At Platypus, we believe that equity markets are likely to remain under pressure for some time.
For a while, markets were starting to get some support from the consistently good economic data and corporate earnings reports from the United States, but this was altered by the US employment report for May which was disappointing both in quantity and quality (95 percent of the new job additions were temporary census workers).
Furthermore, investors remain largely sceptical of the European bailout plan that was announced in May. As was the case when the US released its Troubled Asset Relief Program (TARP), investors will take some time to believe that the immediate problem has been fixed. It took almost six months for equity markets to stabilise following the announcement of TARP, so it is probably unrealistic to expect markets to be anything but volatile in the short term.
The proposed resources super profits tax (RSPT) also continues to create uncertainty in the local equities market and will do so until the issue is resolved, in light of the vast number of listed mining stocks in Australia. It seems likely that the current RSPT proposal will be amended once negotiation takes place between the government and the resource companies, which will help provide some clarity and certainty for investors.
Our continuing view is that we expect the market to trade in a range (that started in October last year) between approximately 5000 on the high side and 4100 on the downside, so we are in the middle of that range now.
We believe the market here in Australia will remain within this range until possibly the end of the calendar year, or at least until a federal election is held. Equity valuations are currently attractive for investors but overall there is too much global uncertainty for the market to resume its bull trend with any conviction. The global macroeconomic situation, particularly in Europe, is counteracting the strong bottom-up earnings story we are seeing both in Australia and from US companies.
The main global macro issues for domestic fund managers to navigate are:
1. Concerns over sovereign debt defaults/restructure
2. Stability of the Euro currency and European banking system
3. Chinese economic tightening
4. US monetary policy.
All of these factors have the potential to affect the ‘global risk trade’ and currency flows. Australia is seen as a proxy for this risk trade, hence any major shift by investors to global risk aversion will see the Australian dollar and equity market aggressively sold off.
The Chinese economic situation has a direct implication for commodities demand and prices, and therefore will affect our local resource stocks directly. We would consider a tempered slowing of the Chinese economy to be generally positive; however any aggressive move, for example to cool the Chinese property market, would have negative implications for the Australian market.
On balance, most of the bad news would appear to be factored into stock prices, given the very cheap valuations on offer currently. However a global macro 'shock' could easily see the market move down towards 4000 points.
Investors are still tainted from the experience of the global financial crisis (GFC) in 2008/09 and seeing their portfolios fall by up to 50 percent. As a result, there is still concern about equity markets and some investors are wondering whether the GFC could happen again.
As such, investors are currently demanding a large risk premium to own equities and valuations are likely to remain attractive for some time. One consideration worth mentioning is that company balance sheets are in very good shape with low debt levels, and at Platypus we do not expect much pressure on listed corporates to raise equity. This is in contrast to the GFC when many corporates raised equity to reduce their high debt levels.
In our view, it is unlikely we will see another 50 percent fall in the equity market; however, the market will remain volatile with big swings in either direction still on the cards.
This volatility will encourage investors to remain in cash, even if equities appear to be a better alternative on valuation grounds. Bank stocks are offering grossed-up (franking credit included) dividend yields of over eight percent, but many investors would still prefer the comfort of a possible six percent return on cash.
We believe that if we can see a sustained period of lower market volatility, then more retail investors will be attracted back into equities. Valuations are very appealing and dividend yields on stocks are better than cash. The Australian market is trading on approximately 12 times forward earnings and offering two years of double digit earnings growth. We expect dividends to increase in line with earnings growth. The chart below shows the P/E (valuation) history of the Australian sharemarket over the past three years.
Looking at specific sectors in the market, we think that the discretionary retail, banks and healthcare sectors are looking promising at the moment. CBA is a favourite pick, as are Resmed and CSL.
The retail sector has been subject to weakness as companies post lacklustre sales figures, as a consequence of cycling previous stimulus packages combined with price deflation driven by heightened discounting and low fresh food prices.
While we expect retail sector sales growth to remain under pressure over the near term, we would also treat any market sell-off as an opportunity to add to positions as difficult comps roll off and the Reserve Bank pauses in its pattern of increasing interest rates.
The Reserve Bank has recently changed its rhetoric on rates, suggesting the cash level of 4.5 percent is 'around average levels'. Given the obvious impact recent rate hikes have had on the domestic economy (most notably in retail sales) and heightened risks from offshore, we believe rates are on hold for the foreseeable future, which should give retail a much needed boost. We would be accumulating consumer discretionary stocks on weakness.
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Simon Bonouvrie is portfolio manager at Platypus Asset Management, an Australian equities joint venture partner of Australian Unity Investments.
