Feature Stories | Jan 23 2018
This article was first published for subscribers on December 20, 2017, and is now open for general readership.
Australia’s growth in 2017 has lagged that of a synchronised global economy, reflected in a positive but underperforming stock market. Is 2018 the year of catch-up? Or are further domestic pressures building?
– Brokers mostly upbeat, but not all
– Banks, miners and consumers in the spotlight
– Growth preferred over value
– Wide range of index forecasts
By Greg Peel
This Outlook feature follows on from Outlook For 2018: Global, published last week. If there is one stand-out element of pundit views of the global economy in 2018, it is a general consistency. The synchronised growth story will continue into 2018, central banks will remain relatively supportive and US tax reform will provide an added boost. But…
But risks will begin to emerge in 2018 that will not deliver, but may portend the coming end to the Goldilocks period that dominated 2017. Investors are not yet complacent, let alone euphoric, hence caution and cash on the sidelines suggest stock market gains have not yet run their course. Volatility will, however, begin to make a comeback.
If there is a stand-out element of the views of stock brokers, research houses and economists with regard Australia in 2018, it is a lack of consistency. Most pundits are upbeat about 2018, but certainly not all. With regard the Australian stock market, divergence of views can be immediately noted in a range of end-2018 targets for the ASX200, from those sourced for this feature, of 5800 to 6500.
While views on the global market may be relatively consistent, there are still peculiarities within individual regions. The US is all about Trump and tax reform, alongside Fed policy tightening. The UK has to deal with Brexit. The EU has to hang together to consolidate its recovery while the ECB looks to ease as well. China has a growing debt problem and seemingly perpetual risk of slowdown.
Australia offers a long list of peculiarities. We have a resources sector riding high on Chinese government crackdowns. We have a banking sector under siege from regulators and politicians. We are now seeing both the end of the mining investment slump and the end of the housing boom. We have consumers overstretched by mortgages set at historically low variable interest rates who are seeing no wage growth as they run out of savings. We have governments pouring funds into infrastructure, and businesses feeling the most confident they have since pre-GFC days.
We have a whole series of factors to consider as we head into 2018. How the year plays out will depend on just how much influence each of these factors has. Where the pundits see the situation by end-2018 depends entirely on how these various risk/reward scenarios play out, in their own views.
Opinions are divided.
Year to date, the Australian stock market has risen 5% compared to the US rally of 25%. Deutsche Bank suggests Australian equites have lagged global peers by around -10%. Yet take out the banks, and ASX200 has tracked broadly in line.
The Big Four Australian banks represent 25% of the market cap of the ASX200. The Big Five gets us to 27%. The ASX20 – twenty highest market cap stocks – boasts nine members of the financials sector, not counting property stocks, when we add in wealth managers/insurers. Add in regionals and other non-bank financials and the financials sector, ex-REITs, is 35% of the ASX200.
2018 started well for Australian stocks, riding along on the Trump wave, but then we fell into a hole after April. We were stuck in that hole for five months before finally managing to climb out in October. Meanwhile, Wall Street surged on to post ever higher highs.
It was all about the banks.
The banks brought it upon themselves. On the one hand they became more and more lax about lending money into the housing boom which they themselves were fuelling by doing so. On the other hand, a string of scandals meant the government could simply no longer ignore the ever growing, increasingly angry, pitchfork wielding mob. The tipping point was yet another string of bank profits in the billions.
The regulators acted, and tightened the screws. The government acted, first with a bank levy and now with a Royal Commission. In isolation the banks are facing a slowdown in mortgage lending in 2018 but a potential pick-up in business lending. Capital positions are sound and the ongoing process of divesting non-banking businesses (insurance/wealth management) is bringing a new round of capital management for shareholders. Rising global rates should be a positive.
The negative is sentiment. While the banks will always find a share price floor based on dividend yield, upside is limited when the market continues to worry about what might come out of the Royal Commission (running all next year), what further politically-motivated screws the government might turn, and what further housing boom screws the regulators might turn.
If the banks are not going to find investor support in 2018, can the ASX200 push onto new horizons without that huge chunk of market cap?
Macquarie’s stance on the banks is Neutral. Bank balance sheets are in good shape, the broker notes, and will benefit from improving growth and yield curve steepening early in 2018, but the government “has the sector in its crosshairs”, leaving the regulatory risk premium elevated and limiting performance upside.
UBS cites a marginally disappointing full-year result season for the majors as reason to downgrade its recommendation on the banks to Neutral from Overweight. UBS prefers non-bank financials, which offer leverage to higher interest rates and buoyant capital market conditions.
Morgan Stanley, too, has a preference for non-banks in the sector.
Citi sees “household-facing” sectors offering less to investors in 2018, and this includes the banks.
The consensus on Australian banks is relatively consistent among brokers. As Citi puts it, “sentiment towards the banks and the political uncertainty seem to have been factors holding the market back” in 2017, and such sentiment is unlikely to improve in the near term.
The opposite is true when it comes to the resource sectors, or more specifically, commodity prices in 2018. Broker views are polarised.
Materials represent around 17% of ASX200 market cap and energy 5%. BHP ((BHP)) alone is 5% and its spin-off South32 ((S32)) another 1%, with Rio Tinto ((RIO)) on 1.7%. Woodside Petroleum ((WPL)) dwarfs other energy sector components at 1.5%.
ANZ Bank’s economists suggest that for the first time since 2011, there is some prospect of commodity prices enjoying sustained gains. Commodity demand is becoming broader, shareholders are focused on returns (capital management) which limits new investment in supply, China continues to clamp down on excess and polluting supply, and new sources of commodity demand are emerging (batteries, EVs).
And from a technical perspective, commodity price action looks strong.
As 2017 draws to a close, resources continue to offer the best combinations of value and growth, says Deutsche Bank.
The resources sector does present a source of some potential upside to 2018 earnings estimates, says UBS, as was the case in 2016 and 2017. Were the broker to mark its 2018 commodity price forecasts to current spot, earnings upgrades in the order of 20-30% would follow.
Macquarie, too, oft points out that its own forecasts are well below spot pricing.
UBS retains an Overweight in in resources, in part due to expectation of solid global growth in 2018 supporting commodity prices, but also because of relatively undemanding valuations and the ability of the resource sector to act as a hedge against rising inflation and interest rate risks.
UBS does see downside risk for certain individual commodity prices, namely alumina, manganese and coal, as supply returns beyond the Chinese winter. But China’s focus on reform and pollution will continue through to 2018 and together with producer discipline outside of China, the analysts expect elevated commodity prices, and hence healthy profits and increased returns for the sector.
Citi sees upside risk to the ASX200 in 2018 as concentrated in the resource sector, which could trade above 2x book value (1.7x now).
Morgan Stanley sees “merit” in holding resource and energy exposures given sustained momentum forecast for global growth as well as improved quantum and quality of earnings for key names.
So far, so good. But…
Macquarie has downgraded its recommendation on resources to Neutral. The miners are momentum stocks and are losing earnings support despite free cash flow generation, the broker notes. Slowing Chinese growth is a downside risk for spot commodity prices with any upside surprises being relatively short-lived. There are nevertheless sub-themes within the commodities space that “still have legs”, the broker suggests, such as anything to do with electric vehicles.
Enter Ord Minnett…
“Our positioning on commodities is unambiguously negative, with precious metals the only segment of the market for which we see potential upside from current levels.”
Ords is particularly negative across the bulks complex, forecasting an iron ore price -9.0% below current spot and -6.6% below forward prices. For thermal coal, the broker’s forecast is -12.4% below forward pricing and for coking coal, -19.0% below.
Ords has downgraded its recommendation on the resource sector to Neutral. As an asset class, commodities are projected to deliver poor returns in 2018, with agriculture and precious metals the only bright spot. So says the broker.
The issues facing the average Australian household heading into 2018 are well documented. The housing boom has been fuelled by historically low interest rates that have led households into mortgages that represent more than the traditional third, and in some cases up to a half, of household monthly budgets, in terms of repayments. Interest rates are most likely to rise from here, albeit perhaps not at all in 2018.
Inflation may be low but wage growth is negligible, meaning wages are going backwards in real terms. Utility bills have risen by ridiculous amounts, adding further burdens on top of mortgages. The return to a mindset of savings as a result of the GFC has now evaporated – savings have now fallen back to the low levels they were before the crisis.
The housing market is cooling. While household wealth is predominately tied up in the family home, history shows consumer spending is closely correlated with house prices given a consumer who “feels” wealthy will be more inclined to spend.
On the flipside, supermarket wars ensure the household grocery-spend has come down, down in real terms these past few years. Globalisation and the internet mean Australians no longer pay unsubstantiated premiums for the likes of electronic goods, and many other products. Amazon fear has retailers rushing to discount prices even in the lead-up to Christmas. But this benefit to households is no comfort for Australian listed retailers.
“Australia has lagged the global recovery,” notes Morgan Stanley, “and we see this continuing in 2018 as a tightening credit cycle for housing and negative real income growth see consumer weakness overwhelm a pick-up in capex, and we revise down our 2018 GDP growth forecast to 1.5%, well below consensus of 2.8%".
That’s it then.
Morgan Stanley believes the heavy-lifting, with regard Australia’s GDP growth, will be done by state-based fiscal spending and sequential strength in infrastructure, but the domestic earnings cycle is “hamstrung by both slowing housing signals and fatigued consumers”.
Morgan Stanley’s right – consensus is for around a 2.8% GDP growth rate in 2018. Morgan Stanley, therefore, is on the outer with its consumer weakness warning.
Janus Henderson expects consumption to grow “at a modest pace”. Macquarie suggests consumer spending will “muddle along” amid ongoing weak wages growth.
Macquarie believes economic growth should become marginally stronger through 2018 with credit restrictions “working to reduce housing risk”, which is a positive twist on Morgan Stanley’s assumed negative impact from a “tightening credit cycle for housing”. But Macquarie also believes the attack on traditional bricks & mortar retail will continue.
This attack will potentially even drag down areas deemed almost “untouchable” to date, such as hardware. “It is too early to go back into this space,” says Macquarie. The broker recommends no retail or food staples.
The counter-argument to Macquarie’s supermarket/hardware warning comes from those who believe that by repositioning, the supermarkets can offer some hope of recovery from knocked-down levels. Citi, for example, likes Woolworths ((WOW)).
However the consumer sector performs in 2018 – whether indeed it does manage to at least “muddle along – there’s little disagreement the Australian consumer remains vulnerable. High levels of household debt and low levels of savings mean the consumer is in no position to weather any shocks.
While there is an almost unanimous expectation that the next rise in the RBA cash rate will be up – variation in views come down to the timing, be it late 2018 or not until 2019 – there is still a cohort who suggest the next move will be down. This is not to suggest therefore there will be relief in sight for indebted households, rather it will be household indebtedness and an end to the positive housing cycle that forces the central bank’s hand.
There is general agreement the banks will not lend much support to the Australian stock market in 2018. There are differing views on the direction of commodity prices, although most analysts are pro-resources for another year. Consumer spending is a bone of contention, and at best a fragile sector. So what’s the good news?
There is little doubt the housing sector boom is at best cooling, at worst turning, as we head into 2018. For the past several years, strength in the housing sector has offset slow-burn weakness driven by the steady winding down of mining and energy investment. The housing sector will not be as predominant an economic driver in 2018, but the good news is the mining slowdown has pretty much come to an end.
That brings us back to neutral. Driving the economy forward in 2018 will be aforementioned government infrastructure spending. From a stock market perspective, this will benefit the building materials and engineering & contractors sector. Public spending will provide a significant chunk of GDP growth.
In the private arena, the signs for a pick-up in business capital expenditure are positive. It’s been a long time coming.
In the period since the GFC, businesses have been focused on cutting costs and repairing balance sheets. Historically low interest rates have allowed for refinancing and for those that can afford it, share buybacks. Indeed, shareholders have been the winners in the period since the GFC, having been wiped out during, as companies have sought to win back favour with capital management – buybacks, capital returns and increased dividends.
The concept of mining and energy companies being among the highest yield stocks in the market would have been met with hearty laughter in times gone by.
But companies are now lean and balance sheets healthy. Cash flow, particularly in the resources sector, is strong. As the GFC approaches its tenth anniversary, companies must look towards the next decade, and that means growth. And growth means investment.
The latest private capex data, from the September quarter, suggest it’s early days but it appears the capex tide is turning. Spending expectations over FY18 have surprised economists to the upside. Global interest rates may be set to rise but there is no expectation of such for Australia for a while yet. Financing remains affordable.
“The domestic infra/capex thematic has longevity,” Macquarie declares.
The good news is we don’t have to fear offshore influences, as most analysts expect synchronised global economic growth to continue into 2018, as was outlined in the Global version of this feature. Against a backdrop of solid major trading partner growth, and with public infrastructure work yet to be done, Janus Henderson believes Australia is well placed to manage the end of the housing boom. Alongside modest consumption growth we’ll see net exports benefitting from further LNG capacity expansion. Business investment is poised to become a source of growth as the drag from falls in mining investment finally ends.
Janus Henderson forecasts economic growth rising to 3%, in stark contrast to Morgan Stanley’s prediction of 1.5%.
One point to make on the “end of the mining investment boom”, as it is usually referred to, is that it is often mistaken as the “end of the mining boom”, suggesting doom and gloom. The reality is that investment was made over a number of years into production, and we have now moved into the production phase from the construction phase at a time most commodity prices are favourable.
LNG exporters are not exactly flavour of the month with households and businesses having heart attacks with each new gas bill, but the fact remains LNG exports are set to eventually exceed iron ore exports as Australia’s biggest single contributor to economic growth.
Most analysts also expect 2018 will be the year the Aussie dollar finally drops down to more sensible levels, as US tax reform and Fed rate hikes finally drive the US dollar higher. A weaker Aussie is net positive for the Australian economy, being one of export dominant over domestic consumption.
It is often overlooked that travel is one of Australia’s biggest exports. There weren’t many extra shrimps being thrown on the barbie when the Aussie was above parity, but the tourism industry is beginning to bounce back, with China the new primary driver.
The bottom line is that we will head into 2018 with a changing in the guard of economic drivers. There will be rotation among sectors.
And if that is the case, there should be rotation among stock market sectors as well.
Stocks are typically divided into two camps for investment purposes – value and growth. Value stocks are typically identified by a low price/earnings ratio, where the share price is not reflecting earnings capacity. Growth stocks tend to have a high PE ratio but only because of rising earnings trajectories, which suggest PEs will normalise into time.
There is no rule to say you can only invest in one or the other, but typically equity strategists will cycle between the two. Value investing made Warren Buffett what he is today, but “cheap” does not by default mean “value”.
The “cheap” end of the Australian equity market is under pressure from cyclical and structural growth risks, warns Macquarie. This is a classic “value trap”, where no sustainable growth rebound is evident. Stick to growth and quality, says the broker.
It is this belief that informs Macquarie’s aversion to bricks & mortar retailing in 2018. Amazon is not the disruptor in the space, the broker screams from the rooftop, technology is. The pace of technology is accelerating at an exponential rate, Macquarie notes, and Australia is in the early stages of a long, technology-driven disruption cycle that compresses pricing power and margins.
We often tend to look at the stock market as a whole, and the ASX200 as its benchmark. There is much discussion about how the banks and miners will fare, given the extent of their market cap influence. But investors in “the index” would have been crying in their morning cereal during the long, dark months of a range-bound index from May to October, watching the share price of a2 Milk ((A2M)), for example, surging ever higher.
Morgan Stanley is the most downbeat with regard to the ASX200 in 2018 among the sources drawn upon for this feature, but on the flipside, the broker sees “good alpha opportunity”.
Alpha is the up/downside risk offered by an individual stock in its individual space as opposed to the “beta” risk of the market as one whole. If you buy “the index”, through perhaps an ETF or holding a portfolio of only big caps, you are playing beta risk. Holding a portfolio of “stories” – Chinese consumer growth, disruptor technology, batteries and EVs, ‘big data”, “the cloud”, and others beside – means you’re playing alpha risk.
It is of course a risky business. Many a high-flying, “new world” growth stock has had the rug pulled out from under them in 2017, and perhaps others will suffer the same fate in 2018.
Morgan Stanley likes stocks that will benefit from a lower Aussie as an alpha play. These include the true “global growers” and key name resource stocks. Exposure to infrastructure is recommended as are non-bank financials.
Macquarie likes domestic infra, the US housing market and soft commodities (eg fertiliser). UBS has pulled back to Underweight on some of the 2017 high-flyers, such as healthcare, online media and Chinese consumer plays, but is Overweight “GARP” stocks – growth at a reasonable price.
Solid returns are still achievable in this market, Morgans believes, but they should not come at the expense of investors taking on excessive levels of risk.
If there is one theme we can be relatively confident of in 2018, it’s that of M&A. If this past month is anything to go by, mergers & acquisitions will step up in pace next year. As to which companies are potential targets, well, there are no particular themes. This is evidenced only this past week when a takeover bid was made for “new world”, cloud-based software company Aconex, hot on the heels of a bid for very “old world” shopping mall icon Westfield.
Corporate balance sheets are in good shape and there are opportunities to be had. Industry consolidation will no doubt continue into 2018.
Credit Suisse notes Chinese authorities have recently introduced new policy to encourage more outbound acquisitions.
From another angle altogether, Credit Suisse points out that the average allocation to cash of superannuation funds is currently 14% — “unusually high” given the low level of the cash rate. If we all had a dollar for every time someone has mentioned “cash on the sidelines” since 2009 then we’d have no need to trade the stock market. But it’s there.
And despite the synchronised global rally of 2017, with Australia lagging, retail investors remain conspicuous in their absence. Is 2018 the year the cab drivers finally jump in?
At the time of writing, the ASX200 had closed at 6071.
I opened this feature noting that among those sourced, forecasts for the index at year-end range from 5800 to 6500.
No prizes for guessing that Morgan Stanley is the low marker, providing a 5800 forecast underpinned by a belief the Australian consumer will drag down the economy in 2018.
Morgan Stanley further notes that if the Fed does hike three more times in 2018, and the RBA remains on hold, the “carry trade” for foreigners investing in Australia diminishes in appeal as the interest rate differential gap closes. The broker also notes a forecast dividend yield in 2018 for the ASX200 of 4.4% represents a trend to below the long-run average.
“But Australia still offers a world-leading dividend yield,” Deutsche Bank points out.
UBS has set its 2018 target at 6275.
Assuming strength in the resources sector over the course of the year, Citi is targeting 6400.
Support from rising earnings and still-low rates underpins Credit Suisse’s 6500 target.
A modest forecast of a 4% increase in earnings coupled with a rise in market PE to 17x from 16x gets Macquarie to its 6500 forecast.
Each of the brokers sourced for this feature offer lists of likes and dislikes among individual stocks for 2018. We could go on forever, and often specific choices among brokers clash, only serving to confuse readers.
FNArena updates broker stock picks regularly in the editor’s Weekly Analysis columns, thus readers are directed to those as 2018 unfolds.
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