Equity Strategy: Brokers Rolling Over

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– Oz economic outlook softening
– Cyclical valuations pricing in strength
– Defensive valuations pricey
– Brokers in disagreement

By Greg Peel

BA-Merrill Lynch’s global investment strategists prefer stocks to bonds in the current investment environment, but see stock upside as becoming limited. Not only have valuations become less attractive, complacency has set in.

Complacency has become a growing theme of concern among investment analysts, with the most recognisable measure of risk aversion – the VIX volatility index on the S&P 500 – sitting a number below 11. The last time it was below 11 was in early 2007. The implication here is that investors are content nothing in particular is on the horizon which could upset the US equity market, and history suggests this is the typical mood just prior to something happening which does.

The more pragmatic implication is that very few investors are holding or demanding put option protection to the downside, suggesting any minor downside trigger would prompt a fall where no safety nets are in place to dampen its ferocity.

Global credit spreads are also very low at present, notes Merrills, meaning fixed income investors are prepared to accept low yielding corporate debt on the assumption risk of failure is diminished. With global interest rates so low there is a strong demand for yield which has helped to push down these risk spreads to levels which may not fully price in true risk. The good news, however, is there is nothing like the level of leverage in financial markets currently as there was pre-GFC, nor signs of blind speculation in stock markets, that could suggest a snowballing correction.

Merrills has trimmed its equity allocation by 2% and placed those proceeds into cash.

In terms of the Australian stock market, Goldman Sachs is “shifting defensive”. Last year’s RBA rate cuts have delivered a disappointing response from Australia’s non-mining economy, suggests Goldman, leaving current conditions consistent with sub-trend growth just as the fall-off in mining investment is set to become an economic drag.

But wasn’t the March quarter GDP a strong result? Only if considered in terms of real GDP growth, suggests Deutsche Bank, but not if considered in terms of the number that really matters, real income growth, which was below trend. March is now past history anyway, and conditions have softened since.

Both Goldman and Deutsche point squarely at Australia’s budget blues and the hit they have delivered to consumer confidence and retail spending. Goldman describes the response as “severe” (note today’s Westpac survey shows consumer confidence stabilising, but at the strongly negative level to which it plunged in May) and notes wage growth remains “anaemic”. Deutsche suggests retail spending is “already rolling over”.

On the corporate front, March quarter updates from listed companies were net more positive than negative but again, March is ancient history. Companies are still in cost reduction mode, notes Goldman, while Deutsche suggests investor sentiment is set to be hit if there is disappointment heading into the August result season. The issue here is that stock valuations remain elevated in general, thus not pricing in an increase in risk. Goldman also points to a still-high Aussie dollar, and warns the “peak contribution from housing may have passed”.

Consensus suggests rising revenues and margins for Australian companies ahead. Goldman believes ongoing cost reductions will continue to provide earnings support but sees significant earnings risk for cyclical industrials and miners.

The only real upside valuation case one can make for the Australian market (from a local and global perspective) at present is yield says Goldman, and the broker sees few risks to dividends. So rather than exiting to cash the Goldman strategists are advising a switch to defensive stocks for which yield is secure.

This is not easy given elevated valuations for yield stocks in particular, but Goldman likes the opportunity provided by infrastructure and singles out Spark Infrastructure ((SKI)) and DUET ((DUE)) as offering a rare combination of solid yield (6.5%+) and low cyclical economic exposure. Otherwise the broker identifies Goodman Group ((GMG)), QBE Insurance ((QBE)) and Flexigroup ((FXL)) as stocks to add and Transurban ((TCL)), Lend Lease ((LLC)), SFG Australia ((SFW)) and SAI Global ((SAI)) as stocks to sell out of, with the latter three all currently offering M&A premiums. Transurban’s road tolls are more economically sensitive than utility infrastructure such as gas pipes.

Deutsche disagrees with Goldman on housing, suggesting that while building approvals have fallen recently, they have only fallen for apartment blocks which are less material-intensive per dwelling than houses. Previous strong approvals readings suggest there is plenty in the construction pipeline. Deutsche also suggests the Australian consumer could well “get back on track” later this year (presumably after budget shock wanes) which would thus prompt businesses into restocking and investment.

Deutsche is hanging onto its housing sector allocations, but like Goldman is Overweight defensives, specifically general insurers, REITs, utilities and healthcare. The broker is Underweight miners but Overweight LNG.

Yesterday Morgan Stanley joined a handful of others suggesting the Aussie dollar could return to parity by year-end. Deutsche’s forecast remains US85c, on the belief US bond yields look now to have bottomed. A lower currency is a positive for Australian equities (but rising bond yields would impact on high-yield defensives).

UBS is also anticipating a bond sell-off (rising yields) in coming months, and also forecasts an Aussie of US85c by year-end. UBS is thus in disagreement with Goldman, given UBS remains Underweight yield. The broker is also in direct contrast in highlighting Transurban as its stand-out yield preference.

Thereafter the division is less clear, with UBS also favouring QBE Insurance along with ResMed ((RMD)), CSL ((CSL)) and Crown Resorts ((CWN)).

Among the most obvious chasers of yield are Australian Self-Managed Super Fund trustees. The bell has just rung as the SMSF cohort welcomes its one millionth member, and Credit Suisse notes SMSFs have increased their average equity allocation over the past twelve months by 1.1 percentage points to 43%. SMSFs own 16% of the Australian equity market.

SMSFs are by their nature diligent savers and conservative investors, notes Credit Suisse, with a median age in the early sixties. Conservatism stems from being close to “harvesting” their retirement investment and it is of no surprise high-yield stocks are favoured. SMSFs have grown their assets under management more than fivefold in a decade (reflecting new SMSF’s, not 600% returns).

For those investing/trading outside the superannuation sphere, SMSFs offer a sneaky exploitation opportunity, Credit Suisse implies (albeit in not so many words). Given a lower risk tolerance, they buy stocks with attractive yields but not necessarily stocks with the potential to raise their dividends, and thus yields. The trick is thus to by the latter now, and sell to the SMSFs when they catch up on increased dividends.

Such an opportunity exists, Credit Suisse suggests, in Caltex ((CTX)), Fairfax Media ((FXJ)), Flight Centre ((FLT)), Myer ((MYR)) and Perpetual ((PPT)).
 

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