest rates and not much in the way of fiscal austerity.
The broker also sees a chance that Japan could post a sustained run of current account deficits, which would signal a turning point for the economy and financial markets, as Japan would then be reliant on overseas investors to fund its budget deficit. Macquarie believes this could not only trigger a higher risk premium priced into Japanese bonds, but could also lead to a much weaker yen and then hopefully, a stronger resolve to reform the economy.
Here’s a rather ugly one to think about: the broker sees a chance the Aussie could actually hit $1.20 against the greenback. Despite the Australian economy softening steadily over the last year, the Australian dollar has remained rock solid above parity against the US dollar thanks to a AAA credit rating and a higher yield given our low rates are nowhere near as low as almost everybody’s else’s low rates. And with the chance of even further quantitative easing in other developed economies, there’s even more upward pressure on the Aussie. While the RBA is likely to do what it can from allowing this to happen, the broker notes FX markets are notorious for overshooting and an AUD anywhere near $1.20 would be disastrous for Australia’s trade sector.
Lastly, Macquarie thinks that while unlikely, productivity could increase given trends have been fairly weak in Australia for the past 5 or 6 years. Companies have been cutting costs for the last four years, while technology has continued to progress. The broker points to the 1990s, when technological developments helped deliver a strong and sustained boost in productivity. Such an outcome would not only be good for profits, it would also deliver stronger growth as well.
We’ll finish off with a few tips from Credit Suisse. The first thing the analysts want you to know is that while many may see the banks as a quality yield play given the solid performance over the last few years, the broker believes that at this stage banks have become bond proxies to a point and thus the broker is shifting to an Underweight stance on banks.
Credit Suisse also sees risk emerging for over-geared housing investors, noting that leveraged property investors are struggling to turn a profit given net rental yields are far below prevailing interest rates. About a 50% level of gearing is all that’s possible, with higher levels only serving to see investors subsidising losses on property portfolios in the hope of future capital gains. Not sustainable, says Credit Suisse, especially given its pessimistic view about the prospect of house price inflation, citing the fact the sector is 20%–40% overvalued by historical standards, while housing demand is extremely low.
However, the broker does believe the over-gearing situation does not need to end is disaster. Were the RBA to remain on an aggressive footing and end up bringing rates down to around 1.5%, debt dynamics would stabilise and ultimately house prices could stabilise. But the RBA doesn’t seem planning these sorts of cuts and even if they were, there’s also the prospect of lenders keeping the money.
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