Recently I had a discussion with BT Investment Management (BTIM) regarding the current state of the markets both in Australia and globally. BTIM manages a significant pool of funds for investors, currently more than $40billion. I asked them the following questions:
How do you see the situation playing out in the US and Europe?
- The weight of evidence is line-ball as to whether the US is going back into recession. If you look at the bond markets, it is definitely going into recession and there is no doubt and the recent surveys also would back this up – for example, our Fixed interest team’s observation that when the Philly Fed Business Outlook surveys get reading to these levels, the US always goes into recession. While, some of the underlying data actually seems to be holding up (e.g. retail sales), expectations are extremely weak.
- So what can change to the positive in the US? They do have some weapons in their armoury. It has been suggested that they could step into the equities market or initiate another round of QE. The latter would come under a lot of scrutiny as the last bout proved to have only a short term effect.
- The risk is that the Fed looks desperate. As one Fed member pointed out, their job is not to bail out equity markets and the situation is not comparable of 2008 as the financial system remains intact and corporates have strong balance sheets – US banks will not fail and this looks more like a conventional ‘demand-driven’ slow-down.
- The quick reversal in equity markets has been driven by the sharp realisation that growth forecasts are way too high, as well as worsening sentiment exacerbated by the political impasse over the US debt ceiling
- In Europe, the situation still looks more worrying as there are issues with the banking system, which looks like it is going to need recapitalising at some point. Where they get that source capital from remains to be seen but partial nationalisation would seem on the cards at this point. Furthermore confidence in policy makers remains very low on both sides of the Atlantic – which has done serious damage to investor sentiment.
- France is now the issue….growing at 0% and banks will need recapitalising. The recent ECB buying has been supporting Italian yields (22bn) worth moved yields down to c.5% where they’ve stayed but the question is how long they can sustain this buying for. And will the French be able to keep stumping up the cash for the EFSF? Ultimately Germanywill have to fund the Eurozone bail-out and at this point there is not the political will to do so.
What is the likely impact of these events in Australia?
- The Australian share market is likely to be influenced by these macro issues for the short term so you can expect returns to mirror US and European markets rather than stock specific issues – despite the fact that it has been a positive reporting season. The Australian market however is arguably more defensively positioned.
- Market valuations are not stretched either on an absolute basis, relative to other countries or relative to its own history. In the domestic economy related stocks in particular, there is already a lot of bad news priced in. While these stocks are likely to trade in line with macro themes too, the downside is ultimately more limited. For context, the average Australian industrial stock is now trading on a yield of over 5% (ex franking), which is a large discount to the bond yield.
- The Australian market has already underperformed other markets this year so it has arguably less downside.
China is continuing to grow strongly and as we know Australia is very dependant on this. What are you thoughts on their growth in coming years?
- Chinese growth remains robust and in our view is likely to remain so, particularly as the Chinese can quickly move from a tightening monetary stance to a neutral stance if required.
- The large amount of investment in the resource sector is likely to continue, providing a solid base for earnings for next year for companies across a lot of different industries. The RIO buyback and announcement bid for Coal & Allied a couple of weeks ago demonstrated that those with cash are prepared to spend and we don’t see this changing. (Very different from 2008). However, the ‘wall of work’ building up in resource infrastructure’ projects is bound to come off if softer global conditions persist. Activity is likely to remain strong but importantly expectations will come off.
- The two most significant commodities that Australia produces, iron ore and coal, are not subject to the same levels of speculation and volatility as other commodities as they are contract rather than exchange traded. This means they will reflect the underlying supply/demand fundamentals rather than market sentiment. Nonetheless, the overall level of commodity prices remains high and is a clear risk if global conditions soften materially.
Are corporate earnings and current dividend yields in Australia sustainable?
- Market consensus earrnings forecasts have been too high in our opinion but even if they are cut to more realistic levels, there is still, on aggregate, high single digit earnings growth for next year, which will also be reflected in dividends.