Equity Strategy: Beyond Macro Volatility And A Disappointing Result Season

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This article was first published for FNArena subscribers on September 14 and is now open to general readership.

– China/Fed dominate the macro
– Disappointing guidance subdues the micro
– Outlook positive in specific sectors
– Queensland the state to watch

By Greg Peel

This year's August reporting season in Australia was met in the last couple of weeks by the dominant macro forces of China fears and Fed fears, reflected in big falls for first the Chinese stock market an then, on a combination of both forces, big falls on Wall Street, which impacted on markets globally.

During this period the ongoing Australian corporate reporting season, which is concentrated in the last two weeks of August, took a bit of a back seat. There were still a few notable stock-specific responses apparent from positive results, but realistically everything was hit by the same tidal wave of macro selling.

Broken China

Stockbroker Morgans is none too concerned with the Chinese stock market per se, suggesting it is not particularly representative of the Chinese economy, as is the case for stock markets in the US and Australia, for example. By comparison, the capitalisation of the Chinese stock market relative to GDP is only 8% of that of the US stock market. Moreover, China's big corporations are all government-owned and thus not reliant on the stock market for equity funding.

Morgans analysis suggests China's monthly purchasing managers' indices (PMI) explain almost 70% of the variation in China's economic growth. While the market tends to focus more heavily on China's manufacturing sector PMI, Morgans finds the non-manufacturing (service) sector PMI better explains variation in GDP, likely due to Beijing's policy of shift away from a manufacturing-based economy to a an economy based on services and domestic demand.

Last month China's manufacturing PMI slipped into contraction, just, at 49.7. China's services PMI also slowed, but remains in expansion at 53.4. For the time being, Morgans believes Beijing's GDP growth target of 7% for 2015 is still achievable.

That leaves us with Fed monetary policy.

More Correction

Morgans view is that the US stock market still has further to fall before year-end and the next leg will be triggered by the Fed's first rate rise. US unemployment is now at 5.1%, which is the level at which the central bank believes inflation begins to become an issue. To not act soon would risk a further fall in unemployment fuelling accelerated inflation and leading the US back into recession.

Thus Morgans believes it is certain the Fed will act at one of the three FOMC meetings remaining in 2015 – September, October or December. September is favoured.

The broker makes the interesting point that given the last time the Fed raised its interest rate was eight years ago, and that means there are plenty of participants in the US stock market who have never experienced such an event. Morgans believes that on the announcement of a rate hike, the market will sell off to test conditions. But that fresh leg down, the broker believes, will herald the end of the correction.

The rebound, suggests Morgans, will be swift.

The impact of a rate rise on the US economy is not the only concern among US and global markets.

The Fed's longstanding zero-rate policy has forced US investors to look offshore for return on investment and up until this year, emerging markets had been a popular destination of choice. With the market expecting the Fed to begin normalising policy very soon, already emerging market investments have been swiftly sold off and funds repatriated. EM currencies have, a result, taken a dive.

The coincident fall in commodity prices has only exacerbated the issue for the likes of Brazil and Russia, and the China slowdown has reverberated through to the smaller Asian economies reliant on Chinese growth. In terms of reliance on commodities and Chinese imports, we can use the Aussie dollar as a benchmark. It's fallen by over a third from its heights above parity.

The difference is that Australia has welcomed the devaluation. China has been forced to devalue its currency, while the freefall in other emerging market currencies has crushed the purchasing power of consumers and scuppered economic growth.

The currency sell-off has ushered in comparisons with the Asian Currency Crisis of 1997-98.

Citi calculates an emerging market sentiment indicator. Last week it was sitting at minus 1.4, close to the GFC low of minus 1.5. In 1997 the indicator bottomed out at minus 1.6. History suggests an indicator level of minus 1.0 to minus 1.5 represents a contrarian buy signal. When the indicator bottomed at minus 1.6 in 1997, the subsequent return over 12 months was positive 67%.

Indeed, Citi's analysis suggests the probability of positive returns over 12 months after the indicator falls into the minus 1.0-1.5 range is 100%, with a median return of 31.2%.

Back to the Australian reporting season…

Disappointing

While macro chaos impacted heavily on the Australian stock market in August there is no hiding the fact, suggests Morgans, that the season was "patchy at best and concerning at worst".

Analysts had already begun revising down their FY15 and FY16 earnings expectation in the lead-up to August. While weaker FY15 forecasts were largely met, disappointing overall guidance has meant a further 1% has been stripped off the FY16 net forecast. For many companies guidance was non-committal, reflecting caution, while anecdotal outlook statements were more cautious than has been the case in the past several periods, Morgans notes.

The buzzwords for August 2015 were "uncertainty" and "challenging conditions".

As is typically the case, those companies missing forecast expectations were punished more heavily than those beating forecasts were rewarded. However, given the overriding macro influence during half the season, "rewards" were never going to be particularly distinct this time around.

Companies offering FY16 guidance that missed expectations were particularly punished. Stock-specific issues impacted on the likes of Seek ((SEK)) and Insurance Australia Group ((IAG)), difficult sector conditions were the issue for the likes of Orica ((ORI)), Origin Energy ((ORG)) and Downer EDI ((DOW)), and currency/interest rate problems affected Computershare ((CPU)), Ansell ((ANN)), Cochlear ((COH)) and others.

Those posting "excellent" results were not rewarded, Morgans notes, given uncertain outlooks. These include JB Hi-Fi ((JBH)), Harvey Norman ((HVN)), Corporate Travel Management ((CTD)) and Domino's Pizza ((DMP)).

There were some positive exceptions nonetheless, featuring companies that had attracted very weak forecasts but delivered results that suggest cyclical low points have been reached. These include The Reject Shop ((TRS)), Treasury Wine Estates ((TWE)), GWA Group ((GWA)) and Sims Metal Management ((SGM)).

And there were also some results that were genuinely positive, thanks to cost cutting, for example Medibank Private ((MPL)), or thanks to capitalising on specific positive themes, for example Blackmores ((BKL)), Bellamy's Australia ((BAL)) and APN Outdoor ((APO)).

Macquarie, too, has concluded that while six month results were in line with forecasts, FY16 guidance disappointed, leading the broker to substantially lower already conservative estimates.

Industrials were the key source of disappointment, leading the broker to trim its FY16 sector earnings growth forecast almost two percentage points to 9.1%. Notable disappointment came from CSL ((CSL)), Computershare, Seek and Telstra ((TLS)). The broker's growth forecast is lower than the 9.4% achieved by the sector in FY15. Macquarie does not expect negative earnings growth, but suggests overall growth will be "anaemic at best".

Foreign exchange tailwinds were a feature for many a company in FY15 but ongoing benefits have already been factored into FY16 forecasts. The Aussie would have to fall "materially" below US$0.68 to drive another round of currency-related forecast upgrades, Macquarie suggests.

Another dominant feature was cost-cutting. This was particularly true for a resource sector combatting falling commodity prices, and here South32 ((S32)), Origin Energy, Oil Search ((OSH)) and BlueScope Steel ((BSL)) stand out. But many non-resource company results also featured cost-out benefits. Those with opportunity for ongoing cost-outs include QBE Insurance ((QBE)), Medibank Private, Ramsay Healthcare ((RHC)), Boral ((BLD)) and Aurizon ((AZJ)).

Capital management remained an ongoing theme, Macquarie notes. A long list of companies increased their dividend payout ratios or announced special dividends or share buybacks, including AGL Energy ((AGL)), Genworth Mortgage Insurance ((GMA)), Henderson Group ((HGG)), Adelaide Brighton ((ABC)), QBE Insurance, Tabcorp ((TAH)), Asaleo Care ((AHY)), Qantas ((QAN)), Aurizon and Flight Centre ((FLT)).

It must be understood, however, that while investors reward stocks offering more cash back in the hand or capital value increases through buybacks, the reality is funds returned to shareholders are funds not deployed for earnings growth. This is particularly the case if funds are made available for distribution not through business growth but through cost cuts.

In other words there is an element of "be careful what you wish for". Macquarie notes also that not every company rewarding shareholders was met with a positive response, due to weak earnings. These include CSL, Carsales.com ((CAR)) and Computershare.

There is also a distinction between dividend growth that is sustainable, given it is earnings growth-based, and hand-outs that are possibly the end of the line, given diminishing scope for further cost cuts and limited earnings upside. Macquarie is positive on the sustainable dividend growth offered by Wesfarmers ((WES)), Transurban ((TCL)) and Goodman Group ((GMG)).

In terms of positive earnings growth outlooks, Macquarie likes Amcor ((AMC)), Ramsay Healthcare, Healthscope ((HSO)), Cover-More ((CVO)) and Mantra Group ((MTR)).

Outlook

UBS expects the current correction to be transitory. Despite considerable recent pressure, the broker believes the big picture global backdrop of very low interest rates and moderate growth is positive for stocks.

UBS has nevertheless reduced forecast earnings for Australian stocks, and as such has downgraded its year-end target for the ASX200 to 5550 from a prior 5800.

The broker has now moved to a Tactical Overweight on the banks from Underweight, due to the enticing 6.3% net yield, but warns dividend growth potential from here appears limited. Investors looking beyond index tracking and its heavy weighting of banks and resources are likely to find better opportunities, UBS suggests, supported by the weaker Aussie, pockets of life in the domestic economy and ongoing cost-cutting.

The broker forecasts 8% FY16 earnings growth for the industrials ex-financials, down from the 12% achieved in FY15 with some help from the falling currency. UBS' year-end Aussie target of US$0.70 may yet still have some downside skew and the broker remains drawn to US dollar earners, encouraged by the quality of stocks in that basket.

UBS has added AMP ((AMP)), Qube Holdings ((QUB)), Sims Metal Management and Veda Group ((VED)) to its preferred portfolio. Out goes Automotive Holdings ((AHG)), Downer EDI, James Hardie ((JHX)) and Tatts Group ((TTS)).

Deutsche Bank believes there is little to gain from lingering on the problems the Australian economy faces with the unwinding of the resource sector boom, falling resource capex and commodity prices and weak real income growth. These stories have pervaded for three years now. The more recent development, which tells Deutsche more about the outlook for earnings, is improvement in the non-resource economy.

The RBA's easy policy has contributed to unemployment stabilising and non-resource growth hitting a three-year high, the broker notes. Non-resource growth is broadly offsetting the drag from the resource slowdown. While the momentum of earnings revisions is below average, momentum looks better for cyclical industrials and small caps, which tells Deutsche more about the cycle. The outlook is positive.

Housing starts aren't high relative to population and construction as a share of GDP is barely above average and well below past peaks. Upside to property prices should continue, Deutsche suggests. Despite fears weak wage growth would weigh on consumer spending, many companies reported solid spending growth with their earnings results. There are now some early signs of better wages, and households can draw on elevated savings and will continue to benefit from record low inflation in essential items.

Much has been made of the June quarter capex spending and spending intentions data which revealed that while resource sector spending will fall as expected, non-resource businesses also intend to cut back, and hence not provide the offset required. Deutsche Bank is sceptical of the survey results because other indicators are positive. Profit growth has reached a four-year high and the data suggest more hiring, borrowing and vehicle purchases.

This solid backdrop should be good for banks, which Deutsche prefers over resources. Given low rates of gearing among borrowers, bad debts are not expected to rise. Credit growth is reasonable at 6% and further upside is likely. Capital ratios have been significantly bolstered and on a PE of 12x, the banks are 10% cheap on the broker's valuation.

By contrast, resources are not cheap on a PE of 15x. There is potential for further earnings downgrades, China's nominal GDP growth remains low and producer prices and exports continue to weaken. Deutsche expects some improvement thanks to the Chinese government's stimulus measures, but not enough to help commodity prices given oversupply. The outlook for energy is a little brighter, but would require strong demand in the upcoming northern winter. The broker has cut energy to Underweight.

Deutsche continues to prefer ongoing cost-cut stories such as QBE Insurance, AGL Energy and AMP. Offshore-exposed stocks are looking pricey but the broker is still keen on stocks delivering good growth regardless of currency moves, such as James Hardie, Aristocrat Leisure ((ALL)), CSL and Sonic Healthcare ((SHL)). While yield will remain in demand, Deutsche prefers stocks offering earnings growth as well rather than traditional defensive yield plays.

Deutsche has added Medibank Private, Spotless Group ((SPO)), Bank of Queensland ((BOQ)) and Qantas to its model portfolio and removed ResMed ((RMD)), Asciano ((AIO)), Flight Centre and Iress ((IRE)).

The addition of Bank of Queensland in the broker's portfolio is underpinned by a belief we are about to see an increase in migration from NSW to the Sunshine State.

NSW is enjoying a firm labour market but wage growth remains no better than in other states, Deutsche notes, while houses have become ever more unaffordable due to investor demand. Previous Sydney house price booms have typically encouraged migration to other states, yet migration out of NSW has now hit a 35-year low. A tipping point must soon be upon us, the broker suggests, and migration should at least return to average levels over the next 1-2 years.

Queensland's population growth is at its lowest since World War II. Unemployment in the state has risen due to the resource sector downturn, yet more than half of all Australian jobs are in the sectors of health, education, public administration, construction and hospitality, Deutsche notes, and there's no reason to believe one state would require fewer workers in these fields than any other.

Resource labour demand may be ebbing but the big LNG export ramp-up underway will boost state revenues, and indeed the Queensland government has forecast a return to growth rates above the national average. Tourism is a significant contributor to state GDP and the lower Aussie will lead to greater domestic interstate travel as well as increasing international inbound tourism, with casino development providing a drawcard for Asian visitors in particular.

There are a range of listed companies offering significant exposure to the Queensland economy. Those Deutsche Bank rates Buy include Bank of Queensland, Echo Entertainment ((EGP)), Mantra Group, Village Roadshow ((VRL)) and Collins Food ((CKF)).

Other companies standing to benefit from an improving Queensland economy are Stockland ((SGP)), Suncorp ((SUN)), Tatts Group, AP Eagers ((APE)), Cromwell Property ((CMW)), Villa World ((VLW)) and Devine ((DVN)).

Increasing migration north from NSW would also have the reverse impact of cooling Sydney property prices, Deutsche suggests. Improving affordability will aid the sustainability of the housing construction cycle, which is a positive for housing-exposed companies.
 

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