The performance of Australian equities has been strong this year and Hamish Tadgell questions if this can continue.
It has been a remarkable 12 months for the Australian share market and for global markets generally, in particular the United States.
After a period in the second half of 2018 when markets looked increasingly jittery, there was a significant turnaround in market sentiment at the close of the year and the beginning of 2019. Global equity markets experienced their strongest quarterly start to a year in the first three months of 2019 and the Australian equity market broadly followed international markets, delivering the best quarterly return in nearly a decade.
Indeed, since January 2019, the Australian share market is up around 16 per cent – by any stretch an exceptionally strong run. Initially this was driven by the so-called Fed pivot – the US Federal Reserve moving away from its stated stance of raising interest rates – but more recently spurred on by the federal government’s re-election and the Reserve Bank of Australia domestically commencing another easing cycle, and markets pricing in further rate cuts.
The key question for investors is: Can this run continue? There are a number of important issues to look at to help investors understand what might be coming next and how they should position their portfolios.
The search for yield
In a period of weak growth and low rates, the market has taken rate cuts as a signal to rotate to yield and growth stocks, having lost faith that lower rates will stimulate economic activity.
The rally in bond proxies and yield stocks, such as real estate investment trusts (REIT) and infrastructure, has been extraordinary as the market has chased income. However, what is interesting is that, despite dividend yields being close to historical lows in these stocks, the spread to bonds is still wide by historical standards as the Australian 10-year bond has hit new all-time lows.
The big question is: Will Australian equity yields continue to compress further? The defensive qualities of these assets are likely to see them well supported if economic activity slows, but in a number of cases dividend payout ratios and the margin of safety around valuation are starting to look very stretched.
A pick-up in sentiment following the election, lower rates and any income benefit from tax cuts (if passed) may help a gradual recovery in the property market and more consumer-facing discretionary retail sectors. In theory, this should also be beneficial for the banks. However, this needs to be balanced against the fact lower rates are also negative for bank margins and they still face rising regulatory costs and compliance.
It is important to draw a distinction between the market set-up and rebound we have recently seen versus the strong market rally in 2017. Back then, Australian equities were fuelled by a strong synchronised rebound in global growth and earnings, supported by the loosest financial conditions in the US since the start of the financial crisis.
The strong performance in the market since the start of 2019 has been driven by valuation expansion on changes in interest rate expectations, with earnings flat to modestly down in aggregate.
This has been particularly evident in the flight to yield with defensive and/or bond proxy yield-sensitive stocks (REITs and infrastructure) and long-duration growth stocks (particularly technology) rallying strongly.
Globally, growth looks to have stabilised at lower levels. The downside risks to growth feared at the end of last year now appear to have been exaggerated, but the prospect of a strong boost to growth also appears limited with China-US trade tensions overhanging.
The significance of the Fed pivot and the Federal Reserve’s sensitivity to financial conditions and markets should not be underestimated. For now, concerns the Fed will continue to tighten and the long-term deflation trend in place for the past 25 years will be breached have been arrested.
The question in the last quarter of 2018 was whether the Fed under the chairmanship of Jerome Powell, when faced with either a market break or unexpected economic weakness, would act independently and continue to tighten towards its stated neutral target setting of 2 per cent, or default to lower rate policies again. It is now clear the ‘moral hazard’ (that is, the asymmetric promise to help if times get tough but leave markets alone when times are good) is alive and well.
From a practical perspective, investors are now assuming the Fed remains sensitive to negative financial markets and rising credit spreads more than the risks of rising financial asset prices and extreme monetary policy.
After such an exceptionally strong start to the year, there is a natural tendency to think markets are due for a pullback. However, with the dramatic shift in policy and positioning, there is also the question as to whether the ingredients are in place for a market melt-up.
A melt-up is often associated with the late cycle or final ‘optimism’ phase of the market before the next correction. There are increasing signs many of the indicators historically associated with a melt-up are evident. Price acceleration, growing concentration in a smaller number of stocks, focus on ‘winners’ rather than long-term value, growing signs of fear of missing out, outperformance of quality and low-beta stocks in a rapidly rising market, and pockets of extreme expensiveness are all on show.
A key factor in the short-term Australian equities outlook for investors will be the August reporting season – otherwise known as confession season.
In itself, overvaluation and pricing are rarely the trigger and don’t necessarily help in judging the size and timing of an impending market break. Price acceleration has tended to be the strongest indicator – stronger than pure price or value. The other harder-to-call but often real measure of market excess is the growing touchy-feely measures of excess and craziness where hero stocks start attracting more of the headlines, the initial public offer window opens, and there’s growing vindictiveness to the bears for costing investors money.
There are certainly signs of these elements emerging. However, it is also vital to keep in mind this has been anything but a conventional cycle and the typical phasing has been distorted by extreme monetary policy.
It has been a long cycle characterised by low growth, below-trend inflation, low-interest rates (and risk premium) and high valuations. This adds weight to our view overpricing and valuation are unlikely to be lead indicators this cycle. Rather the touchy-feely measures will potentially be better triggers – and we are not there yet.
A key factor in the short-term outlook for investors will be the August reporting season – otherwise known as confession season.
The February reporting season was the weakest since the start of the global financial crisis, with earnings for the ASX 200 essentially flat. Every sector except mining saw consensus downgrades, with margins a bigger drag than softer revenues as rising cost pressures were clearly evident.
These trends have continued to be on show in recent months and we expect will continue to feature through the August reporting season.
Notably, so far this financial year there have been over 200 downgrades, compared to around 140 for the same period in 2018. More particularly, this May was the worst, in terms of downgrades, for the past three years.
The reasons have been varied, but some of the more common themes have included tighter credit, weak consumer spending, bad weather, trade wars and softer Chinese economic conditions, Brexit/United Kingdom weakness and increasing raw material prices. More generally, we have seen the backdrop of slower top-line growth and rising costs drag on operating leverage, leading to margin pressure.
A notable feature of the February reporting season was the flow of dividends as companies looked to pay out excess franking credits in anticipation of a change in government and the franking laws. This is not expected to be repeated in August, outside the big miners, which are awash with cash on the back of the sustained higher iron ore price.
Investors should be aware there are obvious signs of late-cycle activity, despite volatility subsiding.
More important will be company outlook comments. We expect talk to be around the increasing business and consumer confidence on the back of the election and tax and interest rate cuts, but expect most companies to maintain a reasonably cautious tone.
Opportunities for Australian equities
So what Australian equities opportunities could investors be considering? There are a few key themes we currently see as offering good possibilities for investors seeking stable returns and steady growth, including:
Infrastructure – we continue to see the east coast infrastructure theme as a sustainable area of growth. The big projects, such as WestConnex in Sydney or the Melbourne Metro Tunnel, are well-telegraphed, hard to turn off once they start, and tend to take longer and cost more than expected.
Energy – east coast gas is another theme we like. The confluence of the closure of Hazelwood power station and onshore moratorium on Victorian gas exploration, coupled with the start of exporting east coast liquefied natural gas, has seen Victorian and east coast domestic gas prices rise. This is benefiting conventional producers such as Cooper Energy and Beach Petroleum.
Fintech – disintermediation of traditional banking sector growth in fintech is another theme we like. Technology is transforming all industries, including banking and finance, however, regulation has tended to be a barrier to change in the financial sector. In the past few years, and particularly in the wake of the financial services royal commission, there has been a discernible change in the regulatory environment, with new challenger and digital banking licences and open banking providing a host of opportunities for new entrants.
Overall, we have become more constructive and slightly more balanced on the outlook for Australia. On the one hand, recent data points to more encouraging news for equity markets. Many of the concerns from earlier in the year have faded, but not all have disappeared. In addition, central banks have pulled back on tightening measures and turned dovish, and any positive news would be welcome.
However, investors should be aware there are obvious signs of late-cycle activity, despite volatility subsiding. Coupled with potential global issues still waiting to be resolved, the remainder of 2019 could well bear out the truth of the apocryphal Chinese curse – “may you live in interesting times”.