It now seems almost certain that Australia has been through the worst of the global financial crisis and is now on the road to recovery. At Platypus, our view is that there is unlikely to be any further shocks to the system, as central banks and governments are very much in control at the moment and will do whatever it takes to sustain markets and economies.
The continued gains in the Australian equity market – with every sector posting gains in September – and the decision by the Reserve Bank of Australia (RBA) to raise interest rates in early October means that Australia is now at the forefront of developed markets around the world in terms of economic strength and stability.
The most recent economic data suggests that the Australian economy will soon return toward a three percent growth rate, and that corporate Australia will enjoy a relatively rapid profit recovery. In support of this view is the RBA’s prediction in early October that “overall, growth through 2010 looks likely to be close to trend”.
Many people were taken by surprise by the RBA’s decision to raise interest rates in October rather than wait another month or two, but in hindsight it seems to be the obvious decision and, from a stock market investor’s point of view, it should be viewed as a positive.
While interest rate increases are often interpreted as a negative for equities by commentators and investors, we think under the circumstances it is unambiguously bullish for the stock market. In the first place, the RBA’s decision to raise rates before any other world economy will provide support for the Australian dollar for several months to come. It is extremely unlikely that either the US or Europe will be in a position to raise their rates for some time and, as a result, we should see significant foreign flows of capital into our investment markets and a continuation of the rise in the Australian dollar.
Secondly, if the RBA’s forecast on growth turns out to be correct, it implies that corporate profits will recover faster than the market is currently expecting.
In short we think the trends in the stock market that have been evident since March will continue through to December and the Australian stock market should comfortably reach the 5,000 target.
Our only concern is that the first series of rate hikes will kill consumer confidence. As the chart below shows, there is a strong inverse relationship between interest rates and consumer confidence and if the consumer falters the economy is likely to falter as well.
The challenge for the RBA is to convince the public that interest rates are simply going back to a neutral setting now that the economy is clearly on the mend, rather than being tightened to check any exuberant behaviour.
It is inevitable that consumer and investor behaviour will ultimately be crimped by rising interest rates; however, if the RBA is right in its thinking, it will be 12 months or more before the level of rates is high enough to really bite into consumers’ pockets. In the meantime investors can look forward to further gains in the stock market and the currency as the recovery accelerates.
Overall, we believe that the ‘crisis’ part of the Global Financial Crisis is now over. Clearly, there are still a number of issues to play out, not least of which is increased regulation. Over the last 24 months, bad business practices have been continually exposed which will impact negatively on ongoing sentiment. Re-regulation is the inevitable response. This poses a risk that policy makers go overboard with regulatory clamp down which in turn suppresses returns for investors in years to come.
The consensus view is that we will experience a sub-par economic recovery globally; however the resilience of the Australian economy continues to stun most commentators. The Government’s fiscal measures have worked more or less as intended, and consumer confidence has increased as interest rates fell. The Chinese economy has also continued to perform more strongly than some anticipated, responding dramatically to monetary and fiscal easing. Of particular importance to Australia is that Chinese imports of raw materials remain strong.
It is worth noting that those who believe the emerging markets have ‘decoupled’ from the US and other developed markets have largely been vindicated by recent events. For instance, China has grown at an annualised rate in the mid teens during second quarter 2009 at a time when the US, Japan and Europe went backwards. India will show a robust high single digit growth in coming months despite the poor monsoons. All this is evidence of decoupling driven by China and India’s ascendancy to become the next economic superpowers over the next few decades.
As mentioned earlier, the consensus view is that the Australian dollar will continue to head up. Currencies tend to overshoot on the upside and downside because they are driven by flow of funds and momentum. There is no easy way to value currencies and valuation often acts as an anchor for other asset classes that limits overshoots. The Australian economy has done exceptionally well vis-à-vis other Western economies so there is fundamental justification for why the dollar is strong and will probably remain so until the economic growth in the rest of developed world catches up. Currencies are notoriously difficult to forecast and calling a top will once again prove impossible other than to say that it will surprise everyone when it does happen.
In Australia, retail sales growth is strong and leading indicators are improving. The US economy appears to be stabilising and this recovery, along with consumer and business confidence, is crucial to an ongoing recovery post the current boost provided by inventory rebuild and fiscal stimulus.
Hence, the recovery remains fragile and profits are still going backwards. Therefore it is vital that the Government keeps in place everything that has been announced in its stimulus package. The ongoing recovery depends on consumer and business confidence remaining relatively buoyant. If programs are cut prematurely it could put the recovery at risk.
At Platypus, we are now investing on the basis of the recovery continuing. While large-cap consumer discretionary stocks such as David Jones and JB Hi-Fi have been outstanding performers for us, we expect there is more to go. We are also beginning to reinvest back into small caps, in particular industrials. Even if small cap stocks have bounced off their absolute bottom, they are at very reasonable valuations and make an attractive investment option.
However, while we still see further upside for the market, it is probably in the final phase of the initial recovery rally. To date, the rise in the market has been driven solely by valuation expansion (see chart below), which again is typical during the first phase of a recovery accompanied with low-cyclical earnings.
Overall, banks have performed strongly since January this year, with stock prices more than doubling from their lows. We believe that, while we have seen the best percentage gains for banks, they will continue to perform well.
Australian banks are essentially a gauge on our economy and, as the economy has clearly turned a corner, the outlook for banks has improved dramatically. Historically, banks tend to perform well in the early phases of an interest rate tightening cycle due to improvements in funding spread and the expectation that the economy is doing better. We think that the bad debt cycle for banks may peak in 2010 and that FY2011 and FY2012 could resemble "hockey-stick" style earnings recovery for the sector. Banks have experienced strong revenue growth over the past 18 months which has not translated into profit growth. However as the bad debt cycle tapers off, this revenue growth will be translated into leverage at the profit line.
In the commodities space, we are generally bullish, and particularly bullish in our view of copper and steel-making coal.
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* Prasad Patkar is portfolio manager with Platypus Asset Management, an Australian equities joint venture partner of Australian Unity Investments