It’s funny how fast the mood can turn from positive to gloomy. When it comes to Australian equities, that’s just what has happened in recent weeks.
Uncertainty over the Government’s proposed Resources Super Profits Tax (RSPT) has combined with concern over European sovereign debt and fear of a Chinese economic slowdown to create a very unsettled outlook.
As Wilson HTM allocation strategist Damien Klassen noted, “We are relatively positive on equities over the medium-term from an earnings growth perspective, but there are a lot of grey clouds and risks on the horizon.”
Investment experts believe proposals like the resources tax and National Broadband Network are having an impact on markets.
“There are some big uncertainties around at the moment and this will lead to a risk premium expansion,” Klassen said.
Like many investment strategists, he is concerned about the potential for things to go wrong.
“Investors need to watch the market carefully as there are a whole bunch of things coming to a head at the moment,” Klassen said.
CMC market strategist, Ric Spooner, agrees risk concerns have reappeared on the horizon.
“There is still a lot of risk around, such as the sovereign debt issues and if the Chinese economy slows to more than the 8-10 per cent growth projected,” he said.
Adding to the chorus, Perpetual senior portfolio manager, Matt Williams, also believes the outlook is less certain than earlier in the year.
“The market has changed to maximum bearishness and concern about the RSPT,” he said.
Money in, money out
Until recent weeks, positive perceptions about Australian equities had seen strong inflows of international investment dollars, according to Aviva Investors head of equities, Glenn Hart.
“Before May, Australia had experienced unprecedented popularity globally due to its proximity to China and also the reliability and strength of our currency,” he said.
“Australia earned a lot of respect for how we came through the GFC and our relative performance compared to other countries, which has led to the currency being pushed up.”
It has also been a big positive for local shares.
“Big foreign flows have come into our market and pushed stocks up to 5000. There has been an overweight by people into Australia,” Hart explained.
The recent Government proposals, however, appear to have altered this view.
“The resources tax has really shocked international investors and added an element of sovereign risk that was not there before. It has definitely changed the perception of international investors,” Hart said.
Klassen believes this will see international investment dollars retreat from the Australian market, with reduced support for local share prices.
“From an international perspective, a lot of investors have decided they do not need to be in this market,” he said.
“People are still interested in Australia due to the growth and stability aspects, but they will now demand a greater return for investing here. The new tax proposal will add an extra level of uncertainty for investors.”
This turnaround may represent a lost opportunity for the Australian market, as it traditionally only receives investment flows in line with its tiny weighting in total global sharemarket capitalisation.
“We get the 2 per cent attention that our market is weighted in the world,” Williams said.
Spooner agrees that apart from the recent post-GFC period, this is largely the pattern for Australian shares. “We have a reasonably small market, so we only get our normal weighting.”
The concentration of resource stocks also influences international allocations. “We are usually viewed as a commodity market, despite having some high quality industrials,” Williams said.
Australian shares are also seen as a safe way to access the fast-growing Asian economies.
“There is a significant view among some investors that Australia is a proxy and a good way to get exposure to Asia and the emerging markets story through good, well-managed, developed market companies,” Spooner explained.
However, this has a flipside in that views on the growth prospects for China are increasingly having an impact on Australian share prices.
“Those international investors who are negative on China can’t short China, so the Australian resources sector is a good second choice,” Klassen said.
Looking on the bright side
While the Government’s tax and regulatory proposals may have unsettled international investors, the local market still looks attractive — particularly given the strength of the Australian economy.
In its May 2010 Statement on Monetary Policy, the Reserve Bank of Australia was very positive about the local economy. It forecast Australian GDP growth to be 3.25 per cent in 2010, before it strengthened to 3.75-4 per cent during 2011/12. Such strong economic forecasts encourage an upbeat assessment of the Australian sharemarket, according to Spooner.
“On balance, I am pretty optimistic. The current valuations can be characterised as fairly neutral at a price earnings ratio of around 15 and this is in line with the past 10 years,” he said.
Klassen agrees: “We expect things to tick along not too badly in the Australian market.”
Hart is another who believes things look good over the medium-term. “From now a 5-10 per cent return would be on par with historical precedents.”
These positive views are dependent on investors being realistic and not expecting the 20 per cent returns the market provided prior to the GFC. “We are in a low growth environment and it is unlikely we will get growth surprises that will lead to strong rises in the near term,” Hart said.
The turnaround in international economies should also provide a boost.
“Given the clear improvement in the US and Europe — putting aside the sovereign debt problems — if the data continues to come through, then we would expect to see more earnings visibility and this will lead to 8-10 per cent growth,” Williams said.
Spooner agrees the outlook is for continuing growth. “The economic outlook is that we are in the early stages of economic recovery, despite there being a lot of risk attached,” he said.
Bargains on offer
Reviewing the current market, Klassen believes it looks pretty good value. “The market is still very cheap as long as the big risks don’t occur.”
Despite the strong market gains, ING Investment Management (INGIM) senior portfolio manager, Gian Pandit, believes great opportunities remain for Australian investors, with “bargain stocks still to be discovered”.
“Whilst the market recovery has been substantial, we believe the corporate scene is still only in the early stages of its earnings recovery. Most of the ongoing upside should belong to those areas lagging the local cycle most,” he said.
“The existing strong earnings growth outlook for the market and what we believe are still cheap valuations suggest that the Australian sharemarket has the capacity to rise by a further 15 per cent over the next year.”
Although there are uncertainties, Spooner points to the growth already locked into the Australian economy.
“Within Australia, there is a number of big infrastructure projects such as LNG [Liquefied Natural Gas] and the BER [Building the Education Revolution] locked in already and that will keep going whatever else happens,” he said.
“These will continue even if the economy slows, so there are worthwhile opportunities to invest.”
Volatility influencing sectors
Although these projects are positives, the current investment environment is likely to see continuing volatility.
“We are in a much more volatile period than in the past decade,” Hart explained.
“We expect over the next few years the market will be interrupted by actual sovereign debt defaults and that will be destabilising. It is unpleasant, but it should not be unexpected.”
The continuing volatility also makes it hard to pick the likely outperformers when it comes to market sectors.
“The sectors are seeing huge changes at the moment and so it is a bit difficult to make predictions,” Klassen said.
Hart agrees: “During the GFC and into early 2010 we saw a lot more trending sectors, but at the moment the market is not giving clear directions on broad thematics.”
“During the period February/March/April, we saw a great coming together of all sectors and stocks. This meant it was difficult to get outperformance from picking sectors and stocks,” he said.
Hart believes the best path for investors may be to use quieter periods to get set in good companies. “Periods of volatility lead to divergent sectoral performance. If there is low volatility, then use the time to get invested in high quality stocks in preparation for volatility.”
On the other hand, Spooner is positive about some sectors due to the ongoing strength of the Australian economy and our links to economic powerhouses such as China.
“Australia continues to be a better story than most other markets and so stocks such as consumer discretionary will benefit,” he said.
“If we are in a recovery phase, the cyclical stocks are the ones that will outperform. In the second phase, cyclical industrial stocks and materials will continue to do well.
“The energy sector also has good prospects and will benefit from recovery. It is important to remember the supply constraints we saw in 2007 haven’t gone away and in 2011/12 we may see shortages in oil and gas re-emerge. In fact we may have added to the problem, due to the pullback in investment and slowdown in the growth of productive capacity.”
Even the question of whether value or growth stocks will do better is uncertain.
“Value stocks have been a great place to be in 2009, but if we are now in a recovery phase with growth coming through, then growth stocks could be the place to be going forward,” Spooner said.
Klassen is more cautious. “While there is uncertainty in the market, the growth sector will find it very hard to outperform over the long-term,” he said.
“You are better not to be too overweight value or growth at the moment and not tilt one way or the other. It is not clear at all whether growth or value will win.”
Investors return to the market
Although the recent uncertainty has clouded the medium-term outlook, there is renewed interest in investing in Australian equities with funds under management (FUM) climbing.
According to Williams, investors are starting to get over their GFC-induced fear. “FUM flows are starting to build back from 12 months ago when there was very little interest.”
Spooner agrees: “We have seen an increase in activity in our Australian equities business in recent weeks.”
In part, interest has been boosted by the strong rally in local shares and their outperformance compared to unhedged international equity investments.
“A lot of people have given up on international equities as their experience over the past decade has been so poor from an Australian dollar investor perspective,” Williams said.
These trends are reflected in a recent investor attitude survey conducted by CMC Markets. It found 74 per cent of investors felt Australian equities were the best place to be invested, with only 26 per cent favouring international equities. Older investors in particular favoured Australian equities, with only 13 per cent of baby boomers interested in international equities compared to 56 per cent of Generation Y respondents.
“The result is understandable, as most investors have a bias towards investing in their own country and the strength of the Australian dollar has meant over the past 10 years Australian equities have outperformed,” Spooner explained.
The renewed interest in Australian equities has also seen investment firms introduce new products designed to capture some of the inflows.
Staying home
With ongoing global volatility, keeping your money in the Australian sharemarket has been proved to be a good strategy.
As CMC market strategist Ric Spooner said: “A strong allocation to Australian equities has been a clear winner in recent times. The strength of the Australian dollar has led to unhedged exposure to international equities being a major underperformer.”
For investors reluctant to chance further underperformance, there are ways to ensure a portfolio overweight in Australian equities still performs and captures some of the diversification benefits offered by offshore investments.
“You can replicate quite a bit of international equities exposure with well-chosen Australian stocks if an investor is so minded,” Spooner said.
He suggests buying companies involved in selling resources as a simple way to obtain emerging market exposure, as is investing in services and engineering companies that service the resources sector. Australian companies with extensive business interests offshore — such as ANZ’s banking operations — are another option.
“There are also companies where you obtain an oblique or second-hand benefit,” Spooner said.
“These are Australian companies with good brand franchises that import a lot of what they sell and you also get the benefits from strong local economic and consumer growth. These include Pacific Brands, GUD and JB-HiFi.”
However, Spooner believes international equities should remain a key part of any well-diversified investment portfolio. “One should never completely ignore a major asset class and so investors should have some exposure to international equities.”
Also, investing at home is not without its own problems, as the ‘home country bias’ can push up prices.
The size of the investible asset pool in Australia and the lack of investment opportunities can distort the local market, according to Perpetual senior portfolio manager, Matt Williams.
“The Australian market can push companies to multiples that they would not receive in other markets,” he said.