Weekly Broker Wrap: Time To Take On More Equities?

This story features WOOLWORTHS GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: WOW

-More growth in Japan can help
-Legal risks for supermarkets?
-Web turning positive for department stores
-Time to take more equity risk?
 

By Eva Brocklehurst

The new Japanese government may signal important changes for Australia. Morgan Stanley notes the trading link is still significant, despite being eclipsed by China in recent years. An improvement in Japanese growth should provide a moderate boost to local exports, although it is still likely that growth in Asia, ex-Japan, will remain the single most important global influence on Australia. The broker notes a 2% lift in Japanese GDP adds the same to global growth as a 0.7% lift in Chinese GDP and while that's good, it's not huge.

Japan accounts for 7% of global steel production, down from 25% in the early 1980s, so as a trading partner for Australia's major exports of iron ore and coal it is less significant. Morgan Stanley notes Japanese-Australian trade is most significant in the seaborne coal market, both of which are already in moderate oversupply. In the tourism sector, once a highlight, the Japanese share of Australia's inbound tourism market has also fallen. According to Morgan Stanley, this is partly from the very large change in bilateral exchange rates over the past decade, as the Australian dollar has risen sharply against the yen. It is another indicator of where Japan's importance for Australia has been overtaken by China. Nevertheless, any recovery in Japan's stagnant economy should deliver some moderate support for Australia.

Citi has had a look at the Australian Competition and Consumer Commission agenda on Coles and Woolworths ((WOW)). A breach of consumer law through unconscionable conduct, or misuse of market power, could result in legal action and penalties. The ACCC has collected information from suppliers about the retailers' behaviour that may be illegal, if proven accurate. Citi notes examples include the way retailers decide on whether to add or delete ranges, the request for direct payments and demands for lower cost of goods sold.

In defence, both retailers have codes of conduct that include relationships with suppliers. Citi believes the critical issue is how these are implemented in practice. The retailers take the view that shelf space is a scarce resource and they are trying to grow profit. In the broker's estimation, both supermarkets require gross profit margin expansion to satisfy market expectations for earnings growth. If private label growth is limited or negotiating is affected by potential legal action, then margin expansion may slow. Citi says the explicit earnings risk from unconscionable conduct is $1.1 million for each breach. Misuse of market power is $10 million or more for a breach. So, it could be substantial.

Citi notes these risks are not reflected in the companies' share prices –  Wesfarmers ((WES)) in the case of Coles – given consensus forecasts imply margin expansion for both retailers over the next three years. The broker has a Hold rating on Woolworths and Sell on Wesfarmers but on fundamental valuation. Therefore, Citi maintains, legal risks do pose downside potential. To put this in perspective, on the FNArena database there are three Buy, three Hold and two Sell ratings for Woolworths. The consensus target price is $29.65, offering 13.5% downside to Friday's closing share price. In the case of Wesfarmers there are one Buy, four Hold and two Sell recommendations on the database. Here the consensus target is $36.60, offering 8.1% downside.

Moving from downside risks to upside, Credit Suisse believes the web is turning positive for department stores this year. The broker looked at growth in web traffic and conversion rates for David Jones ((DJS)) and Myer ((MYR)) and found upside risk for sales and earnings estimates over the next three years. Conversion rates are estimated at around 10%. Myer's unique audience is estimated to have risen 10% year-on-year in December as David Jones' audience by 74%. The broker has a Buy rating for Myer and a Sell rating on David Jones, but notes the rating on David Jones is primarily because of uncertainty over cost structures. On the FNArena database there are five Hold and three Sell ratings for David Jones. Myer is more mixed. There are two Buy, four Hold and two Sell.

Rising home prices should put consumers in a better frame of mind. Macquarie, channeling economist Milton Friedman, notes consumers spend a portion of what they regard as permanent income while windfall gains are saved. Increases in wealth may have been seen as a windfall in the past but many now regard this as more permanent and, when it comes to wealth effects, the family home is the biggest asset. So, consumption in countries with higher rates of home ownership tends to respond more to changes in house prices.

On a macro view, in 2013, the broker believes the consumer will notice the effect of quantitative easing when the price of homes start to rise again and the most positive impact will be on markets where house prices have had a large correction. Macquarie think the US is likely to have the largest gains in house prices. The broker notes UK house prices are still falling, but at a slower rate. Here, with credit easing and real income growth accelerating, there is upside risk to house prices. This, in turn, should be positive for financial stocks, which are a large part of the UK equity market.

House prices in Germany are still rising, but at a slower rate, so the wealth effect is fading. Macquarie does not see a positive wealth effect in the rest of Europe in 2013, but with credit expected to ease, the worst is likely to be over. Given negative sentiment, the broker views Spain as the contrarian opportunity. House prices there are still falling, but the rate of decline slowed at the end of 2012. Confirmation of a trough would be bullish for Spanish stocks.

Changes in stock prices can also affect consumption but in Friedman's thesis, these are less powerful than a rise in house prices. It takes longer for gains to be seen as permanent, and hence an income source that can be spent. Here, Macquarie notes Australia appears to be an anomaly. While house prices do impact consumption, the impact of stock prices seems to be stronger. The broker sheets this home to the comparatively higher rates of participation in the equity market.

For investors not wanting to invest in equities, property is a good alternative, according to Macquarie, as it is more bond-like but also provides some hedge against the inflation that is expected to result from quantitative easing. The broker notes cheap liquidity is already boosting house prices and having an impact on the consumer.

In summary, Macquarie thinks now is the time to buy growth assets. Government and corporate bonds do not provide high enough yields to compensate for the potential interest rate, inflation and default risks. On a horizon of six months global equity markets look overbought to the broker, and there may be a mid-year correction. Despite this, money is moving back into stocks for the first time in years, global growth is improving and rising house prices should provoke the consumer to spend. As a result, Macquarie believes the best days for bonds are over. Bond prices no longer account for inflation or credit risks. The broker favours financials that benefit from the shift to equities, and rising interest rates.
 

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