Equity Strategy Updates

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– Bullishness reigns
– International exposure more critical
– Yield still sought
– Beware crowded trades

By Greg Peel

The developed market equity rally of the past three years is becoming a victim of its own success, with investors concerned about what might stop it, if not reverse it. JP Morgan’s global asset allocation team has considered the questions raised in client discussions and has concluded that the right call is still to stay “significantly” long equities.

The main risks to the equity rally, in JP Morgan’s view, are economic shocks, over-valuation, financial instability, a bond sell-off and geopolitical shocks. Which, realistically, is a bit like saying “the greatest risks to the market are anything which might be a risk”.

JPM’s bullish equity stance is based on low macroeconomic volatility and no return to speak of from cash, which means economic risk must come from a significant fall in growth, which depresses earnings and raises recession risk, or from a rapid acceleration in growth, which would force significant Fed rate hikes.

In the case of the former, the strategists note the US March quarter GDP result would qualify as a “significant fall in growth”, if the negative 2.9% result is measured against earlier expectations of 2.5% growth. Yet Wall Street took this outcome in its stride, citing the impact from unusual weather and expectations of a strong bounce-back in the June quarter. June quarter expectations have now eased off somewhat nevertheless, with earlier 3% growth consensus (up to 4% within the range) drifting back to a more conservative 2.5%. At 2.5%, there is no apparent “payback” from the March quarter, JP Morgan notes, just a return to earlier expectations.

Of greater risk than a short-term economic shock or recession in the current climate is a fall in the long-term growth trend, the strategists suggest, which would not ultimately be bullish for stocks. Outside the US, Europe has begun to slow again prompting action from the ECB, China requires targeted stimulus and Japanese stimulus is yet to produce hoped for results. But the paradox lies in that stimulus – if the trend slows, monetary policy will remain accommodative, bond yields will remain low and volatility will be suppressed.

To the latter abovementioned risk, that of a sudden surge in growth, JP Morgan notes this did occur in 1994 as the US bounded out of the tech wreck, 9/11 and nineties recession and the Fed was forced to scramble to raise rates. But the difference this time is the world is still in a GFC aftermath, featuring ongoing deleveraging by governments, banks and households. This minimises the risk of any positive shock, the strategists suggest.

For the record, JP Morgan expects the Fed to execute its first rate rise in the September quarter 2015 and the funds rate to reach 3.5% by 2017.

Looking at the Australian stock market, Citi has been evaluating funds flow data provided by the ABS for the March quarter, which comes as a companion to the GDP report. March is now two quarters ago, but this particular report lags the GDP release.

Citi notes a broader demand for equities earlier this year from late last year which the broker observes appears to have continued through to mid-year. Solid net equity purchases were recorded from foreign investors and local super funds, and an abatement of net selling was observed from other domestic investors. The improved flows to some extent reflect the surge in IPOs and capital raisings of the last six months, Citi acknowledges, but that surge itself is representative of improved market conditions and investor sentiment also appears to have improved. Foreign investors are once again increasing their flows into emerging markets relative to developed markets, and Australia continues to be seen as the developed proxy for emerging markets.

Recent surveys also suggest Australian retail investors are showing greater interest in equities and superannuation, Citi notes.

Yet Citi expects investor interest will remain relatively well contained in the near term. Given Fed QE has proved an important source of liquidity since the GFC, the winding down of QE brings with it a level of caution. In Australia, super funds and households continue to be relatively conservative, given still substantial deposits in banks. Gains for the stock market should thus be measured in the near term, requiring proof of corporate earnings growth to sustain them, Citi suggests.

To the subject of earnings growth, Deutsche Bank observes the last month and a half has seen an increase in earnings downgrades for Australian corporates (65% compared with 53% previously in FY14). The fall in consumer and business sentiment suggests this trend may continue, Deutsche suggests.

Consumer spending is likely to remain soft given both poor sentiment and low wages growth, and the slight improvement in sentiment in recent weeks may yet prove fleeting once the federal budget is finally delivered, Deutsche warns. US bond yields remain low and hence the Aussie dollar remains elevated, although the analysts cite improving US data in their expectation of less dovishness from the Fed ahead, which should push US bond yields up.

Housing is nevertheless a bright light, with Deutsche’s key indicator of rent/buy cost pointing to ongoing construction strength. Building material producers are yet to raise prices as they have in previous cycles, so further upside is possible. Global energy demand is resilient at a time non-OPEC supply growth forecasts are being lowered, which should ensure good earnings growth for Australia’s energy sector, the analysts suggest, as LNG projects begin to deliver.

Credit growth has edged up for the banks, but Deutsche does not see a lot of upside here as construction growth is not being supported by leverage growth this time around. Meanwhile positive implications can be taken from improving Chinese export numbers, albeit Australian miners are now more reliant on China’s domestic property market than China’s export manufacturing sector, and that is likely to remain challenged for the time being.

Macquarie’s observation is that the Australian economic cycle is now “desynhcronised” from and lags that of its developed world peers, most notably the US and UK. To that end, offshore earnings have become a more important source of growth for many Australian-listed companies. Australia’s industrial sector, not counting banks, resources and REITs, is more “international” today compared to a decade ago, Macquarie notes.

This shift is critical as far as the Macquarie equity strategists are concerned, given they believe the relatively strong domestic demand growth enjoyed by Australian companies over the last decade has now come to an end. Companies operating in offshore markets will at least enjoy access to a larger pool of growth opportunities.

This observation is underscored by Macquarie’s compound annual revenue growth forecasts out to FY16. The strategists are forecasting 7.3% growth for internationally exposed industrials (including a positive currency element) but only 3.4% for domestic-focussed companies. Earnings growth of 13.4% is forecast for the internationals over the next three years compared to 6.6% for the domestics.

Those internationally-focused stocks which Macquarie sees as offering superior revenue growth and margin expansion ahead include CSL ((CSL)), Computershare ((CPU)), Sonic Healthcare ((SHL)), Ansell ((ANN)), James Hardie ((JHX)), Seek ((SEK)), Aristocrat Leisure ((ALL)), Flight Centre ((FLT)), Navitas ((NVT)), Breville Group ((BRG)), Ozforex Group ((OFX)), Domino’s Pizza ((DMP)) and Sirtex Medical ((SRX)).

There is nevertheless a bunch of domestic-focused stocks that still stand out amongst the others, Macquarie suggests, being Transurban ((TCL)), Perpetual ((PPT)), REA Group ((REA)), Carsales.com ((CRZ)), TPG Telecom ((TPM)), Slater & Gordon ((SGH)) and iiNet ((IIN)).

One element of Australian market investment that persists is the hunger for dividend yield. Clearly the banks have been well sought for this reason, although the influence of dividends on equity returns is spread across a number of stocks and sectors. Indeed, Credit Suisse’s quant boffins have run some numbers, and found something surprising.

While the numbers suggest bank share prices have been driven more by yield than by earnings growth over time, the past couple of years has actually seen a greater focus away from banks to other sectors in the search for yield, such that yield-driven support for the banking sector has actually waned.

The CS quants also like to focus on what they call “crowded trades” when a reporting season is approaching. A crowded trade is one in which institutions (long only) and hedge funds (long or short) are all invested in the same direction. These trades are the most exposed to share price reversals in the lead-up to and during the reporting season. Short-covering rallies can famously be sharp on good news surprises, but Credit Suisse has found crowded longs are more subject to reversal risk over time given the greater pool of long traders compared to short traders.

Stocks the boffins suggest appear crowded to the long side are Henderson Group ((HGG)), Beach Energy ((BPT)), Computershare and Transpacific Industries ((TPI)) among the ASX 100, and Papillon Resources ((PIR)), Emeco ((EHL)), Sundance Energy ((SEA)), Troy Resources ((TRY)), Sirius Resources ((SIR)), Boart Longyear ((BLY)), OceanaGold ((OGC)) and Fleetwood ((FWD)) among the smalls. Interestingly, every one of those small stocks is mining or mining services company.

Crowded shorts include David Jones ((DJS)), Primary Health Care ((PRY)), Orica ((ORI)) and Ansell (an interesting list given DJs is subject to takeover and not one of these stocks is 5% or more shorted according to ASIC data), and The Reject Shop ((TRS)), Acrux ((ACR)), Buru Energy ((BRU)), Paladin Energy ((PDN)), Regis Resources ((RRL)), Super Retail ((SUL)), Southern Cross Media ((SXL)) and Tox Free Solutions ((TOX)) in the smalls.

Of this smalls short list, all bar the last three stocks are shorted by 5% or more according to ASIC data. TRS, ACR and PDN are double-digit shorted. [See: The Short Report].

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